Accelrys (ACCL) - Description of business
We develop and commercialize software for computation, simulation, management and mining of scientific data used by biologists, chemists and materials scientists, including nanotechnology researchers for product design as well as drug discovery and development. Our technology and services are designed to meet the needs of todays leading research organizations. We are headquartered in San Diego, California and were incorporated in Delaware in 1993. Our company website is located at www.accelrys.com. Copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports are available without charge on our website as soon as reasonably practicable after being filed with or furnished to the U.S. Securities and Exchange Commission (the SEC).
Restatement of Financial Statements
In this Report, we have restated our previously issued consolidated financial statements to reflect certain accounting adjustments. The decision to restate our consolidated financial statements was made by the Audit Committee of our Board of Directors on December 16, 2005, following consultation with, and upon the recommendation of, management and Ernst & Young LLP (E&Y), our independent registered public accounting firm. Our decision to restate was made in connection with a review of our Annual Report on Form 10-K for the year ended March 31, 2005 by the Corporation Finance Division of the SEC.
Our restated consolidated financial statements contained in this Report reflect changes to the timing of revenue recognized under term-based and perpetual software license arrangements which include multiple elements (typically software licenses and post-contract customer support, referred to as PCS) and a change in accounting for software development costs. Our restated consolidated financial statements also reflect the reclassification of general and administrative expenses and interest income between continuing and discontinued operations, the reclassification of cash flows from discontinued operations as
net cash provided by (used in) discontinued operating, investing and financing activities, as opposed to a single line item as previously reported, and the reclassification of investments in auction rate securities to marketable securities from cash and cash equivalents. The impact of the restatement on our previously issued consolidated financial statements is described more fully in Managements Discussion and Analysis of Financial Condition and Results of Operations and in Note 2 to our restated consolidated financial statements included elsewhere in this Report.
In connection with the restatement, management identified and reported to the Audit Committee certain control deficiencies that constituted material weaknesses in internal control over financial reporting. As a result of the identification of the material weaknesses, we have identified certain control enhancements and improvements that, once fully implemented, will strengthen our internal control over financial reporting. The material weaknesses and the identified control improvements and enhancements to be implemented are described more fully in Controls and Procedures included elsewhere in this Report.
We have not amended our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the restatement, and the financial statements and related financial statement information contained in those reports should no longer be relied upon. Throughout this Report, all amounts presented from prior periods and prior period comparisons are labeled as restated and reflect the balances and amounts on a restated basis.
Description of Our Industry
For companies in the pharmaceutical, biotechnology, chemical, petrochemical and materials industries, innovation in the discovery and development of new products and the rapid, cost-effective commercialization of these products can be crucial to success. Companies in these industries invest considerable resources in technologies that suggest productive new pathways for research projects, increase the efficiency of discovery and development processes, or enable them to maximize the use of corporate scientific data, information and knowledge. One such set of technologies is software-based computation, analysis, informatics, workflow and knowledge management tools. These tools allow users to simulate key chemical and biological systems, understand and predict fundamental properties, and assist in the design of new or improved products and processes. They also manage and mine scientific data, turning it into useful information and supporting decision processes and research and development workflows.
Description of Our Business
We design, develop, market, and support software and related services that facilitate the discovery and development of new and improved products and processes in the pharmaceutical, biotechnology, chemical, petrochemical and materials industries. Using our products, researchers may increase the speed and efficiency of the research and development cycle, thereby reducing product development costs and shortening the time to market for new product introductions and process improvements. Our customers include leading commercial, government and academic organizations. Many of the largest pharmaceutical, biotechnology, chemical, petroleum and semiconductor companies worldwide use our software. We market our products and services worldwide, principally through our direct sales force, augmented by the use of third-party distributors.
Our objective is to strengthen our position as a leading provider of software-based scientific computation, analysis, informatics, knowledge management, workflow products and services worldwide. We plan to accomplish this objective by providing a comprehensive set of integrated solutions that are central to the enterprise-wide research and development activities of our customers, and by connecting
these tools within an information technology framework that makes it easier for research and development organizations to manage data, information, knowledge, and collaborative processes.
Products and Services
The following is a brief description of each of our product lines:
Modeling and Simulation Software. Many factors that affect a molecule, including activity, bioavailability, toxicity, shelf life and environmental impact, are governed by fundamental properties such as shape, structure and reactivity that are determined at the sub-atomic, molecular, or near-molecular levels. A spectrum of simulation technologiesquantum mechanical simulation, molecular simulation, and mesoscale simulationpredict these properties and help researchers discover new products, sharpen the focus of experimental activities and improve ultimate product performance. We are a leading provider of such modeling and simulation software.
We have a broad product suite consisting of over 100 application modules based on proprietary and licensed technologies that employ fundamental scientific principles, advanced computer visualization, molecular modeling techniques and computational chemistry. These products allow scientists to perform computations of chemical, biological and materials properties, to simulate, visualize and analyze chemical and biological systems, and to communicate the results to other scientists. We also offer open access to many of our core software development environments, within which customers and third-party licensees can develop, integrate and distribute their own software applications for computational chemistry, biology and materials research.
We plan to continue enhancing our product and service offerings for computational chemists and biologists, who are the principal users of modeling and simulation products. In addition, we plan to broaden our user base by enabling straightforward access to our modeling and simulation software from personal computers thereby making our products available to a much larger population of biologists, chemists and engineers. This also helps expert modelers to connect and communicate more effectively to the wider research organization. Further, these products assist organizations in capturing, managing, and sharing the critical knowledge developed in modeling.
Informatics Software. We are a leading provider of tools to capture, store, manage, and mine scientific data and information. Informatics is a well-established technology in life sciences, where bioinformatics tools are integral to genetic and biological research, and cheminformatics applications are widely used to manage chemical information.
Our bioinformatics solutions include a suite of programs enabling molecular biologists to search, edit, compare, map and align sequence data. Researchers use these tools to enable the analysis of DNA and protein sequences and structure, predict RNA secondary structure and annotate protein sequences. Such capabilities help them to use the genomic data that is being made available by projects such as the Human Genome Project. In addition, we provide enterprise-wide data management and analysis tools that assist in the management of this data. Data visualization and analysis capabilities allow this data to be viewed and understood on standard desktop computers.
Our cheminformatics software is based on standard database architectures such as Oracle ® and Microsoft ® Access ® . We provide data visualization and analysis software to search, retrieve, and use chemical structures, biological and chemical data, experimental data, and registration information. Many of these tools use industry standard software components and are compliant with applications such as Microsoft Excel ® , allowing chemists to interact with chemical data within familiar productivity tools. We also use this component technology and our database architectures to build enterprise-wide systems for our clients.
Workflow Software Solution. Our workflow software solution allows customers to analyze and mine extremely large data sets in real time. Informatics analyses generally require multiple computational steps. To address this issue, our solutions allow for automated data analysis protocols to be saved for re-use or shared with a broad community of users within the organization.
In addition to software modules, we also offer the following services:
Customer Support and Training. Expert telephone support, an Internet-based knowledge-base and request-tracking system, and on-site training, web-based training, and scheduled training workshops, are all designed to enhance customer success in the application of our technologies.
Contract Research. Our scientists can be contracted to work on specific projects. These services provide a high level of collaboration with the client and include mentoring and knowledge transfer related to the application of our modeling tools.
Consulting Services. We offer consulting services including installation, non-complex implementation and integration.
Our customer base consists of commercial, governmental and academic organizations. No single customer accounted for more than 10% of our revenue during any of the three most recently completed fiscal years.
Commercial Customers. Our commercial customers include many of the worlds largest pharmaceutical, biotechnology, chemical, petroleum and material science companies. In each of the past three fiscal years, a significant portion of our total revenue has been derived from pharmaceutical, biotechnology and chemical companies.
Governmental Customers. Many governmental institutions in the United States, Canada, Europe and the Asia/Pacific region use our products.
Academic Customers. Many universities in the United States, Europe and the Asia/Pacific region use our products. This use historically has been for purposes of academic research, but we believe our products increasingly may be used as a part of formal university teaching curricula.
Strategic and Academic Alliances
We have entered into a number of strategic alliances relating to product development, product distribution and joint marketing. We plan to continue to cultivate relationships with academic, governmental and commercial research organizations for purposes of identifying and licensing new technology to use in product development. In addition, we plan to maintain and expand our alliances focusing on the compatibility of our products with databases and database management systems, other computational chemistry and molecular simulation products, and products in related markets such as imaging and clinical informatics. We also intend to continue to enter into porting and joint marketing arrangements with hardware vendors on whose systems our products operate.
Sales and Marketing
We market our products and services worldwide. Historically, we have generated approximately 55%, 25% and 20% of our revenues from the United States, Europe and Asia-Pacific, respectively. Please refer to Note 3 to our restated consolidated financial statements included elsewhere in this Report for a breakdown of revenues and long-lived assets by geographic region. Our continuing reliance on sales in international markets exposes us to risks attendant to foreign sales, as described more fully in Item 1A of this Report.
We sell our products and services through our direct sales force, telesales and, in some markets, arrangements with distributors. Our direct sales representatives focus on a defined list of customers or cover an assigned geographic territory. These direct sales representatives typically work closely with our pre-sales scientists in order to demonstrate our products and their applicability to various research and development efforts. Our telesales effort is directed at smaller sized commercial accounts and academic institutions. Our distributor relationships are primarily focused in the Asian market, primarily in Japan, China and Korea, and complement our direct sales force in those markets. Historically, we have conducted a small percentage of our business via our webstore, and we are currently enhancing our web-based sales channel.
In support of our sales activities, we participate in industry trade shows, publish our own newsletters, place advertisements in other industry publications, publish articles in industrial and scientific publications, conduct direct mail campaigns, sponsor industry conferences and seminars, and maintain a website that contains information about us and our product and service offerings.
Our products, generally a CD-ROM containing the purchased software, together with the associated product literature, are generally shipped to our customers at the time of placing and processing their order. We recently initiated an electronic software distribution (ESD) pilot program, which, if implemented, will allow our customers to download our products over the World Wide Web.
Our customers buying habits have historically resulted in a higher concentration of sales in the third quarter of our fiscal year, due to traditionally higher purchasing activity in the month of December in many commercial organizations.
Customer Service and Support
We are committed to providing customers with superior support, including telephone, e-mail, fax and Internet-based technical support services; training; user group conferences; and targeted contract services involving application of our technology and scientific expertise to particular research needs of customers. We believe that customer service, support and training are key to the adoption and successful utilization of our products.
Our support services give customers access to new releases, technical notes, documentation addenda and other support which enables customers to utilize our products more effectively, including access to our technical and scientific support personnel during extended business hours. Both internally and through our distribution channels, we offer training conducted by staff knowledgeable in both the theory and application of our products. Technical newsletters and bulletins and advance notification about future software releases are sent to customers to keep them informed and to help them with resource allocation and scheduling. To maintain an ongoing understanding of customer requirements, we sponsor scientific symposia and user group meetings throughout the year.
Development of our software is focused on expanding product lines, designing enhancements to our core technology and integrating existing and new products into our principal software architecture and platform technology. We intend to offer regular updates to our products and to continue to look for opportunities to expand our existing product suite.
We develop most of our products internally and, during the years ended March 31, 2006 and 2005 and December 31, 2003, and the three months ended March 31, 2004, we incurred product development expenses totaling $21.7 million, $22.7 million, $22.4 million and $5.2 million, respectively. We have also licensed products or otherwise have acquired products, or portions of our products, from the open source community, as well as corporate, governmental and academic institutions. These arrangements sometimes
involve joint development efforts and frequently require the payment of royalties by us. The development and royalty obligations, scope of distribution rights, duration and other terms of these arrangements vary depending on the product, the market, resource requirements, the other parties with which we contract and other factors. We intend to continue to license or otherwise acquire technology or products from third parties.
The market for our products is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Our competitors offer a variety of products and services to address this market. We believe that the principal competitive factors in this market are product quality, flexibility, ease-of-use, scientific validation and performance, functionality and features, open architecture, quality of support and service, reputation and price. Competition currently comes from the following principal sources (and competitors that supply such sources listed in alphabetical order): other software packages for analysis of chemical and biological data ( Elsevier MDL, IDBS, LION bioscience); workflow and data-pipeline applications (Inforsense); desktop software applications (CambridgeSoft, Tripos), including chemical drawing applications (CambridgeSoft, Elsevier MDL), molecular modeling and analytical data simulation applications (Chemical Computing Group, OpenEye, Schrodinger, Tripos); other types of simulation software provided to engineers (Reactive Design); and firms supplying databases, such as chemical or genomic information databases (Elsevier MDL, LION bioscience), and database management systems and information technology (Elsevier MDL, IDBS, LION bioscience).
Intellectual Property and Other Proprietary Rights
We rely primarily on a combination of copyright, trademark and trade secret laws, confidentiality procedures and contractual provisions to protect our proprietary rights. We also have 20 United States and foreign patents and several patent applications. We believe that factors such as the technological and creative skills of our personnel, new product development, frequent product enhancements, name recognition and reliable product maintenance are essential to establishing and maintaining a technological leadership position. There can be no assurance that our means of protecting our proprietary rights in the United States or abroad will be adequate. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. Further, there can be no assurance that our patents will offer any protection or that they will not be challenged, invalidated or circumvented.
As of March 31, 2006, we had 479 full-time employees. None of our employees are covered by collective bargaining agreements. Substantially all of our employees, other than certain of our executive officers and employees with customary employment arrangements within Europe, are at will employees, which means that each employee can terminate his or her relationship with us and we can terminate our relationship with him or her at any time. We offer industry competitive wages and benefits and are committed to maintaining a workplace environment that promotes employee productivity and satisfaction. We believe our relations with our employees are good.
Item 1A. Risk Factors
You should carefully consider the risks described below before investing in our publicly-traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, technological obsolescence, labor relations, general economic conditions, geopolitical changes and international operations. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity. The risks described below could cause our actual results to differ materially from those contained in forward-looking statements we have made in this Report, the information incorporated herein by reference and those we may make from time to time.
Certain Risks Related to Our Marketplace and Environment
Our revenue from the sale of modeling, simulation and informatics software to the life science discovery research marketplace, which has historically constituted a significant portion of our overall revenue, has been declining over the past several years and may continue to decline in future years. Historically we have derived a significant portion of our revenue from the sale of modeling, simulation and informatics software to the discovery research departments in pharmaceutical and biotechnology companies. Such revenues have been declining over the past several years. We believe this decline is due to several factors, including industry consolidation, a general reduction in the level of discovery research activity by our customers, increased competition, including competition from open source software, and reductions in profit and related information technology spending by our customers, due in part to the expiration of patents on profitable drugs. If such declines continue and we do not increase the revenue we derive from our other product and service offerings, our business could be adversely impacted.
Our ability to sustain or increase revenues will depend upon our success in developing, marketing and selling software and service solutions to both our existing customers and to new customers. Our strategy involves transforming our product and service offerings by providing tools and components to our customers which allow our customers to integrate software applications and data more easily. A key enabler of this strategy is the data pipelining and workflow technology we acquired through the September 2004 acquisition of SciTegic, Inc. We are utilizing SciTegics Pipeline Pilot technology to enable our customers to build solutions which allow them to receive greater value from their data, information and knowledge. Selling this type of solution is fundamentally different than our historical sale of modeling and simulation products, and this type of offering is dependant upon our ability to build a successful services offering. Our sales and services management are focused on transforming our sales process to allow us to be successful with this type of sale. In addition, we are adding personnel and defining services offerings to enable our customers to successfully deploy these solutions. There can be no assurance that we will be successful in this transformation of our sales processes and in the building of our services capabilities. If we are not successful, our ability to sustain or increase revenue may be adversely impacted.
Our ability to sustain or increase revenues will depend upon our success in entering new markets and in deriving additional revenues from our existing customers. Our products are currently used primarily by molecular modeling and simulation specialists in discovery research organizations. Our strategy is to expand usage of our products and services by marketing and distributing our software to a broader, more diversified group of biologists, chemists, engineers and informaticians within our existing pharmaceutical and biotechnology customers, as well as to new customers in other industries. However, our products and services may not achieve market acceptance or penetration in targeted new departments within our customers or in new industries. As a result, we may not be able to sustain or increase revenue.
We may be unable to develop strategic relationships with our customers. Our strategy is to expand usage of our products and services by marketing and distributing solutions to a broader, more diversified group of biologists, chemists, engineers and informaticians throughout our customers research and development organizations. A key component of our business strategy is to become a preferred provider of scientific
software and solutions. Becoming a preferred vendor will require substantial re-training and new skills development within our sales and service personnel and deployment of a successful account-management sales model. We believe that developing strategic relationships with our customers may lead to additional revenue opportunities. However, there can be no assurance that any such relationships will develop or that such relationships will produce additional revenue or profit opportunities.
Consolidation within the pharmaceutical and biotechnology industries may continue to lead to fewer potential customers for our products and services. A significant portion of our customer base consists of pharmaceutical and biotechnology companies. Continued consolidation within the pharmaceutical and biotechnology industries may result in fewer customers for our products and services. If one of the parties to a consolidation uses the products or services of our competitors, we may lose existing customers as a result of such consolidation.
Health care reform and restrictions on reimbursement may affect the ability of pharmaceutical, biotechnology and industrial chemical companies to purchase or license our products or services, which may affect our results of operations and financial condition. The continuing efforts of government and third-party payers in the markets we serve to contain or reduce the cost of health care may reduce the profitability of pharmaceutical, biotechnology and industrial chemical companies causing them to reduce research and development expenditures. Because our products and services depend on such research and development expenditures, our revenues may be significantly reduced. We cannot predict what actions federal, state or private payers for health care goods and services may take in response to any health care reform proposals or legislation.
We face strong competition in the scientific software sector. The market for our products is intensely competitive. We currently face competition from other scientific software providers, larger technology and solutions companies, in-house development by our customers, as well as academic and government institutions and the open source community.
Some of our competitors and potential competitors in this sector have longer operating histories than us and have greater financial, technical, marketing, research and development and other resources. Many of our competitors offer products and services directed at more specific markets than those we target, enabling these competitors to focus a greater proportion of their efforts and resources on these markets. Some offerings that compete with our products are developed and made available at lower cost by government organizations and academic institutions, and these entities may be able to devote substantial resources to product development and also offer their products to users for little or no charge. We also face competition from open source software initiatives, in which developers provide software and intellectual property free over the Internet. In addition, many of our customers spend significant internal resources in order to develop their own software.
There can be no assurance that our current or potential competitors will not develop products, services or technologies that are comparable to, superior to, or render obsolete, the products, services and technologies we offer. There can be no assurance that our competitors will not adapt more quickly than us to technological advances and customer demands, thereby increasing such competitors market share relative to ours. Any material decrease in demand for our technologies or services may have a material adverse effect on our business, financial condition and results of operations.
We are subject to pricing pressures in the markets we serve. We operate in an intensely competitive marketplace which has led to significant pricing pressure and declines in average selling price over the past several years. In response to competition and general adverse economic conditions in the markets we serve, we may be required to modify our pricing practices. Changes in our pricing model could lead to a decline or delay in revenue as our sales force and customers adjust to the new pricing policies. This development may adversely affect our revenue and earnings.
Our operations may be interrupted by the occurrence of a natural disaster or other catastrophic event at our primary facilities. Our research and development operations and administrative functions are primarily conducted at our facilities in San Diego, California, Cambridge, United Kingdom, and Bangalore, India. We also conduct sales and customer support activities at our facilities in Burlington, Massachusetts, Paris, France, and Tokyo, Japan. Although we have contingency plans in effect for natural disasters or other catastrophic events, catastrophic events could still disrupt our operations. For example, our San Diego and Tokyo facilities are located in areas that are particularly susceptible to earthquakes. Any natural disaster or catastrophic event in our facilities or the areas in which they are located could have a significant negative impact on our operations.
Our insurance coverage may not be sufficient to avoid material impact on our financial position or results of operations resulting from claims or liabilities against us, and we may not be able to obtain insurance coverage in the future. We maintain insurance coverage for protection against many risks of liability. The extent of our insurance coverage is under continuous review and is modified as we deem it necessary. Despite this insurance, it is possible that claims or liabilities against us may have a material adverse impact on our financial position or results of operations. In addition, we may not be able to obtain any insurance coverage, or adequate insurance coverage, when our existing insurance coverage expires. For example, we do not carry earthquake insurance for our facilities in Tokyo, Japan or San Diego, California, because we were unable to obtain such insurance on commercially reasonable terms.
Certain Risks Related to Our Operations
Defects or malfunctions in our products could hurt our reputation among our customers, result in delayed or lost revenue and expose us to liability. Our business and the level of customer acceptance of our products depend upon the continuous, effective and reliable operation of our software and related tools and functions. To the extent that defects cause our software to malfunction and our customers use of our products is interrupted, our reputation could suffer and our revenue could decline or be delayed while such defects are remedied. We may also be subject to liability for the defects and malfunctions of third-party technology partners and others with whom our products and services are integrated.
Delays in the release of new or enhanced products or services or undetected errors in our products or services may result in increased cost to us, delayed market acceptance of our products and delayed or lost revenue. To achieve market acceptance, new or enhanced products or services can require long development and testing periods, which may result in delays in scheduled introduction. Any delays in the release schedule for new or enhanced products or services may delay market acceptance of these products or services and may result in delays in new customer orders for these new or enhanced products or services or the loss of customer orders. In addition, new or enhanced products or services may contain a number of undetected errors or bugs when they are first released. Although we test each new or enhanced software product or service before being released to the market, there can be no assurance that significant errors will not be found in existing or future releases. As a result, in the months following the introduction of certain releases, we may need to devote significant resources to correct these errors. There can be no assurance, however, that all of these errors can be corrected.
We are subject to risks associated with the operation of a global business. Our non-U.S. operations are subject to risks inherent in the conduct of international business, including:
· unexpected changes in regulatory requirements;
· longer payment cycles;
· currency exchange rate fluctuations;
· import and export license requirements;
· tariffs and other barriers;
· political unrest, terrorism and economic instability;
· disruption of our operations due to local labor conditions;
· limited intellectual property protection;
· difficulties in collecting trade receivables;
· difficulties in managing distributors or representatives;
· difficulties in managing an organization spread over various countries;
· difficulties in staffing foreign subsidiary or joint venture operations; and
· potentially adverse tax consequences.
Our success depends, in part, on our ability to anticipate and address these risks. There can be no assurance that we will do so effectively, or that these or other factors relating to our international operations will not adversely affect our business or operating results.
In order to improve our financial position, we have reduced our headcount, which could negatively impact our business. We have undergone several reductions-in-force over the past few years, and our workforce has declined by approximately 200 people since March 2002. While we believe we have sufficient staff to operate our business, we do not have duplicative or redundant resources in many of our functions or operations. As a result, there can be no assurance that further attrition will not impact our ability to operate our business, or adversely impact our revenues.
Failure to attract and retain skilled personnel, including the personnel necessary to address the identified material weaknesses in our internal control over financial reporting, could have a material adverse effect on us. Our success depends in part on the continued service of key scientific, sales, business development, marketing, engineering, management and accounting personnel and our ability to identify, hire and retain additional personnel. There is intense competition for qualified personnel. Immigration laws may further restrict our ability to attract or hire qualified personnel. We may not be able to continue to attract and retain the personnel necessary for the development of our business. Failure to attract and retain key personnel could have a material adverse effect on our business, financial condition and results of operations. Further, we are highly dependent on the principal members of our technical, scientific and management staff. One or more of these key employees could retire or otherwise leave our employ within the foreseeable future, and the loss of any of these people could have a material adverse effect on our business, financial condition and results of operations. We do not intend to maintain key person life insurance on the life of any employee.
In addition to the foregoing, as described in greater detail elsewhere in this Report, we recently concluded that we had material weaknesses in our internal control over financial reporting as of March 31, 2006. These material weaknesses, which principally arose due to our lack of a sufficient number of employees with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles relevant to our business, were at least partially responsible for our need to restate our previously issued consolidated financial statements as described elsewhere in this Report. While we have recruited additional qualified personnel since March 31, 2006, one or more of these qualified recruits or existing personnel could leave our employ within the foreseeable future. If not timely and adequately addressed, the loss of any of these individuals could impair our ability to maintain effective internal control over financial reporting and thereby cause a material adverse effect on our business.
If we choose to acquire businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business or technology in a cost-effective and non-disruptive manner. From time to time, we may choose to acquire businesses, products or technologies instead of developing them ourselves. We do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired businesses, operate them profitably or retain their key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms and, in the case of equity financing that may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.
Certain Risks Related To Our Financial Performance
We have a history of losses and our future profitability is uncertain. We generated net losses for the years ended March 31, 2006 and 2005 and December 31, 2003, and the three months ended March 31, 2004. Continuing net losses may limit our ability to fund our operations and we may not generate income from operations in the future. Our future profitability depends upon many factors, including several that are beyond our control. These factors include without limitation:
· changes in the demand for our products and services;
· the introduction of competitive software;
· our ability to license desirable technologies;
· changes in the research and development budgets of our customers and potential customers; and
· our ability to successfully, cost effectively and timely develop, introduce and market new products, services and product enhancements.
Our sales forecast and/or revenue projections may not be accurate. We use a pipeline system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor the status of proposals, including the date when they estimate a customer will make a purchase decision and the potential size of the order. We aggregate these estimates on a quarterly basis in order to generate a sales pipeline. While the pipeline process provides us with some guidance in business planning and forecasting, it is based on estimates only and is therefore subject to risks and uncertainties. Any variation in the conversion of the pipeline into revenue or the pipeline itself could cause us to improperly plan or budget and thereby adversely affect our business, results of operations and financial condition.
If we are unable to license software to, or collect receivables from our customers our operating results may be adversely affected. The majority of our current customers are well-established, large pharmaceutical customers and universities, and other customers include smaller biotechnology companies. We have not experienced significant customer defaults during the past three fiscal years and have recorded a provision for bad debts of less than $0.5 million in each of those periods. Our financial success depends upon the creditworthiness and ultimate collection of amounts due from our customers. If we are not able to collect from our customers, we may be required to write-off significant accounts receivable and recognize bad debt expenses which could materially and adversely affect our operating results.
Our quarterly operating results, particularly our quarterly cash flows, will fluctuate. Quarterly operating results may fluctuate as a result of a number of factors, including lengthy sales cycles, market acceptance of new products and upgrades, timing of new product introductions, changes in pricing policies, changes in general economic and competitive conditions, and the timing and integration of acquisitions. We may also experience fluctuations in quarterly operating results due to general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies. In particular, we historically received approximately 40% of our annual orders in the fiscal quarter ended December 31. As a result, our cash flows from operations generally are positive in the fiscal quarter ended March 31, and we generally experience negative cash flows from operations in the other three fiscal quarters. Due to the possibility of fluctuations in our revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.
Changes in the accounting treatment of employee stock-based compensation will adversely affect our results of operations. In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard (SFAS) No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), which revises SFAS No. 123, Accounting for Stock-Based Compensation . SFAS No. 123R requires that employee stock-based compensation is measured based on the grant-date fair value of the related employee equity award and is treated as an expense that is reflected in the financial statements over the related service period. SFAS No. 123R applies to all employee equity awards granted after adoption and to the unvested portion of employee equity awards outstanding as of adoption. We currently anticipate adopting SFAS No. 123R using the modified-prospective method effective April 1, 2006. Because employee stock-based compensation expense will be reflected in our financial statements, the adoption of the SFAS No. 123R is anticipated to have a significant adverse impact on our future reported results of operations, although at this time, we are unable to quantify such impact. However, the pro forma impact on our reported results of operations for prior periods of recognizing the fair value of employee stock-based compensation in accordance with SFAS No. 123 is described in Note 3 to our consolidated financial statements included elsewhere in this Report.
The recently completed restatement of our historical financial statements has already consumed, and may continue to consume, a significant amount of our resources and may have a material adverse effect on our business and stock price. In December 2005, we announced that our previously issued consolidated financial statements would be restated to reflect certain accounting adjustments. The restatement process was highly time and resource-intensive and involved substantial attention from management and significant legal and accounting costs. Although we have now completed the restatement, we cannot guarantee that we will have no further inquiries from the SEC or NASDAQ regarding our restated financial statements or matters relating thereto. Likewise, many companies that have been required to restate their historical financial statements have subsequently experienced stockholder lawsuits relating to their restatements. Any future inquiries from the SEC or NASDAQ as a result of the restatement of our historical financial statements will, regardless of the outcome, likely consume a significant amount of our resources in addition to those resources already consumed in connection with the restatement itself.
If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results, and current and potential stockholders may lose confidence in our financial reporting. We are required by the SEC to establish and maintain adequate internal control over financial reporting that provides reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. We are likewise required, on a quarterly basis, to evaluate the effectiveness of our internal controls and to disclose any changes, significant deficiencies or material weaknesses in those internal controls.
As described in greater detail elsewhere in this Report, in connection with the restatement process, we identified material weaknesses in our internal control over financial reporting. These material weaknesses
generally relate to our historical lack of a sufficient number of employees with appropriate levels of accounting knowledge, experience and training in the application of generally accepted accounting principles relevant to our business. Given these material weaknesses, management was unable to conclude that we maintained effective internal control over financial reporting as of March 31, 2006. Further, these material weaknesses resulted in an adverse opinion by our independent registered public accounting firm as to the effectiveness of our internal control over financial reporting.
Since the determination regarding our material weaknesses, we have devoted significant effort and resources to the remediation and improvement of our internal control over financial reporting. In particular, as described elsewhere in this Report, we have recruited a number of qualified individuals to assist in maintaining adequate internal controls, we have initiated a revenue recognition training program and we have implemented an enhanced quarterly and annual financial statement close, review and reporting process. Although we believe that these efforts and resources have strengthened our internal control over financial reporting and address the concerns that gave rise to the material weaknesses as of March 31, 2006, we cannot be certain that these measures will ensure that we maintain adequate internal control over our financial reporting in future periods. Any failure to maintain such internal controls could adversely impact our ability to report our financial results on a timely and accurate basis. If our financial statements are not accurate, investors may not have a complete understanding of our operations. Likewise, if our financial statements are not filed on a timely basis as required by the SEC and NASDAQ, we could face severe consequences from those authorities. In either case, there could result a material adverse affect on our business. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.
We may be required to indemnify Pharmacopeia Drug Discovery, Inc. (PDD), or may not be able to collect on indemnification rights from PDD. On April 30, 2004, we spun-off our drug discovery subsidiary, PDD, into an independent, separately traded, publicly held company through the distribution to our stockholders of a dividend of one share of PDD common stock for every two shares of our common stock. As part of the spin-off, we agreed to indemnify the indebtedness, liabilities and obligations of PDD. One such obligation includes a guarantee by us to the landlord of PDDs obligations under the existing New Jersey laboratory and headquarters leases, with respect to which PDD will indemnify us should we be required to make any payment under the guarantee. These indemnification obligations could be as significant as the remaining future minimum lease payments, which totaled approximately $25 million as of March 31, 2006. PDDs ability to satisfy any such indemnification obligations (including, without limitation, PDDs commitment to indemnify us in the event of our payment under our guarantee of its leases) will depend upon PDDs future financial strength. We cannot assure you that, if PDD becomes obligated to indemnify us for any substantial obligations, PDD will have the ability to do so. There also can be no assurance that we will be able to satisfy any indemnification obligations to PDD. Any failure by PDD to satisfy its obligations and any required payment by us could have a material adverse effect on our business.
Enacted and proposed changes in securities laws and regulations have increased our costs and may continue to increase our costs in the future. The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) required changes in some of our corporate governance and securities disclosure and compliance practices. Under Sarbanes-Oxley, publicly held companies, including us, are required to, among other things, furnish independent annual audit reports regarding the existence and reliability of their internal control over financial reporting and have their chief executive officer and chief financial officer certify as to the accuracy and completeness of their financial reports.
We expect continued compliance with Sarbanes-Oxley to remain costly. Further, Sarbanes-Oxley and the related SEC and NASDAQ compliance rules may make it more difficult and expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers. We
continually evaluate and monitor regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.
Our business, financial condition and results of operations may be adversely impacted by fluctuations in foreign currency exchange rates. Our international sales generally are denominated in local currencies. Fluctuations in the value of currencies in which we conduct business relative to the United States dollar result in currency transaction gains and losses, and the impact of future exchange rate fluctuations cannot be accurately predicted. Future fluctuations in currency exchange rates may have a material adverse impact on revenue from international sales, and thus on our business, financial condition and results of operations. When deemed appropriate, we may engage in currency exchange rate hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations. However, currency hedging policies may not be successful, and they may increase the negative impact of exchange rate fluctuations.
If we consume cash more quickly than expected, we may be unable to raise additional capital and we may be forced to curtail operations. We anticipate that our existing capital resources will be adequate to fund our operations for at least the next twelve months. However, changes may occur that would consume available capital resources before that time. Our capital requirements will depend on numerous factors, including:
· costs associated with software sales;
· the purchase of additional capital equipment;
· acquisitions of other businesses or technologies;
· costs associated with the restatement of our historical financial statements as described elsewhere in this Report; and
· costs associated with addressing the material weaknesses in our internal control over financial reporting as described elsewhere in this Report.
If we determine that we must raise additional capital, we may attempt to do so through public or private financings involving debt or equity. However, additional capital may not be available on favorable terms, or at all. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, products or potential markets that we would not otherwise relinquish.
Certain Risks Related to Owning Our Stock
We expect that our stock price will fluctuate significantly, and you may not be able to resell your shares at or above your investment price. The stock market, historically and in recent years, has experienced significant volatility particularly with technology company stocks. The volatility of technology company stock prices often does not relate to the operating performance of the companies represented by the stock. Factors that could cause volatility in the price of our common stock include without limitation:
· actual and anticipated fluctuations in our quarterly financial and operating results;
· market conditions in the technology and software sectors;
· issuance of new or changed securities analysts reports or recommendations;
· developments or disputes concerning our intellectual property or other proprietary rights or other legal claims;
· introduction of technological innovations or new commercial products by us or our competitors;
· market acceptance of our products and services;
· additions or departures of key personnel;
· public perception of the impact of the restatement of our historical consolidated financial statements as described elsewhere in this Report; and
· the disclosure of the material weaknesses in our internal control over financial reporting as described elsewhere in this Report.
These and other external factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have periodically instituted securities class action litigation against the issuer.
As institutions hold the majority of our common stock in large blocks, substantial sales by these stockholders could depress the market price for our shares. As of April 11, 2006, the top ten institutional holders of our common stock held approximately 48% of our outstanding common stock. As a result, if one or more of these major stockholders were to sell all or a portion of their holdings, or if the market were to perceive that such sale or sales may occur, the market price of our common stock may fall significantly.
Because we do not intend to pay dividends, our stockholders will benefit from an investment in our common stock only if our stock price appreciates in value. We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends in the foreseeable future. As a result, the success of an investment in our common stock will depend entirely upon any future appreciation in its value. There is no guarantee that our common stock will appreciate in value or even maintain the price at which it was purchased.
Anti-takeover provisions under the Delaware General Corporation Law, provisions in our certificate of incorporation and bylaws, and our adoption of a stockholder rights plan may render more difficult the accomplishment of mergers or the assumption of control by a principal stockholder, making more difficult the removal of management. Certain provisions of the Delaware General Corporation Law may delay or deter attempts to secure control of our company without the consent of our management. Also, our governing documents provide for a staggered board of directors, which will make it more difficult for a potential acquirer to gain control of our board of directors. In 2002, we adopted a stockholder rights plan, which is triggered upon commencement or announcement of a hostile tender offer or when any one person or group acquires 15% or more of our common stock. The rights plan, once triggered, enables our stockholders (other than the stockholder responsible for triggering the rights plan) to purchase our common stock at reduced prices. These provisions of our governing documents and stockholder rights plan, and of Delaware law, could have the effect of delaying, deferring or preventing a change of control, including without limitation a proxy contest, making more difficult the acquisition of a substantial block of our common stock. The provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. Further, the existence of these anti-takeover measures may cause potential bidders to look elsewhere, rather than initiating acquisition discussions with us.
Certain Risks Related to Intellectual Property
We may not be able to protect adequately the trade secrets and confidential information that we disclose to our employees. We rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. Competitors through their independent discovery (or improper means, such as unauthorized disclosure or industrial espionage) may come to know our proprietary information. We generally require employees and consultants to execute confidentiality and assignment-of-inventions agreements. These agreements typically provide that all materials and
confidential information developed by or made known to the employee or consultant during his, her or its relationship with us are to be kept confidential, and that all inventions arising out of the employees or consultants relationship with us are our exclusive property. Our employees and consultants may breach these agreements, and in some instances we may not have an adequate remedy. Additionally, in some instances, we may have failed to require that employees and consultants execute confidentiality and assignment-of-inventions agreements.
Foreign laws may not afford us sufficient protections for our intellectual property, and we may not seek patent protection outside the United States. We believe that our success depends, in part, upon our ability to obtain international protection for our intellectual property. However, the laws of some foreign countries may not be as comprehensive as those of the United States and may not be sufficient to protect our proprietary rights abroad. In addition, we generally do not pursue patent protection outside the United States because of cost and confidentiality concerns. Accordingly, our international competitors could obtain foreign patent protection for, and market overseas, products and technologies for which we are seeking patent protection in the United States.
A patent issued to us may not be sufficiently broad to protect adequately our rights in intellectual property to which the patent relates. Due to cost and other considerations, we generally do not rely on patent protection to enforce our intellectual property rights, and have filed only a limited number of patent applications. Even if patents are issued to us, these patents may not sufficiently protect our interest in our software or other technologies because the scope of protection provided by any patents issued to or licensed by us are subject to the uncertainty inherent in patent law. Third parties may be able to design around these patents or develop unique products providing effects similar to our products. In addition, others may discover uses for our software or technologies other than those uses covered in our patents, and these other uses may be separately patentable. A number of pharmaceutical and biotechnology companies, software organizations and research and academic institutions, have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, patent applications or patents may conflict with our technologies, patent applications or patents. These conflicts could also limit the scope of patents, if any, that we may be able to obtain, or result in the denial of our patent applications.
We may be subject to claims of infringement by third parties. A number of patents may have been issued or may be issued in the future that could cover certain aspects of our technology or functionality of our products and could prevent us from using technology that we use or expect to use, or making or selling certain of our products. In addition, to the extent our employees are involved in research areas similar to those areas in which they were involved at their former employers, we may inadvertently use or disclose alleged trade secrets or other proprietary information of their former employer. Thus, our products may infringe patent or other intellectual property rights of third parties, and we may be subject to infringement claims by third parties. Any such claims, with or without merit, could be time consuming to defend, result in costly litigation, divert managements attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such licenses may not be available on terms acceptable to us, if at all. In the event of a successful claim of product infringement against us, our failure or inability to license or design around the infringed technology could have a material adverse effect on our business, financial condition and results of operations.
Third-party software codes incorporated into our products could subject us to liability or limit our ability to sell such products. Some of our products include software codes licensed from third parties, including the open source community. Some of these licenses impose certain obligations upon us, including royalty and indemnification obligations. In the case of codes licensed from the open source community, the licenses may also limit our ability to sell products containing such code. Though we generally review the applicable licenses prior to incorporating third party code into our software products, there can be no assurance that
such third party codes incorporated into our products would not subject us to liability or limit our ability to sell the products containing such code, thereby having a material adverse affect upon our business.
Item 1B. Unresolved Staff Comments