Form 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

Form 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2006

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

(Commission file number: 000-30931)

 


 

OPNET TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

 


 

Delaware   7372   52-1483235
(State or other jurisdiction of incorporation or organization)  

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification No.)

 

7255 Woodmont Avenue

Bethesda, MD 20814

(Address of principal executive office)

 

(240) 497-3000

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer or large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer    ¨        Accelerated filer    x        Non-accelerated filer    ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

The number of shares of the registrant’s Common Stock outstanding on October 31, 2006 was 20,460,991.

 



Table of Contents

TABLE OF CONTENTS

 

                 Page

            PART I     
            FINANCIAL INFORMATION     
ITEM                 
1.     Condensed Consolidated Financial Statements (unaudited)     
          Condensed Consolidated Balance Sheets as of September 30, 2006 and March 31, 2006    3
          Condensed Consolidated Statements of Operations for the Three and Six Months Ended September 30, 2006 and 2005    4
          Condensed Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2006 and 2005    5
          Notes to Condensed Consolidated Financial Statements    6
2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations    15
3.     Quantitative and Qualitative Disclosures About Market Risk    25
4.     Controls and Procedures    25
            PART II     
            OTHER INFORMATION     
1.     Legal Proceedings    26
1A.     Risk Factors    26
2.     Unregistered Sales of Securities and Use of Proceeds    33
4.     Submission of Matters to a Vote of the Security Holders    34
6.     Exhibits    34
        Signatures    35
        Exhibit Index    36

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. Condensed Consolidated Financial Statements

 

OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(unaudited)

 

    

September 30,

2006


   

March 31

2006


 
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 44,112     $ 66,710  

Marketable securities

     42,316       19,151  

Accounts receivable, net of $144 and $140 in allowance for doubtful accounts at September 30, and March 31, 2006, respectively

     16,900       12,765  

Unbilled accounts receivable

     4,123       2,616  

Deferred income taxes, prepaid expenses and other current assets

     3,307       2,339  
    


 


Total current assets

     110,758       103,581  

Property and equipment, net

     6,322       6,088  

Intangible assets, net

     1,245       1,240  

Goodwill

     14,639       14,639  

Deferred income taxes and other assets

     1,673       1,799  
    


 


Total assets

   $ 134,637     $ 127,347  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY                 

Current liabilities:

                

Accounts payable

   $ 423     $ 1,019  

Accrued liabilities

     7,543       8,539  

Deferred and accrued income taxes

     361       527  

Current portion of notes payable

     —         47  

Deferred rent

     138       89  

Deferred revenue

     18,881       15,800  
    


 


Total current liabilities

     27,346       26,021  
    


 


Accrued liabilities

     127       —    

Notes payable

     —         103  

Deferred rent

     950       1,033  

Deferred revenue

     706       779  

Deferred income tax

     14       13  
    


 


Total liabilities

     29,143       27,949  
    


 


Commitments and contingencies (Note 9)

                

Stockholders’ equity:

                

Common stock-par value $0.001; 100,000 authorized; 26,974 and 26,738 shares issued at September 30 and March 31, 2006, respectively; 20,396 and 20,194 shares outstanding at September 30 and March 31, 2006, respectively

     27       27  

Additional paid-in capital

     83,242       80,984  

Deferred compensation

     —         (393 )

Retained earnings

     30,213       26,850  

Accumulated other comprehensive income (loss)

     190       (345 )

Treasury stock, at cost – 6,577 and 6,543 shares at September 30, and March 31, 2006, respectively

     (8,178 )     (7,725 )
    


 


Total stockholders’ equity

     105,494       99,398  
    


 


Total liabilities and stockholders’ equity

   $ 134,637     $ 127,347  
    


 


 

See accompanying notes to condensed consolidated financial statements.

 

3


Table of Contents

OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

    

Three Months Ended

September 30,


  

Six Months Ended

September 30,


 
     2006

   2005

   2006

   2005

 

Revenue:

                             

New software licenses

   $ 11,183    $ 7,584    $ 21,509    $ 14,210  

Software license updates and technical support

     6,983      5,951      13,437      11,724  

Professional services

     5,451      4,729      11,303      8,807  
    

  

  

  


Total revenue

     23,617      18,264      46,249      34,741  
    

  

  

  


Cost of revenue:

                             

New software licenses

     195      182      321      362  

Software license updates and technical support

     761      673      1,468      1,293  

Professional services

     3,782      3,170      7,523      6,444  

Amortization of acquired technology

     186      192      377      383  
    

  

  

  


Total cost of revenue

     4,924      4,217      9,689      8,482  
    

  

  

  


Gross profit

     18,693      14,047      36,560      26,259  
    

  

  

  


Operating expenses:

                             

Research and development

     5,373      4,677      10,589      9,188  

Sales and marketing

     8,904      6,258      16,967      12,176  

General and administrative

     2,620      3,091      5,388      6,041  
    

  

  

  


Total operating expenses

     16,897      14,026      32,944      27,405  
    

  

  

  


Income (loss) from operations

     1,796      21      3,616      (1,146 )

Interest and other income, net

     988      614      1,891      1,127  
    

  

  

  


Income (loss) before provision for income taxes

     2,784      635      5,507      (19 )

Provision (benefit) for income taxes

     1,057      195      2,144      (5 )
    

  

  

  


Net income (loss)

   $ 1,727    $ 440    $ 3,363    $ (14 )
    

  

  

  


Basic net income (loss) per common share

   $ 0.09    $ 0.02    $ 0.17    $ (0.00 )
    

  

  

  


Diluted net income (loss) per common share

   $ 0.08    $ 0.02    $ 0.16    $ (0.00 )
    

  

  

  


Basic weighted average common shares outstanding

     20,266      20,311      20,228      20,336  
    

  

  

  


Diluted weighted average common shares outstanding

     21,019      20,552      20,920      20,336  
    

  

  

  


 

 

See accompanying notes to condensed consolidated financial statements.

 

4


Table of Contents

OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Six Months Ended
September 30,


 
     2006

    2005

 

Cash flows from operating activities:

                

Net income (loss)

   $ 3,363     $ (14 )

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

                

Depreciation and amortization

     1,157       1,164  

Provision for losses on accounts receivable

     4       (7 )

Deferred income taxes

     110       815  

Non-cash stock-based compensation expense

     864       12  

Loss on disposition of fixed assets

     5       2  

Changes in assets and liabilities:

                

Accounts receivable

     (5,646 )     (568 )

Prepaid expenses and other current assets

     (962 )     (205 )

Other assets

     42       29  

Accounts payable

     (596 )     (674 )

Accrued liabilities

     (970 )     (530 )

Accrued income taxes

     (196 )     (209 )

Deferred revenue

     3,008       7  

Tax benefit from exercise of stock options

     —         (625 )

Deferred rent

     (34 )     22  
    


 


Net cash provided by (used in) operating activities

     149       (781 )
    


 


Cash flows from investing activities:

                

Purchase of property and equipment

     (1,020 )     (616 )

Purchase of investments

     (49,888 )     (12,727 )

Proceeds from sale/maturity of investments

     26,700       36,368  

Acquired technology

     (281 )     —    
    


 


Net cash (used in) provided by investing activities

     (24,489 )     23,025  
    


 


Cash flows from financing activities:

                

Payment of note payable

     (150 )     —    

Acquisition of treasury stock

     (453 )     (1,094 )

Proceeds from exercise of common stock options

     1,059       50  

Tax benefit from exercise of stock options

     364       —    

Issuance of common stock under employee stock purchase plan

     364       239  
    


 


Net cash provided by (used in) financing activities

     1,184       (805 )
    


 


Effect of exchange rate changes on cash and cash equivalents

     558       (198 )
    


 


Net (decrease) increase in cash and cash equivalents

     (22,598 )     21,241  

Cash and cash equivalents, beginning of period

     66,710       38,171  
    


 


Cash and cash equivalents, end of period

   $ 44,112     $ 59,412  
    


 


 

See accompanying notes to condensed consolidated financial statements.

 

5


Table of Contents

OPNET TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

 

1. Organization and Significant Accounting Policies

 

Organization. OPNET Technologies, Inc., (hereafter, the Company or OPNET), is a provider of management software for networks and applications. The Company’s solutions address: application performance management, capacity planning and design, network operations, and network research and development. The Company sells products to corporate enterprises, government and defense agencies, network service providers, and network equipment manufacturers. The Company markets product suites in North America primarily through a direct sales force and, to a lesser extent, several resellers and original equipment manufacturers. Internationally, the Company conducts research and development through a wholly-controlled subsidiary in Ghent, Belgium and markets products through wholly-owned subsidiaries in Paris, France; Frankfurt, Germany; Slough, United Kingdom; and Sydney, Australia; third-party distributors; and value-added resellers. The Company is headquartered in Bethesda, Maryland and has offices in Cary, North Carolina; Dallas, Texas; Santa Clara, California; and Nashua, New Hampshire.

 

The accompanying condensed consolidated financial statements include the Company’s results and the results of the Company’s wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. The interim condensed consolidated financial statements included herein are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, and applicable rules and regulations of the Securities and Exchange Commission, or SEC regarding interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended March 31, 2006 filed with the SEC. The March 31, 2006 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP. In the opinion of management, these interim condensed consolidated financial statements reflect all adjustments of a normal and recurring nature necessary to present fairly the Company’s results for the interim periods. The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amount of revenue and expenses during the reporting periods. Actual results could differ from those estimates. In addition, the Company’s operating results for the three and six months ended September 30, 2006 may not be indicative of the operating results for the full fiscal year or any other future period.

 

Supplemental Cash Flow Information

 

     Three Months Ended
September 30,


   Six Months Ended
September 30,


         2006    

       2005    

       2006    

       2005    

     (in thousands, except per share data)

Cash paid during the fiscal year:

                           

Income tax

   $ 1,954    $ 73    $ 2,070    $ 123

Interest

   $ 22    $ 36    $ 74    $ 64

 

2. Recently Issued Accounting Pronouncements

 

In June 2006, the Financial Accounting Standards Board, or FASB, issued FASB interpretation, or FIN, No. 48, “Accounting for Uncertainty in Income Taxes,” which is effective for fiscal years beginning after

 

6


Table of Contents

December 15, 2006. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with Statement of Financial Accounting Standards, or SFAS, No. 109, “Accounting for Income Taxes.” This interpretation illustrates how a company should recognize, measure, present and disclose uncertain tax positions that the Company has taken or expects to take on a tax return in its financial statements. The Company is currently evaluating the impact of adopting FIN No. 48 on its financial position and results of operations.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” or SFAS No. 157. This standard clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company has not yet determined the impact that the implementation of SFAS No. 157 will have on their results of operations or financial condition.

 

In September 2006, the Securities and Exchange Commission, or SEC, issued Staff Accounting Bulletin No. 108, Topic 1N, or SAB 108. SAB 108 interprets the staff’s views regarding the process of quantifying financial statement misstatements and is effective for financial statements issued for fiscal years ending after November 15, 2006. The Company will apply the guidance provided by SAB 108 as necessary.

 

In September 2006, FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)”, or SFAS No. 158. The statement requires an entity to recognize on its balance sheet an asset for a defined benefit postretirement plan’s overfunded status or a liability for a plan’s underfunded status, measure a plan’s assets and obligations as of the end of the employer’s fiscal year and recognize changes in the funded status of a plan in comprehensive income (a component of shareholders’ equity) in the year in which the changes occur. The statement also expands the disclosure requirements associated with defined benefit postretirement plans. The statement does not change the calculation of the net periodic benefit cost to be included in net income. The statement is effective for fiscal years ending after December 15, 2006, except for the provision that a plan’s assets and obligations be measured as of the end of the employer’s fiscal year which is effective for fiscal years ending after December 15, 2008. The Company’s results of operations and financial condition will not be impacted by SFAS No. 158.

 

3. Stock-Based Compensation

 

The Company’s Amended and Restated 2000 Stock Incentive Pan, or 2000 Plan, provides for the granting of incentive and non-qualified stock options and restricted stock to purchase up to 5,540 shares of the Company’s common stock. The number of shares available for issuance will automatically increase on the first trading day of each calendar year by an amount equal to the lesser of 3% of the shares of common stock outstanding on the last trading day of the preceding calendar year, or an amount determined by the Board of Directors, not to exceed an annual increase of 1,000 shares. The Board of Directors voted not to increase the number of shares for issuance on the first trading day of calendar year 2006. Options are granted for terms up to ten years and generally vest over periods ranging from one to six years from the date of the grant. Restricted stock granted under this plan generally vests over four years from the date of the grant. New option grants and restricted stock grants are granted from new shares of the Company’s common stock.

 

The Company’s 1993 Incentive Stock Option Plan, or 1993 Plan, provides for the granting of incentive stock options to purchase up to 3,000 shares of common stock of the Company. Options are granted for terms of up to ten years, and generally vest over periods ranging from one to six years from the date of the grant. The Board of Directors approved a resolution to make no further grants for options or stock awards under the 1993 Plan upon approval of the 2000 Plan.

 

7


Table of Contents

In March 2000, the Board of Directors approved the adoption of the 2000 Director Stock Option Plan, which provides for the automatic annual granting of options to purchase stock to the Company’s directors, who are not its employees, for up to a total of 225 shares of common stock of the Company.

 

During fiscal year 2001, the Board of Directors approved the adoption of the 2000 Employee Stock Purchase Plan, or ESPP, which provides every employee, including members of the Board of Directors who are employees, to collectively purchase up to a total of 300 shares of common stock of the Company. An employee may authorize a payroll deduction up to a maximum of 10% of her or his compensation during the plan period. The purchase price for each share purchased is the lesser of 85% of the closing price of the common stock on the first or last day of the plan period and is considered compensatory under SFAS 123R, “Share-based Payments.”

 

On April 1, 2006, the Company adopted SFAS 123R, which revised SFAS 123, “Accounting for Stock-Based Compensation.” Prior to fiscal year 2007 and the adoption of SFAS 123R, the Company followed the intrinsic value method of accounting for its stock-based employee compensation arrangements as defined by Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees.”

 

SFAS 123R requires an entity to recognize an expense within its income statement for all share-based payment arrangements, which includes employee stock option plans, restricted stock grants, and ESPP. The Company has elected to continue straight-line amortization of stock-based compensation expense for the entire award over the service period since the awards have only service conditions and graded vesting. The Company adopted SFAS 123R under the modified prospective method. Under the modified prospective method, SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after April 1, 2006 as well as to the nonvested portion of awards outstanding as of April 1, 2006. Stock based compensation for awards granted prior to April 1, 2006 is based upon the grant date fair value of such compensation as determined under the pro forma provisions of SFAS No 123.

 

Prior to the adoption of SFAS 123R, the Company reported tax benefits from the exercise of stock options as an operating cash flow in the consolidated statement of cash flows. In the period beginning April 1, 2006, excess tax benefits from the exercise of stock options are presented as a cash flow from financing activity. For the three months ended September 30, 2006, excess tax benefits from the exercise of stock options were $154. There were no excess tax benefits for the three months ended September 30, 2005. For the six months ended September 30, 2006 and 2005, excess tax benefits from the exercise of stock options were $364 and $7, respectively.

 

A summary of the total stock based compensation expense for the three and six months ended September 30, 2006 is as follows:

 

     Three Months Ended
September 30, 2006


   Six Months Ended
September 30, 2006


     (in thousands)

Stock options

   $ 478    $ 695

Restricted Stock

     47      76

ESPP

     54      92
    

  

Total stock based compensation

   $ 579    $ 864
    

  

 

The nonvested stock based compensation expense of $1,773 is comprised of $918 related to unvested stock options, $768 related to unvested restricted stock and $87 related to the ESPP. The cost of the nonvested stock options, nonvested restricted stock and ESPP are expected to be recognized over a weighted average period of 1.2 years, 3.6 years and 3 months, respectively.

 

Stock Options

 

The Company’s stock option programs are accounted for as equity awards. The expense is based on the grant-date fair value of the options granted, and is recognized over the requisite service period.

 

8


Table of Contents

A summary of the option transactions for the three and six months ended September 30, 2006 and 2005 is as follows:

 

     Three Months Ended September 30, 2006

     Options

    Weighted
Average
Exercise Price


   Weighted
Average
Remaining
Contract Life
(Years)


   Aggregate
Intrinsic
Value


   Weighted
Average
Grant Date
Fair Value


     (In thousands)

Outstanding at beginning of period

   3,125     $ 10.46    —        —      $ 7.37

Granted

   30     $ 13.25    —      $ 398    $ 2.53

Exercised

   (53 )   $ 7.62    —      $ 272    $ 5.44

Forfeited or expired

   (11 )   $ 11.15    —      $ 121    $ 7.81
    

 

                  

Outstanding at end of period

   3,091     $ 10.53    5.41    $ 32,548    $ 7.36
    

 

                  

Exercisable at end of period

   2,885     $ 10.60    5.21    $ 30,574    $ 7.50
    

 

                  

Nonvested at end of period

   206     $ 9.59    8.17    $ 1,974    $ 5.46
    

 

                  
     Three Months Ended September 30, 2005

     Options

    Weighted
Average
Exercise Price


   Weighted
Average
Remaining
Contract Life
(Years)


   Aggregate
Intrinsic
Value


   Weighted
Average
Grant Date
Fair Value


     (In thousands)

Outstanding at beginning of period

   3,526     $ 10.11    —        —      $ 7.14

Granted

   30     $ 8.61    —        —      $ 4.31

Exercised

   (3 )   $ 5.75    —      $ 5    $ 4.02

Forfeited or expired

   (4 )   $ 10.54    —      $ 1    $ 7.38
    

 

                  

Outstanding at end of period

   3,549     $ 10.10    5.80    $ 2,931    $ 7.12
    

 

                  

Exercisable at end of period

   2,757     $ 10.34    5.29    $ 2,492    $ 7.36
    

 

                  

Nonvested at end of period

   792     $ 9.28    7.55    $ 439    $ 6.28
    

 

                  
     Six Months Ended September 30, 2006

     Options

    Weighted
Average
Exercise Price


   Weighted
Average
Remaining
Contract Life
(Years)


   Aggregate
Intrinsic
Value


   Weighted
Average
Grant Date
Fair Value


     (In thousands)

Outstanding at beginning of period

   3,233     $ 10.37    —        —      $ 7.31

Granted

   30     $ 13.25    —      $ 398    $ 2.53

Exercised

   (146 )   $ 7.23    —      $ 799    $ 5.11

Forfeited or expired

   (26 )   $ 11.88    —      $ 306    $ 8.20
    

 

                  

Outstanding at end of period

   3,091     $ 10.53    5.41    $ 32,548    $ 7.36
    

 

                  

Exercisable at end of period

   2,885     $ 10.60    5.21    $ 30,574    $ 7.50
    

 

                  

Nonvested at end of period

   206     $ 9.59    8.17    $ 1,974    $ 5.46
    

 

                  

 

9


Table of Contents
     Six Months Ended September 30, 2005

     Options

    Weighted
Average
Exercise
Price


   Weighted
Average
Remaining
Contract
Life
(Years)


   Aggregate
Intrinsic
Value


   Weighted
Average
Grant Date
Fair Value


     (In thousands)

Outstanding at beginning of period

   3,573     $ 10.10    —        —      $ 7.13

Granted

   30     $ 8.61    —        —      $ 4.31

Exercised

   (14 )   $ 3.56    —      $ 59    $ 2.45

Forfeited or expired

   (40 )   $ 10.80    —      $ 5    $ 7.58
    

 

                  

Outstanding at end of period

   3,549     $ 10.10    5.80    $ 2,931    $ 7.12
    

 

                  

Exercisable at end of period

   2,757     $ 10.34    5.29    $ 2,492    $ 7.36
    

 

                  

Nonvested at end of period

   792     $ 9.28    7.55    $ 439    $ 6.28
    

 

                  

 

To estimate the grant-date fair value of its stock options, the Company uses the Black-Scholes option-pricing model, consistent with that used for pro forma disclosure under SFAS No 123. The Black-Scholes model estimates the per share fair value of an option on its date of grant based on the following: the option’s exercise price; the price of the underlying stock on the date of grant; the estimated dividend yield; a “risk-free” interest rate; the estimated option term; and the expected volatility. For the “risk-free” interest rate, the Company uses a U.S. Treasury Bond due in a number of years equal to the option’s expected term. To estimate expected volatility, the Company analyzes the historic volatility of its common stock.

 

The weighted average fair value at date of grant for options granted during the three months ended September 30, 2006 was $2.53. The weighted average assumptions are as follows:

 

     Three and Six Months
Ended September 30,
2006


    Three and Six Months
Ended September 30,
2005


 

Risk-free interest rate

   5.02 %   3.90 %

Expected dividend yield

   0.00 %   0.00 %

Expected life

   1 year     4 years  

Volatility factor

   43 %   61 %

 

Compensation cost for option grants is recognized on a straight-line basis over the requisite service period for the entire award (from the date of grant through the period of the last separately vesting portion of the grant). Compensation cost is recognized within the income statement in the same expense line as the cash compensation paid to the respective employees. SFAS 123R also requires the Company to estimate forfeitures in calculating the expense related to stock-based compensation. The Company has concluded that its historical forfeiture rate is the best measure to estimate future forfeitures of granted stock options. The impact on compensation cost due to changes in the expected forfeiture rate will be recognized in the period that they become known. To date there has been no change in the Company’s forfeiture rate of 5%, so there has been no impact on compensation cost.

 

During the three months ended September 30, 2006 and 2005, respectively, we received proceeds of approximately $401 and $15 and issued 53 and 3 shares of common stock, pursuant to employee exercises of stock options. During the six months ended September 30, 2006 and 2005, respectively, we received proceeds of approximately $1,059 and $50 and issued 147 and 14 shares of common stock, pursuant to employee exercises of stock options.

 

10


Table of Contents

Because the Company adopted SFAS 123R using the modified prospective basis, the prior interim period has not been restated. The following table sets forth the effect on net income and basic and diluted earnings per share as if the Company had applied the fair value recognition provisions for its stock-based compensation arrangements for the three and six month periods ended September 30, 2005:

 

    

Three Months Ended

September 30, 2005


   

Six Months Ended

September 30, 2005


 
     (In thousands, except per share data)  

Net income (loss)

   $ 440     $ (14 )

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

     3       12  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

     (444 )     (885 )
    


 


Pro forma net loss

   $ (1 )   $ (887 )
    


 


Basic net income (loss) per common share:

                

As reported

   $ 0.02     $ 0.00  

Pro forma

   $ (0.00 )   $ (0.04 )

Diluted net income (loss) per common share:

                

As reported

   $ 0.02     $ 0.00  

Pro forma

   $ (0.00 )   $ (0.04 )

 

On October 26 2005, the Company’s Board of Directors approved the accelerated vesting of all unvested options that had an exercise price of $11.75 or greater and were held by current employees, including executive officers. This accelerated vesting affected options with respect to 254 shares of the Company’s common stock that was not vested under such options, and was effective for stock options outstanding as the close of business on October 26, 2005.

 

The Board of Director’s primary purpose in accelerating vesting was to eliminate future stock-based employee compensation expense that the Company would have otherwise recognized in its consolidated statement of operations with respect to these accelerated options once SFAS 123R became effective. Furthermore, the Board of Directors concluded that the retention value of the unvested portion of these options was minimal given the then-current market price for the Company’s common stock. Because these options have exercise prices well in excess of the Company’s then-current stock price which was $8.13 at the close of business on October 26, 2005, as reported by the NASDAQ National market, the Board of Directors concluded that these options would not offer sufficient incentive to the employees to remain with the Company when compared to the future compensation expense that would have been attributable to the options. The estimated maximum future expense that was eliminated was approximately $922.

 

All of these options had an exercise price of $11.75, a grant date of October 23, 2003, and a vesting schedule that provided for pro rata annual vesting for 99.8% of the grants over five years from the date of the grant and for all cliff vesting for 0.2% of the grant in three years from the date of the grant. In the case of options held by executive officers of the Company, vesting was accelerated with respect to the following number of shares: Marc Cohen 48,000 shares.

 

Restricted Stock

 

The Company’s restricted stock grants are accounted for as equity awards. The expense is based on the closing price of its common stock on the award date, and is recognized on a straight-line basis over the requisite service period. The Company did not grant any restricted stock prior to February 2006. The restricted stock agreements do not contain any post-vesting restrictions.

 

11


Table of Contents

A summary of the restricted stock grants is as follows:

 

    

Three Months Ended

September 30, 2006


  

Six Months Ended

September 30, 2006


    

Restricted

Stock Grants


  

Weighted

Average

Grant Fair

Value


  

Restricted

Stock Grants


  

Weighted

Average

Grant Fair

Value


     (in thousands, except per
share data)
   (in thousands except per
share data)

Nonvested at beginning of period

   61    $ 9.85    43    $ 9.39

Granted

   24    $ 12.20    42    $ 11.68

Vested

   —        —      —        —  

Forfeited

   —        —      —        —  
    
  

  
  

Nonvested at end of period

   85    $ 10.51    85    $ 10.51
    
  

  
  

 

4. Intangible Assets

 

Intangible assets consisted of the following:

 

     At September 30,
2006


    At March 31,
2006


 
     (in thousands)  

Acquired and purchased technology

   $ 2,547     $ 4,165  

Accumulated amortization

     (1,302 )     (2,925 )
    


 


Intangible assets, net

   $ 1,245     $ 1,240  
    


 


 

Acquired and purchased technology resulted in amortization expense for the three months ended September 30, 2006 and 2005 of $186 and $192, respectively and for the six months ended September 30, 2006 and 2005 of $377 and $383, respectively. Amortization expense from acquired technology is included in cost of revenue in the condensed consolidated statements of operations. The Company amortizes the intangible assets on a straight-line basis over their expected useful lives of three to five years. The Company currently expects amortization expenses attributable to these acquisitions of $723 in the fiscal year ending March 31, 2007, $543 in fiscal year ending March 31, 2008, and $356 in the fiscal year ending March 31, 2009.

 

5. Earnings Per Share

 

The following is a reconciliation of the amounts used in calculating basic and diluted net income per common share for the three and six months ended September 30, 2006 and 2005:

 

    

Three Months Ended

September 30,


  

Six Months Ended

September 30,


 
     2006

   2005

   2006

   2005

 
     (in thousands, except per share data)  

Net income (loss) (numerator):

                             

Basic and diluted net income (loss)

   $ 1,727    $ 440    $ 3,363    $ (14 )
    

  

  

  


Shares (denominator):

                             

Weighted average basic shares outstanding

     20,266      20,311      20,228      20,336  

Plus:

                             

Effect of other dilutive securities—options

     738      241      681      —    

Effect of other dilutive securities—unvested stock

     15      —        11      —    
    

  

  

  


Weighted average diluted shares outstanding

     21,019      20,552      20,920      20,336  
    

  

  

  


Net income (loss) per common share:

                             

Basic

   $ 0.09    $ 0.02    $ 0.17    $ (0.00 )

Diluted

   $ 0.08    $ 0.02    $ 0.16    $ (0.00 )

 

12


Table of Contents

6. Stockholders’ Equity

 

In January 2006, the Company amended the plan period end date for the ESPP, so that the plan periods would no longer end on the last day of the calendar quarter. In order to implement this change, the ESPP plan period that began January 1, 2006 was extended one month, to run from January 1, 2006 through July 31, 2006. As a result of this change in the plan period, there were no purchases of common stock under the ESPP in the three months ended June 30, 2006.

 

During the six months ended September 30, 2006 and 2005, respectively, employees purchased 47 and 35 shares of common stock under the ESPP, resulting in proceeds to us of approximately $365 and $239. During the three months ended September 30, 2005, employees did not purchase any share of common stock under the ESPP.

 

7. Business Segment and Geographic Information

 

The Company operates in one industry segment, the development and sale of computer software programs and related services. Revenue from transactions with United States government agencies were approximately 50% and 47% of total revenue for the three months ended September 30, 2006 and 2005, respectively. Revenue from transactions with United States government agencies were approximately 46% of total revenue for the six months ended September 30, 2006 and 2005, respectively. No single customer accounted for 10% or more of revenue for the three and six months ended September 30, 2005 and 2006. In addition, there was no country, with the exception of the United States, where aggregate sales accounted fro 10% or more of total revenue. Substantially all assets were held in the United States at September 30, and March 31, 2006. Revenue by geographic area and as a percentage of total revenue follows:

 

    

Three Months Ended

September 30,


   

Six Months Ended

September 30,


 
     2006

    2005

    2006

    2005

 
     (dollars in thousands)  

Geographic Area:

                                

United States

   $ 19,782     $ 14,407     $ 37,460     $ 27,414  

International

     3,835       3,857       8,789       7,327  
    


 


 


 


Total revenue

   $ 23,617     $ 18,264     $ 46,249     $ 34,741  
    


 


 


 


Geographic Area:

                                

United States

     83.8 %     78.9 %     81.0 %     78.9 %

International

     16.2 %     21.1 %     19.0 %     21.1 %
    


 


 


 


Total revenue

     100.0 %     100.0 %     100.0 %     100.0 %
    


 


 


 


 

8. Comprehensive Income (Loss)

 

Comprehensive income (loss) includes net income (loss), foreign currency translation adjustments, and unrealized gain or loss on marketable securities. The components of comprehensive income (loss), net of tax, are as follows:

 

     Three Months Ended
September 30,


   Six Months Ended
September 30,


 
         2006    

        2005    

       2006    

        2005    

 
     (in thousands)  

Net income (loss)

   $ 1,727     $ 440    $ 3,363     $ (14 )

Foreign currency translation adjustments

     228       —        558       (242 )

Unrealized (loss) gain on marketable securities

     (10 )     14      (24 )     44  
    


 

  


 


Total comprehensive income (loss)

   $ 1,945     $ 454    $ 3,897     $ (212 )
    


 

  


 


 

13


Table of Contents

9. Commitments and Contingencies

 

On September 27, 2004, the Company received notice of a lawsuit filed by Compuware Corporation, in the United States District Court for the Eastern District of Michigan, alleging patent infringement and seeking injunctive relief and unspecified monetary damages. On February 6, 2006, the Company filed a lawsuit against Compuware Corporation in Montgomery County, Maryland, Circuit Court, seeking damages and injunctive relief for Compuware’s misappropriation and misuse of the Company’s trade secrets, confidential and proprietary information and unfair competition; however, the lawsuit was not served on Compuware. On April 10, 2006, the Company signed a confidential settlement agreement with Compuware Corporation that amicably resolved all disputed matters in the lawsuits filed by each company in Michigan and in Maryland on terms the Company believes are favorable to it. Specifically, no material amounts were exchanged by the parties and the settlement agreement did not entail a royalty or licensing agreement between the parties.

 

The Internal Revenue Service, or IRS, is examining the Company’s federal corporate income tax returns for fiscal 2002 and 2003. While the IRS examination of its returns is not final at this time, the Company has reached an agreement with respect to the amount of research and development tax credits that it claimed on its tax returns for those years. As a result of this agreement, the Company reduced the amount of the research and development tax credits claimed on its tax returns for fiscal 2002 and 2003 by approximately $350. As a result, the quarter ended December 31, 2004 of fiscal 2005 tax provision reflected the reversal of approximately $350 of previously claimed research and development tax credits. The IRS also asserted tax deficiencies related to the timing of revenue reported on its tax returns for fiscal 2002 and 2003. The IRS has asserted that revenue associated with certain contracts reported on its fiscal year 2003 tax return should have been included in taxable income on its tax return for the fiscal 2002. The Company does not believe any tax deficiencies related to the timing of reporting revenue will be material to the financial statements.

 

The Company is involved in other claims and legal proceedings arising from normal operations. The Company does not expect these matters, individually or in the aggregate, to have a material effect on the Company’s financial condition, results of operations, or cash flows.

 

10. Treasury Stock

 

On January 31, 2005, the Company announced that the Board of Directors had authorized the repurchase of up to 1,000 shares of the Company’s common stock from time to time on the open market or in privately negotiated transactions. This stock repurchase program does not have a specified termination date. Any repurchased shares will be available for use in connection with the Company’s stock plans or other corporate purposes. The Company expended $453 and $733 to purchase 34 and 90 shares during the three months ended September 30, 2006 and 2005, respectively, at an average price of $13.33 and $8.14. The Company expended $453 and $1,094 to purchase 34 and 135 shares during the six months ended September 30, 2006 and 2005, respectively, at an average price of $13.33 and $8.08. As of September 30, 2006, the Company had repurchased 444 shares of common stock under this program.

 

14


Table of Contents

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (in thousands, except per share data)

 

The following discussion and analysis relate to our financial condition and results of operations for the three and six months ended September 30, 2006 and 2005, and should be read in conjunction with the condensed consolidated financial statements and the related notes included elsewhere in this report. You should also read the following discussion and analysis in conjunction with the consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in the Annual Report on Form 10-K for the year ended March 31, 2006, filed with the SEC. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under Item 1A – “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.

 

Overview

 

OPNET Technologies, Inc. is a provider of management software for networks and applications. Our products address application performance management, network configuration management, capacity planning, and network research and development. Our customers include corporate enterprises, government and defense agencies, network service providers, and network equipment manufacturers. Our products are designed to help customers make better use of resources, reduce operational problems and improve competitiveness.

 

We operate in one reportable industry segment, the development and sale of computer software programs and related services. Our operations are principally in the United States, and we have subsidiaries in Australia, Belgium, France, Germany and the United Kingdom. We primarily depend upon our direct sales force to generate revenue in the United States. Sales outside the United States are made through our international sales team as well as third-party distributors and value-added resellers, who generally are responsible for providing technical support and service to customers within their territory.

 

Our revenue is derived from three primary sources: (1) new software licenses, (2) software license updates and technical support, and (3) professional services, which include consulting and training services. New software license revenue represents all fees earned from granting customers licenses to use our software, and exclude revenue derived from software license updates, which are included in software license updates and technical support revenue. Our software master license agreement provides our customers with the right to use the software either perpetually, which we refer to as perpetual licenses, or during a defined term, generally for two to four years, which we refer to as term licenses. For the six months ended September 30, 2006, perpetual licenses represented approximately 99% of software license transactions. Substantially all of our software license arrangements include both perpetual licenses and software license updates and technical support. Software license updates and technical support revenue represent fees associated with the sale of unspecified license updates and technical support under our maintenance agreements. We offer professional services, under both time and material and fixed-price agreements, primarily to facilitate the adoption of the technology.

 

We consider our consulting services business to be an integral part of the business model as it is centered on our software product offerings. Because the consulting services business facilitates the adoption of our solutions, we believe that it ultimately generates additional sales of software licenses.

 

The key strategies of our business plan include increasing sales to existing customers, increasing deal size by selling modules and introducing new products, improving our sales and marketing execution, establishing alliances to extend our market reach and increasing our international presence. We have focused sales, marketing, and other efforts on corporate enterprise and United States Government opportunities, and to a much lesser extent, service provider and network equipment manufacturer opportunities. Our focus and strategies are designed to increase revenue and profitability. Because of the uncertainty surrounding the amount and timing of revenue growth, we expect to closely manage the increases in total expenses as we implement these strategies.

 

15


Table of Contents

In March 2005, we entered into a multi-year worldwide distribution agreement with Cisco Systems. Under the terms of the agreement, Cisco distributes a broad range of our software products. We also collaborate with Cisco’s Network Management Technology Group to develop new network management solutions. Cisco began sales of our products during the second half of calendar year 2005, and we started recording revenue from the Cisco Systems agreement during the fourth quarter of fiscal 2006.

 

In November 2005, we entered into a global sales and marketing agreement with Computer Associates. Under the terms of the agreement, Computer Associates began marketing our systems performance and capacity modeling technologies. Computer Associates began reference sales of our products in the third quarter of fiscal 2006, and we started recording revenue from the Computer Associates agreement during the third quarter of fiscal 2006.

 

Summary of Our Financial Performance and Trends That May Affect Business and Future Results

 

During the three months ended September 30, 2006, or Q2 2007, as compared to the three months ended June 30, 2006, or Q1 2007, we generated growth in total revenue, gross profit, net income, and deferred revenue. Our operating margin decreased to 7.6% for Q2 2007 from 8.0% for Q1 2007.

 

The following table summarizes information on certain key metrics:

 

     Three Months Ended

    Amount
Change


    Percentage
Change


 
     September 30,
2006


    June 30,
2006


     
     (dollars in thousands, except per share data)  

Operations Data:

                              

Total revenue

   $ 23,617     $ 22,632     $ 985     4.4 %

Total cost of sales

   $ 4,924     $ 4,765     $ 159     3.3 %

Gross profit

   $ 18,693     $ 17,867     $ 826     4.6 %

Gross profit as a percentage of total revenue (gross margin)

     79.2 %     78.9 %              

Total operating expenses

   $ 16,897     $ 16,047     $ 850     5.3 %

Income from operations

   $ 1,796     $ 1,820     $ (24 )   (1.3 )%

Income from operations as a percentage of total revenue (operating margin)

     7.6 %     8.0 %              

Net income

   $ 1,727     $ 1,635     $ 92     5.6 %

Diluted net income per common share

   $ 0.08     $ 0.08     $ 0.00     0.0 %

Total employees (period end)

     455       447       8     1.8 %

Total average employees

     453       442       11     2.5 %

Total consultants (period end)

     104       94       10     10.6 %

Total average quota-carrying sales persons

     72       70       2     2.9 %

Financial Condition and Liquidity Data:

                              

Cash, cash equivalents, and marketable securities (period end)

   $ 86,428     $ 86,912     $ (484 )   (0.6 )%

Cash flows provided by operating activities

   $ 149     $ 952     $ (803 )   (84.3 )%

Total deferred revenue (period end)

   $ 19,587     $ 18,468     $ 1,119     6.1 %

 

The increase in total revenue in Q2 2007 from Q1 2007 was primarily attributable to an 8.3%, or $857, increase in new software license revenue. The increase in new software license revenue in Q2 2007 as compared to Q1 2007 was due to an increase in software license revenue to United States government customers, which was partially offset by a decrease in sales to enterprise customers and sales to service providers.

 

Our international revenue decreased 22.6% to $3,835 for Q2 2007, from $4,954 for Q1 2007. International revenue accounted for 16.2% and 21.9% of total revenue for Q2 2007 and Q1 2007, respectively. We expected to experience a decrease in international revenue from Q1 2007 to Q2 2007 due to a decrease in business activity we historically experience in Europe during the months of July and August. We expect revenue from sales outside the United States to continue to account for a significant portion of total revenue in the future but fluctuate from period to period. Sales to corporate enterprises accounted for the largest portion of international

 

16


Table of Contents

revenue during Q2 2007. We believe that continued growth and profitability will require further expansion of the sales, marketing and customer service functions in the international markets.

 

Our gross margin for Q2 2007 increased to 79.2% from 78.9% for Q1 2007. The sequential increase in gross margin was primarily due to an $857 sequential increase in license revenue. License revenue accounted for 47.4% of total revenue in Q2 2007 as compared to 45.6% in Q1 2007. Gross margin on license revenue for Q2 2007 was 98.3%, which was considerably higher than gross margin on other revenue sources.

 

Our operating margin decreased to 7.6% during Q2 2007 from 8.0% during Q1 2007. The decrease in operating margin during Q2 2007 as compared to Q1 2007 was largely the result of an increase in sales and marketing expenses. The increase in sales and marketing expenses was primarily the result of a $750 sequential increase in sales commissions. The $750 increase in sales commissions was the result of a significant increase in bookings during Q2 2007 as compared to Q1 2007. Since we generally calculate sales commissions based on bookings as opposed to revenue, the significant sequential increase in bookings contributed to the $750 increase in sales commissions.

 

We anticipate the following trends and patterns over the next several quarters:

 

Total Revenue. We currently expect future growth opportunities in revenue to come from sales to enterprise customers and the United States government. We expect revenue from sales to service providers and network equipment manufacturers to fluctuate from quarter to quarter with the potential for periods of declining license revenue. Our ability to increase professional service revenue will depend upon our ability to maintain several large consulting contracts with the United States government and to attract and retain additional qualified consultants, including those with security clearances. As a result of these factors, we believe that we may experience fluctuations in quarterly revenue.

 

International Revenue. Our international sales are impacted by the mix of direct and indirect sales channels and our focus on increasing sales to corporate enterprises. We believe that these factors impact the timing of sales orders as well as our ability to forecast future revenue. As a result, we expect our international sales in absolute dollars and as a percentage of total revenue to fluctuate from quarter to quarter.

 

Gross Profit Margin. We anticipate an increase in the cost of professional services primarily from hiring additional consultants to support demand for our consulting services. Our overall gross profit margin will be affected by the profitability of individual consulting engagements. Our overall gross profit margin will also be affected by the ratio of revenue from new software licenses and software license updates and technical support to total revenue, as revenue from new software licenses and software license updates and technical support have substantially higher gross margins than the gross margin on revenue from professional services.

 

Research and Development Expenses. We believe that a significant level of research and development investment will be required to maintain our competitive position, broaden our product lines and support channel initiatives, as well as enhance the features and functionality of our current products. We anticipate hiring additional engineers, and we expect to incur additional research and development expense in connection with such new hires. We expect that the absolute dollar amount of these expenditures will continue to grow but could generally decrease as a percentage of total revenue in future periods. Our ability to decrease these expenses, as a percentage of revenue, will depend upon increases in revenue growth, among other factors.

 

Sales and Marketing Expenses. We depend upon our direct sales model to generate revenue and believe that increasing the size of our quota-carrying sales team is essential for long-term growth. We plan to add quota-carrying sales persons during the remainder of fiscal 2007 to pursue our growth strategies. We anticipate that we will continue to commit substantial resources to sales and marketing in the future and that sales and marketing expenses may increase both in absolute dollars and as a percentage of total revenue in future periods.

 

17


Table of Contents

General and Administrative Expense. General and administrative expenses are expected to increase as we continue to expand our operations; however, we expect the dollar amount of general and administrative expenses to decrease during fiscal 2007, as compared to fiscal 2006, due to the settlement of the lawsuit filed by Compuware Corporation (see Note 9 to the consolidated financial statements for additional information).

 

Operating Margin. Because a significant portion of our software license arrangements close in the latter part of each quarter, we may not be able to adjust our cost structure in the short-term to respond to lower than expected revenue, which would adversely impact our operating margin and earnings.

 

Critical Accounting Policies and Use of Estimates

 

Please refer to our Annual Report on Form 10-K for the year ended March 31, 2006 for a further discussion of our critical accounting policies.

 

Stock-Based Compensation

 

On April 1, 2006, we adopted SFAS 123R, which revised SFAS 123, “Accounting for Stock-Based Compensation.” Prior to fiscal year 2007 and the adoption of SFAS 123R, we followed the intrinsic value method of accounting for our stock-based employee compensation arrangements as defined by Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees.”

 

SFAS 123R requires an entity to recognize an expense within its income statement for all share-based payment arrangements, which includes employee stock option plans, restricted stock grants, and ESPP. We have elected to continue straight-line amortization of stock-based compensation expense for the entire award over the service period since the awards have only service conditions and graded vesting. We adopted SFAS 123R under the modified prospective method. Under the modified prospective method, SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after April 1, 2006 as well as to the unvested portion of awards outstanding as of April 1, 2006. Stock based compensation for awards granted prior to April, 1, 2006 is based upon the grant date fair value of such compensation as determined under pro forma provisions of SFAS No 123.

 

Stock Options

 

Our stock option programs are accounted for as equity awards. The expense is based on the grant-date fair value of the options granted, and is recognized over the requisite service period.

 

To estimate the grant-date fair value of our stock options, we use the Black-Scholes option-pricing model, consistent with that used for pro forma disclosure under SFAS No 123. The Black-Scholes model estimates the per share fair value of an option on its date of grant based on the following: the option’s exercise price; the price of the underlying stock on the date of grant; the estimated dividend yield; a “risk-free” interest rate; the estimated option term; and the expected volatility. For the “risk-free” interest rate, we use a U.S. Treasury Bond due in a number of years equal to the option’s expected term. To estimate expected volatility, we analyzed the historic volatility of our common stock.

 

Compensation cost for option grants is recognized on a straight-line basis over the requisite service period for the entire award (from the date of grant through the period of the last separately vesting portion of the grant). Compensation cost is recognized within the income statement in the same expense line as the cash compensation paid to the respective employees. SFAS 123R also requires us to estimate forfeitures in calculating the expense related to stock-based compensation. We have concluded that our historical forfeiture rate is the best measure to estimate future forfeitures of granted stock options. The impact on compensation costs due to changes in the expected forfeiture rate will be recognized in the period that they become known.

 

18


Table of Contents

Restricted Stock

 

Our restricted stock grants are accounted for as equity awards. The expense is based on the closing price of our common stock on the award date, and is recognized on a straight-line basis over the requisite service period. We did not grant any restricted stock prior to February 2006. The restricted stock agreements do not contain any post-vesting restrictions.

 

Results of Operations

 

The following table sets forth items from the consolidated statements of operations expressed as a percentage of total revenue for the periods indicated:

 

     Three Months Ended
September 30,


    Six Months Ended
September 30,


 
         2006    

        2005    

        2006    

        2005    

 

Revenue:

                        

New software licenses

   47.4 %   41.5 %   46.5 %   40.9 %

Software license updates and technical support

   29.6     32.6     29.1     33.7  

Professional services

   23.0     25.9     24.4     25.4  
    

 

 

 

Total revenue

   100.0     100.0     100.0     100.0  
    

 

 

 

Cost of revenue:

                        

New software licenses

   0.8     1.0     0.7     1.0  

Software license updates and technical support

   3.2     3.7     3.2     3.7  

Professional services

   16.0     17.4     16.2     18.5  

Amortization of acquired technology

   0.8     1.0     0.8     1.2  
    

 

 

 

Total cost of revenue

   20.8     23.1     20.9     24.4  
    

 

 

 

Gross profit

   79.2     76.9     79.1     75.6  
    

 

 

 

Operating expenses:

                        

Research and development

   22.8     25.6     23.0     26.5  

Sales and marketing

   37.7     34.3     36.7     35.0  

General and administrative

   11.1     16.9     11.6     17.4  
    

 

 

 

Total operating expenses

   71.6     76.8     71.3     78.9  
    

 

 

 

Income (loss) from operations

   7.6     0.1     7.8     (3.3 )

Interest and other income, net

   4.2     3.4     4.1     3.2  
    

 

 

 

Income (loss) before provision for income taxes

   11.8     3.5     11.9     (0.1 )

Provision for income taxes

   4.5     1.1     4.6     0.0  
    

 

 

 

Net income (loss)

   7.3 %   2.4 %   7.3 %   (0.1 )%
    

 

 

 

 

The following table sets forth, for each component of revenue, the cost of each component of revenue as a percentage of the related revenue for the periods indicated:

 

     Three Months Ended
September 30,


    Six Months Ended
September 30,


 
         2006    

        2005    

        2006    

        2005    

 

Cost of Revenue:

                        

New software licenses

   1.7 %   2.4 %   1.5 %   2.6 %

Software license updates and technical support

   10.9     11.3     10.9     11.0  

Professional services

   69.4     67.0     66.6     73.2  

 

19


Table of Contents

Revenue

 

New Software License Revenue. New software license revenue was $11,183 and $7,584 for the three months ended September 30, 2006 and 2005, respectively, representing an increase of 47.5%. For the three months ended September 30, 2006, as compared to the same period in fiscal 2006, the increase in license revenue was primarily due to an increase in sales to United States government customers and enterprise customers, which was partially offset by a decrease in sales to service providers. New software license revenue was $21,509 and $14,210 for the six months ended September 30, 2006 and 2005, respectively, representing an increase of 51.4%. For the six months ended September 30, 2006, as compared to the same period in fiscal 2006, the increase in license revenue was primarily due to an increase in sales to enterprise customers and sales to United States government customers, which was partially offset by a decrease in sales to service providers.

 

Software License Updates and Technical Support Revenue. Software license updates and technical support revenue was $6,983 and $5,951 for the three months ended September 30, 2006 and 2005, respectively, representing an increase of 17.3%. Software license updates and technical support revenue was $13,437 and $11,724 for the six months ended September 30, 2006 and 2005, respectively, representing an increase of 14.6%. Software license updates and technical support revenue growth rates are affected by the overall new software license revenue growth rates, as well as the renewal rate of annual maintenance contracts by existing customers. The increase in software license updates and technical support revenue for the three and six months ended September 30, 2006, as compared to the same period in fiscal 2006, reflect increases in the overall customer-installed base.

 

Professional Service Revenue. The components of professional services for the three and six months ended September 30, 2006 and 2005 were as follows:

 

     Three Months Ended
September 30,


   Six Months Ended
September 30,


         2006    

       2005    

       2006    

       2005    

     (in thousands)

Consulting services

   $ 5,141    $ 4,446    $ 10,559    $ 8,178

Training and other income

     310      283      744      629
    

  

  

  

Professional service revenue

   $ 5,451    $ 4,729    $ 11,303    $ 8,807
    

  

  

  

 

Professional service revenue was $5,451 and $4,729 for the three months ended September 30, 2006 and 2005, respectively, representing an increase of 15.3%. Consulting service revenue accounted for 94.3% and 94.0% of professional service revenue for the three months ended September 30, 2006 and 2005, respectively. Professional service revenue was $11,303 and $8,807 for the six months ended September 30, 2006 and 2005, respectively, representing an increase of 28.3%. Consulting service revenue accounted for 93.4% and 92.9% of professional service revenue for the six months ended September 30, 2006 and 2005, respectively. The increase for the three and six months ended September 30, 2006 as compared to the same period in the prior fiscal year was primarily due to an increase in revenue from United States government customers, and to a lesser extent, enterprise customers.

 

In January 2003, we were awarded a long term consulting contract with the United States Department of Defense. In January 2005, we were awarded the contract option for calendar year 2005 in the amount of $2,965. The option contributed approximately $1,945 and $657 of consulting revenue for fiscal 2006 and fiscal 2005, respectively

 

In February 2006, we were awarded the contract option for calendar year 2006 in the amount of $2,899. The option contributed approximately $688 and $1,379 of consulting revenue for the three and six months ended September 30, 2006, respectively. The funding under this contract through September 30, 2006 was $2,968. The option year for calendar year 2007 under this contract may be exercised by the United States Department of

 

20


Table of Contents

Defense at its discretion. Our future results of operations could be adversely affected if any of the remaining options are not exercised or the contract otherwise does not receive additional funding. Funding under this award may be increased or decreased during the calendar year.

 

International Revenue.

 

Our international revenue was $3,835 and $3,857 for the three months ended September 30, 2006 and 2005, respectively. The decrease in our international revenue was primarily the result of a decrease in sales to service providers and in sales to network equipment manufacturers, which was partially offset by an increase in sales to enterprise customers. Our international revenue decreased as a percentage of total revenue to 16.2% for the three months ended September 30, 2006 from 21.1% for the same period in fiscal 2006. Our international revenue was $8,789 and $7,327 for the six months ended September 30, 2006 and 2005, respectively. The increase in our international revenue was primarily the result of an increase in sales to enterprise customers. Our international revenue decreased as a percentage of total revenue to 19.0% for the six months ended September 30, 2006 from 21.1% for the same period in fiscal 2006. Our international revenue is primarily generated in Europe and Japan. We have focused our efforts on increasing international sales to enterprise customers. Revenue from enterprise customers and service providers accounted for the largest percentage of international revenue for the three months ended September 30, 2006 and 2005, respectively. Revenue from enterprise customers accounted for the largest percentage of international revenue for the six months ended September 30, 2006 and 2005.

 

Cost of Revenue.

 

Cost of new software license revenue consists primarily of royalties, media, manuals, and distribution costs. Cost of license updates and technical support revenue consist of royalties, media, distribution costs, and personnel-related costs in providing technical support. Cost of professional service revenue consists primarily of personnel-related costs in providing consulting and training to our customers. Gross margins on new software license revenue and software license updates and technical support revenue are substantially higher than gross margin on professional service revenue, due to the low materials, packaging and other costs of software products compared with the relatively high personnel costs associated with providing professional services.

 

Cost of New Software License Revenue. Cost of software license revenue was $195 and $182 for the three months ended September 30, 2006 and 2005, respectively. Gross margin on software license revenue increased to 98.3% for the three months ended September 30, 2006 from 97.6% for the same period in fiscal 2006. Cost of software license revenue was $321 and $362 for the six months ended September 30, 2006 and 2005, respectively. Gross margin on software license revenue increased to 98.5% for the six months ended September 30, 2006 from 97.5% for the same period in fiscal 2006. The cost of new software license revenue is primarily comprises royalty payments required for certain of our software license sales. Consequently, the proportion of licenses sold that require royalty payments impacts the gross margin. The increase in the cost of new software licenses for the three months ended September 30, 2006 as compared to the same period in fiscal 2006 was the result of an increase in sales of software that require royalty payments. The decrease in the cost of new software licenses for the six months ended September 30, 2006 as compared to the same period in fiscal 2006 was the result of a decrease in sales of software that require royalty payments.

 

Cost of Software License Updates and Technical Support Revenue. Cost of software license updates and technical support revenue were $761 and $673 for the three months ended September 30, 2006 and 2005, respectively. The increase in the cost of software license updates and technical support revenue for the three months ended September 30, 2006 as compared to the same period in fiscal 2006 was the result of an increase in staffing levels necessary to support our customers. Gross margin on software license updates and technical support revenue increased to 89.1% for the three months ended September 30, 2006 from 88.2% for the same period in fiscal 2006. Cost of software license updates and technical support revenue were $1,468 and $1,293 for the six months ended September 30, 2006 and 2005, respectively. The increase in the cost of software license updates and technical support revenue for the six months ended September 30, 2006 as compared to the same period in fiscal 2006 was the result of an increase in staffing levels necessary to support our customers. Stock-

 

21


Table of Contents

based compensation expense allocated to cost of software license updates and technical support in connection with our application of SFAS 123R was $6 and $9 for the three and six months ended September 30, 2006, respectively. We did not recognize any stock-based compensation expense related to SFAS 123R in fiscal 2006. Gross margin on software license updates and technical support revenue increased to 89.1% for the six months ended September 30, 2006 from 89.0% for the same period in fiscal 2006.

 

Cost of Professional Service Revenue. Cost of professional service revenue was $3,782 and $3,170 for the three months ended September 30, 2006 and 2005, respectively. The increase in cost of professional service revenue was primarily due to an increase in personnel costs related to the increase in our consulting staff to meet demand for consulting services. Gross margin on professional service revenue decreased to 30.6% for the three months ended September 30, 2006 from 33.0% for the same period in fiscal 2006. The decrease in gross margin for the three months ended September 30, 2006 as compared to the same period in fiscal 2006 was primarily the result of an increase in personnel costs and a decrease in consulting staff utilization. Cost of professional service revenue was $7,523 and $6,444 for the six months ended September 30, 2006 and 2005, respectively. The increase in cost of professional service revenue was primarily due to an increase in personnel costs related to the increase in our consulting staff to meet demand for consulting services. Gross margin on professional service revenue increased to 33.4% for the six months ended September 30, 2006 from 26.8% for the same period in fiscal 2006. The increase in gross margin for the six months ended September 30, 2006 as compared to the same period in fiscal 2006 was primarily due to an increase in the effective billing rates of consulting projects. Stock-based compensation expense allocated to cost of professional services in connection with our application of SFAS 123R was $80 and $118 for the three and six months ended September 30, 2006, respectively. We did not recognize any stock-based compensation expense related to SFAS 123R in fiscal 2006.

 

Operating Expenses

 

Research and Development. Research and development expenses were $5,373 and $4,677 for the three months ended September 30, 2006 and 2005, respectively, representing an increase of 14.9%. Research and development expenses were $10,589 and $9,188 for the six months ended September 30, 2006 and 2005, respectively, representing an increase of 15.2%. The increase in expenses for the three and six month periods ended September 30, 2006 and 2005, respectively, was primarily due to higher personnel costs as a result of increased staffing levels required for developing new products as well as sustaining and upgrading existing products. Stock-based compensation expense allocated to research and development in connection with our application of SFAS 123R was $209 and $315 for the three and six months ended September 30, 2006, respectively. We did not recognize any stock-based compensation expense related to SFAS 123R in fiscal 2006.

 

Sales and Marketing. Sales and marketing expenses were $8,904 and $6,258 for the three months ended September 30, 2006 and 2005, respectively, representing an increase of 42.3%. Sales and marketing expenses were $16,967 and $12,176 for the six months ended September 30, 2006 and 2005, respectively, representing an increase of 39.3%. The increase in expenses for the three and six months ended September 30, 2006 and 2005, respectively, was due to higher commission expense, and to a lesser extent, higher personnel costs as a result of increased staffing levels necessary to pursue our business plan. Stock-based compensation expense allocated to sales and marketing in connection with our application of SFAS 123R was $112 and $176 for the three and six months ended September 30, 2006, respectively. We did not recognize any stock-based compensation expense related to SFAS 123R in fiscal 2006.

 

General and Administrative. General and administrative expenses were $2,620 and $3,091 for the three months ended September 30, 2006 and 2005, respectively, representing a decrease of 15.2%. The decrease in expense was primarily the result of a $1,105 decrease in legal fees associated with the lawsuit filed by Compuware Corporation, which was partially offset by increases in compensation costs. General and administrative expenses were $5,388 and $6,041 for the six months ended September 30, 2006 and 2005, respectively, representing a decrease of 10.8%. The decrease in expense was primarily the result of a $1,464 decrease in legal fees associated with the lawsuit filed by Compuware Corporation (see note 9 to the consolidated

 

22


Table of Contents

financial statements for additional information on the lawsuit filed by Compuware Corporation), which was partially offset by increases in compensation costs and professional services. Stock-based compensation expense allocated to general and administrative expense in connection with our application of SFAS 123R was $126 and $169 for the three and six months ended September 30, 2006, respectively. We did not recognize any stock-based compensation expense related to SFAS 123R in fiscal 2006.

 

Interest and Other Income, net. Interest and other income, net, was $988 and $614 for the three months ended September 30, 2006 and 2005, respectively. Interest and other income, net, was $1,891 and $1,127 for the six months ended September 30, 2006 and 2005, respectively. The increase in interest income was primarily the result of an increase in interest rates for the three and six months ended September 30, 2006 as compared to the same periods in fiscal 2006.

 

Provision for Income Taxes. Our effective tax rates were 38.0% and 30.7% for the three months ended September 30, 2006 and 2005, respectively. Our effective tax rates were 38.9% and 24.8% for the six months ended September 30, 2006 and 2005, respectively. The increase in our effective tax rate for the three and six months ended September 30, 2006 as compared to the same periods in fiscal 2006 was primarily the result of a decrease in tax credits we had available to offset income tax expense. The decrease in tax credits we had available to offset income tax expense for the three and six months ended September 30, 2006 as compared to the same periods in fiscal 2006 was primarily due to the December 31, 2005 expiration of the R&D Tax Credit as defined in section 41 of the Internal Revenue Code. The effective tax rate differs from the statutory tax rate and varies from period to period due principally to the amount of income before taxes from various tax jurisdictions, state taxes, foreign tax expense and the amount of foreign tax credits.

 

Liquidity and Capital Resources

 

Since inception, we have funded our operations primarily through cash provided by operating activities and through the sale of equity securities. In August 2000, we completed our initial public offering in which we raised approximately $54,114, net of underwriting discounts and offering expenses payable by us. As of September 30, 2006, we had cash, cash equivalents and marketable securities totaling $86,428.

 

Cash provided by operating activities was $149 for the six months ended September 30, 2006, and cash used in operating activities was $781 for the six months ended September 30, 2005. Cash provided by operating activities is primarily derived from net income, as adjusted for non-cash items such as depreciation and amortization expense, and changes in operating assets and liabilities. The increase in cash provided by operating activities for the six months ended September 30, 2006 as compared to the same period in fiscal 2006 was primarily attributable to an increase in deferred revenue and net income, which was partially offset by an increase in accounts receivable.

 

Net cash used in investing activities was $24,489 for the six months ended September 30, 2006, and net cash provided by investing activities was $23,025 for the six months ended September 30, 2005. Investing activities include the purchase, sale or maturity of marketable securities and expenditures for property and equipment. For the six months ended September 30, 2006, funds were used to purchase marketable securities of $49,888, purchase property and equipment of $1,020, and to purchase acquired technology of $281. Proceeds from the sale or maturity of investments were $26,700 for the six months ended September 30, 2006. For the six months ended September 30, 2005, funds were used to purchase marketable securities of $12,727, and to purchase property and equipment of $616. Proceeds from the sale or maturity of investments were $36,368 for the six months ended September 30, 2005.

 

Net cash provided by financing activities was $1,184 for the six months ended September 30, 2006, and net cash used in financing activities was $805 for the six months ended September 30, 2005. We used cash of $150 to repay the principal balance of a loan from the Department of Economic Development of the Sate of Maryland under the Maryland Economic Development Assistance Fund during the six months ended September 30, 2006. We used cash of $453 and $1,094 to acquire 34 and 135 shares of treasury stock during the six months ended

 

23


Table of Contents

September 30, 2006 and 2005, respectively. Cash provided by financing activities generally reflects the proceeds received from the exercise of stock options and the sale of common stock under our ESPP. Prior to the adoption of SFAS 123R, we reported tax benefits from the exercise of stock options as an operating cash flow in the consolidated statement of cash flows. In the period beginning April 1, 2006, excess tax benefits from the exercise of stock options are presented as a cash flow from financing activities. For the six months ended September 31, 2006 and 2005, excess tax benefits from the exercise of stock options were $364 and $7, respectively.

 

We had commitments under certain contractual arrangements to make future payments for goods and services. These contractual arrangements secure the rights to various assets and services to be used in the future in the normal course of business. For example, we are contractually committed to make certain minimum lease payments for the use of property under operating lease agreements. In accordance with current accounting rules, the future rights and related obligations pertaining to such contractual arrangements are not reported as assets or liabilities on our consolidated balance sheets. We expect to fund these contractual arrangements with our cash and marketable securities as well as cash generated from operations in the normal course of business.

 

The following table summarizes our contractual arrangements at September 30, 2006, and the timing and effect that such commitments are expected to have on our liquidity and cash flow in future periods.

 

     Payments Due by Period

Contractual Obligations


   Total

   Less Than
1 Year


   1 – 3 Years

   3 - 5 Years

   More than
5 Years


     (dollars in thousands)

Facilities Operating Lease Obligations

   $ 13,661    $ 3,452    $ 6,293    $ 3,916    $ —  

Purchase Obligations

     154      61      93      —        —  
    

  

  

  

  

Total

   $ 13,815    $ 3,513    $ 6,386    $ 3,916    $ —  
    

  

  

  

  

 

In November 2006, we plan to enter into an operating lease to replace existing space that will increase our operating lease obligations in aggregate by $43 over the next year. As of September 30, 2006, we do not have any material capital lease obligations, either individually or in the aggregate.

 

We expect working capital needs to increase in the foreseeable future in order to execute our business plan. We anticipate that operating activities, as well as planned capital expenditures in the normal course of business, will constitute a material use of our cash resources. In addition, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or products.

 

We believe that our current cash and cash equivalents, marketable securities, and cash generated from operations will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least the next 12 months.

 

Contingencies

 

The Internal Revenue Service, or IRS, is examining our federal corporate income tax returns for fiscal 2002 and 2003. While the IRS examination of our returns is not final at this time, we have reached an agreement with respect to the amount of research and development tax credits that we claimed on our tax returns for those years. As a result of this agreement, we reduced the amount of the research and development tax credits claimed on our tax returns for fiscal 2002 and 2003 by approximately $350. As a result, our Q3 fiscal 2005 tax provision reflected the reversal of approximately $350 of previously claimed research and development tax credits. The IRS also asserted tax deficiencies related to the timing of revenue reported on our tax returns for fiscal 2002 and 2003. The IRS has asserted that revenue associated with certain contracts reported on our fiscal year 2003 tax return, should have been included in taxable income on our tax return for the fiscal 2002. We do not believe any tax deficiencies related to the timing of reporting revenue will be material to the financial statements.

 

24


Table of Contents

We are involved in other claims and legal proceedings arising from our normal operations. We do not expect these matters, individually or in the aggregate, to have a material effect on our financial condition, results of operations, or cash flows.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We consider all highly liquid investments purchased with a maturity of three months or less to be cash equivalents, and those with maturities greater than three months are considered to be marketable securities. Cash equivalents and marketable securities consist primarily of investment grade securities with high credit ratings of relatively short duration that trade in highly liquid markets. Accordingly, we have no quantitative information concerning the market risks and believe that the risk is minimal. We currently do not hedge interest rate exposure, but we do not believe that an increase in interest rates would have a material effect on the value of the cash equivalents or marketable securities.

 

At September 30, 2006, we had $44,112 in cash and cash equivalents and $42,316 in marketable securities. Based on our cash, cash equivalents, and marketable securities as of September 30, 2006, a 100 basis point increase/decrease in the interest rates would increase/decrease our annual interest income and cash flows by approximately $864.

 

The majority of the revenue transactions and all operating expenses of our foreign subsidiaries are denominated in local currencies. We currently do not hedge foreign exchange rate risk. Due to the limited nature of our foreign operations, we do not believe that a 5% change in exchange rates would have a material effect on our business, financial condition, or results of operations.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Our management, with the participation of the Chief Executive Office and Chief Financial Officer, evaluated the effectiveness of the disclosure controls and procedures as of September 30, 2006. The “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2006, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective.

 

No change in our internal control over financial reporting occurred during the fiscal quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

25


Table of Contents

PART II. OTHER INFORMATION

(in thousands, except per share data)

 

ITEM 1. Legal Proceedings

 

We are involved in various other claims and legal proceedings arising from its normal operations. Management does not consider any of these matters to be material.

 

ITEM 1A. Risk Factors

 

The following important factors, among others, could cause actual results to differ materially from those indicated by forward-looking statements made in this Report and presented elsewhere by management from time to time.

 

Our operating results may fluctuate significantly as a result of factors outside of our control, which could cause the market price of our stock to decline.

 

Our operating results have fluctuated in the past, and are likely to fluctuate significantly in the future. Our financial results may, as a consequence, fall short of the expectations of public market analysts or investors, which could cause the price of our common stock to decline. Our revenue and operating results may vary significantly from quarter to quarter due to a number of factors, many of which are beyond our control. Factors that could affect our operating results include:

 

    the timing of large orders;

 

    changes in the proportion of software arrangements requiring contract accounting;

 

    changes in the mix of sales, including the mix between higher margin software products and lower margin services and maintenance, and the proportion of license sales requiring us to make royalty payments;

 

    the timing and amount of marketing, sales, and product development expenses;

 

    the cost and time required to develop new software products;

 

    the introduction, timing, and market acceptance of new products introduced by us or competitors;

 

    changes in network technology or in applications, which could require us to modify our products or develop new products;

 

    general economic conditions, which can affect our customers’ purchasing decisions, the length of the sales cycle, and the customers’ ability to pay in a timely manner, if at all;

 

    changes in our pricing policies or those of competitors; and

 

    the timing and size of potential acquisitions by us.

 

We expect to make significant expenditures in all areas of our business, particularly sales and marketing operations, in order to promote future growth. Because the expenses associated with these activities are relatively fixed in the short term, we may be unable to adjust spending quickly enough to offset any unexpected shortfall in revenue growth or any decrease in revenue levels. In addition, our revenue in any quarter depends substantially on the orders we receive and ship in that quarter. We typically receive a significant portion of orders in any quarter during the last month of the quarter, and we cannot predict whether those orders will be placed and shipped in that period. If we have lower revenue than we expect, we probably will not be able to reduce our operating expenses quickly in response. Therefore, any significant shortfall in revenue or delay of customer orders could have an immediate adverse effect on our operating results in that quarter.

 

For all of these reasons, quarterly comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication of our future performance.

 

26


Table of Contents

The market for intelligent network management software is new and evolving, and if this market does not develop as anticipated, our revenue could decline.

 

We derive all of our revenue from the sale of products and services that are designed to allow our customers to manage the performance of networks and applications. Accordingly, if the market for intelligent network management software does not continue to grow, we could face declining revenue, which could ultimately lead to us becoming unprofitable. The market for intelligent network management software solutions is in an early stage of development. Therefore, we cannot accurately assess the size of the market and may be unable to identify an effective distribution strategy, the competitive environment that will develop, and the appropriate features and prices for products to address the market. If we are to be successful, our current and potential customers must recognize the value of intelligent network management software solutions, decide to invest in the management of their networks, and, in particular, adopt and continue to use our software solutions.

 

Our customers are primarily in four target groups and our operating results may be adversely affected by changes in one or more of these groups.

 

Our software solutions and services are designed to meet the needs of enterprises, United States government agencies, service providers, and network equipment manufacturers. We market our solutions and services to those four customer groups. Consequently, our financial results depend, in significant part, upon the economic conditions of enterprises, United States government agencies, service providers, and network equipment manufacturers. An economic downturn or adverse change in the regulatory environment or business prospects for one or more of these customer groups may decrease our revenue or lower our growth rate.

 

The United States Department of Defense may not extend one consulting contract with us, which could harm our business.

 

In January 2003, we were awarded a consulting contract with the United States Department of Defense. The funding under this contract for calendar year 2003 was $3,147, and there are four successive option years under the contract that may be exercised by the United States Department of Defense in its discretion. In January 2004, the United States Department of Defense exercised the first of four possible contract extensions. The funding under this contract for calendar year 2004 was $3,520. In January 2005, United States Department of Defense exercised the second of four possible contract extensions. The funding under this contract for calendar year 2005 was $2,965. In February 2006, United States Department of Defense exercised the third of four possible contract extensions. The funding under this contract for calendar year 2006 was $2,899. Our results of operations could be adversely affected if any of the remaining options are not exercised, the contract otherwise does not receive additional funding, or has a reduction in funding.

 

A decline in information technology spending may result in a decrease in our revenue or lower our growth rate.

 

A decline in the demand for information technology among our current and prospective customers may result in decreased revenue or a lower growth rate for us because our sales depend, in part, on the customers’ budgets for new or additional information technology systems and services. A continued economic downturn may cause our customers to reduce or eliminate information technology spending and force us to lower the prices of our solutions, which would substantially reduce the number of new software licenses we sell and the average sales price for these licenses. Accordingly, we cannot assure you that we will be able to increase or maintain our revenue.

 

Our sales to United States government agencies subjects us to special risks that could adversely affect our business.

 

We derive a substantial portion of our revenue from sales directly or indirectly to Unites States government agencies. Transactions with Unites States government agencies accounted for approximately 46% of our total

 

27


Table of Contents

revenue for the six months ended September 30, 2006 and 2005, respectively. Government sales entail a variety of risks including:

 

    Government contracts are subject to the approval of appropriations by the United States Congress to fund the expenditures by the agencies under these contracts. Congress often appropriates funds for government agencies on a yearly basis, even though their contracts may call for performance over a number of years.

 

    A significant decline in government expenditures generally, or a shift in budget priorities away from agencies or programs that we support, could cause a material decline in our government business. In particular, a decline in government spending on information technology or related services could hurt our government business.

 

    Our products and services are included on a General Services Administration, or GSA,, schedule. We believe that the GSA schedule facilitates our sales to Unites States government agencies. The loss of the GSA schedule covering our products and services could adversely affect our results of operations.

 

    We must comply with complex federal procurement laws and regulations in connection with government contracts, which may impose added costs on our business.

 

    Some of our government business requires that we maintain facility security clearances, and requires some of our employees to maintain individual security clearances. If we were to lose these clearances, our government business might decline.

 

    The federal government audits and reviews the performance of federal contractors on contracts, pricing practices, cost structure, and compliance with applicable laws, regulations, and standards. An audit of our work could result in a finding that we overcharged the government, which could result in an adjustment to our previously reported operating results. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines, and suspension or debarment from doing business with United States federal government agencies.

 

    Many of our government contracts are firm fixed-price contracts. To the extent that the assumptions we have used in pricing these contracts prove inaccurate, we could incur losses on contracts, which would adversely affect our operating results.

 

    A portion of our sales to the United States government are made indirectly as a subcontractor to another government contractor, referred to as the prime contractor, who has the direct relationship with the government. We also team with prime contractors to bid on competitive government opportunities for which we hope to serve as a subcontractor. If prime contractors lose existing business on which we serve as a subcontractor, or fail to win the competitive bids on which we team with them, our government business would be hurt.

 

    We could face expense and delay if any of our competitors, or competitors of the prime contractors to which we serve as a subcontractor, protest or challenge contract awards made to us or our prime contractors pursuant to competitive bidding.

 

    Federal government contracts contain provisions and are subject to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts. These rights and remedies allow government clients, among other things, to terminate existing contracts, with short notice, for convenience without cause; reduce or modify contracts or subcontracts; and claim rights in products, systems, and technology produced by us.

 

If our newest products, particularly those targeted primarily for enterprises and United States government agencies, do not gain widespread market acceptance, our revenue might not increase and could even decline.

 

We expect to derive a substantial portion of our revenue in the future from sales to enterprises and United States government agencies of version 12.0 of IT Guru, which was released in September 2006, and its

 

28


Table of Contents

associated modules including Application Characterization Environment, ACE Decode Module, ACE Advanced Console, NetDoctor, Planning and Design, and Flow Analysis, and VNE Server 4.0 which was released in September 2006. Our business depends on customer acceptance of these products and our revenue may not increase, or may even decline, if our target customers do not adopt and expand their use of our products. In addition, sales of our OPNET Modeler product, which we have been selling since 1987, have fluctuated from quarter-to-quarter, including periods of declining sales. Sales of our OPNET Modeler could decline in the future for a variety of reasons, including market saturation and the financial condition of network equipment manufacturers, and if sales of our newer products do not grow at a rate sufficient to offset the shortfall, our revenue would decline.

 

We may not be able to grow our business, if service providers do not buy our products.

 

An element of our strategy is to increase sales to service providers. Accordingly, if our products fail to perform favorably in the service provider environment, or fail to gain wider adoption by service providers, our business and future operating results could suffer.

 

Our lengthy and variable sales cycle makes it difficult to predict operating results.

 

It is difficult for us to forecast the timing and recognition of revenue from sales of our products because prospective customers often take significant time evaluating our products before licensing them. The period between initial customer contact and a purchase by a customer may vary from three months to more than a year. During the sales process, the customer may decide not to purchase or may reduce proposed orders of our products for various reasons, including changes in budgets and purchasing priorities. Our prospective customers routinely require education regarding the use and benefit of our products. This may also lead to delays in receiving customers’ orders.

 

If we do not successfully expand our sales force, we may be unable to increase sales.

 

We sell our products primarily through our direct sales force, and we must expand the size of the sales force to increase revenue. If we are unable to hire or retain qualified sales personnel, if newly hired personnel fail to develop the necessary skills to be productive, or if they reach productivity more slowly than anticipated, our ability to increase our revenue and grow our business could be compromised. Our sales people require a long period of time to become productive, typically three to nine months. The time required to reach productivity, as well as the challenge of attracting, training, and retaining qualified candidates, may make it difficult to meet sales force growth targets. Further, we may not generate sufficient sales to offset the increased expense resulting from growing the sales force, or we may be unable to manage a larger sales force.

 

Our ability to increase our sales will be impaired if we do not expand and manage our indirect distribution channels.

 

To increase sales, we must, among other things, further expand and manage our indirect distribution channels, which consist primarily of international distributors and original equipment manufacturers and resellers. If we are unable to expand and manage our relationships with our distributors, our distributors are unable or unwilling to market and sell our products effectively, or we lose existing distributor relationships, we might not be able to increase revenue. Our international distributors and original equipment manufacturers and resellers have no obligation to market or purchase our products. In addition, they could partner with our competitors, bundle or resell competitors’ products, or internally develop products that compete with our products.

 

We may not be able to successfully manage our expanding operations, which could impair our ability to operate profitably.

 

We may be unable to operate our business profitably if we fail to manage our growth. Our growth has sometimes strained, and may in the future continue to strain, our managerial, administrative, operational, and

 

29


Table of Contents

financial resources and controls. We plan to continue to expand operations and increase the number of full-time employees. Our ability to manage growth will depend in part on our ability to continue to enhance operating, financial, and management information systems. Our personnel, systems, and controls may not be adequate to support our growth. In addition, our revenue may not continue to grow at a sufficient rate to absorb the costs associated with a larger overall employee base.

 

If we are unable to introduce new and enhanced products on a timely basis that respond effectively to changing technology, our revenue may decline.

 

Our market is characterized by rapid technological change, changes in customer requirements, frequent new product and service introductions and enhancements, and evolving industry standards. If we fail to develop and introduce new and enhanced products on a timely basis that respond to these changes, our products could become obsolete, demand for our products could decline and our revenue could fall. Advances in network management technology, software engineering, and simulation technology, or the emergence of new industry standards, could lead to new competitive products that have better performance, more features, or lower prices than our products and could render the products unmarketable.

 

Our future revenue is substantially dependent upon our existing customers continuing to license additional products, renew maintenance agreements and purchase additional services.

 

Our existing customers have traditionally generated additional revenue from consulting services, renewed maintenance agreements and purchase of additional software licenses, which represent a majority of annual revenue. The maintenance agreements are generally renewable at the option of the customers and there are no mandatory payment obligations or obligations to license additional software. In addition, customers may decide not to purchase additional products or services. If our existing customers fail to renew their maintenance agreements or purchase additional products or services, our revenue could decrease.

 

Increases in professional service revenue as a percentage of total revenue could decrease overall margins.

 

We realize lower margins on professional service revenue than we do on other types of revenue. As a result, if professional service revenue increases as a proportion of total revenue, our gross margins will be lower.

 

If we fail to retain our key personnel and attract and retain additional qualified personnel, we might not be able to maintain our current level of revenue.

 

Our future success and our ability to maintain our current level of revenue depend upon the continued service of our executive officers and other key sales and research and development personnel. The loss of any of our key employees, in particular Marc A. Cohen, our chairman of the board and chief executive officer, and Alain J. Cohen, our president and chief technology officer, could also adversely affect our ability to pursue our growth strategy. We do not have employment agreements or any other agreements that obligate any of our officers or key employees to remain with us.

 

We must also continue to hire highly qualified individuals, particularly software engineers and sales and marketing personnel. Our failure to attract and retain technical personnel for our product development, consulting services, and technical support teams may limit our ability to develop new products or product enhancements. Competition for these individuals is intense, and we may not be able to attract and retain additional highly qualified personnel in the future. In addition, limitations imposed by federal immigration laws and the availability of visas could impair our ability to recruit and employ skilled technical professionals from other countries to work in the United States.

 

30


Table of Contents

Our international operations subject our business to additional risks, which could cause our sales or profitability to decline.

 

Our plan is to increase our international sales activities, but these plans are subject to a number of risks that could cause sales to decline or could otherwise cause a decline in profitability. These risks include:

 

    difficulty in attracting distributors that will market and support products effectively;

 

    difficulty in accounts receivable collection and longer collection periods;

 

    the need to comply with varying employment policies and regulations that could make it more difficult and expensive to manage employees if the need to establish more direct sales or support staff outside the United States occurs;

 

    potentially adverse tax consequences;

 

    the effects of currency fluctuations; and

 

    political and economic instability.

 

We expect to face increased competition, which could cause us to lose sales, resulting in lower profitability.

 

Increasing competition in the market could cause us to lose sales and become unprofitable. We believe that the market for intelligent network management software is likely to become more competitive as it evolves and the demand for intelligent network management solutions continues to increase. At least one of our current competitors and many of our potential competitors are larger and have substantially greater financial and technical resources than we do. In addition, it is possible that other vendors as well as some of our customers or distributors will develop and market solutions that compete with our products in the future.

 

If our products contain errors and we are unable to correct those errors, our reputation could be harmed and our customers could demand refunds from us or assert claims for damages against us.

 

Our software products could contain significant errors or bugs that may result in:

 

    the loss of or delay in market acceptance and sales of products;

 

    the delay in introduction of new products or updates to existing products;

 

    diversion of resources;

 

    injury to our reputation; and

 

    increased support costs.

 

Bugs may be discovered at any point in a product’s life cycle. We expect that errors in our products will be found in the future, particularly in new product offerings and new releases of current products.

 

Because our customers use our products to manage networks that are critical to their business operations, any failure of our products could expose us to product liability claims. In addition, errors in our products could cause the customers’ networks and systems to fail or compromise their data, which could also result in liability to us. Product liability claims brought against us could divert the attention of management and key personnel, could be expensive to defend, and may result in adverse settlements and judgments.

 

Our software products rely on our intellectual property, and any failure to protect our intellectual property could enable our competitors to market products with similar features that may reduce our revenue and could allow the use of our products by users who have not paid the required license fee.

 

If we are unable to protect our intellectual property, our competitors could use our intellectual property to market products similar to our products, which could reduce our revenue. In addition, we may be unable to

 

31


Table of Contents

prevent the use of our products by persons who have not paid the required license fee, which could reduce our revenue. Our success and ability to compete depend substantially upon the internally developed technology that is incorporated in our products. Policing unauthorized use of our products is difficult, and we may not be able to prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as those in the United States. Others may circumvent the patents, copyrights, and trade secrets we own.

 

In the ordinary course of business, we entered into a combination of confidentiality, non-competition and non-disclosure agreements with our employees. These measures afford only limited protection and may be inadequate, especially because our employees are highly sought after and may leave our employ with significant knowledge of our proprietary information. In addition, any confidentiality, non-competition and non-disclosure agreements we enter into may be found to be unenforceable, or our copy protection mechanisms embedded in our software products could fail or could be circumvented.

 

Our products employ technology that may infringe on the proprietary rights of others, and, as a result, we could become liable for significant damages.

 

We expect that our software products may be increasingly subject to third-party infringement claims as the number of competitors in the industry segment grows and the functionalities of products in different industry segments overlap.

 

Regardless of whether these claims have any merit, they could:

 

    be time-consuming to defend;

 

    result in costly litigation;

 

    divert management’s attention and resources;

 

    cause us to cease or delay product shipments; or

 

    require us to enter into royalty or licensing agreements.

 

These royalty or licensing agreements may not be available on terms acceptable to us, if at all. A successful claim of product infringement against us or our failure or inability to license the infringed or similar technology could adversely affect our business because we would not be able to sell the affected product without redeveloping it or incurring significant additional expense.

 

Future interpretations of existing accounting standards could adversely affect our operating results.

 

The Securities and Exchange Commission, Financial Accounting Standards Board, American Institute of Certified Public Accountants and various other accounting authoritative bodies continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Future interpretations of existing accounting standards or changes in business practices could result in future changes in revenue recognition accounting policies that could have a material adverse effect on our results of operations.

 

As with other software vendors, we may be required to delay revenue recognition into future periods, which could adversely affect our operating results.

 

We have in the past had to, and in the future may have to, defer recognition for license fees due to several factors, including whether:

 

    software arrangements include undelivered elements for which we do not have vendor specific evidence of fair value;

 

32


Table of Contents
    we must deliver services for significant customization, enhancements and modifications of our software;

 

    the transaction involves material acceptance criteria or there are other identified product-related issues;

 

    the transaction involves contingent payment terms or fees;

 

    we are required to accept a fixed-fee services contract; or

 

    we are required to accept extended payment terms.

 

Because of the factors listed above and other specific requirements under accounting principles generally accepted in the United States of America for software revenue recognition, we must have very precise terms in our software arrangements in order to recognize revenue when we initially deliver software or perform services. Negotiation of mutually acceptable terms and conditions can extend the sales cycle, and sometimes we do not obtain terms and conditions that permit revenue recognition at the time of delivery.

 

If we undertake acquisitions, they may be expensive and disruptive to our business and could cause the market price of our common stock to decline.

 

We may acquire or make investments in companies, products or technologies if opportunities arise. Any acquisition could be expensive, disrupt our ongoing business, distract our management and employees, and adversely affect our financial results and the market price of our common stock. We may not be able to identify suitable acquisition or investment candidates, and if we do identify suitable candidates, we may not be able to make these acquisitions or investments on commercially acceptable terms or at all. If we make an acquisition, we could have difficulty integrating the acquired technology, employees, or operations. In addition, the key personnel of the acquired company may decide not to work for us.

 

We also expect that we would incur substantial expenses if we acquired other businesses or technologies. We might use cash on hand, incur debt, or issue equity securities to pay for any future acquisitions. If we issue additional equity securities, our stockholders could experience dilution and the market price of our stock may decline.

 

Our products are subject to changing computing environments, including operating system software and hardware platforms, which could render our products obsolete.

 

The evolution of existing computing environments and the introduction of new popular computing environments may require us to redesign our products or develop new products. Computing environments, including operating system software and hardware platforms, are complex and change rapidly. Our products are designed to operate in currently popular computing environments. Due to the long development and testing periods required to adapt our products to new or modified computing environments, our research and development efforts could be distracted and we could experience significant delays in product releases or shipments, which could result in lost revenue and significant additional expense.

 

ITEM 2. Unregistered Sales of Securities and Use of Proceeds

 

In August 2000, we closed an initial public offering of our common stock. The Registration Statement on Form S-1 (No. 333-32588) was declared effective by the Securities and Exchange Commission on August 1, 2000 and we commenced the offering on that date. After deducting the underwriting discounts and commissions and the offering expenses, the net proceeds from the offering were approximately $54,114. We continue to use the net proceeds for general corporate expenses, working capital and capital expenditures.

 

33


Table of Contents

Issuer Purchases Of Equity Securities

 

Period


   Total Number of
Shares Purchased


   Average Price Paid
per Share


   Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs(1)


   Maximum Number of
Shares That May Yet
Be Purchased Under
the Plans or
Programs


July 1 – 31, 2006

   —        —      —      590

August 1 – 31, 2006

   2    $ 12.55    2    588

September 1 – 30, 2006

   32    $ 13.37    32    556
    
  

  
  

Total

   34    $ 13.33    34    556
    
  

  
  

(1) On January 31, 2005, we announced that our Board of Directors had authorized the repurchase of up to 1,000 shares of our common stock from time to time on the open market or in privately negotiated transactions. This stock repurchase program does not have a specified termination date. Any repurchased shares will be available for use in connection with our stock plans or other corporate purposes.

 

ITEM 4. Submission of Matters to a Vote of Security Holders

 

At the Annual Meeting of Stockholders of OPNET held on September 13, 2006, OPNET’s nominees for the two Class II Directors for the ensuing three years were elected and the selection of Deloitte & Touche LLP as OPNET’s independent auditors for the current fiscal year was ratified.

 

With respect to the election of two Class III Directors, the voting was as follows:

 

Nominees


   For

   Withheld

Marc A. Cohen

   18,003,210    1,147,229

William F. Stasior

   17,928,655    1,221,784

 

With respect to ratification of the selection of Deloitte & Touche LLP as OPNET’s independent auditors for the current fiscal year, the voting was as follows:

 

For

   11,791,188

Against

   7,349,091

Abstain

   10,160

 

ITEM 6. Exhibits

 

Exhibits: See Exhibit Index

 

34


Table of Contents

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

           

OPNET TECHNOLOGIES, INC.

           

(Registrant)

           

By:

 

/s/ Mel F. Wesley


Date: November 6, 2006

     

Name:

 

Mel F. Wesley

           

Title:

 

Vice President and Chief Financial Officer

 

35


Table of Contents

OPNET TECHNOLOGIES, INC.

EXHIBIT INDEX

 

Exhibit
Number


  

Description


  

Source


*31.1    Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended    Exhibit 31.1 to this Quarterly Report on Form 10-Q.
*31.2    Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended    Exhibit 31.2 to this Quarterly Report on Form 10-Q.
*32.1    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002    Exhibit 32.1 to this Quarterly Report on Form 10-Q.
*32.2    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002    Exhibit 32.2 to this Quarterly Report on Form 10-Q.

* filed herewith

 

36