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DWCH > SEC Filings for DWCH > Form 10-K on 22-Dec-2011All Recent SEC Filings

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Form 10-K for DATAWATCH CORP


22-Dec-2011

Annual Report


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements of Datawatch and its subsidiaries which appear elsewhere in this Annual Report on Form 10-K.

GENERAL

Introduction

Datawatch is engaged in the design, development, manufacture, marketing, and support of business computer software primarily for the report analytics and business service management markets to allow organizations to access and analyze information in a more meaningful fashion.

During fiscal year 2011, the Company implemented a change in leadership with the goal of creating a higher growth strategy. On February 11, 2011, the Company appointed Michael A. Morrison as President and CEO. The Company has since repositioned its products into the report analytics solutions described below.

The Company's principal product lines are Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence) and Business Service Management Solutions (including Visual QSM and Visual HD). Included in the above categories are:

Monarch, a desktop reporting and data analysis 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;

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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, such as Excel, via email;

Monarch Enterprise Server, an enterprise solution that provides web-enabled report storage, transformation and distribution including data analysis, visualization and MS Excel integration for easy to use and cost effective self-serve reporting and analytics;

Monarch RMS, a web-based report analysis solution that integrates with any existing enterprise report management or content management archiving solution;

Datawatch Dashboards, an interactive dashboard solution that provides a visual overview of operational performance as well as the ability to monitor specific business processes and events;

Monarch Report Manager on Demand, a system for high-volume document capture, archiving, and online presentation;

iMergence, an enterprise report mining system;

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.

The Company offers its enterprise products through perpetual licenses and subscription pricing models. 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 subscription renewal rate is the same as the initial subscription rate. During fiscal years 2011 and 2010, subscription revenues were approximately $299,000 and $313,000, respectively.

CRITICAL ACCOUNTING POLICIES

In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on judgments 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 Reserve

The Company sells its solutions directly to end-users, through value added resellers and through distributors. Sales to distributors and resellers accounted for approximately 41% and 43%, of total sales for fiscal years 2011 and 2010, respectively. Revenue from the sale of all software products (when separately sold) is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed or determinable, collectability is reasonably assured, 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 customarily defined. The Company's software products can be installed and used by customers on their own with little or no configuration 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 to the Company.

Datawatch software products are generally sold in multiple element arrangements which may include software licenses, professional services and post-contract customer support. In such multiple element

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arrangements, the Company applies the residual method in determining revenue to be allocated to the 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 professional 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-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 period of support (generally one year). Such deferred amounts are recorded as part of deferred revenue in the Company's Consolidated Balance Sheets included 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 revenue is recognized ratably over the period of the subscription. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The subscription renewal rate is the same as the initial subscription 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. The Company also offers a 30 day money-back guarantee on its Monarch product sold directly to end-users. Additionally, the Company provides its distributors with stock-balancing rights. Revenue from the sale 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, and the returns history with, 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 $70,000 and $35,000 as of September 30, 2011 and 2010, 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 collectability 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 $78,000 and $129,000 as of September 30, 2011 and 2010, respectively.

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Income Taxes

The Company has deferred tax assets primarily related to net operating loss carryforwards and tax credits that expire at different times through and until 2031. At September 30, 2011, the Company had U.S. federal tax loss carryforwards of approximately $7.1 million, expiring at various dates through 2031, including $182,000 resulting from the Mergence acquisition undertaken during 2004 which are subject to additional annual limitations as a result of the changes in Mergence's ownership, and had approximately $1.4 million in state tax loss carryforwards, which also expire at various dates through 2031. An alternative minimum tax credit of approximately $164,000 is available to offset future regular federal taxes. Research and development credits of approximately $624,000 expire beginning in 2011. In addition, the Company has the following foreign net operating loss carryforwards: United Kingdom losses of $7.5 million with no expiration date, Australia losses of $3.6 million with no expiration date and Germany losses of $98,000 with no expiration date.

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 therefore a full valuation allowance has been provided against the deferred tax assets at September 30, 2011 and 2010. 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 the full valuation allowance were approximately $7.2 million as of September 30, 2011.

The Company follows the accounting requirements for uncertain tax positions. The comprehensive model addresses the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. In accordance with these requirements, 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 positions 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.

At October 1, 2009, the Company had a cumulative tax liability of $125,000 related to foreign tax exposure. During each of the fiscal years ended September 30, 2010 and 2011, the Company increased its tax liability by $25,000, resulting in a cumulative tax liability of $175,000 at September 30, 2011. These amounts have been recorded as an increase to other long-term liabilities 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 of the product (which approximates the ratio that current gross

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revenues for a product bear to the total of current and anticipated future gross revenues for that product), which is generally 18 to 24 months. The net amount of capitalized software development costs and purchased software was approximately $14,000 and $396,000 at September 30, 2011 and 2010, respectively. During fiscal 2011, the Company did not capitalize any software development costs related to new products in development.

Valuation of Intangible Assets and Other Long-Lived Assets

Intangible assets consist of internally developed software, patents and customer lists acquired through business combinations. The values allocated to these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset. The Company reviews intangible assets and other long-lived assets whenever an 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. No impairment charges were taken for intangible assets during fiscal year 2011.

Accounting for Share-Based Compensation

The Company recognizes share-based compensation expense in accordance with generally accepted accounting principles which require that all share-based awards, including grants of employee stock options, be recognized in the financial statements based on their fair value at date of grant.

The Company recognizes the fair value of share-based awards over the requisite service period of the individual awards, which generally equals the vesting period. For the fiscal year ended September 30, 2011, the Company recorded share-based compensation expense of approximately $264,000. 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 is based on 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 fiscal year ended September 30, 2011, the Company used an expected stock-price volatility of 67% based upon the historical volatility at the time of issuance.

With regard to the expected option life assumption, the Company considers the exercise behavior of past grants and models the pattern of aggregate 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 year ended September 30, 2011, the Company used an expected option life assumption of 5 years.

With regard to the forfeiture rate assumption, the Company reviews historical voluntary turnover rates. For stock option grants issued during the fiscal year ended September 30, 2011, 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 rate is higher than estimated.

The Company also periodically grants awards of restricted stock units ("RSU") to each of its non-employee directors and some of its employees on a discretionary basis pursuant to its stock compensation plans. Each RSU entitles the holder to receive, at the end of each vesting period, a specified number of shares of the Company's common stock. Each RSU vests at the rate of 33.33% on each of the first through third anniversaries of the grant date. Additionally, some of the RSUs are subject to a further vesting condition that the Company's common stock must trade at a price greater than $10 per share on a national securities exchange for a period of twenty consecutive days prior to the fifth anniversary of the grant date. For such RSUs, the Company applies the Monte Carlo option-pricing model for determining the fair value on the date of grant.

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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 consolidated financial statements. The operating results for any period should not be considered indicative of the results expected for any future period.

                                                  Year Ended September 30,
                                                     2011              2010
         REVENUE:
         Software licenses                               55 %              54 %
         Maintenance                                     35                36
         Professional Services                           10                10
         Total revenue                                  100               100

         COSTS AND EXPENSES:
         Cost of software licenses                       13                14
         Cost of maintenance and services                14                16
         Sales and marketing                             35                33
         Engineering and product development             14                15
         General and administrative                      24                20
         Total costs and expenses                       100                98
         INCOME FROM OPERATIONS                           -                 2
         Other income (expense), net                      1                 -
         INCOME BEFORE INCOME TAXES                       1                 2
         (Provision) benefit for income taxes             -                 -
         NET INCOME                                       1                 2

              Fiscal Year Ended September 30, 2011 as Compared to
                      Fiscal Year Ended September 30, 2010

Total Revenues

The following table presents total revenue, total revenue increase (decrease)
and percentage change in total revenue for the years ended September 30, 2011
and 2010:

                           Year Ended September 30,          Increase        Percentage
                            2011               2010         (Decrease)         Change
                                        (In thousands)

Software licenses       $      9,858       $      9,563     $       295               3%
Maintenance                    6,219              6,322            (103 )            -2%
Professional Services          1,808              1,789              19               1%

Total revenue           $     17,885       $     17,674     $       211               1%

Revenue for the fiscal year ended September 30, 2011 was $17,885,000, which represents an increase of $211,000 or approximately 1% from revenue of $17,674,000 for the fiscal year ended September 30, 2010. For fiscal 2011, Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence), and Business Service Management Solutions (including Visual QSM and Visual HD) revenue accounted for 91% and 9% of total revenue, respectively, as compared to 90% and 10%, respectively, for fiscal 2010.

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Software license revenue for the fiscal year ended September 30, 2011 was $9,858,000 or approximately 55% of total revenue, as compared to $9,563,000, or approximately 54% of total revenue for the fiscal year ended September 30, 2010. This represents an increase of $295,000 or approximately 3% from fiscal 2010. The overall increase in software license revenue consists of a $361,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products) which was partially offset by a $66,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products). The Company attributes the overall increase in software license revenue to its new product positioning and the investments the Company has made in its sales and marketing organization which has resulted in increased enterprise license sales during the year.

Maintenance revenue for the fiscal year ended September 30, 2011 was $6,219,000 or approximately 35% of total revenue, as compared to $6,322,000 or approximately 36% of total revenue for the fiscal year ended September 30, 2010. This represents a decrease of $103,000 or approximately 2% from fiscal 2010. The decrease in maintenance revenue consists of a $74,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products) and a $29,000 decrease in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products). The Company attributes the overall decrease in maintenance revenue to lower renewal rates of enterprise product customers which was partially offset by maintenance on the Monarch product line.

Professional services revenue for the fiscal year ended September 30, 2011 was $1,808,000 or approximately 10% of total revenue, as compared to $1,789,000 or approximately 10% of total revenue for the fiscal year ended September 30, 2010. This represents an increase of $19,000 or approximately 1% from fiscal 2010. The increase in professional services revenue consists of a $197,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products) and a $178,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products).

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 years ended September 30, 2011 and 2010:

                                Year Ended September 30,           Increase /         Percentage
                                 2011               2010           (Decrease)           Change
                                               (in thousands)
Cost of software licenses    $      2,237       $      2,382      $        (145 )             -6%
Cost of maintenance and
services                            2,537              2,893               (356 )            -12%
Sales and marketing                 6,268              5,786                482                8%
Engineering and product
development                         2,502              2,658               (156 )             -6%
General and
administrative                      4,274              3,564                710               20%

Total costs and operating
expenses                     $     17,818       $     17,283      $         535                3%

Cost of software licenses for the fiscal year ended September 30, 2011 was $2,237,000 or approximately 23% of software license revenues, as compared to $2,382,000 or approximately 25% of software license revenues for the fiscal year ended September 30, 2010. The percentage and dollar decrease in cost of software . . .

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