Quest Software, Inc (QSFT) - Description of business

,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” include or may include forward-looking statements within the meaning of the federal securities laws. We have based these forward-looking statements on currently available information and our current beliefs, expectations and projections about future events. All forward-looking statements contained herein are subject to numerous risks and uncertainties. Our actual results and the timing of certain events could differ materially from those projected in the forward looking statements due to a number of factors discussed under the heading “Risk Factors” in this Report and in our other filings with the Securities and Exchange Commission (“SEC”). Should one or more of these risks or uncertainties materialize, or should the underlying estimates or assumptions prove incorrect, actual results or outcomes may vary significantly from those suggested by forward-looking information. Any forward-looking statements contained in this document are based on information available at the time of filing and we make no undertaking to update any of these forward-looking statements.

PART I

Item 1. Business

Introduction

Quest Software designs, develops, distributes and supports software products that improve the performance and productivity of our customers’ packaged and custom software applications and associated software infrastructure components such as databases, application servers and operating systems. Quest is an “Independent Software Vendor,” or “ISV,” a company whose products support other vendors’ software or hardware products. We both develop internally and acquire the products within our portfolio.

We generate revenues by licensing our products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. Our products improve the management and performance of our customers’ key software applications and component infrastructure and can significantly reduce customers’ capital and operating expenses by minimizing hardware, software and/or personnel costs. Our major product areas are Application Management, Database Management and Infrastructure Management. Examples of the benefits delivered by our products’ include:

  •   the ability to deploy, manage and control complex application environments from the end user to the database;

  •   the improvement of application and database code quality; and

  •   the improved management, migration and integration of large, multi-user Microsoft Active Directory, Exchange and Windows Server deployments within the extended enterprise, including Linux and UNIX.

Application Management is a core competence and represents an important product area for us. Application management is predicated on ensuring performance and availability of mission-critical applications throughout their life cycle. This includes the monitoring and performance management of customers’ primary enterprise software applications, whether packaged or custom-developed. These applications are highly complex and require substantial investment, personnel and expertise in their development, deployment and management. A key Application Management discipline involves measuring the service levels provided by an application, such as application response times and application outages, and providing the capabilities to diagnose the root causes of performance problems and the means to provide necessary corrective action. Most enterprise packaged and custom-developed applications run within multi-vendor infrastructure environments. Therefore, the need exists for heterogeneous management tools that have deep monitoring and diagnostic and reporting capabilities for each component of the application stack. Quest offers application management products for the following application platforms: custom web applications (based on Java 2 Enterprise Edition “J2EE”), PeopleSoft, Oracle E-Business Suite, Siebel and SAP.

Database Management is a market where we initially built a market-leading reputation and today continues to represent a core technical strength for the company. In this area we improve database administrator (“DBA”) and developer productivity and improve database performance. We are currently recognized as a leading Oracle and Microsoft ISV. Databases continue to grow in size, complexity and mission criticality every year. Furthermore, the heterogeneous mix of databases within large organizations continues to expand. These trends create demand for our database tools, which are designed to: 1) improve the utilization and reliability of large-scale databases; and 2) improve the effectiveness and productivity of the developers, database administrators and other personnel responsible for maintaining reliability and performance. In addition to Oracle and Microsoft DBMS products, we also offer solutions for other popular database products including IBM DB2, Sybase ASE and MySQL.

In the last few years we have continued to expand our Infrastructure Management product group and have built up significant technical competencies and product portfolios for the widely-adopted Microsoft Windows Server, Active Directory and Exchange platforms. Active Directory is an essential part of Microsoft’s Windows architecture that acts as the central authority to define and maintain the network infrastructure, perform system administration and control the user experience of a customer’s Microsoft infrastructure, including Microsoft Exchange, Microsoft’s widely used email system. When an individual logs onto his or her employer’s e-mail system, for example, he or she is logging on through Active Directory, which stores and verifies the person’s passwords, access rights and system profiles. Active Directory is a powerful system that is gaining wider acceptance as a primary system for controlling and validating user access rights, with Microsoft’s desktop predominance driving this trend. We believe Microsoft Active Directory will continue to play a strategic role in the enterprise. During 2005, we introduced products to extend Active Directory throughout the heterogeneous enterprise with integration and support for both Linux and UNIX. These products were based upon the acquired products and technologies from Vintela, Inc., acquired in July 2005. We also acquired products to assist customers with the migration to the Exchange platform whether they were on earlier versions of a Microsoft product or other messaging systems including Domino/Notes or GroupWise. Through acquisitions and the continued market acceptance of these infrastructure products for Windows Server, Active Directory and Exchange environments, our Infrastructure Management products have been our fastest growing product area over the last few years.

We invest a significant portion of revenues in our product development and management capabilities, and just over one-third of our employees work in product development, quality assurance or technical documentation roles. In building our products, we stress technical innovation and depth, ease of deployment, ease of use and tangible, readily articulated customer benefits. We sell our products primarily via our direct field salesforce and, increasingly, our telesales organization, supplemented by indirect sales through resellers and distributors. We operate in 28 countries worldwide.

We are a California corporation incorporated in 1987. Our principal offices are located at 5 Polaris Way, Aliso Viejo, California, 92656. We operate on a calendar fiscal year.

Products

We market products that we have grouped into three main categories: Application Management, Database Management and Infrastructure Management. Major products in these categories are described as follows.

Application Management

Our Application Management products are focused on helping the IT organization manage complexity by increasing quality, performance and control throughout the application lifecycle. The principal products that comprise our application management offerings include our Foglight and Spotlight products, and for custom J2EE applications, our PerformaSure and JProbe products. We also combine these products into suites for both pre-production and production application environments which pair business-centric views of applications with deep domain expertise to both measure and improve the performance of packaged and custom applications.

Application Assurance Suite for Java & Portals. Custom-developed J2EE applications require a unique set of performance management solutions to assure performance and reliability across the entire application lifecycle. We provide an integrated solution designed to help all the stakeholders in J2EE measure, analyze and optimize the performance of their application environments before they are released to staging and production. Our Application Assurance Suite for Java & Portals is a low-overhead performance diagnostic tool for multi-tiered Java application and enterprise portals running in pre-production and test environments. The suite is composed of several products including:

  •   JProbe, a performance toolkit for Java tuning,

  •   JClass, Java components for visualization and reporting, and

  •   QDesigner, a database application design tool that combines object-oriented design and physical data modeling capabilities in a single integrated environment.

Performance Management Suite for Java & Portals. By extending our portfolio of products into the production environment, customers can ensure high-quality delivery of applications to end-users across the enterprise while managing the many facets of the dynamic infrastructure. Foglight is an application management solution that monitors every tier in critical application stacks including databases, networks, application servers, web servers and applications alerting administrators to problems before they impact end-users. Foglight offers an array of specialized cartridges focused on ERP and CRM applications to provide a complete monitoring solution for a distributed IT environment. Our series of complementary Spotlight diagnostic products allow IT personnel to drill down into the components of an application, database or other layer of the application stack all the way down to the end user. Our User Experience Monitor allows administrators to measure and manage web-based applications from the end-users’ perspective.

Stat ® ACM. Stat ACM (Application Change Management) helps IT managers lower their PeopleSoft and Oracle E-Business Suite total cost of ownership by providing end-to-end change management and version control. It helps keep up with change configurations and customizations so that they are updated, approved and deployed to instances throughout the application implementation lifecycle. By tracking version control and versioning capabilities as well as process management, change request tracking, requirements management and distributed development support, Stat ACM adds visibility, hides complexity and automates workflow through an easy-to-use GUI (graphical user interface) environment.

Database Management

A company’s database management systems represent some of the most complex and critical components within its infrastructure. As companies broaden their utilization of databases from multiple platform vendors, database administrators and developers are required to learn to use a myriad of non-integrated toolsets across their environment to manage the performance and complexity of this tier. Our market leading database management products support the needs of today’s database developers and DBA’s by providing superior domain capabilities and cross-platform productivity tools to improve database quality and performance.

We acquired Imceda Software, Inc. in May 2005. This acquisition adds backup and recovery solutions to our comprehensive product portfolio for the large and fast growing SQL Server database market.

Code Quality and Optimization . These tools improve the productivity and capability of database developers working in the Oracle Procedural Language (PL)/SQL environment. The primary products in this product family are TOAD ® and SQL Navigator. ® We provide a complete and integrated development environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and general administration features improve the quality and performance of database applications before they enter production.

The Quest Central ® product family for Oracle, SQL Server, DB2 and Sybase.  Administering large heterogeneous database systems in production involves many tedious, error-prone and repetitive tasks. To streamline these tasks and improve the accuracy and effectiveness of database administrators ( “DBAs” ), we have developed the Quest Central product family. Quest Central is a suite of tools that enables the DBA to identify the cause of performance problems without manual trial and error or decentralized tools. These products provide details on historical performance analysis and metrics to provide insight as to how performance issues occur. The Quest Central family of products provides a consistent presentation delineating the performance management of multiple databases enabling DBAs to manage more databases without adding resources. We are currently marketing and selling Quest Central DBA product families for Oracle, Microsoft SQL Server, DB2 and Sybase ASE databases.

SharePlex ® . SharePlex provides real-time replication of Oracle databases for customers who need to ensure a current, secondary copy of their transactional Oracle database is available if the primary database is unavailable. Many customers use SharePlex to offload management reporting, so the activity no longer compromises the performance of transaction processing. Finally, SharePlex is also frequently used to eliminate end user disruption by providing continuous access to data during the migration of operating systems, hardware platforms and major application releases.

Infrastructure Management

Microsoft applications and their associated infrastructure platform continue to be a global standard. Our products enable IT personnel to simplify, automate and secure their infrastructure with management, migration and integration capabilities for this environment. Our products are focused on key elements of the infrastructure including Microsoft’s Active Directory, Exchange and Windows Server. We acquired Vintela, Inc. in July 2005. This acquisition expands our product portfolio of infrastructure management solutions to allow existing Microsoft products, such as Active Directory, Windows Group Policy, Systems Management Server (SMS) 2003, and Microsoft Operations Manager (MOM) 2005, to integrate with systems outside the realm of Windows, including Unix, Linux, Java and Mac systems. Our Infrastructure Management products include:

Quest Management for Active Directory . Microsoft Active Directory is technically complex and requires meticulous management to ensure the accuracy and security of its content across the entire enterprise. Quest Management for Active Directory is a set of products that provide diagnostics, recovery, detailed auditing, group policy management, reporting, self-service, role-based delegation and user provisioning. Our products offer a practical approach to automated user provisioning and provide a comprehensive delegation model, consolidated reporting and auditing and expert advice on problem resolution for teams managing complex Microsoft infrastructures.

Quest Management for Exchange.  E-mail growth is leading to increased traffic, storage and support issues, including compliance. Quest Management for Exchange provides a comprehensive set of tools to migrate, store, recover and intelligently manage growth and the related spending for mission-critical Exchange infrastructures. Our products enable mailbox and public folder management, distribution list management, usage analysis, and diagnostics to optimize investment and performance in Exchange environments. This allows administrators and managers to better target investments, enforce corporate policies, enhance customer service, reduce administrative costs and improve troubleshooting efficiency. Additional functionality and integration is available for customers who have chosen Microsoft Operations Manager (MOM) as their unattended monitoring solution.

Quest Migration Suite for Active Directory.  The Quest Migration Suite for Active Directory is a ZeroIMPACT ™ solution for planning and executing migration projects to Active Directory from Windows NT or Novell NDS. It supports thorough migration planning and Active Directory pruning and grafting—with no interruption to business workflow. Its distributed processing and robust project management features simplify migration processes.

Quest Migration Suite for Exchange . The Quest Migration Suite for Exchange is also a ZeroIMPACT solution that helps plan and execute migration projects to Exchange 2000/2003 from Exchange 5.5 or 2000. In addition this product enables customers to migrate from a Domino/Notes or GroupWise environment to Exchange. It helps to ensure seamless migration processes and provides a centralized place for project management as well as analysis tools and reporting mechanisms.

Quest InTrust . Quest InTrust offers auditing and policy compliance to help systems administrators securely collect, store and report on event data to meet the needs of external regulations, internal policies and best practices.

Vintela Authentication Services. Vintela Authentication Services, (“VAS”) allows Unix and Linux to take advantage of the access, authentication and authorization within Active Directory. This product functionally extends Active Directory’s security, compliance and authentication capabilities into the extended enterprise.

Sales, Marketing and Distribution

We market and sell our products and services worldwide primarily through our direct sales organization and, increasingly, our telesales organization. At December 31, 2005, we had approximately 458 full-time direct sales representatives. Approximately 80% of our sales representatives are field sales personnel, who sell all of our products other than those sold by our telesales representatives. The remaining 20% of our sales representatives are telesales representatives, who sell products such as our Oracle and J2EE development and certain Microsoft related products that are generally evaluated through Internet downloads rather than on-site technical demonstrations. We have approximately 236 pre-sales systems engineers who work with these field sales teams to provide technical assistance and demonstrations to sales prospects. We supplement our direct sales organization with indirect sales channels such as value added resellers and distributors. We also employ local resellers in certain international territories not covered by our local sales offices.

We have sales offices in many major cities of the United States, Europe, Asia and Australia to facilitate close contact between current and potential customers and our field sales organization. Our European operation, which has received considerable focus and investment, has been our fastest growing geographic region over the last several years. In 2003, we began to expand our direct sales efforts into Asia with the opening of a sales office in Japan. In 2004, we continued our expansion into Asia by adding offices in five countries: China, Korea, Hong Kong, Singapore and Malaysia. In 2005, we continued to invest in our Asia operations by hiring additional industry experienced sales personnel. We are also investing in developing localized versions of certain of our products in order to broaden the portfolio of offerings we can sell in Asia.

Our marketing efforts are designed to create awareness, generate leads, and assist the worldwide sales organization with converting leads into closed sales. We use a full complement of marketing vehicles including industry trade shows and conferences, user groups and discussion forums, educational white papers and knowledge briefs, electronic and print advertising, webcasts, direct marketing via electronic and postal mailings, and online advertising. Strategic and channel partners often assist us with the development, funding and execution of our marketing programs. Targeted campaigns and sales programs are developed based on objective, audience and product mix and are executed in our regions around the world to maximize revenue opportunities as quickly as possible.

Our professional consulting and training services organization complements our direct sales organization by providing customers with a full range of support services, including implementations, configuration services and training. We believe that professional consulting and training services are important to customer satisfaction and the development of long-term customer relationships.

For information regarding our segment revenue and revenue by geographic area, please refer to Note 13 of our “Notes to Consolidated Financial Statements.”

Customer Service and Support

A high level of customer service and support is critical to the successful marketing and sale of our products and the development of long-term customer relationships. We have a reputation for providing a high level of customer support and believe this is a competitive differentiator. Enrollment in our customer maintenance program is annual and entitles a customer to:

  •   problem resolution services,

  •   new functional enhancements of a product, and

  •   ongoing compatibility with new releases of the database, application or other platforms supported by the product.

Customer support is provided domestically through our offices in Aliso Viejo and internationally through our offices in Europe and Canada.

Research and Development

We believe that strong research and product development capabilities are essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing our products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $87.9 million, $78.3 million, and $67.4 million for the years ended December 31, 2005, 2004 and 2003, respectively. We have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems and IBM database technologies. We have also built-up these competencies through small and medium-sized acquisitions. In addition to the U.S., we have significant product development operations in Canada, Australia, Russia and Israel.

Competition

The market for application management solutions is emerging rapidly, and, as a result, is intensely competitive and characterized by rapidly changing technology and evolving standards. We expect competition to

continue to increase both from existing competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:

  •   the ease of use, performance, features, price and reliability of our products as compared to those of our competitors;

  •   the value proposition of our products in terms of return on investment and/or reduced cost of ownership;

  •   the timing and market acceptance of new products and enhancements to existing products developed by us and our competitors;

  •   the quality of our customer support; and

  •   the effectiveness of our sales and marketing efforts.

We compete in some cases with the vendors of databases, applications, infrastructure and other systems that our products help to improve and manage. To the extent these vendors are able to include similar or equivalent functionality of our software as standard features of their underlying database solution or application our revenues could be eroded. For example, competition with Oracle over the last four years has materially reduced license revenues generated by certain of our Database Management products including SharePlex and Quest Central for Oracle. This competition continues to increase with Oracle’s introduction of the current version of its database, known as Oracle 10g. Oracle 10g’s component called Oracle Enterprise Manager has enhanced capabilities in its functions that compete with Quest Central for Oracle and with certain Oracle monitoring capabilities of Foglight. Oracle recently announced general availability of products to compete with our market leading Code Quality and Optimization products for Oracle databases, which contribute significantly to our revenues and net income. To date, we have not faced any major competition from Microsoft for our Infrastructure Management products.

We also compete with other vendors of database, application and infrastructure management tools. Public companies with whom we compete include:

  •   the large, well established systems management vendors, primarily Oracle, as discussed above, IBM/Tivoli, Hewlett Packard, CA, BMC Software and Symantec, which acquired Veritas and Bindview during 2005;

  •   other application and database management vendors such as Mercury Interactive and Embarcadero;

  •   providers of Microsoft Active Directory and Exchange management and migration tools, primarily NetIQ.

Some of our competitors and potential competitors have greater name recognition, a larger installed customer base company-wide and significantly greater financial, technical, marketing, and other resources than we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.

Because there are relatively low barriers to entry in the software market, we may encounter additional competition as other established and emerging companies enter our field and introduce new products and technologies. Venture capitalists and others have funded numerous database, application and infrastructure management companies. Accordingly, it is likely that new competitors or alliances among current and new competitors will emerge and rapidly gain acceptance.

There can be no assurance that we will be able to compete successfully against current and future competitors. Increased competition could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially affect our business, operating results or financial condition.

Seasonality

We have experienced seasonality in our orders and revenue, which has resulted in seasonality in our earnings. We tend to experience a higher volume of transactions and associated revenues in our third and fourth quarters ending September 30 and December 31, respectively, as a result of our customers’ spending patterns and, to a lesser extent, the structure of our sales commission program. As a result of this seasonality for license transactions, we tend to have higher orders and revenues in the fourth quarters of a year than orders and revenues in the first quarter of the following year. We expect this seasonality to continue in the future.

Proprietary Rights

We rely on a combination of patents, copyrights, trademarks, service marks, 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 U.S. 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 and services to enhance our products and services 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.

As of March 8, 2006, we have been granted or own by assignment 4 patents issued in the United States and have 9 patent applications on file with the United States Patent and Trademark Office (including continuation and divisional applications) for elements contained in our products and services. We intend to continue to file patent applications as appropriate in the future. We cannot be sure, however, that any of our pending patent applications will be allowed, that any issued patents will protect our intellectual property or will not be challenged by third parties, or that the patents of others will not seriously harm our ability to do business. In addition, others may independently develop similar or competing technologies or design around any of our patents. We do not believe we are significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

Although we believe that our products and services 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.

Employees

As of December 31, 2005, we employed 2,763 full-time employees, including 1,084 in sales and marketing, 94 in professional services, 1,088 in research and development, 194 in customer service and support and 303 in general and administrative, including information services personnel. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support and research and development personnel. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting qualified personnel. None of our employees are represented by a labor union; we have never experienced any work stoppages and we believe that our relationships with our employees are good.

Website

Our website is located at www.quest.com. We make available, free of charge on or through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Information contained on our website is not part of this annual report on Form 10-K.

Item 1A. Risk Factors

An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of the business and the industry in which we compete.

Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose part or all of your investment.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market, competitive and technological conditions in the software industry

The market for our software products and services is characterized by:

  •   rapidly changing technology;

  •   frequent introduction of new products and services and enhancements to existing products and services by platform vendors of database, application and infrastructure products and by our competitors;

  •   increasing complexity and interdependence of software applications;

  •   consolidation of the software industry;

  •   changes in industry standards and practices;

  •   ability to attract and retain key personnel; and

  •   changes in customer requirements and demands.

To maintain our competitive position, we must continue to enhance our existing products and develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers, which requires significant investment in research and development resources and capabilities, involves significant technical and business risks and requires substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements, 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, or if we are incapable of timely bringing new or enhanced products to market, our products and services may become obsolete, we may not generate suitable returns from our research and development investments, and our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.

Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline

Our revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors. These factors include the following:

  •   the size and timing of customer orders. See “—The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results.”

  •   the discretionary nature of our customers’ purchasing decisions and budget cycles;

  •   the timing of revenue recognition for sales of software products and services;

  •   the extent to which our customers renew their maintenance contracts with us;

  •   exposure to general economic conditions and reductions in corporate IT spending;

  •   changes in our level of operating expenses and our ability to control costs;

  •   our ability to attain market acceptance of new products and services and enhancements to our existing products;

  •   our ability to introduce new products or enhancements to existing products and services in a timely manner;

  •   our ability to maintain our field and inside sales organizations with adequate numbers of sales and services personnel, and to minimize our costs of sales and marketing through efficient allocation of sales resources and methods to products having different sales characteristics and profiles;

  •   the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;

  •   the relative growth rates of competing operating system, database and application platforms and competitive conditions among vendors of these platforms;

  •   the unpredictability of the timing, level of sales and subsequent revenue recognition of our expanded efforts within our indirect sales channels;

  •   costs related to acquisitions of technologies or businesses, including amortization costs for intangible assets with indefinite lives and uncertainties arising from the integration of products, services, employees and operations of acquired companies; and

  •   the timing of releases of new versions of third-party software products that our products support or with which our products compete.

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product-to-product and customer-to-customer. We base our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast. Therefore, we may not learn of shortfalls in revenue or earnings or other failures to meet our expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues, which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters and, to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future.

Due to these 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. Fluctuations in our results of operations are also likely to affect the market price of our common stock, if our operating results differ from expectations of investors or securities analysts, and may not be related to or indicative of our long-term performance.

The recent accounting pronouncement requiring employee stock-based payments to be accounted for using a fair-value method will materially reduce our reported operating margins, operating income, net income and net income per share

We currently account for the issuance of stock options under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which eliminates the alternative to use the intrinsic value method of accounting under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supersedes APB No. 25, and its related implementation guidance. SFAS 123R will require us to measure all employee stock-based compensation awards using a fair value method and record such amounts as an expense in our statement of operations. We adopted SFAS 123R in our first quarter of 2006, beginning January 1, 2006. The additional expense associated with stock options will be substantial and will materially reduce our operating margins, operating income, net income and net income per share. These reductions in our operating results may result in a reduction to our stock price and market value, the magnitude of which cannot be determined. Note 1 of our “Notes to Consolidated Financial Statements” contains a detailed presentation of our current methods of accounting for stock-based compensation plans and includes pro forma fair value disclosures currently required under SFAS No. 123.

Variations in the size and timing of our customer orders and differing nature of our products and services could expose us to revenue fluctuations and higher operating costs

Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as SharePlex, can last from three to nine months, or longer, and often require pre-purchase evaluation periods and customer education, which can affect timing of orders. Further, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon current order volumes to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter.

Our product portfolio is engineered for a broad variety of operating system, database and application platforms, and having a diverse set of functions and features. Some products, such as our database management products and other component products, are directed at database administrators and are generally sold at lower price points, and we strive to generate demand for these products through our telesales organization and marketing programs designed to maximize lead generation and website traffic. Sales of other, enterprise-wide products, such as SharePlex, our application management offerings and products acquired from Vintela, require substantial time and effort from our sales and support staff as well as involvement by our professional services organizations and, to an increasing degree, our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. Historically, we have not placed significant reliance on large sales transactions in any given quarter, with a substantial volume of our revenues being driven from smaller transactions. However, if we encounter difficulty sustaining our component product volumes, and cannot generate a sufficient number of large customer orders, or if customers delay or cancel such orders in a particular quarter, our revenues and operating results may be adversely affected. For these reasons, we face increasing complexity in building and sustaining the optimum combination of field and inside sales personnel to address the various and changing sales and distribution characteristics of our products, which in turn impacts our ability to manage and minimize our sales and marketing costs.

We rely heavily on our direct sales activities for license and services revenues, including renewals of annual post-contract technical support services. We have in the past restructured or made other adjustments to our sales force in response to management changes, product changes, performance issues and other internal considerations. We recently made some adjustments to our coverage model to increase focus on global and other major accounts. We’ve also recently increased headcount in our telesales and sales associate groups and relocated our U.S. support billing personnel. These changes can result in a temporary lack of focus and reduced productivity, which could have temporary negative effects on our license or services revenues.

Accordingly, if our revenue growth rates slow or our revenues decline, or if we fail to efficiently correlate our sales and marketing resources to our various products and their differing sales and distribution strategies, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

Many of our products are vulnerable to direct competition from Oracle and other platform vendors

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings and expand their development products possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and has continued to increase with Oracle’s introduction of the next version of its database, known as Oracle 10g. Oracle 10g has enhanced capabilities in the functions competitive with SharePlex, Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight. We believe increased competition from Oracle has materially depressed our SharePlex and Quest Central for Oracle revenues over the last four years. Oracle recently announced general availability of products to compete with our market leading Code Quality and Optimization products for Oracle databases, which contribute significantly to our revenues and net income.

In some cases these types of platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

Our migration products for Microsoft’s Active Directory and Exchange are vulnerable to fluctuations in the rate at which customers migrate to these products

Our products for the migration, administration and management of Microsoft’s Active Directory and Exchange products currently contribute approximately one-third of our revenue from software license sales and have been the primary contributors to license revenue growth in fiscal 2005 and 2004. Our ability to sell licenses for our Active Directory and Exchange migration products depends in part on the rate at which customers migrate to newer versions of Microsoft’s Windows 2000 or Windows XP operating system or to newer versions of Microsoft Exchange, and from other messaging platforms to Exchange. If these migration rates were to materially decrease, our license revenues from these migration products would likely decline.

Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors introduce

competitive products or acquire or form strategic relationships with our competitors, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft, SAP and Siebel (now a part of Oracle). Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by either introducing products that compete with our products or acquiring or forming strategic alliances with our competitors. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers, and may be in better position to withstand and respond to the current factors impacting this industry. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.

Failure to develop and sustain additional distribution channels in the future may adversely affect our ability to grow revenues

We intend to direct additional efforts to drive domestic and international revenue growth through sales of our products and services through indirect distribution channels, such as global hardware and software vendors, systems integrators, or value-added resellers. Our ability to increase future revenues depends on our ability to expand our indirect distribution channels. If we fail in our efforts to maintain, expand and diversify our indirect distribution channels, our business, results of operations and financial condition could be adversely affected. Increasing activity in indirect distribution channels will present a number of additional risks, including:

  •   we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities, which may result in lost sales and customer confusion;

  •   our channel partners can cease marketing and distributing our products and services with limited or no notice and with little or no penalty;

  •   our channel partners may not be able to effectively sell our products and services;

  •   our channel partners may experience financial difficulties that might lead to delays, or even default, in their payment obligations;

  •   we may not be able to recruit additional channel partners, or replace any of our existing ones; and

  •   our channel partners may also offer competitive products and services, and may not give priority to marketing our products or services.

Failure to maintain effective internal control over financial reporting could adversely affect the price of our common stock

Pursuant to rules adopted by the SEC implementing Section 404 of the Sarbanes-Oxley Act of 2002, we are required to assess the effectiveness of our internal controls over financial reporting and report whether such internal controls are effective. Our auditors must issue an attestation report on such assessment. Accordingly, we have undertaken to evaluate, test and remediate, if necessary, our internal controls pursuant to a clearly defined internal plan and schedule. Although we believe that our efforts will enable us to provide the required report and our independent auditors to provide the required attestation as of the end of each fiscal year, there can be no assurance that our assessment will conclude that our internal controls over financial reporting are effective.

Future weaknesses or significant deficiencies in our internal control over financial reporting could adversely affect the market price of our common stock.

Intense competition in the markets for our products could adversely affect our results of operations

The markets for our products are highly competitive. As a result, our future success will be affected by our ability to, among other things, outperform our competitors in meeting the needs of current and prospective customers and identifying and addressing new technological and market opportunities. Our competitors may develop more advanced technology, adopt more aggressive pricing policies and undertake more effective sales and marketing campaigns and may be able to leverage more extensive financial, technical or partner resources. If we are unable to maintain our competitive position, our revenues may decline and our operating results may be adversely affected.

Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates

Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.

Our international operations and our planned expansion of our international operations expose us to certain risks

We maintain research and development operations primarily in Canada, Australia, Russia and Israel, and continue to expand our international sales activities as part of our business strategy. As a percentage of total revenues, revenues outside of North America were 34% and 31% for the years ended December 31, 2005 and 2004, respectively. As a result, we face increasing risks from our international operations, including, among others:

  •   difficulties in staffing, managing and operating our foreign operations;

  •   difficulties in coordinating the activities of our geographically dispersed and culturally diverse operations;

  •   difficulties in adapting our existing foreign operations, particularly in Asia, to the control structure and requirements of a US public entity given those Asian countries historical environment and their cultural approach to conducting business;

  •   longer payment cycles and difficulties in collecting accounts receivable;

  •   seasonal reductions in business activity during the summer months in EMEA and in other periods in other countries;

  •   increased financial accounting and reporting burdens and complexities;

  •   difficulties in hedging foreign currency transaction exposures;

  •   limitations on future growth or inability to maintain current levels of revenue from international operations if we do not invest sufficiently in our international operations;

  •   potentially adverse tax consequences;

  •   potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;

  •   delays in localizing our products;

  •   political unrest or terrorism, particularly in areas in which we have facilities;

  •   our ability to adapt and conform to accepted local business practices and customs, including providing letters of credit or other forms of support to or for the benefit of our subsidiaries or resellers;

  •   compliance with a wide variety of complex foreign laws and treaties, including employment restrictions; and

  •   compliance with licenses, tariffs and other trade barriers.

Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that investment and additional resources required in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.

Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies. For example, we acquired Imceda Software, Inc., (“Imceda”), Vintela, Inc., (“Vintela”) and Wingra Technologies, Inc., (“Wingra”) during 2005. Acquisitions require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. In addition, integrating multiple acquisitions at the same time, which we must now do with Vintela and Imceda, places significant strain on our existing personnel and resources. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves and reduce our financial flexibility. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.

Accounting for equity investments in companies may affect our operating results

We have made equity investments in other software companies and a private equity fund. Some of these investments have not performed well, and we’ve recognized accounting charges due to the impairment of the value of our investments. Other investments have performed better, including our investment in one software company, which was subsequently acquired by a publicly traded company. We regularly consider opportunities to make equity investments in other companies focused on software development or marketing activities, and expect from time to time to complete additional investments. These investments are risky because the market for the products and technologies being developed by these companies are typically in the early stages and may never materialize. In addition, we have made at least one investment in a private software company that has required us to consolidate the results of operations of this company into ours and we may determine in the future to invest in additional companies at similar levels. We may be required to incur charges for the impairment of value of our investments. We will be required to closely monitor the financial health of the private companies in which we hold or make equity investments. If we are required to consolidate the operating results of these companies and they are unable to operate to a profit, our operating results may be adversely affected. For

investments accounted for under the equity method, we will also be required to record losses if we determine that an impairment exists.

We face risks associated with governmental contracting

We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of “open source” products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.

Our efforts to constrain costs may strain our management, administrative, operational and financial infrastructure

We are focused on increasing our operating margins. These efforts place a strain on our management, administrative, operational and financial infrastructure. Our ability to manage our increasingly complex operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. There can be no guarantees that we will be successful in achieving our profitability targets in any future quarterly or annual period.

We may not generate increased business from our current customers, which could slow our revenue growth in the future

Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.

Failure to develop or leverage strategic relationships could harm our business by denying us selling opportunities and other benefits

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.

Failure to adequately protect our intellectual property rights could harm our competitive position

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to establish and protect our proprietary rights in our products and services.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend

Our success and ability to compete are also dependent upon our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. Any future third party claim could be time consuming, divert management’s attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.

Our business may be adversely affected if our software contains errors or security flaws

The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors or security flaws will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate them with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or security flaws or if we fail to meet our customers’ expectations. As a result of the foregoing, we could experience:

  •   loss of or delay in revenues and loss of market share;

  •   loss of customers;

  •   damage to our reputation;

  •   failure to achieve market acceptance;

  •   diversion of development resources;

  •   increased service and warranty costs;

  •   legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and

  •   increased insurance costs.

The detection and correction of any security flaws can be time consuming and costly. In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products

Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.

Natural disasters or power outages could disrupt our business

A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods, fires and similar events, as well as from power outages. We have in the past experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.

Failure to attract and retain personnel may negatively impact our business

Our ability to manage the operation of our business and our future success depend on our ability to attract, motivate and retain qualified employees. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other officers and key employees. As our business grows, we will need to hire additional administrative, sales and marketing, support, research and development and other personnel. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered.

We have historically used stock-based compensation as an important tool to attract and retain employees, generally through stock options granted under our stock incentive plans. The number of options available for grant under our stock incentive plans is limited and any future increase would require shareholder approval. There can be no guarantees that we will be able to obtain shareholder approval for required future increases in the number of shares authorized under our stock incentive plans. In addition, when we change the way we account

for stock options as a result of pending changes in accounting rules, we may reduce our reliance on the use of stock options, which may negatively affect our ability to recruit and retain qualified personnel.

Item 1B. Unresolved Staff Comments

None.

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