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GUID > SEC Filings for GUID > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for GUIDANCE SOFTWARE, INC.

Form 10-Q for GUIDANCE SOFTWARE, INC.


2-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under "Risk Factors," in our Annual Report on Form 10-K for the year ended December 31, 2011 under "Risk Factors" and in other parts of this Quarterly Report.

Overview

We were incorporated and commenced operations in 1997. From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase® Forensic products and related services. We have experienced increases in our revenue as a result of the release of EnCase® Enterprise in 2002, the release of EnCase® eDiscovery in 2005 and the release of EnCase® Information Assurance in 2006 (which was replaced by EnCase® Cybersecurity in 2009), which expanded our customer base into corporate enterprises and federal government agencies. In May 2010, we added a family of data acquisition forensic hardware products including forensic duplicators, multiple write blockers and other hardware through our acquisition of Tableau. In February 2012, we added cloud-based document review and production software-as-a-service for corporations and law firms through our acquisition of CaseCentral.

We develop and provide leading software and hardware solutions for digital investigations, including EnCase® Enterprise, a network-enabled product primarily for large corporations and government agencies, and EnCase® Forensic, a desktop-based product primarily for law enforcement agencies. We anticipate that sales of subscriptions for our cloud-based review and production software, our EnCase® Enterprise products and related services, in particular our EnCase® eDiscovery and EnCase® Cybersecurity solutions, and the sales of our forensic hardware products, will comprise a substantial portion of our future revenues.

Factors Affecting Our Results of Operations

There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:

† Legislative and regulatory developments. Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework. Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products.

† Information technology budgets. Deployment of our solutions may require substantial capital expenditures by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns.

† Law enforcement agency budgets. We sell our EnCase® Forensic products and training services primarily to law enforcement agencies. Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing. Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations.

† Prevalence and impact of hacking incidents and spread of malicious software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products. Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products.

† Seasonality in revenues. We experience seasonality in our revenues, with the third and fourth quarters typically having the highest revenues for the year. We believe that this seasonality results primarily from our customers' budgeting cycles. The federal government's budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year. In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular quarter unpredictable for a significant portion of that quarter. We expect that this seasonality in our revenues and unpredictability of our revenues within particular quarterly periods will continue for the foreseeable future.


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† Amount of commercial litigation. Because commercial litigation often involves eDiscovery, an increase in commercial litigation could increase demand for our products and services, while a decrease in commercial litigation could decrease demand.

Critical Accounting Policies and Estimates

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. There have no significant changes in those critical accounting policies and estimates during the three and nine months ended September 30, 2012 other than the addition to revenue recognition mentioned below.

With the acquisition of CaseCentral in February 2012, we now also generate revenue from cloud-based document review and production software-as-a-service where customers have the right to access our document review management software via the web; however, they may not take possession of the software at any time during the term of the agreement. In general, we recognize revenue for subscriptions on a straight-line basis over the contractual contract period commencing on the date the subscription is made available to the customer. Usage-based fees, which are determined monthly, are recognized when incurred.

When subscription services and usage-based fee arrangements involve multiple elements that qualify as separate units of accounting, we allocate arrangement consideration in multiple deliverable revenue arrangements at the inception of an arrangement to all deliverables based on the relative selling price method in accordance with the selling price hierarchy, which includes: 1) vendor-specific objective evidence of fair value ("VSOE"), if available, 2) third-party evidence ("TPE") if VSOE is not available; or 3) best estimate of selling price ("BESP") if neither VSOE nor TPE is available.

† VSOE. We determine VSOE based on its historical pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for these services fall within a reasonably narrow pricing range.

† TPE. When VSOE cannot be established for deliverables in a multiple element arrangement, we apply judgment with respect to whether we can establish a selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from our peers and our offerings contain a significant level of differentiation such that comparable pricing of services with similar functionality has not been able to be obtained. Furthermore, we have been unable to reliably determine selling prices of similar competitive services on a stand-alone basis. As a result, we have not been able to establish selling prices based on TPE.

† BESP. When VSOE or TPE is unable to be established, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the service was sold on a stand-alone basis. We determine BESP for deliverables by considering multiple factors including but not limited to prices we charge for similar offerings, market conditions, competitive landscape and pricing practices.

We have not established VSOE or TPE for our subscription services or usage-based fee arrangements and therefore we use BESP to allocate the selling price to subscription services and usage-based fee deliverables.


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Results of Operations



The following table sets forth our results of operations for the three and nine
months ended September 30, 2012 and 2011, respectively, expressed as a
percentage of total revenues:



                                      Three Months Ended         Nine Months Ended
                                        September 30,              September 30,
                                      2012         2011         2012          2011
Revenues:
Product revenue                          48.1 %       54.4 %       42.9 %        47.6 %
Subscription revenue                      7.3            -          7.2             -
Services and maintenance revenue         44.6         45.6         49.9          52.4
Total revenues                         100.00        100.0       100.00         100.0

Cost of revenues:
Cost of product revenue                   6.1          5.3          6.2           5.8
Cost of subscription revenue              2.7            -          3.1             -
Cost of services and maintenance
revenue                                  18.1         19.7         19.4          23.1
Total cost of revenues                   26.9         25.0         28.7          28.9
Gross profit                             73.1         75.0         71.3          71.1

Operating expenses:
Selling and marketing                    32.7         35.9         32.5          35.6
Research and development                 17.2         17.0         19.1          19.0
General and administrative               14.8         15.2         17.9          16.3
Depreciation and amortization             4.8          5.0          5.7           5.2
Total operating expenses                 69.5         73.1         75.2          76.1
Operating income (loss)                   3.6          1.9         (3.9 )        (5.0 )

Other income and expense:
Interest income                             -            -            -             -
Interest expense                            -            -            -             -
Other income, net                           -            -            -             -
Total other income and expense              -            -            -             -
Income (loss) before income
taxes                                     3.6          1.9         (3.9 )        (5.0 )
Income tax provision                      0.1          0.1          0.3           0.2
Net income (loss)                         3.5 %        1.8 %       (4.2 )%       (5.2 )%

The following table sets forth share-based compensation expense recorded in each of the respective periods (in thousands):

                                        Three Months Ended            Nine months ended
                                          September 30,                 September 30,
                                       2012           2011           2012           2011
Non-cash Share Based
Compensation Data (1):
Cost of product revenue             $        25    $        22    $        72    $       61
Cost of subscription revenue                 38              -            108             -
Cost of services and maintenance
revenue                                     256            228            735           698
Selling and marketing                       408            396          1,217         1,305
Research and development                    365            322            990         1,107
General and administrative                  377            362          1,103         1,194
Total non-cash share based
compensation                        $     1,469    $     1,330    $     4,225    $    4,365



(1) Non-cash share-based compensation recorded in the three and nine month periods ended September 30, 2012 and 2011 relates to stock options and restricted share awards granted to employees measured under the fair value method. See Notes 9 and 10 to the condensed consolidated financial statements.


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Comparison of Results of Operations for the Three and Nine Months Ended September 30, 2012 and 2011

Sources of Revenues

Our software product sales transactions typically include the following elements: (i) a software license fee paid for the use of our products under a perpetual license term, or for a specific term; (ii) an arrangement for first-year support and maintenance, which includes unspecified software updates, upgrades and post-contract support; (iii) and professional services for installation, implementation, consulting and training. With our acquisition of CaseCentral in February 2012, we began to generate revenue from cloud-based document review and production software sold as subscription services. We derive the majority of our revenue from sales of our software products. We sell our software products and services primarily through our direct sales force and in some cases we utilize resellers. We sell our hardware products primarily through resellers.

                              Three Months Ended               Nine Months Ended
                                September 30,                    September 30,
(Dollars in                         Change                           Change
thousands)                2012        %         2011       2012        %         2011
Product revenues        $ 17,394     17%      $ 14,818   $ 39,945     12%      $ 35,558
Subscription revenue       2,648     100%            -      6,716     100%            -

Services and
maintenance revenues:
Services                   7,074     46%         4,843     19,700     12%        17,600
Maintenance                9,025     19%         7,597     26,867     25%        21,568
Total services and
maintenance revenues      16,099     29%        12,440     46,567     19%        39,168
Total revenues          $ 36,141     33%      $ 27,258   $ 93,228     25%      $ 74,726

Product Revenues

We generate product revenues principally from two product categories: Enterprise products and Forensic products. Our Enterprise products include perpetual licenses and Pay-Per-Use fees related to our EnCase® Enterprise, eDiscovery, Legal Hold, EnCase® Cybersecurity and OEM add-on products. Our Forensic products include revenue related to EnCase® Forensic, EnCase® Portable, and forensic hardware sales. Our Forensic products also include our Premium License Support Program ("PLSP") product, which was sold on a subscription basis for a term of one or three years; sales of PLSP ended in June 2011 when we introduced EnCase® Forensic v7. During the first two quarters of each fiscal year, we typically experience our lowest levels of product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest quarter for sales to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter.

Product revenues increased by $2.6 million, or 17%, from $14.8 to $17.4 million and by $4.4 million, or 12%, from $35.6 million to $39.9 million for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The increases in product revenues for the three months and nine months ended September 30, 2012 were primarily due to increased demand for our EnCase®Enterprise products and an increase in sales of our hardware products.

Subscription Revenue

With our acquisition of CaseCentral in February 2012, we began to generate revenue from cloud-based document review and production software sold as subscription services. Subscription service customers have the right to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement. In general, we recognize revenue for subscriptions on a straight-line basis over the contract period commencing on the date the subscription is made available to the customer. Usage-based fees, that are determined monthly, are recognized when incurred.

Subscription revenue was $2.6 million and $6.7 million for the three and nine months ended September 30, 2012, respectively, compared with none in the same periods in 2011. We started to earn revenue from cloud-based document review and production software products in February 2012 as a result of our acquisition of CaseCentral.

Services and Maintenance Revenues

Services and maintenance revenues increased by $3.7 million, or 29%, from $12.4 million to $16.1 million and $7.4 million, or 19%, from $39.2 million to $46.6 million for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011.

Services revenues increased $2.2 million, or 46%, from $4.8 million to $7.1 million and $2.1 million, or 12%, from $17.6 million to $19.7 million for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The increase for the three and nine months ended September 30, 2012 was primarily due to an increase in professional services revenues due to our acquisition of CaseCentral in February 2012 and an increase in training revenue as a result of higher demand for training classes related to new product releases that occurred in 2011 and early 2012.


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Maintenance revenues increased $1.4 million, or 19%, from $7.6 million to $9.0 million and $5.3 million, or 25%, from $21.6 million to $26.9 million for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The increases were primarily a result of sustained increases in our installed product base and high annual renewal rates by customers desiring continuing maintenance support on our products.

Cost of Revenues



                              Three Months Ended                   Nine Months Ended
                                 September 30,                       September 30,
(Dollars in
thousands)               2012      Change %      2011        2012      Change %      2011
Cost of product
revenues               $   2,208     53%       $   1,439   $   5,795     33%       $   4,349
Cost of subscription
revenue                      981     100%              -       2,850     100%              -

Cost of services and
maintenance
revenues:
Services revenue           6,111     29%           4,754      16,595      8%          15,396
Maintenance revenue          428    (31)%            619       1,491    (20)%          1,861
Total cost of
services and
maintenance revenues       6,539     22%           5,373      18,086      5%          17,257
Total cost of
revenues               $   9,728     43%       $   6,812   $  26,731     24%       $  21,606

Share-based
compensation
included above:
Cost of product
revenue                $      25               $      22   $      72               $      61
Cost of subscription
revenue                $      38               $       -   $     108               $       -
Cost of services and
maintenance revenue    $     257               $     228   $     735               $     698

Gross Margin
Percentage
Products                    87.3 %                  90.3 %      85.5 %                  87.8 %
Subscriptions               62.9 %                     - %      57.6 %                     - %
Services and
maintenance                 59.4 %                  56.8 %      61.2 %                  55.9 %
Total                       73.1 %                  75.0 %      71.3 %                  71.1 %

Cost of Product Revenues

Cost of product revenues consists principally of the cost of producing our software products, the cost of manufacturing our hardware products and product distribution costs, including the cost of compact discs, packaging, shipping, customs duties, and, to a lesser extent, compensation and related overhead expenses. While these costs are primarily variable with respect to sales volumes, they remain low in relation to the revenue generated and result in higher gross margins than our services and training businesses. Our gross margins can be affected by product mix, as our enterprise products are generally higher margin products than our forensic products, which include software and hardware.

Cost of product revenues increased $0.8 million or 53%, from $1.4 million to $2.2 million, and $1.4 million, or 33%, from $4.3 million to $5.8 million, for the three and nine months ended September 30, 2012, respectively, compared with the same periods in 2011. The increases were primarily a result of higher sales of our forensic hardware products.

Product revenue gross margin for the three and nine months ended September 30, 2012 decreased to 87.3% and 85.5%, respectively, compared to 90.3% and 87.8% for the same periods in 2011. The decreases in gross margin percentage were primarily due to an increase in sales of forensic hardware products, which have lower margins.

Cost of Subscription Revenue

The cost of subscription revenue consists principally of employee compensation costs, including share-based compensation and related overhead, software maintenance paid to third party vendors, and SaaS hosting infrastructure costs. The cost of subscription revenue was $1.0 million and $2.9 million, for the three and nine months ended September 30, 2012, respectively, compared with none in the same periods in 2011, as the cloud-based document review and production software products did not become a part of our product mix until the completion of our acquisition of CaseCentral in February 2012.

Cost of Services and Maintenance Revenues

The cost of services and maintenance revenues are largely comprised of employee compensation costs, including share-based compensation, and related overhead, travel and facilities costs. The cost of maintenance revenue is primarily outsourced, but also includes employee compensation cost for customer technical support and related overhead costs.


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Total cost of services and maintenance revenue increased $1.2 million, or 22%, from $5.4 million to $6.5 million, for the three months ended September 30, 2012 and $0.8 million, or 5%, from $17.3 million to $18.1 million for the nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The increase for the three months ended September 30, 2012 was primarily due to the increase in cost of services revenue of $1.4 million, or 29%, from $4.8 million to $6.1 million. This increase was primarily due to an increase in services costs due to the acquisition of CaseCentral in February 2012. The increase in cost of services revenue of $1.2 million, or 8%, from $15.4 million to $16.6 million for the nine months ended September 30, 2012 was primarily due to higher compensation costs associated with higher revenues and by an increase in costs due to the acquisition of CaseCentral in February 2012. Services and maintenance gross margin for the three and nine months ended September 30, 2012 increased to 59.4% and 61.2%, respectively, compared to 56.8% and 55.9% for the same periods in 2011. The increases in gross margin were primarily a result of higher gross margins on our services revenue due to an increase in utilization rates during the periods.

Operating Expenses



                               Three Months Ended                 Nine Months Ended
                                 September 30,                      September 30,
(Dollars in
thousands)                2012      Change %     2011        2012      Change %     2011
Selling and marketing
expenses                $  11,790     20%      $   9,791   $  30,341     14%      $  26,606
Research and
development expenses    $   6,224     34%      $   4,642   $  17,807     25%      $  14,211
General and
administrative
expenses                $   5,351     29%      $   4,143   $  16,664     37%      $  12,188
Depreciation and
amortization expenses   $   1,745     29%      $   1,353   $   5,335     37%      $   3,881

Share-based
compensation included
above:
Selling and marketing
expenses                $     575              $     396   $   1,217              $   1,305
Research and
development expenses    $     365              $     322   $     990              $   1,107
General and
administrative
expenses                $     377              $     362   $   1,103              $   1,194

As a percentage of
revenue:
Selling and marketing
expenses                     32.6 %                 35.9 %      32.5 %                 35.6 %
Research and
development expenses         17.2 %                 17.0 %      19.1 %                 19.0 %
General and
administrative
expenses                     14.8 %                 15.2 %      17.9 %                 16.3 %
Depreciation and
amortization expenses         4.8 %                  5.0 %       5.7 %                  5.2 %

Selling and Marketing Expenses

Selling and marketing expenses consist primarily of personnel costs and costs related to our sales force and marketing staff. Selling and marketing expenses also include expenses relating to advertising, brand building, marketing promotions and trade show events (net of amounts received from sponsors and participants), product management, and travel and allocated overhead.

Selling and marketing expenses increased $2.0 million, or 20%, from $9.8 million to $11.8 million, and $3.7 million, or 14%, from $26.6 million to $30.3 million, for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The increases in selling and marketing expenses for the three and nine months ended September 30, 2012 were driven primarily by an increase in headcount and related expenses as a result of the acquisition of CaseCentral in February 2012 as well as an increase in commission expense due to an increase in revenues during the periods.

Research and Development Expenses

Research and development expenses consist primarily of compensation, including share-based compensation and related overhead expenses. In order to develop new . . .

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