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| ARST > SEC Filings for ARST > Form 10-K on 9-Jul-2009 | All Recent SEC Filings |
9-Jul-2009
Annual Report
The following discussion and analysis should be read in conjunction with our
"Selected Consolidated Financial Data" and consolidated financial statements and
notes thereto included elsewhere in this Annual Report on Form 10-K. This Annual
Report on Form 10-K contains "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, or the Securities Act,
and Section 21E of the Securities Exchange Act of 1934, as amended, or the
Exchange Act. These statements are often identified by the use of words such as
"may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate,"
or "continue," and similar expressions or variations. These statements are based
on the beliefs and assumptions of our management based on information currently
available to management. Such forward-looking statements are subject to risks,
uncertainties and other factors that could cause actual results and the timing
of certain events to differ materially from future results expressed or implied
by such forward-looking statements. Factors that could cause or contribute to
such differences include, but are not limited to, those identified herein, and
those discussed in the section titled "Risk Factors," set forth in Item 1A of
this Annual Report on Form 10-K and in our other SEC filings. You should review
these risk factors for a more complete understanding of the risks associated
with an investment in our securities. We disclaim any obligation to update any
forward-looking statements to reflect events or circumstances after the date of
such statements.
Overview
We are a leading provider of compliance and security management solutions that protect enterprises and government agencies. Our products help customers comply with corporate and regulatory policy, safeguard their assets and processes and control risk. Our platform collects and correlates user activity and event data across the enterprise so that businesses can rapidly identify, prioritize and respond to compliance violations, policy breaches, cybersecurity attacks and insider threats. Our ESM products correlate massive numbers of events from thousands of security point solutions, network and computing devices and applications, enabling intelligent identification, prioritization and response to external threats, insider threats and compliance and corporate policy violations. We also provide complementary software that delivers pre-packaged analytics and reports tailored to specific compliance and security initiatives, as well as appliances that streamline event log archiving.
We were founded in May 2000 and first sold our initial ESM product in June 2002. We initially funded our operations primarily through convertible preferred stock financings that raised a total of $26.8 million. Our revenues have grown from $32.8 million in fiscal 2005 to $136.2 million in fiscal 2009.
In February 2008, we completed our IPO, in which we sold 6,000,000 shares of common stock, at an issue price of $9.00 per share. We raised a total of $54.0 million in gross proceeds from our IPO, or $45.9 million in net proceeds after deducting underwriting discounts of $3.8 million and offering expenses of $4.3 million.
We achieved positive cash flows from operations in fiscal 2004 through 2009. We generated $16.8 million of cash from our operating activities during fiscal 2009, and we generally expect to continue to generate positive cash flows from operating activities on an annual basis. As of April 30, 2009, we had cash and cash equivalents and accounts receivable of $124.7 million, and an aggregate of $17.8 million in accounts payable and accrued liabilities.
Important Factors Affecting Our Operating Results and Financial Condition
We believe that the market for our products is in the early stages of development. We have identified factors that we expect to play an important role in our future growth and profitability. These factors are:
Sales of ESM Products and Appliance Products to New Customers. The market for compliance and security management software solutions is growing, with new purchases often driven by corporate compliance initiatives. We typically engage in a proof of concept with our customers to demonstrate the capabilities of our ESM products in their specific environment. A new sale usually involves the sale of licenses for one or more ESM Managers, licenses for the number and type of devices the customer intends to manage with ArcSight ESM, licenses for our console and web interfaces, installation services, training and an initial maintenance arrangement. In many cases, customers will also purchase one of our complementary software modules which enable them to implement specific sets of off-the-shelf rules for our event correlation engine that address
specific compliance and security issues and business risks. In addition, customers may purchase our ArcSight Logger appliances to address their log archiving needs. Our continued increase in the number of new customers is partly a result of sales of our ArcSight Logger products to mid-market companies. A key component of our growth will depend on our ability to sell our products to new customers. We also anticipate that a growing proportion of future new customers will be a result of initial sales of ArcSight Logger, our new ArcSight Express product and our other products sold in an appliance form factor.
Continued Sales to Our Installed Base. Many customers make an initial purchase from us and then decide whether to use our products with respect to a larger portion of their business and technology infrastructure or buy additional complementary products from us. Thus, a key component of our growth will be our ability to successfully maintain and further develop the relationships with our existing customers.
Development and Introduction of New Products. We believe it is important that we continue to develop or acquire new products and services that will help us capitalize on opportunities in the compliance and security management market. Examples of new product introductions in fiscal 2009 included our Compliance Insight Package for NERC CIP standards 002-009 and our ArcSight Express product. We continue the enhancement of our ESM products and solutions, such as the introduction of ESM appliances in June 2008, the integration with the Cisco Mobility Services Engine announced in May 2009, and the introduction of an all-in-one PCI log management appliance in July 2008 and ArcSight Logger 3.0 in September 2008. In addition, we continue to develop and release appliance versions of our software products and updates to complementary solution packages for our ArcSight Logger product.
Development of Our Channel Network. Historically, we have sold our products primarily through our direct sales force, with sales to government or international purchasers through resellers and systems integrators. We recently expanded our sales channel to assist us in penetrating the mid-market, particularly as we expanded our appliance-based offerings. We believe that our current and any new appliance-based products that we develop will be sold more effectively through resellers and, if we are successful in introducing these new products, we will become more dependent on the development of an effective channel network. Further training, certification and development of our existing channel partners will be a key factor in the success of this strategy.
Sources of Revenues, Cost of Revenues and Operating Expenses
Our sales transactions typically include the following elements: a software license fee paid for the use of our products in perpetuity or, in limited circumstances, for a specified term; an arrangement for first-year support and maintenance, which includes unspecified software updates and upgrades; and professional services for installation, implementation and training. We derive the majority of our revenues from sales of software products. We introduced complementary appliance products in fiscal 2007. We sell our products and services primarily through our direct sales force. Additionally, we utilize resellers and systems integrators, particularly in sales to government agencies and international customers.
We recognize revenues pursuant to American Institute of Certified Public Accountants, or AICPA, Statement of Position, or SOP, No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Software Revenue Recognition with Respect to Certain Arrangements, or collectively, SOP 97-2, which, if revenues are to be recognized upon product delivery, requires among other things vendor-specific objective evidence of fair value, or VSOE, for each undelivered element of multiple element customer contracts.
Revenues in fiscal 2007 and prior years were impacted by multiple element sales transactions consummated for which the revenues were deferred because we did not have vendor-specific objective evidence of fair value, or VSOE, for some product elements that were not delivered in the fiscal year of the transaction. Following identification in mid-fiscal 2007 of transactions with such undelivered elements, with respect to some of these transactions, we and our customers amended the contractual terms to remove the undelivered product elements and in other instances we have since delivered such product elements. The net impact of these transactions reduced revenues in fiscal 2006 by $6.3 million and increased revenues in fiscal 2009, 2008 and 2007 by $0.9 million, $2.9 million and $1.8 million, respectively. In each case, the net impact caused our fiscal period-to-period revenue growth rate to appear lesser or greater, as applicable, than it otherwise would. See "Item 6: Selected Financial Data"
and "Item 8: Financial Statements and Supplementary Data - Quarterly Results of Operations" for additional discussion and information regarding these transactions. As of April 30, 2009, 2008 and 2007, deferred revenues included $1.6 million, $2.5 million and $5.4 million, respectively, related to transactions such as these.
In addition, if we determine that collectibility is not reasonably assured, we defer the revenues until collectibility becomes reasonably assured, generally upon receipt of cash. Deferred revenue and accounts receivable are reported net of adjustments for sales transactions invoiced during the period that are recognized as revenue in a future period once cash is received and all other revenue recognition criteria have been met, which are sometimes referred to as net-down adjustments. Accordingly, we believe that in order to understand the change in both deferred revenue and accounts receivable from one period to another the impact of these net-down adjustments should be considered.
Historically sales to the U.S. government have represented a significant portion of our revenues, while international sales have represented a smaller portion of our revenues. We expect revenues from sales to agencies of the U.S. government to continue to grow both in absolute dollars and as a percentage of revenues. In addition, we expect that sales to customers outside of the United States will continue to grow in absolute dollars.
Product Revenues
Product revenues consist of license fees for our software products and, beginning in fiscal 2007, also includes revenues for sales of our appliance products. License fees are based on a number of factors, including the type and number of devices that a customer intends to monitor using our software as well as the number of users and locations. In addition to our core solution, some of our customers purchase additional licenses for optional extension modules that provide enhanced discovery and analytics capabilities. Sales of our appliance products consist of sales of the appliance hardware and associated perpetual licenses to the embedded software. We introduced our first appliance products in June 2006 and our first ArcSight Logger product, our most widely adopted appliance product to date, in December 2006. Appliance fees are based on the number of appliances purchased and, in some cases, on the number of network devices with which our customer intends to use the appliances. We generally recognize product revenues at the time of product delivery, provided all other revenue recognition criteria have been met.
Historically, we have engaged in long sales cycles with our customers, typically three to six months and more than a year for some sales, and many customers make their purchase decisions in the last month of a fiscal quarter, following procurement trends in the industry. Further, average deal size can vary considerably depending on our customers' configuration requirements, implementation plan and budget availability. As a result, it is difficult to predict timing or size of product sales on a quarterly basis. In addition, we may fail to forecast sufficient production of our appliance products due to our limited experience with them, or we may be unable to physically deliver appliances within the quarter, depending on the proximity of the order to the end of the quarter. These situations may lead to delay of revenues until we can deliver products. The loss or delay of one or more large sales transactions in a quarter could impact our operating results for that quarter and any future quarters into which revenues from that transaction are delayed.
In addition, we believe that our product revenue has been somewhat seasonal historically, with the first quarter of our fiscal year typically having relatively lower product revenue and the fourth quarter of our fiscal year typically having relatively higher product revenue. We believe that this seasonality results from a number of factors, including:
• the budgeting, procurement and work cycles of our customers, including customers in the public sector;
• the timing of our annual sales "club" for top performers and annual training for our entire sales force in our first fiscal quarter;
• seasonal reductions in business activity during the summer months in the United States, Europe and certain other regions;
• sales to customers with a standard December 31 fiscal year end that may positively impact our license revenue in the third quarter of our fiscal year; and
• the structure of our direct sales incentive and compensation program, which may reinforce the tendency of our direct sales team to book the largest volume of deals toward the end of our fiscal year.
The timing of our fiscal quarters and the U.S. federal government's September 30 fiscal year end may impact product sales to governmental agencies in the second quarter of our fiscal year, offsetting the otherwise seasonal downturn in later summer months. We expect these seasonal factors to continue to impact our business in the future, and any seasonality that we experience may cause fluctuations in our operating results. We believe that our rapid historical growth, the timing of the launch of new products and the timing of large product sales transactions near period boundaries, may have overshadowed the nature or magnitude of seasonal or cyclical factors that might have influenced our business to date. They may do so again in the future. Seasonal or cyclical variations in our operations may become more pronounced over time and may materially adversely affect our results of operations in the future.
As of April 30, 2009, 2008 and 2007, deferred product revenues were $9.8 million, $13.6 million and $10.3 million, respectively. Included in deferred product revenues as of April 30, 2009, 2008 and 2007 were $1.3 million, $2.2 million and $4.9 million, respectively, related to multiple element arrangements where one or more product elements for which we did not have VSOE remained undelivered. The remainder of deferred product revenues as of April 30, 2009, 2008 and 2007 were $8.5 million, $11.4 million and $5.4 million, respectively, and primarily related to product revenues to be recognized ratably over the term of the maintenance arrangements, prepayments in advance of delivery and other delivery deferrals. Deferred revenue and accounts receivable are reported net of adjustments for sales transactions invoiced during the period that are recognized as revenue in a future period once cash is received and all other revenue recognition criteria have been met. These net-down adjustments decrease both accounts receivable and deferred revenue. Accordingly, we believe that in order to understand the change in both deferred revenue and accounts receivable from one period to another the impact of these net-down adjustments should be considered. As of April 30, 2009, 2008 and 2007, deferred product revenues of $9.8 million, $13.6 million and $10.3 million, respectively, were reduced by net-down adjustments of $5.4 million, $3.3 million and $2.6 million, respectively. Our operating results in any particular quarterly period in fiscal 2010 may be similarly impacted by the recognition of previously deferred revenue, where the associated costs were recorded in prior periods. See "Critical Accounting Policies, Significant Judgments and Estimates - Revenue Recognition" and Note 2 to our Consolidated Financial Statements ("Significant Accounting Policies - Revenue Recognition") elsewhere in this report.
Maintenance Revenues
Maintenance includes rights to unspecified software product updates and upgrades, maintenance releases and patches released during the term of the support period, and internet and telephone access to maintenance personnel and content. Maintenance revenues are generated both from maintenance that we agree to provide in connection with initial sales of software and hardware products and from maintenance renewals. We generally sell maintenance on an annual basis. We offer two levels of maintenance - standard and premium. The premium level is for customers that require 24-hour coverage seven days a week. In most cases, we provide maintenance for sales made through channel partners. In addition, we sell an enhanced maintenance offering that provides frequent security content updates for our software. Maintenance fees are treated as deferred revenue at the time the maintenance agreement is initiated and recognized ratably over the term of the maintenance agreement. As our customer base expands, we expect maintenance revenues to continue to grow, as maintenance is sold to new customers and existing customers renew.
As of April 30, 2009, deferred maintenance revenues were $32.4 million, of which $26.7 million represented current deferred maintenance revenues. As of April 30, 2008, deferred maintenance revenues were $24.3 million, of which $20.0 million represented current deferred maintenance revenues. As of April 30, 2007, deferred maintenance revenues were $17.1 million, of which $14.5 million represented current deferred maintenance revenues. Deferred maintenance revenues relate to advanced payments for support contracts that are recognized ratably. As of April 30, 2009, 2008 and 2007, the deferred maintenance revenues of $32.4 million, $24.3 million and $17.1 million, respectively, were reduced by net-down adjustments of $2.6 million, $1.5 million and $0.9 million, respectively. Net-down adjustments decrease both accounts receivable and deferred revenue and typically relate to billed but unpaid customer transactions for maintenance renewal support terms where services have not yet been provided, or where revenue from the customer is only recognized when cash has been paid and all other revenue recognition criteria have been met. See "Critical Accounting Policies, Significant Judgments and Estimates -
Revenue Recognition" and Note 2 to our Consolidated Financial Statements ("Significant Accounting Policies - Revenue Recognition") elsewhere in this report.
Services Revenues
Services revenues are generated from sales of services to our customers, including installation and implementation of our software, consulting and training. Professional services are not essential to the functionality of the associated software products. During fiscal 2009, we entered into an increasing number of service engagements to staff and manage the security operation centers, or SOCs, of certain large customers. These SOC engagements are typically longer in duration than other services engagements and support the day-to-day monitoring of customer SOC environments. We generally sell our services on a time-and-materials basis and recognize revenues as the services are performed. Services revenues have generally increased over time as we have sold and delivered installation and training services to our new customers and continued to sell training and consulting services to our existing customers, including our new SOC services.
As of April 30, 2009, 2008 and 2007, deferred service revenues were $2.9 million, $3.4 million and $2.2 million, respectively, in each case all of which represented current deferred services revenues. Deferred services revenues relate to customer payments in advance of services being performed. As of April 30, 2009, 2008 and 2007, the deferred service revenues of $2.9 million, $3.4 million and $2.2 million, respectively were reduced by net-down adjustments of $1.0 million, $0.7 million and $0.9 million, respectively. Net-down adjustments decrease both accounts receivable and deferred revenue and typically relate to billed but unpaid customer transactions for service engagements where services have not yet been provided, or where revenue from the customer is only recognized when cash has been paid and all other revenue recognition criteria have been met. See "Critical Accounting Policies, Significant Judgments and Estimates - Revenue Recognition" and Note 2 to our Consolidated Financial Statements ("Significant Accounting Policies - Revenue Recognition") elsewhere in this report.
Cost of Revenues
Cost of revenues for our software products consists of third-party royalties and license fees for licensed technology incorporated into our software product offerings. Cost of revenues for appliance products consists of the hardware costs of the appliances and third-party royalties for licensed technology. The cost of product revenues is primarily impacted by the mix of software and appliance products as well as the relative ratio of third-party royalty bearing products included in software sales transactions. Sales of our appliance products are generally at a lower gross margin than sales of our software products.
Cost of maintenance revenues consists primarily of salaries and benefits related to maintenance personnel, royalties and other out-of-pocket expenses, and facilities and other related overhead.
Cost of services revenues consists primarily of the salaries and benefits of personnel, travel and other out-of-pocket expenses, facilities and other related overhead that are allocated based on the portion of the efforts of such personnel that are related to performance of professional services, and cost of services provided by subcontractors for professional services. Services gross margin may fluctuate as a result of periodic changes in our use of third party service providers, resulting in lower or higher gross margins for these services.
We intend to increase sales to the mid-market, a goal that we believe will be aided by our recent introduction of additional appliance products. We expect the percentage of our mid-market sales made through our distribution channel will be greater than it has been to date. We also expect a high percentage of our international sales to continue to be made through our distribution channel. Sales through the channel tend to be at a lower gross margin than direct sales. As a result, we may report lower gross margins in future periods than has been the case for prior periods.
Operating and Non-Operating Expenses
Research and Development Expenses. Research and development expenses consist primarily of salaries and benefits of personnel engaged in the development of new products, the enhancement of existing products, quality assurance activities and, to a lesser extent, facilities costs and other related overhead. We expense all of our research
and development costs as they are incurred. We expect research and development expenses to increase in absolute dollars for the foreseeable future as we continue to invest in the development of our products.
Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, commissions and benefits related to sales and marketing personnel and consultants; travel and other out-of-pocket expenses; expenses for marketing programs, such as for trade shows and our annual users conference, marketing materials and corporate communications; and facilities costs and other related overhead. Commissions on sales of products and maintenance are typically accrued and expensed when the respective revenue elements are ordered. During fiscal 2007, commissions on sales of services were typically accrued and expensed when the services were delivered, and during fiscal 2008 and 2009, as a result of changes in our commission plan structure, commissions on sales of services were typically accrued and expensed when the services were ordered. We also pay commissions for channel sales not only to our channel sales force but also to our direct sales force in an effort to minimize channel conflicts as we develop our channel network. We intend to hire additional sales personnel, initiate additional marketing programs and build additional relationships with resellers and systems integrators on a global basis. Accordingly, we expect that our sales and marketing expenses will continue to increase for the foreseeable future in absolute dollars.
General and Administrative Expenses. General and administrative expenses consist primarily of salaries and benefits related to general and administrative personnel and consultants; accounting and legal fees; insurance costs and facilities costs and other related overhead. We expect that, in the future, general and administrative expenses will increase in absolute dollars as we add personnel and incur additional costs related to the growth of our business and additional legal, accounting and other expenses in connection with our reporting and compliance obligations as a public company.
Other Income (Expense), Net. Other income (expense), net consists of interest earned on our cash investments and foreign currency-related gains and losses. Our interest income will vary each reporting period depending on our average cash balances during the period and the current level of interest rates. Our foreign currency-related gains and losses will also vary depending upon movements in underlying exchange rates.
Accounting for Income Taxes. Our provision for income taxes is calculated in compliance with SFAS No. 109, Accounting for Income Taxes, or SFAS 109, and other related guidance, and generally consists of tax expense related to current period earnings. We estimate income taxes in each of the jurisdictions in which we operate. This process involves determining income tax expense together with calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes. Deferred tax assets are recognized for deductible temporary differences, along with net operating loss carry-forwards, if it is more likely than not that the tax benefits will be realized. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. These temporary differences . . .
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