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	271 MILL ROAD QUORUM OFFICE PARK CHELMSFORD, MASSACHUSETTS 01824 (978) 441-2200
	(Address and telephone number of principal executive office)

 

 

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PART I.		FINANCIAL INFORMATION		Page #
Item 1.		Financial Statements (Unaudited)
a)		Condensed Consolidated Balance Sheets:
		December 31, 2007 and September 30, 2007		3
b)		Condensed Consolidated Statements of Operations:
		Three Months Ended December 31, 2007 and 2006		4
c)		Condensed Consolidated Statements of Cash Flows:
		Three Months Ended December 31, 2007 and 2006		5
d)		Notes to Condensed Consolidated Financial Statements		6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		25
Item 4.		Controls and Procedures		25
PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings		27
Item 1A.		Risk Factors		27
Item 6.		Exhibits		27
SIGNATURES				28
CERTIFICATIONS				29

 

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Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

The Company does not provide forecasts of its future financial performance. However, from time to time, information provided by the Company or statements made by its employees may contain “forward looking” information that involves risks and uncertainties. In particular, statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. The Company cautions readers not to place undue reliance on any such forward looking-statements, which speak only as of the date they are made. The Company disclaims any obligation, except as specifically required by law and the rules of the Securities and Exchange Commission, to publicly update or revise any such statements to reflect any change in the Company’s expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements. The Company’s actual results of operations and financial condition have varied and may in the future vary significantly from those stated in any forward looking statements. Factors that may cause such differences include, without limitation, the risks, uncertainties and other information discussed in Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2007, as well as the accuracy of the Company’s internal estimates of revenue and operating expense levels.

Datawatch is engaged in the design, development, manufacture, marketing, and support of business computer software primarily for the Enterprise Information Management market which incorporates business intelligence, enterprise content management, business service management, help desk and workflow to allow organizations to access and analyze information in a more meaningful fashion.

Datawatch’s principal products are Business Intelligence Solutions (including Datawatch|ES, Monarch, Monarch Data Pump, Monarch|RMS, Datawatch|Researcher, Visual|Insight, iMergence and VorteXML), Content Management Solutions (including Datawatch|BDS and Datawatch|MailManager) and Business Service Management and Workflow Solutions (including BDS|Workflow, Visual|QSM and Visual|HD). Included in the above categories are: Datawatch|ES, an enterprise business intelligence system that provides web-enabled report management, mining and distribution as well as data analysis and MS Excel integration; Monarch, a desktop report mining and business intelligence application that lets users extract and manipulate data from ASCII report files, PDF files or HTML files produced on any mainframe, midrange, client/server or PC system; Monarch Data Pump, a data replication and migration tool that offers a shortcut for populating and refreshing data marts and data warehouses, for migrating legacy data into new applications and for providing automated delivery of reports in a variety of formats via email; Monarch|RMS, a web-based report mining and analysis solution that integrates with any existing Enterprise Report Management (“ERM”) document or content management archiving solution; Datawatch|Researcher, a development platform for building performance management, content and data aggregation and workflow solutions; Visual|Insight, a performance management solution that provides web-based knowledge management and Key Performance Indicator (“KPI”) reporting; iMergence, an enterprise report mining system; VorteXML, a data transformation product for the emerging XML market that easily and quickly converts structured text output from any system into valid XML for web services and more using any DTD or XDR schema without programming; Datawatch|BDS, a system for high-volume document capture, archiving, and online presentation; Datawatch|MailManager, a highly scalable email management solution that provides complete lifecycle, compliance and storage management for Microsoft Exchange environments; BDS|Workflow, a web-enabled enterprise business process management solution that provides highly effective processing of document intensive business transactions; Visual|QSM, a fully internet-enabled IT service management solution that incorporates workflow and network management capabilities and provides web access to multiple databases via a standard browser; and Visual|Help Desk or Visual|HD, a web-based help desk and call center solution operating on the IBM Lotus Domino platform.

On May 3, 2006, Datawatch acquired certain assets of ClearStory Systems, Inc.’s Integrated Document Archiving and Retrieval Systems (“IDARS”) business in exchange for $4,349,000 in cash and incurred $441,000

 

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in direct costs. In accordance with the purchase and sale agreement, payments equal to 30% of revenue for a period of eighteen months from the closing date (May 3, 2006) of the Datawatch|BDS product, excluding the first $337,500 of revenue, net of any claims, commenced during the Company’s third and fourth quarters of fiscal year 2007 and the final payments were made in the first quarter of fiscal year 2008. These amounts were recorded as  goodwill as additional purchase price, as incurred or accrued. At September 30, 2007, the Company had accrued approximately $329,000 related to future earn out payments. The final earn out payments were made in the first quarter of fiscal 2008 and, accordingly, no amounts are accrued at December 31, 2007. Since the acquisition date, the Company recorded approximately $1.1 million related to such earn-out payments. The activities of the IDARS business from May 3, 2006 are included in the Company’s condensed consolidated financial statements.  See Note 2 to the Condensed Consolidated Financial Statements for more detailed financial information on the acquisition of the IDARS business.

During the first quarter of fiscal 2004, the Company introduced a subscription sales model for the sale of its enterprise products. The Company continues to offer its enterprise products through perpetual licenses and introduced the subscription pricing model to allow customers to begin using the Company’s products at a lower initial cost of software acquisition. Subscriptions automatically renew unless terminated with 90 days notice following the first year of the subscription term. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The initial subscription rate is the same as the renewal rate. During the three months ended December 31, 2007 and 2006, revenues under the subscription model were $144,000 and $178,000, respectively.

CRITICAL ACCOUNTING POLICIES

In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on choices made by management, can result in different outcomes. In order for a reader to understand the following information regarding the financial performance and condition of the Company, an understanding of those accounting policies is important. Certain of those policies are comparatively more important to the Company’s financial results and condition than others. The policies that the Company believes are most important for a reader’s understanding of the financial information provided in this report are described below.

Revenue Recognition, Allowance for Bad Debts and Returns

The Company has two types of software product offerings: Enterprise Software and Desktop and Server Software. Enterprise Software products are sold directly to end-users. The Company licenses its Desktop and Server Software products directly to end-users and through distributors and resellers.  Sales to distributors and resellers accounted for approximately 39% and 35%, respectively, of total sales for the three months ended December 31, 2007 and 2006.  Revenue from the license of all software products is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed and determinable, collection is considered probable, persuasive evidence of the arrangement exists and there are no significant obligations remaining.  Both types of the Company’s software product offerings are “off-the-shelf” as such term is defined by Statement of Position No. 97-2, “Software Revenue Recognition.” The Company’s software products can be installed and used by customers on their own with little or no customization required.  Multi-user licenses marketed by the Company are sold as a right to use the number of licenses and license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations of the Company.

Desktop and Server Software products are generally not sold in multiple element arrangements. Enterprise Software sales are generally multiple element arrangements which include software license deliverables, professional services and post-contract customer support, which primarily consists of maintenance. In such multiple element arrangements, the Company applies the residual method in determining revenue to be allocated to a software license. In applying the residual method, the Company deducts from the sale proceeds the vendor specific objective evidence (“VSOE”) of fair value of the services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-

 

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contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and do not involve modification or customization of the software or any other unusual acceptance clauses or terms. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis.  Revenue from post-contract customer support services is deferred and recognized ratably over the contract period (generally one year).  Such deferred amounts are recorded as part of deferred revenue in the Company’s Condensed Consolidated Balance Sheets included elsewhere herein.

The Company also licenses its Enterprise Software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided. The customer is then invoiced every 90 days and, in accordance with SOP 97-2, revenue is recognized ratably over the period the service is provided. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The initial subscription rate is the same as the renewal rate. Subscriptions can be cancelled by the customer at any time by providing 90 days written notice following the first year of the subscription term.

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. Certain software products, including desktop versions of Monarch, Monarch Data Pump, and VorteXML sold directly to end-users, include a guarantee under which such customers may return products within 30 days for a full refund. Additionally, the Company provides its distributors with stock-balancing rights and applies the guidance found in Statement of Financial Accounting Standards No. 48, “Revenue Recognition when Right of Return Exists” (“SFAS No. 48”).  Revenue from the license of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company’s experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at the various distributors and resellers, which the Company monitors frequently. Once the estimates of potential future returns from all sources are made, the Company determines if it has adequate returns reserves to cover anticipated returns and the returns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by the Company. The Company’s returns reserves were $160,000 and $80,000 as of December 31, 2007 and September 30, 2007, respectively.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company analyzes accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends, foreign currency exchange rate fluctuations and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the collectibility of its accounts receivable, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on the Company’s financial position and results of operations. The Company’s allowance for doubtful accounts was $198,000 and $223,000 as of December 31, 2007 and September 30, 2007, respectively.

 

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Income Taxes

The Company has deferred tax assets related to net operating loss carryforwards and tax credits that expire at different times through and until 2026. Significant judgment is required in determining the Company’s provision for income taxes, the carrying value of deferred tax assets and liabilities and the valuation allowance recorded against net deferred tax assets. Factors such as future reversals of deferred tax assets and liabilities, projected future taxable income, changes in enacted tax rates and the period over which the Company’s deferred tax assets will be recoverable are considered in making these determinations. Management does not believe the deferred tax assets are more likely than not to be realized and a full valuation allowance, previously provided against the deferred tax assets, continues to be provided.  Management evaluates the realizability of the deferred tax assets quarterly and, if current economic conditions change or future results of operations are better than expected, future assessments may result in the Company concluding that it is more likely than not that all or a portion of the deferred tax assets are realizable. If this conclusion were reached, the valuation allowance against deferred tax assets would be reduced resulting in a tax benefit being recorded for financial reporting purposes. Total net deferred tax assets subject to a valuation allowance were approximately $3.6 million as of December 31, 2007.

 The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”) on October 1, 2007. FIN 48 provides a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns.

Under FIN 48, the Company first determines whether a tax authority would “more likely than not” sustain its tax position if it were to audit the position with full knowledge of all the relevant facts and other information. For those tax positions that meet this threshold, the Company measures the amount of tax benefit based on the largest amount of tax benefit that the Company has a greater than 50% chance of realizing in a final settlement with the relevant authority. Those tax positions failing to qualify for initial recognition are recognized in the first interim period in which they meet the more likely than not standard, or are resolved through negotiation or litigation with the taxing authority, or upon expiration of the statute of limitations. The Company maintains a cumulative risk portfolio relating to all of its uncertainties in income taxes in order to perform this analysis, but the evaluation of the Company’s tax position in connection with FIN 48 requires significant judgment and estimation in part because, in certain cases, tax law is subject to varied interpretation, and whether a tax position will ultimately be sustained may be uncertain. The actual outcome of the Company’s tax positions, if significantly different from its estimates, could materially impact the financial statements.

Upon adoption of FIN 48, the Company recorded a reduction of the Company’s deferred tax asset in the amount of $690,000 and a corresponding reduction to the tax asset valuation reserve of $690,000 for all identified uncertain tax positions, for any years open under the statute of limitations. The Company recorded a $75,000 tax liability fully related to foreign tax exposure. This amount was recorded as an increase to other long-term liabilities and an increase in the accumulated deficit on the Company’s Consolidated Balance Sheets.

Capitalized Software Development Costs

The Company capitalizes certain software development costs as well as purchased software upon achieving technological feasibility of the related products. Software development costs incurred and software purchased prior to achieving technological feasibility are charged to research and development expense as incurred.  Commencing upon initial product release, capitalized costs are amortized to cost of software licenses using the straight-line method over the estimated life (which approximates the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product), which is generally 24 to 72 months. The Company’s capitalized software was $363,000 and $395,000 at December 31, 2007 and September 30, 2007, respectively.

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Goodwill, Other Intangible Assets and Other Long-Lived Assets

The Company performs an evaluation of whether goodwill is impaired annually or when events occur or circumstances change that would more likely than not reduce the fair value of the applicable reporting unit below its carrying amount. The annual impairment analysis is performed each May of the applicable fiscal year. Fair value is determined using market comparables for similar businesses or forecasts of discounted future cash flows. The Company also reviews other intangible assets and other long-lived assets when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Should the fair value of the Company’s long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary.

Accounting for stock-based compensation

With the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS No. 123(R)”) on October 1, 2005, the Company is required to record the grant date fair value of stock-based compensation awards as compensation costs over the requisite service period. For the three months ended December 31, 2007 and 2006, the Company recorded stock-based compensation expense of approximately $51,000 and $27,000, respectively. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates.

The Company uses an expected stock-price volatility assumption that represents historical volatilities of the underlying stock which are obtained from public data sources. The Company believes this approach results in a reasonable estimate of volatility.  For stock option grants issued during the three months ended December 31, 2007, the Company used an expected stock-price volatility of 73% based upon the implied volatility at the time of issuance.

With regard to the weighted-average option life assumption, the Company considers the exercise behavior of past grants and models the pattern of aggregate historical exercises. Patterns are determined on specific criteria of the aggregate pool of optionees including the reaction to vesting, realizable value and short-time-to-maturity effect. For stock option grants issued during the three months ended December 31, 2007, the Company used an expected option life assumption of five years.

With regard to the forfeiture rate assumption, the Company reviews historical voluntary turnover rates. For stock option grants issued during the three months ended December 31, 2007, the Company used an annual estimated forfeiture rate of 10%. Additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated.

RESULTS OF OPERATIONS

The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the Company’s unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q. The operating results for any period should not be considered indicative of the results expected for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2007.

 

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		Three Months Ended December 31,
		2007				2006
REVENUE:
Software licenses and subscriptions			54.9%				59.5%
Maintenance and services			45.1%				40.5%
Total Revenue			100.0%				100.0%
COSTS AND EXPENSES:
Cost of software licenses and subscriptions			9.4%				9.3%
Cost of maintenance and services			18.4%				17.8%
Sales and marketing			36.6%				40.6%
Engineering and product development			12.4%				12.2%
General and administrative			19.9%				18.5%
Total costs and expenses			96.7%				98.4%
INCOME FROM OPERATIONS			3.3%				1.6%
Interest expense			0.0%				-0.5%
Interest income and other income (expense), net			1.6%				-0.1%
INCOME BEFORE INCOME TAXES			4.9%				1.0%
Provision for income taxes			0.8%				0.4%
NET INCOME			4.1%				0.6%

Three Months Ended December 31, 2007 Compared to

 Three Months Ended December 31, 2006

Total Revenues

The following table presents total revenue, total revenue increase (decrease) and percentage change in total revenue for the three months ended December 31, 2007 and 2006:

		Three Months Ended
		December 31,								Increase				Percentage
		2007				2006				(Decrease)				Change
		(In thousands)
Software licenses and subscriptions		$	3,333			$	3,438			$	(105	)			-3.1%
Maintenance and services			2,734				2,338				396				16.9%
Total revenue		$	6,067			$	5,776			$	291				5.0%

Software license and subscription revenue for the three months ended December 31, 2007 was $3,333,000 or approximately 55% of total revenue, as compared to $3,438,000 or approximately 60% of total revenue for the three months ended December 31, 2006.  This represents a decrease of $105,000 or approximately 3% from the first quarter of fiscal 2007 to the first quarter of fiscal 2008. The overall net decrease in software license and subscription revenue for the three months ended December 31, 2007 consists of a $282,000 decrease in Business Service Management and Workflow Solutions (including Visual|QSM and Visual|HD products) and a $95,000 decrease in Content Management Solutions (including Datawatch|BDS and Datawatch|MailManager products) which were partially offset by a $272,000 increase in Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch|RMS, Datawatch|ES, Datawatch|Researcher, Visual|Insight, iMergence and VorteXML products). The $272,000 increase in Business Intelligence Solutions is comprised of an increase of $444,000 associated with the Monarch product and a net decrease of approximately $172,000 for the other Business Intelligence product lines.

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Maintenance and services revenue for the three months ended December 31, 2007 was $2,734,000 or approximately 45% of total revenue, as compared to $2,338,000 or approximately 40% of total revenue for the three months ended December 31, 2006.  The increase in maintenance and services revenue includes a $277,000 increase in Content Management Solutions (including Datawatch|BDS and Datawatch|MailManager products), a $107,000 increase in Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch|RMS, Datawatch|ES, Datawatch|Researcher, Visual|Insight, iMergence and VorteXML products) and a $12,000 increase in Business Service Management and Workflow Solutions (including Visual|QSM and Visual|HD products). Maintenance and services revenue for the Business Intelligence Solutions product line increased due to higher annual maintenance contracts of $124,000 which were partially offset by lower professional services of $17,000. Maintenance and services revenue for the Content Management Solutions product line increased due to higher annual maintenance contracts of $219,000 and higher professional services of $58,000. Maintenance revenue for the Content Management Solutions product line was also positively impacted by the full recognition of revenue in the first quarter of fiscal 2008 related to the renewal of Datawatch|BDS maintenance contracts acquired through the Company’s acquisition of ClearStory Systems, Inc. on May 3, 2006. As a result of the initial valuation of the acquired maintenance contracts on the date of acquisition, the Company’s deferred revenue in the first quarter of fiscal 2007 was recognized at a discounted rate during the period leading up to the first maintenance renewal for each Datawatch|BDS contract with the Company. Maintenance and services revenue for the Business Service Management and Workflow Solutions product line increased due to higher annual professional services of $13,000 which were partially offset by lower maintenance contracts of $1,000.

Costs and Operating Expenses

The following table presents costs and operating expenses, increase/(decrease) in costs and operating expenses and percentage changes in costs and operating expenses for the three months ended December 31, 2007 and 2006:

		Three Months Ended
		December 31,								Increase				Percentage
		2007				2006				(Decrease)				Change
		(In thousands)
Cost of software licenses and subscriptions		$	572			$	537			$	35				6.5%
Cost of maintenance and services			1,120				1,032				88				8.5%
Sales and marketing expenses			2,220				2,344				(124	)			-5.3%
Engineering and product development expenses			749				705				44				6.2%
General and administrative expenses			1,206				1,068				138				12.9%
Total costs and operating expenses		$	5,867			$	5,686			$	181				3.2%

Cost of software licenses and subscriptions for the three months ended December 31, 2007 was $572,000 or approximately 17% of software license and subscription revenues, as compared to $537,000 or approximately 16% of software license and subscription revenues for the three months ended December 31, 2006. The increase in cost of software licenses and subscriptions of $35,000 is due to an increase in royalty cost specifically related to an increase in desktop sales of $444,000 which was partially offset by reduced amortization of patents and acquired software costs.

Cost of maintenance and services for the three months ended December 31, 2007 was $1,120,000 or approximately 41% of maintenance and service revenues, as compared to $1,032,000 or approximately 44%, of maintenance and service revenues for the three months ended December 31, 2006.  The increase in cost of maintenance and services of $88,000 is primarily attributable to increased international consulting costs.

Sales and marketing expenses for the three months ended December 31, 2007 were $2,220,000, or 37% of total revenues as compared to $2,344,000 or 41% of total revenues for the three months ended December 31,

 

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2006. The decrease in sales and marketing expenses of $124,000, or approximately 5%, is primarily attributable to cost savings resulting from the Company’s restructuring plan which was initiated and completed during the first quarter of fiscal year 2007 which were partially offset by an increase in costs associated with stock compensation expense, depreciation and amortization expense, lead generation, and trade show expense.

Engineering and product development expenses for the three months ended December 31, 2007 were $749,000, or 12% of total revenues as compared to $705,000, or 12% of total revenues for the three months ended December 31, 2006. The increase in engineering and product development expenses of $44,000, or approximately 6%, is primarily attributable to higher use of external development consultants and employee-related costs.

General and administrative expenses for the three months ended December 31, 2007 were $1,206,000, or 20% of total revenues as compared to $1,068,000, or 19% of total revenues for the three months ended December 31, 2006. The increase in general and administrative expenses of $138,000, or approximately 13%, is primarily attributable to an increase in costs associated with accrued professional services, accrued bonuses and employee-related compensation items.

Interest expense for the three months ended December 31, 2006 was $25,000 which resulted from the Company’s $1 million borrowing under its line of credit in the third quarter of fiscal 2006. There was no interest expense for the three months ended December 31, 2007 as the Company elected to repay its outstanding balance under its line of credit in the second quarter of fiscal 2007.

Interest income for the three months ended December 31, 2007 was  $40,000 as compared to $2,000 for the three months ended December 31, 2006. The increase in interest income was a result of higher cash balances generated by the business. Gain (loss) on foreign currency transactions for the three months ended December 31, 2007 was a gain of $56,000 as compared to a loss of $10,000 for the three months ended December 31, 2006.

Income taxes for the three months ended December 31, 2007 were $49,000 as compared to $23,000 for the three months ended December 31, 2006. The increase in income taxes of $26,000 is a result of additional estimated alternative minimum taxes in the U.S. and uncertain tax positions relative to foreign taxes.

Net income for the three months ended December 31, 2007 was $247,000 as compared to net income of $34,000 for the three months ended December 31, 2006.

OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

The Company leases various facilities and equipment in the U.S. and overseas under non-cancelable operating leases that expire through 2011. The lease agreements generally provide for the payment of minimum annual rentals, pro rata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $151,000 and $136,000 for the three months ended December 31, 2007 and 2006, respectively.

As of December 31, 2007, contractual obligations include minimum rental commitments under non-cancelable operating leases as follows:

Contractual Obligations:		Total				Less than 1 Year				1-3 Years				3-5 Years				More than 5 Years
		(in thousands)
Operating Lease
Obligations		$	913			$	348			$	473			$	92			$	—

The Company is also obligated to pay royalties ranging from 7% to 50% on revenue generated by the sale of certain licensed software products. Royalty expense included in cost of software licenses was approximately

 

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$457,000 and $387,000, respectively, for the three months ended December 31, 2007 and 2006. The Company is not obligated to pay any minimum amounts for royalties.

On August 11, 2004, the Company acquired 100% of the shares of Mergence Technologies Corporation. The purchase agreement includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch|Researcher product until September 30, 2010. The Company expensed approximately $4,000 for the three months ended December 31, 2006. No amounts were expensed for the three months ended December 31, 2007.

On May 3, 2006, the Company acquired certain assets of ClearStory Systems, Inc’s. IDARS business. The initial acquisition cost for IDARS was approximately $4,790,000, consisting of $4,349,000 in cash and direct acquisition costs of approximately $441,000.  The acquisition also includes an 18-month earn-out payment equal to 30% of net revenues of products from the IDARS business excluding the first $337,500 of revenues. The earn-out payments are considered additional purchase price and were recorded as additional goodwill. At September 30, 2007, the Company had accrued approximately $329,000 related to such earn-out payments. In accordance with the asset purchase agreement, payments commenced during the Company’s third quarter of fiscal year 2007 and the final payments were made in the first quarter of fiscal year 2008. Accordingly, no amounts are accrued as of December 31, 2007. See Note 2 to the Condensed Consolidated Financial Statements for more detailed financial information on the acquisition of IDARS.

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. If necessary, the Company would provide for the estimated cost of warranties based on specific warranty claims and claim history. However, the Company has never incurred significant expense under its product or service warranties. As a result, the Company believes the estimated fair value of these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of December 31, 2007.

The Company is required by the new sublease agreement related to its Chelmsford, Massachusetts facility to provide a letter of credit in the amount of approximately $125,000 as a security deposit to the landlord of amounts due under the lease. Cash on deposit providing security in the amount of this letter of credit is classified as restricted cash in the Company’s condensed consolidated balance sheets as of December 31, 2007 and September 30, 2007.

The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of December 31, 2007.

Certain of the Company’s agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable us to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of December 31, 2007.

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As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company’s request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company’s director and officer insurance policy limits the Company’s exposure and enables it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. The Company has no liabilities recorded for these agreements as of December 31, 2007.

LIQUIDITY AND CAPITAL RESOURCES

Management believes that its current cash balances and cash generated from operations will be sufficient to meet the Company’s cash needs for working capital and anticipated capital expenditures for at least the next twelve months. At December 31, 2007, the Company had $3,833,000 of cash and equivalents, a decrease of $8,000 from September 30, 2007.

At December 31, 2007, the Company had working capital of approximately $291,000 as compared to a working capital deficit of $279,000 at September 30, 2007. The Company expects cash flows from operations to remain positive as it anticipates continued profitability during the fiscal year ended September 30, 2008. However, if the Company’s cash flow from operations were to decline significantly, it may need to consider further reductions to its operating expenses. The Company does not anticipate additional cash requirements to fund significant growth or the acquisition of complementary technology or businesses. However, if in the future, such expenditures are anticipated or required, the Company may need to seek additional financing by issuing equity or obtaining credit facilities to fund such requirements.

The Company had net income of approximately $247,000 for the three months ended December 31, 2007 as compared to net income of approximately $34,000 for the three months ended December 31, 2006. During the three months ended December 31, 2007 and 2006, approximately $308,000 and $567,000, respectively, of cash was provided by the Company’s operations. During the three months ended December 31, 2007, the main source of cash from operations was the adjustment to net income for depreciation and amortization as well as a decrease in accounts receivable offset by a decrease in accounts payable, accrued expenses and other.

Net cash used in investing activities for the three months ended December 31, 2007 of $521,000 is primarily related to earn-out payments associated with the Company’s IDARS acquisition and the purchase of property and equipment.

Net cash provided by financing activities for the three months ended December 31, 2007 of $233,000 is related to proceeds from the exercise of stock options.

On May 3, 2006, the Company acquired certain assets of ClearStory Systems, Inc’s. Integrated Document Archiving and Retrieval Systems (“IDARS”) business. The acquisition of IDARS was consummated pursuant to an asset purchase agreement dated as of March 10, 2006 among the Company and Clearstory Systems, Inc. The purchase agreement includes a provision for payments over an 18 month period equal to 30% of net revenues of products from the IDARS business, excluding the first $337,500 of revenues, net of any claims. The earn-out payments are considered additional purchase price and were recorded as additional goodwill as incurred. At September 30, 2007, the Company had accrued approximately $329,000 related to such earn-out payments. In accordance with the asset purchase agreement, payments commenced during the Company’s third and fourth quarters of fiscal year 2007 and the final payments were made in the first quarter of fiscal year 2008. Accordingly, no amounts are accrued as of December 31, 2007.

The Mergence purchase agreement dated August 11, 2004 includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch|Researcher product

 

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for a period of six years. As the cash payments are based on recognized revenue and no minimum payments are required, they are not expected to have a significant impact on the Company’s liquidity or cash flows. See the section titled “Off Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments” included elsewhere herein for a more complete disclosure of the Company’s commitments and contingent liabilities.

An existing agreement between Datawatch and Math Strategies grants the Company exclusive worldwide rights to use and distribute certain intellectual property owned by Math Strategies and incorporated by the Company in its Monarch, Monarch Data Pump, VorteXML and certain other products. On April 29, 2004, the Company entered into a two year Option Purchase Agreement with Math Strategies giving the Company the option to purchase these intellectual property rights for $8 million. This option, if exercised, would provide the Company with increased flexibility to utilize the purchased technology in the future. In February 2006, the Company entered into an amendment to the original agreement with Math Strategies dated January 19, 1989.  Pursuant to the amendment to the license agreement, the term of the license agreement was extended to April 30, 2015. In conjunction with the license amendment, the Company also entered into an amendment to the Option Purchase Agreement dated as of April 29, 2004. Under the option purchase amendment, the option has been extended until April 30, 2015. The option purchase amendment changes the purchase price for the option to a formula price based on a multiple of the aggregate royalties paid to Math Strategies by the Company for the four fiscal quarters preceding the exercise of the option.

Management believes that the Company’s current operations have not been materially impacted by the effects of inflation.