10-Q 1 a67361e10-q.txt FORM 10-Q QUARTER ENDED SEPTEMBER 30, 2000 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______________TO _______________. COMMISSION FILE NUMBER 000-26797 -------------------------------------------------------------------------------- CONTINUUS SOFTWARE CORPORATION (Exact name of registrant as specified in its charter) -------------------------------------------------------------------------------- DELAWARE 43-1070080 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 9401 Jeronimo Road Irvine, California 92618 (Address of principal executive offices) (949) 830-8022 (Registrant's phone 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 REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS) AND(2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS: YES NO [X] The number of shares outstanding of the Registrant's Common Stock, $.001 par value, was 11,130,314 on October 23, 2000. ================================================================================ 2 CONTINUUS SOFTWARE CORPORATION TABLE OF CONTENTS PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets at September 30, 2000 (unaudited) and December 31, 1999......... 3 Consolidated Statements of Operations and Comprehensive Operations for the Three and Nine Months Ended September 30, 2000 and 1999 (unaudited).................... 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2000 and 1999 (unaudited)................................................ 5 Notes to Consolidated Financial Statements (unaudited)...................................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................................................. 9 Item 3. Quantitative and Qualitative Disclosure About Market Risk................................... 21 PART II OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds................................................... 21 Item 4. Submission of Matters to a Vote of Security Holders......................................... 22 Item 6. Exhibits and Reports on Form 8-K............................................................ 23 Signatures.................................................................................. 24

2. 3 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONTINUUS SOFTWARE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS EXCEPT SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial statements. 3. 4 CONTINUUS SOFTWARE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial statements. 4. 5 CONTINUUS SOFTWARE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)

See Note 4 for details of assets acquired and liabilities assumed in purchase transaction. The accompanying notes are an integral part of these consolidated financial statements. 5. 6 CONTINUUS SOFTWARE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2000 (UNAUDITED) (IN THOUSANDS EXCEPT FOR SHARE AND PER SHARE AMOUNTS) 1. Basis of Presentation The accompanying consolidated financial statements have been prepared by Continuus Software Corporation (the "Company") without audit (except for balance sheet information as of December 31, 1999) in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The accompanying consolidated financial statements do not include certain footnotes and financial presentations normally required under generally accepted accounting principles and, therefore, should be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. The accounting policies followed by the Company are set forth in Note 1 of the Notes to those Consolidated Financial Statements. The results of operations for the interim periods ended September 30, 2000 are not necessarily indicative of the results to be expected for the entire fiscal year ending December 31, 2000. For further information on additional factors that may affect future results, please refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 2 and the Consolidated Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. 2. Net Loss Per Share Basic earnings per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options and warrants, in the weighted average number of common shares outstanding for a period, if dilutive. 3. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which the Company is required to adopt effective in its fiscal year 2001. SFAS No. 133 will require the Company to record all derivatives on the balance sheet at fair value. The Company does not currently engage in hedging activities but will continue to evaluate the effects of adopting SFAS No. 133. The Company will adopt SFAS No. 133 in its fiscal year 2001. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 summarizes the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 is effective for the fourth quarter of fiscal year 2000. The Company has determined that there will be no impact from SAV 101 on its financial statements. In March 2000, the FASB issued Interpretation No. 44 (FIN 44), "Accounting for Certain Transactions involving Stock Compensation." (FIN 44) is an interpretation of Accounting Principal Board's Opinion No. 25, 6. 7 "Accounting for Stock Issued to Employees" (APB 25). Among other matters, (FIN 44) clarifies the application of APB 25 regarding the definition of employee for purposes of applying APB 25, the criteria for determining whether a plan qualifies as non-compensatory and the accounting consequences of modifications to the terms of a previously issued stock options or similar awards. The Company adopted the provisions of (FIN 44) in the third quarter of 2000. The adoption of (FIN 44) did not have a material impact on the Company's financial condition or results of operations. 4. Pagoda Acquisition On February 10, 2000, the Company completed the purchase of all the outstanding common shares and options to purchase common shares of Pagoda Corporation in exchange for approximately 820,000 shares of the Company's common stock valued at $9,951 and $1,000 in cash, net of cash acquired of $27. The acquisition was accounted for using the purchase method of accounting and the purchase price of $11,114, which included $163 of direct acquisition costs, was allocated as follows: Current assets.............................. $ 124 Notes receivable............................ 187 Property.................................... 26 Goodwill.................................... 8,771 Developed technology........................ 2,083 Other intangibles........................... 175 Liabilities assumed......................... (252) ------- Total purchase price................... $11,114 =======

5. Segment Information Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company's reportable operating segments include software licenses and services. The software licenses operating segment develops and markets the Company's eAsset management products. The services segment provides after-sale support for software products and fee-based training and consulting services related to the Company's products. The Company does not allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of sales and gross profit. 7. 8 Operating segment data for the three months and nine months ended September 30, 2000 and 1999 was as follows:

(1) Includes amortization of developed technology of $260 and $608 for the three and nine months ended September 30, 2000, respectively, which is included in total cost of revenue in the accompanying Consolidated Statements of Operations and Comprehensive Operations. Revenues are attributed to geographic areas based on the location of the entity to which the products or services were sold. United States information is derived from U.S. operations and includes revenues from sales to Canadian entities for the three and nine months ended September 30, 2000 of $400 and $1,000, respectively, and for the three and nine months ended September 30, 1999 of $400 and $1,900, respectively. No single country outside of the United States had a material amount of long-lived assets except for such assets in the United Kingdom of $446 and $541 for the periods ended September 30, 2000 and 1999, respectively.

8. 9 Nine months ended September 30, 2000 Revenues............................... 15,800 18,200 (4,100) 29,900 Gross profit........................... 9,500 10,400 19,900 Long-lived assets...................... 17,200 1,200 (1,400) 17,000 Nine months ended September 30, 1999 Revenues............................... 17,700 13,000 (4,000) 26,700 Gross profit........................... 14,300 5,600 19,900 Long-lived assets...................... 1,700 1,000 2,700

During the three and nine months ended September 30, 2000 and 1999, no single customer accounted for 10% or more of total revenue. 6. Stock Option Plans The following is a summary of stock option or restricted stock transactions under the Company's stock option plans, including the Employee Stock Option Plan and 1997 Equity Incentive Plan, for the three months ended September 30, 2000:

7. Significant Agreement On February 14, 2000, the Company signed a five year lease agreement for its new headquarters. The total value to be paid over the life of the lease is $4,424. Of this amount, $460 will be paid in 2000, $813 in 2001, $930 in 2002, $940 in 2003, $961 in 2004 and $320 in 2005. On May 22, 2000, the Company invested $2,000 in Project 1918, Inc., a new start-up company. In return for this investment, the Company received 2,000,000 shares of Series A-1 Preferred Stock. During the quarter ended September 30, 2000, the Company took a $1,500 write-down in the carrying value of the investment in Project 1918, Inc., an early stage Internet company based on discussions with the management of Project 1918, Inc. regarding the current valuation of the company. 8. Subsequent Event On October 24, 2000, the Company entered into a definitive merger agreement with Telelogic AB. Pursuant to the merger agreement, Telelogic has commenced a cash tender offer for all outstanding shares of Continuus at $3.46 per share and depending on the success of the tender offer, will effect a merger pursuant to which we will become a wholly-owned subsidiary of Telelogic. 9. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained that are not historical facts. When used in this Report, the words "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions are generally intended to identify forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including to differ materially from those expressed or implied by these forward-looking statements, including the factors discussed under "Risk Factors." OVERVIEW We provide software products and services for eAsset management, an emerging market segment that enables organizations to more effectively develop, enhance, deploy and manage their Internet and enterprise software systems. We originally incorporated in 1984 as a supplier of application software for the automotive industry. In 1987, we sold our application software business to focus on the development of a software change management product. In subsequent years, we expanded our focus to encompass a fully integrated change management suite. In 1994, we released the 4.0 version of the Continuus Change Management Suite. In 1998, we began expanding our focus to include eAsset management. Since 1995, we have licensed our products to over 500 customers worldwide. Substantially all revenues have been derived from software licenses or from related services. Software license revenues are primarily based on the number of end-user seats and the number of copies of our server products that are licensed by customers. Customers often obtain an initial license for small groups and may later purchase additional licenses to cover more users. Software license transactions generally average less than $100,000, although larger transactions do occur. We recognize revenues in accordance with the American Institute of Certified Public Accountants Statement of Position No. 97-2. License revenues from sales to end users are recognized upon shipment of the product if a signed contract exists, the fee is fixed and determinable and collection is deemed probable. If an acceptance period is provided, revenue is recognized upon the earlier of customer acceptance or the expiration of that period. Service revenues include consulting, training and maintenance services. We recognize consulting and training service revenues when earned and maintenance revenues ratably over the term of the applicable agreement, generally 12 months. Consulting and training revenues are dependent upon the number of new software licenses and the number of employees and consultants available to staff engagements. Maintenance revenues are also dependent upon new software licenses and the rate at which existing customers renew their support agreements. The gross margins on the software licenses are significantly higher than the gross margins achieved for services. Total gross margins may be lower to the extent that service revenues increase as a percentage of total revenues. We market our software and services in North America through a direct sales organization. Since 1995, we have invested significant financial and management resources to establish and grow our direct sales and support operations in France, Germany, the United Kingdom, Ireland and Australia. Our foreign subsidiaries bill customers and incur expenses in their local currencies, which are translated into U.S. dollars for financial accounting purposes. Accordingly, fluctuations in foreign currency exchange rates may cause fluctuations in our reported operating results. In addition, fluctuations in foreign currency exchange rates impact the dollar value of foreign currency-denominated accounts receivable and other assets. We do not currently utilize foreign currency hedging instruments; however, we believe that 10. 11 hedging may be utilized in the future to manage risks associated with foreign currency fluctuations. We market our software through distributors covering: Australia, Denmark, Finland, India, Italy, Israel, the Netherlands, Norway, Spain and Sweden. The transactions with our distributors are conducted in U.S. dollars. Total revenues from customers located outside North America accounted for approximately 56.7% and 44.2% for the three months ended September 30, 2000 and 1999, respectively. On October 30, 2000, Raindrop Acquisition Corporation, a Delaware corporation and a direct wholly owned subsidiary of Telelogic AB, a company organized under the laws of Sweden, filed a Tender Offer Statement on Schedule TO with the Securities and Exchange Commission to purchase all the outstanding shares of our common stock at a price of $3.46 per share net to the sellers in cash (subject to applicable withholding taxes), without interest, upon the terms and subject to the conditions set forth in the Offer to Purchase, dated October 30, 2000, and the related Letter of Transmittal (which, together with the Offer to Purchase and any amendments or supplements thereto, constitute the "Offer") included in the Schedule TO. The Offer is being made pursuant to an Agreement and Plan of Merger, dated as of October 25, 2000, among Telelogic, Raindrop and us. The merger agreement provides that, among other things, as soon as practicable after the purchase of shares of our common stock pursuant to the Offer and the satisfaction of the other conditions set forth in the merger agreement and in accordance with the relevant provisions of the Delaware General Corporation Law, Raindrop will be merged with and into us. Following consummation of the merger, we will continue as the surviving corporation and will become a wholly owned subsidiary of Telelogic. At the effective time of the merger, each remaining outstanding share of our common stock will be converted into the right to receive $3.46 in cash or any greater amount per share paid pursuant to the Offer. RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 Software Licenses. Software license revenues were $6.0 million and $16.0 million for the three and nine months ended September 30, 2000, respectively, and $5.3 million and $14.3 million for the comparable periods in 1999. This represents increases of 12.7% and 11.60% for the three and nine month periods, respectively. Software license revenues in North America were $1.7 million and $7.4 million for the three and nine months ended September 30, 2000, respectively, and $3.0 and $8.1 million for the comparable periods in 1999. This represents decreases of 43.7% and 8.6% for the three and nine month periods, respectively. Software license revenues from international operations were $4.3 million and $8.6 million for the three and nine months ended September 30, 2000, respectively and $2.3 million and $6.2 million for the comparable periods in 1999. This represents increases of 88.1% and 37.7% for the three and nine month periods, respectively. The decrease in North American revenue for the three and nine months ended September 30, 2000 was due to a trend of downward pressure on deal sizes and longer technical evaluations, particularly in the dot.com and e-business markets. However, the increases in international sales for the three and nine month periods, were a result of increased sales volume primarily due to an increase in the sales force and sales force productivity. Services. Service revenues were $5.0 million and $13.9 million for the three and nine months ended September 30, 2000, respectively, and $4.4 million and $12.4 million for the comparable periods in 1999. This represents increases of 14.5% and 12.1% for the three and nine month periods, respectively. The increases were primarily due to increased orders for maintenance services from new and existing customers. Cost of Software Licenses. The cost of software license revenues includes both the royalty costs associated with third-party software, which is embedded in our products, and the costs associated with product documentation, packaging and shipping. The cost of software license revenues was $260,000 and $835,000 for the three and nine months ended September 30, 2000, respectively and $152,000 and 11. 12 $470,000 for the comparable periods in 1999. This represents increases of 71.1% and 77.7% for the three and nine month periods, respectively. The increases were primarily due to higher license sales and higher royalty costs associated with third party software. Gross margins on software licenses were 95.6% and 94.8% for the three and nine months ended September 30, 2000, respectively, and 97.1% and 96.7% for the comparable periods in 1999. Cost of Services. The cost of service revenues consists primarily of salaries and related expenses for consultants and technical support personnel. The cost of service revenues was $2.9 million and $8.6 million for the three and nine months ended September 30, 2000, respectively, and $2.2 million and $6.3 million for the comparable periods in 1999. This represents increases of 18.6% and 34.8% for the three and nine month periods, respectively. The increases were primarily due to increases in the size of our professional services organization worldwide. Gross margins on service revenues were 40.8% and 38.2% for the three and nine months ended September 30, 2000, respectively, and 48.7% and 48.6% for the comparable periods in 1999. The decrease in gross margins on service revenues was primarily due to increased utilization of third party consultants as well as decreased utilization of employees as new employees train to become more productive in future quarters. Amortization of Developed Technology. Amortization of developed technology was $260,000 and $608,000 for the three and nine months ended September 30, 2000, respectively, compared to none for the comparable periods in 1999. The increase is due entirely to the developed technology purchased as part of the Pagoda acquisition in February 2000. Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and bonuses earned by sales and marketing personnel, field office expenses and travel and entertainment and promotional expenses. Sales and marketing expenses were $6.0 million and $17.4 million for the three and nine months ended September 30, 2000, respectively, and $4.6 million and $12.8 million for the comparable periods in 1999. This represents increases of 32.0% and 35.9% for the three and nine month periods. The higher sales and marketing expenses for the three and nine months ended September 30, 2000 were due to increased marketing programs and increases in sales and marketing personnel expenses, including commissions and compensation, resulting from new hires, a larger sales force and increased sales. As a percentage of total revenues, sales and marketing expenses were 55.0% and 58.2% for the three and nine months ended September 30, 2000, respectively, and 47.3% and 47.9% for the comparable periods in 1999. Research and Development. Research and development expenses consist primarily of expenses related to software development personnel and other costs associated with product development. All costs incurred in the research and development of software products and enhancements to existing software products have been expensed as incurred. Research and development costs were $2.6 million and $6.9 million for the three and nine months ended September 30, 2000, respectively, and $1.4 million and $4.0 million for the comparable periods in 1999. This represents increases of 78.0% and 72.7% for the three and nine month periods, respectively. The increases were primarily due to staffing increases to support the development of new products and the enhancement of existing products. As a percentage of total revenues, research and development expenses were 23.4% and 23.2% for the three and nine months ended September 30, 2000, respectively, and 14.9% and 15.0% for the comparable periods in 1999. General and Administrative. General and administrative expenses consist primarily of salaries, bonuses, payroll taxes and administrative costs, including legal and accounting fees and bad debts. General and administrative expenses were $1.1 million and $3.6 million for the three and nine months ended September 30, 2000, respectively, and $895,000 and $2.4 million for the comparable periods in 1999. This represents increases of 27.8% and 47.4% for the three and nine month periods, respectively. The increases were due to increased personnel expenses, including salaries, bonuses and payroll taxes 12. 13 resulting from new hires and increased legal and accounting fees and other costs as a result of becoming a public company in July 1999. As a percentage of revenue, general and administrative expenses were 10.4% and 11.9% for the three and nine months ended September 30, 2000, respectively, and 9.3% and 9.0% for the comparable periods in 1999. Other Compensation Costs, Goodwill and Other Amortizations. Other compensation costs and amortization of goodwill and intangibles was $543,000 and $1.2 million for the three and nine months ended September 30, 2000, respectively, and $57,000 and $155,000 for the comparable periods in 1999. Compensation costs are related to the grant of options to purchase shares of common stock at exercise prices below the deemed fair market value of the Company's common stock. These costs were $75,000 and $188,000 for the three and nine months ended September 30, 2000, respectively, and $57,000 and $155,000 for the comparable periods in 1999. Goodwill and intangible amortization related to acquisitions was $468,000 and $1.1 million for the three and nine months ended September 30, 2000, respectively. Other Expenses, Net. Other expenses consist primarily of interest income, interest expense and foreign currency translation losses. Other expenses were $1.8 million and $1.9 million for the three and nine months ended September 30, 2000, respectively, and $34,000 and $612,000 for the comparable periods in 1999. The increases for the three and nine month periods ended September 30, 2000, were due to a $1.5 million write-down in the carrying value of the investment in Project 1918, Inc., an early stage Internet company based on discussions with the management of Project 1918, Inc. regarding the current valuation of the company as well as higher losses from foreign currency translation caused by the strengthening of the dollar as compared to certain foreign currencies. As a percentage of total revenues, other expenses were 16.9% and 6.5% for the three and nine months ended September 30, 2000, and 0.4% and 2.2% for the comparable periods in 1999. Income Tax Provision. The income tax provision for the three and nine months ended September 30, 2000 and September 30, 1999, consisted solely of minimum state income taxes due to our net loss on a year to date basis for the nine months ended September 30, 2000 and September 1999. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2000, we had cash and cash equivalents of approximately $6.1 million, a decrease of $5.4 million from December 31, 1999. Investments in securities were $0 at September 30, 2000, down from $9.1 million at December 31, 1999. In July 1999 we received net proceeds of $17.4 million from our initial public offering. Prior to our initial public offering, we financed our operations primarily through private placements of our equity securities, which provided net proceeds totaling $18.4 million. We also borrowed $6.0 million through the issuance of a senior secured convertible debenture in 1997. As of September 30, 2000, we had $332,000 outstanding under capital equipment lease lines of credit and no other outstanding lines of credit. In addition, we have entered into a $2,000,000 revolving line of credit with a commercial bank, which expires in April 2001. We currently have not made any draws on this line of credit. Our operating activities used cash of $9.1 million for the nine months ended September 30, 2000 and provided cash of $3.3 million for the nine months ended June 30, 1999. The increase in cash used by operating activities is primarily due to the increase in net loss. Net cash provided by investing activities was $3.1 million for the nine months ended September 30, 2000 and net cash used in investing activities was $5.1 million for the nine months ended September 30, 1999. Cash paid for the acquisition of Pagoda Corporation, net of cash acquired, was $973,000 for the nine months ended September 30, 2000. Cash paid for the investment in Project 1918, Inc. was $2.0 million for the nine months ended September 30, 2000. Our financing activities provided cash of approximately $461,000 in the nine months ended 13. 14 September 30, 2000 and $16.9 million for the nine months ended September 30, 1999. The primary source of funds in 1999 was our initial public offering. Expenditures for property and equipment were $4.8 million for the nine months ended September 30, 2000 and $627,000 for the nine months ended September 30, 1999. Of the property acquired during the nine months ended September 30, 2000, $1.6 million was related to the new facility costs and the remaining was for computer hardware and software as well as furniture for our new facility. As of September 30, 2000 the Company had outstanding the $6.0 million senior secured convertible debt as well as a $228,000 note payable. We believe that our existing cash balances, cash from operations and cash available from financing activities will be sufficient to finance our operations through at least the next 12 months. EUROPEAN MONETARY UNION Within Europe, the European Economic and Monetary Union introduced a new currency, the euro, on January 1, 1999. The new currency is in response to the European Union's policy of economic convergence to harmonize trade policy, eliminate business costs associated with currency exchange and to promote the free flow of capital, goods and services. On January 1, 1999, the participating countries adopted the euro as their local currency, initially available for currency trading on currency exchanges and non-cash transactions such as banking. The existing local currencies, or legacy currencies, will remain legal tender through January 1, 2002. Beginning on January 1, 2002, euro-denominated bills and coins will be issued for cash transactions. For a period of up to six months from this date, both legacy currencies and the euro will be legal tender. On or before July 1, 2002, the participating countries will withdraw all legacy currencies and exclusively use the euro. Our transactions are recorded in both U.S. dollars and foreign currencies. Future transactions may be recorded in the euro. We have not incurred and do not expect to incur any significant costs from the continued implementation of the euro. However, the currency risk of the euro could harm our business. DISCLOSURE ABOUT FOREIGN CURRENCY RISK A significant portion of our revenues have been derived from international sources, with our international customers accounting for approximately 45.5% of our fiscal 1999 revenues. We regularly pursue new customers in various domestic and international locations. Changes in the value of the U.S. Dollar versus the local currency in which our products are sold, along with the economic and political conditions of such foreign countries, could adversely affect our business, financial condition and results of operations. In addition, the weakening of an international customer's local currency and banking market may negatively impact such customer's ability to meet their payment obligations to us. Although we currently believe that our international customers have the ability to meet all of their obligations to us, there can be no assurance that they will continue to be able to meet such obligations. We regularly monitor the credit worthiness of our international customers and make credit decisions based on both prior sales experience with such customers as well as current financial performance and overall economic conditions. We may decide in the future to offer certain foreign customers extended payment terms. 14. 15 RISK FACTORS Our business, financial condition or results of operations could be harmed by any of the following risks. THE PROPOSED MERGER WITH TELELOGIC MAY NOT BE COMPLETED OR WE MAY NOT REALIZE THE ANTICIPATED BENEFITS OF THE MERGER On October 25, 2000, Continuus entered into a merger agreement with Telelogic AB, pursuant to which a wholly-owned subsidiary of Telelogic has commenced a tender offer to purchase all of the outstanding shares of Continuus' common stock. Consummation of the merger agreement is subject to the satisfaction of several conditions. If the tender offer is not consummated, or if the merger agreement is terminated for any reason, our stock price will likely fall and our relationships with our customers and employees may become unstable which could result in a loss of our employees or customers. Moreover, if the merger agreement is terminated for any reason, we may experience constraints on our liquidity and capital resources and may need to seek an alternative transaction, such as an extensive public auction process, which could cause significant disruption in the existing operations of Continuus. OUR OPERATING RESULTS FLUCTUATE SIGNIFICANTLY Our quarterly revenues and operating results fluctuate significantly and may cause the price of our stock to fall. Our revenues and operating results depend primarily on the volume and timing of customer contracts we receive during a given quarter and the percentage of each contract we can recognize as revenue during each quarter. We have often recognized a substantial portion of our revenues in the last month of a quarter, with a concentration of these revenues in the last weeks or days of the third month. A delay in an anticipated sale near the end of a quarter can seriously harm our operating results for that quarter. Accordingly, our operating results may be below the expectations of analysts and investors. In this event, the price of our common stock will likely fall. Our expense levels are relatively fixed in the short term and are based, in part, on our expectations of our future revenues. As a result, any delay in generating or recognizing revenues could cause significant variations in our operating results from quarter to quarter and could result in increased operating losses. SEASONAL TRENDS IN SALES OF OUR SOFTWARE PRODUCTS MAY AFFECT OUR QUARTERLY OPERATING RESULTS We have experienced and expect to continue to experience seasonality in sales of our software products. These seasonal trends materially affect our quarter-to-quarter operating results. We may experience weaker demand for our products and services in our third quarter each year, particularly in international markets, as a result of reduced sales activities during the summer months. As a result of customer buying patterns, we may also realize lower revenues in the first quarter of each year than in the preceding fourth quarter. WE MAY INCUR FUTURE LOSSES We may not be able to achieve profitability. We incurred a net loss of $11.3 million for the nine months ended September 30, 2000. As of September 30, 2000, we had an accumulated deficit of $34.4 million. We expect to continue to increase our sales and marketing, product development and administrative expenses. As a result, we will need to generate significant additional revenues to achieve profitability. 15. 16 Although our revenues have grown in recent quarters, with the exception of the three months ended June 30, 2000, we cannot be certain that revenue growth will continue or that we will achieve sufficient revenues for profitability. If we do achieve profitability in any period, we cannot be certain that we will sustain or increase profitability on a quarterly or annual basis. A REDUCTION IN REVENUES FROM THE CONTINUUS CHANGE MANAGEMENT SUITE WOULD HARM OUR BUSINESS A decline in the demand for Continuus Change Management Suite and the revenues associated with licenses of the Continuus Change Management Suite would reduce our total revenues and harm our business. We expect that the Continuus Change Management Suite will continue to account for a substantial portion of our total revenues for the foreseeable future. The following events may reduce the demand for the Continuus Change Management Suite: - competition from other products; - significant flaws in our software products or incompatibility with third-party hardware or software products; - negative publicity or evaluation; or - obsolescence of the hardware platforms or software environments in which our systems run. SINCE OUR FUTURE REVENUES PARTIALLY DEPEND ON OUR NEW INTERNET PRODUCTS, OUR REVENUES MAY SUFFER IF WE CANNOT SUCCESSFULLY MARKET THESE NEW PRODUCTS A substantial portion of our revenues in the future may be derived from new Internet products and related services. A decline in the price of, or demand for, new Internet products, or our failure to achieve broad market acceptance of new Internet products, may reduce our revenues. WE MAY NOT BE ABLE TO RECRUIT AND RETAIN THE PERSONNEL WE NEED TO ACHIEVE SIGNIFICANT REVENUE GROWTH We may not be able to recruit and retain the personnel we need to achieve significant revenue growth. Our future success depends upon our ability to recruit, train and retain additional sales and technical support personnel. We sell our products primarily through our direct sales force and we support our customers with our internal technical support staff. In the past, we have had difficulty recruiting and retaining qualified personnel, and we cannot guarantee that we will not experience similar difficulties in the future. Factors that may affect our ability to recruit and retain personnel include: - our ability to effectively manage an expansion of our sales and technical support personnel and retain this personnel; and - competition for qualified personnel from larger, more established companies who have greater financial resources than we do. In 1996 and 1998, we suffered a material decline in sales growth due to turnover in our sales force. If we experience turnover in our sales force in the future, our operating results will suffer. Newly hired sales personnel generally do not become fully productive until they have worked for at least two quarters. Because of the time required to recruit new sales personnel and for them to become fully productive, we cannot quickly and easily expand our sales force in response to unanticipated events. 16. 17 THE SALES CYCLE FOR OUR PRODUCTS IS LONG AND MAY HARM OUR OPERATING RESULTS The period of time between initial customer contact and an actual sales order may span six months or more. This long sales cycle increases the risk that we will not forecast our revenue accurately and adjust our expenditures accordingly. The longer the sales cycle lasts, the more likely a customer is to decide not to purchase our products or to scale down its order of our products for various reasons, including: - changes in our customers' budgets and purchasing priorities; - actions by competitors, including introduction of new products and price reductions; and - diversion of resources and management's attention to other information technology issues. In addition, we often must provide a significant level of education to our prospective customers regarding the use and benefit of our products, which may cause additional delays during the evaluation process. IF WE DO NOT CONTINUE TO RECEIVE REPEAT BUSINESS FROM EXISTING CUSTOMERS, OUR REVENUE WILL SUFFER If we fail to generate repeat and expanded business from our customers, our revenues will suffer. Our ability to generate repeat business from current customers depends on many factors. Most of our current customers initially purchase a limited number of licenses as they implement and adopt our products. Even if the customer successfully uses our products, customers may not purchase additional licenses to expand the use of our products. Purchases of expanded licenses by these customers will depend on their success in deploying our products, their satisfaction with our products and support services and their perception of competitive alternatives. A customer's decision whether to widely deploy our products and purchase additional licenses may also be affected by factors that are outside of our control or which are not related to our products or services. In addition, as we deploy new versions of our products or introduce new product suites, our current customers may not require the functionality of our new products and may not ultimately license these products. INTENSE COMPETITION MAY CAUSE US TO REDUCE PRICES OR LOSE CUSTOMERS The markets for integrated Internet and enterprise software asset management solutions are intensely competitive, subject to rapid change and sensitive to new product introductions or enhancements and marketing efforts by industry participants. We are experiencing significant competition and expect to experience increasing levels of competition in the future. Competition has resulted in price reductions, reduced margins and may result in loss of customers, which in turn could harm our profitability. Many of our existing competitors, as well as a number of potential competitors, have larger technical staffs, more established and larger marketing and sales organizations, and significantly greater financial resources than we do. Moreover, we have limited proprietary barriers to entry that could keep our competitors from developing similar products or selling competing products in our markets. We may not be able to maintain our competitive position against current or future competitors, especially those with greater resources. IF THE EMERGING MARKET FOR EASSET MANAGEMENT SOLUTIONS DOES NOT DEVELOP AS WE ANTICIPATE, OUR REVENUES MAY SUFFER We are expanding beyond our traditional software change management solution to provide our customers with eAsset management, which provides a more comprehensive, integrated solution to support broader 17. 18 needs. Potential customers may not fully appreciate the value of our comprehensive and integrated eAsset management solution as compared to traditional change management software. As a result, the eAsset management market generally may not develop and continue or grow as we anticipate. Any failure of this market to develop or grow would harm our revenues. CHANGES IN INTERNET TECHNOLOGY AND STANDARDS MAY IMPEDE MARKET ACCEPTANCE OF OUR INTERNET PRODUCTS Rapidly changing Internet technology and standards may impede market acceptance of new Internet products. The success of Internet products will require us to develop and introduce new technologies and product suites and to offer functionality that we do not currently provide. New Internet products have been designed and the full eAsset management solution will be designed based upon prevailing Internet technology. If Internet technologies emerge that are incompatible with new Internet products we develop, our products may become obsolete and existing and potential new customers may seek alternatives to them. We may not be able to quickly adapt our products to new Internet technology. THE COSTS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS MAY NEGATIVELY IMPACT OUR OPERATING MARGINS Our international operations require and will continue to require significant management attention and financial resources. If we fail to expand international sales in a timely and cost-effective manner, our operating margins will decrease. We believe that our growth and profitability will depend in part on additional expansion of sales in foreign markets. IF WE CANNOT MANAGE THE ADDITIONAL CHALLENGES PRESENTED BY OUR INTERNATIONAL OPERATIONS, OUR REVENUES AND PROFITABILITY MAY SUFFER We face additional challenges from our continued operations in foreign countries. Our revenues and profitability could suffer if we cannot manage these challenges, which include: - longer payment cycles; - difficulties in staffing and managing foreign operations; - increased sales and marketing and research and development expenses; - costs and risks of relying upon distributors; - various and changing regulatory requirements; - export restrictions and availability of export licenses; - tariffs and other trade barriers; - political and economic instability; and - potentially adverse tax laws. Foreign laws also govern a certain number of our customer purchase agreements, which may differ significantly from U.S. laws. Therefore, we may be limited in our ability to enforce our rights under foreign agreements and to collect payments should any customer refuse to pay us. 18. 19 FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN CURRENCY TRANSACTION LOSSES Our international customers pay us in their local currencies. Consequently, any gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute to fluctuations in our operating results. Although we may utilize some hedging in the future, we currently do not utilize foreign currency hedging instruments. Historically foreign currency gains and losses have not been material to our financial performance. We cannot guarantee that fluctuations in currency rates will not harm our business, operating results and financial condition in the future. FAILURE TO MANAGE OUR GROWING OPERATIONS COULD INCREASE COSTS AND CAUSE DELAYS IN MEETING OUR BUSINESS OBJECTIVES We plan to increase business opportunities through an expansion of our distribution network in the United States and internationally. However, we cannot guarantee that the efforts and funds directed towards expanding our distribution network will succeed. Our failure to implement new operational and financial control systems to accommodate growth could increase costs and cause delays in meeting our objectives. Any future growth will also depend on, among other things, our ability to gain market acceptance for our products in new geographic areas and to monitor and control the additional costs and expenses associated with expansion. We cannot guarantee that we can successfully manage these aspects of our business. Any business opportunities will increase demands on our systems and controls. To deal with these concerns, we will need to implement a variety of new and upgraded operational and financial systems, procedures and controls and to hire additional administrative personnel. We cannot be sure that we can complete the implementation of these systems, procedures and controls or hire needed personnel in a timely manner. OUR PRODUCTS MAY BECOME OBSOLETE AND UNMARKETABLE The introduction of products utilizing new technologies and the emergence of new industry standards could render our existing products and products currently under development obsolete and unmarketable. The following factors characterize the markets for our products: - rapid technological advances; - evolving industry standards; - changes in end-user requirements; and - frequent new product introductions and enhancements. As a result, our future success depends upon our ability to enhance our current products and successfully develop, introduce and sell new products that incorporate new technology and respond to evolving end-user requirements. Any failure to anticipate or adequately respond to technological developments or end-user requirements, any significant delays developing or introducing new products, or any failure of new products or features to provide the benefits expected or to achieve market acceptance could damage our competitive position in the marketplace and reduce revenues. We cannot guarantee that we will succeed in developing and marketing new products or enhancements on a timely basis or that we will not experience significant delays in the future. 19. 20 SIGNIFICANT LIABILITY CLAIMS FROM OUR CUSTOMERS COULD REDUCE OUR REVENUES, INCREASE OUR COSTS AND DELAY MARKET ACCEPTANCE OF OUR PRODUCTS Because our software products are complex, they often contain errors or "bugs" that can be detected at any point in a product's life cycle. These defects are most frequently found during the period immediately following the introduction of new products or enhancements to existing products and may be discovered in the future. Software defects discovered after we ship our products could result in loss of revenues or delays in market acceptance. Although we do from time to time incur costs in correcting software defects, to date, no errors in our software products have materially affected our results of operations. Because we rely on our own products in connection with developing our software, any software errors or defects could make it more difficult for us to develop software in the future. We typically design our customer license agreements to contain provisions which limit our exposure to potential product liability claims. Specifically, in agreements with our customers we attempt to limit our liability for special and indirect damages, as well as damages related to the loss of data, revenue or profits. We also attempt to limit our liability to the contract price or the replacement cost of the software. However, we cannot guarantee that contractual limitations of liability would be enforceable or would otherwise protect us from liability for damages to a customer resulting from a defect in one of our products, or associated with the professional services we render. Although we maintain insurance which covers damages arising from the implementation and use of our products, we are not certain that our insurance would cover or be sufficient to cover any product liability claims against us. Moreover, we incur risks of professional and other liability stemming from our training and consulting services. Any product liability or other claims against us, if successful and of sufficient magnitude, could harm our profitability and future sales. FUTURE ACQUISITIONS MAY DECREASE OUR PROFIT MARGINS BY CONSUMING RESOURCES Acquisitions can be expensive and time-consuming transactions. If we acquire businesses or technologies in future acquisitions, our resources may be diverted to completing the acquisitions and assimilating the acquired businesses or technologies. Our profit margins could be negatively affected by this consumption of resources. THE VALUE OF AN ACQUIRED BUSINESS OR TECHNOLOGY MAY DIMINISH FOLLOWING AN ACQUISITION We do not have significant experience at evaluating or completing acquisitions. If the value of a business or technology we acquire diminishes following an acquisition, our profitability could be harmed. The following occurrences may cause the value to diminish: - we might lose the key employees and customers of an acquired business; - the technology acquired may prove to be unproductive or may infringe on the rights of another; - a newly-acquired business may not perform as well as we expected; and - we may assume unknown liabilities. OUR STOCK PRICE IS VOLATILE The stock market in general, and the Nasdaq National Market and the stock of software companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to a company's operating performance. The trading prices of many software companies' 20. 21 stocks are at or near historical highs and these trading prices and multiples are substantially above historical levels. The trading price of our common stock has also fluctuated and may continue to fluctuate in response to factors described elsewhere in this report and due to: - general market conditions; - announcements of technological innovations or new products; - publicity regarding actual or potential results with respect to technologies or products under development; - changes in recommendations of securities analysts; and - other events or factors, many of which are beyond our control. These broad market and industry factors may reduce our stock price, regardless of our actual operating performance. WE MAY BE SUBJECT TO LITIGATION DUE TO THE VOLATILITY OF OUR STOCK PRICE In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted against volatile companies. Securities class-action litigation, if instituted, could result in substantial costs and a diversion of management's attention and resources, which would harm our profitability. SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD CAUSE OUR STOCK PRICE TO FALL If our stockholders sell substantial amounts of our common stock in the public, the market price of our common stock could fall. Such sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. OUR INVESTMENT IN PROJECT 1918, INC. IS SUBJECT TO A HIGH DEGREE OF RISK In April 2000, we purchased preferred stock of Project 1918, Inc., a newly formed B2B e-commerce company, for $2.0 million. Project 1918, Inc. is a very early stage company, and there is no market for its equity securities. Our investment in Project 1918, Inc. is subject to all of the attendant risks and uncertainties associated with investments in such companies. Under applicable accounting principles, we must review the fair market value of our investment in connection with the preparation of our own financial statements and account for any diminution in value of our investment. If we determine that the fair market value of our investment has declined since the last valuation, we will have to accrue a loss on such investment equal to the decline in value and reflect such loss on our statement of operations. During the quarter ended September 30, 2000, we took a $1.5 million write-down in the carrying value of our investment in Project 1918, Inc. based on discussions with the management of Project 1918, Inc. regarding the current valuation of the company. Given the nature of Project 1918, Inc. and the risk associated with it, we could determine that the investment has become worthless and have to accrue a loss for the remainder of our investment of $500,000. There can be no assurance that any loss accrued would not have a material adverse effect on our operating results. 21. 22 RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which the Company is required to adopt effective in its fiscal year 2001. SFAS No. 133 will require the Company to record all derivatives on the balance sheet at fair value. The Company does not currently engage in hedging activities but will continue to evaluate the effects of adopting SFAS No. 133. The Company will adopt SFAS No. 133 in its fiscal year 2001. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 summarizes the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 is effective for the fourth quarter of fiscal year 2000. The Company has determined that there will be no impact from SAB 101 on its financial statements. In March 2000, the FASB issued Interpretation No. 44 (FIN 44), "Accounting for Certain Transactions involving Stock Compensation." (FIN 44) is an interpretation of Accounting Principal Board's Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). Among other matters, (FIN 44) clarifies the application of APB 25 regarding the definition of employee for purposes of applying APB 25, the criteria for determining whether a plan qualifies as non-compensatory and the accounting consequences of modifications to the terms of a previously issued stock options or similar awards. The Company adopted the provisions of (FIN 44) in the third quarter of 2000. The adoption of (FIN 44) did not have a material impact on the Company's financial condition or results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Our financial instruments include cash and long-term debt. At September 30, 2000, the carrying values of our financial instruments approximated their fair values based on current market prices and our incremental borrowing rate. We currently do not have any material debt with variable interest rates, so we do not have interest rate risk from a liability perspective. We do have cash and cash equivalents and short-term investments. This cash portfolio exposes us to interest rate risk as short-term investment rates can be volatile. Given the short-term maturity structure of our investment portfolio, and the high-grade investment quality of our portfolio, we believe that we are not subject to principal fluctuations and the effective interest rate of our portfolio tracks closely to various short-term money market interest rate benchmarks. We have not invested in derivative financial instruments. We have foreign currency exposure since we transact business in foreign currencies. However, foreign currency translation and transaction gains and losses have not been significant. A significant change in foreign currency values could harm our financial position and results of operations. PART II OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On July 28, 1999, the Company's Form S-1 registration statement (File No. 333-76893) was declared effective by the Securities and Exchange Commission. The registration statement, as amended, covered the offering of 2,523,642 shares of common stock. The offering commenced on July 29, 1999 and the sale to the public of 2,523,642 shares of common stock at $8.00 per share was completed on August 3, 1999 for an aggregate price of approximately $20.2 million. The registration statement covered 22. 23 an additional 378,546 shares of common stock that the underwriters had the option to purchase solely to cover over-allotments. These shares were not purchased and were withdrawn from registration. The managing underwriters for the offering were U.S. Bancorp Piper Jaffray Inc. and CIBC World Markets Corp. Expenses incurred through July 29, 1999 in connection with the issuance and distribution of common stock in the offering included underwriting discounts, commissions and allowances of approximately $1.41 million and other expenses of approximately $1.36 million. Total offering expenses of approximately $2.77 million resulted in net offering proceeds to the Company of approximately $17.4 million. No payments or expenses were paid to directors, officers or affiliates of the Company or 10% owners of any class of equity securities of the Company. Of the net offering proceeds, through September 30, 2000, we used approximately $3 million for capital expenditures, $6 million for sales and marketing activities, and $2 million for product development and support; the balance remains as working capital. ITEM 5. OTHER INFORMATION In August, 2000, Mr. Sol Zechter resigned as a member of our board of directors. Mr. Zechter's board position remains vacant. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A) EXHIBITS: 27.1 Financial Data Schedule B) REPORTS ON FORM 8-K: None. 23. 24 SIGNATURES 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. CONTINUUS SOFTWARE CORPORATION Date: November 14, 2000 By: /s/ Steven L. Johnson --------------------------------- Steven L. Johnson Vice President, Finance, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) 24.

CONTINUUS SOFTWARE CORP /CA 10-Q