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 Annual Report on Form 10-K. 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 under "Risk Factors" or in other parts of this Annual Report on Form 10-K.

Overview

We develop and provide the leading software and hardware solutions for digital investigations, including EnCase® Enterprise, a network-enabled product primarily for corporations and government agencies, and EnCase® Forensic, a desktop-based product primarily for law enforcement agencies and digital investigators.

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 our EnCase® Enterprise products in late 2002, which expanded our customer base into corporate enterprises and federal government agencies. In addition, the releases of our EnCase® eDiscovery solution in late 2005 and EnCase® Information Assurance solution in late 2006 (which was replaced by our EnCase® Cybersecurity solution in 2009) have increased our average transaction size. 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, LLC ("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, Inc. ("CaseCentral") We anticipate that sales of our EnCase Enterprise products and related services, in particular our EnCase eDiscovery and EnCase Cybersecurity solutions, sales of our forensic hardware products and sales of subscriptions for cloud-based document review and production SAAS will comprise a substantial portion of our future revenues.

Important Factors Affecting Our Results of Operations

There are a number of trends that may affect our business and our industry. We have identified factors that we expect to play an important role in our future growth and profitability. 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 a substantial capital expenditure 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 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 period unpredictable for a significant portion of that period. We expect that this seasonality within particular years and unpredictability within particular quarterly periods will continue for the foreseeable future.

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

Summary of Results of Operations

Our total revenue for the year ended December 31, 2012 was $129.5 million, an increase of $24.9 million, or 24%, from 2011. Product revenue was $56.1 million for the year ended December 31, 2012, an increase of $3.8 million, or 7%, from 2011. Subscription revenue was $9.2 million for the year ended December 31, 2012, compared to none in 2011. Services and maintenance revenue was $64.2 million for the year ended December 31, 2012, an increase of $11.9 million, or 23%, from 2011. The increase in our total revenue for the year ended December 31, 2012 compared to 2011 was primarily due to sales of our new subscription based products due to our acquisition of CaseCentral in February 2012, increased services and maintenance revenue as a result of sustained increases in our installed product base and high annual renewals by our customers, and growth in the enterprise software market which lead to increased sales of our EnCase® Enterprise family of products.

Our net loss for the year ended December 31, 2012 was $2.0 million, or $0.08 per share, compared to a net loss of $1.6 million, or $0.07 per share, for 2011. Our profitability is primarily dependent upon revenue from the sale of our products. Cost of revenues for the year ended December 31, 2012 was $36.4 million, an increase of $8.0 million, or 28%, from 2011. The increase was primarily the result of increased sales of subscription based products and professional services. Profitability is also affected by the costs and expenses associated with developing, selling and marketing our products. Operating expenses for the year ended December 31, 2012 were $94.8 million, an increase of $17.1 million, or 22%, from 2011, due primarily to increases in selling and marketing expenses, general and administrative expenses and research and development costs.

Sources of Revenue

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.

                                                  Year Ended December 31,
(Dollars in thousands)             2012       Change %      2011       Change %      2010
Product revenue                  $  56,116       7%       $  52,345      19%       $ 43,930
Subscription revenue                 9,202      100%              -       -               -
Services and maintenance
revenues:
Professional services               18,058      20%          15,037       3%         14,609
Training                             9,835      27%           7,728       -%          7,762
Maintenance                         36,259      23%          29,491      15%         25,599
Total services and
maintenance revenues                64,152      23%          52,256       9%         47,970
Total revenues                   $ 129,470      24%       $ 104,601      14%       $ 91,900

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, and EnCase® Cybersecurity. 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 $3.8 million, or 7%, from $52.3 million for the year ended December 31, 2012 from 2011. The increase was primarily due to increases in Enterprise product revenues and Forensic hardware revenues, partially offset by lower Forensic software revenues. Enterprise product revenues increased by $5.1 million, or 21%, from $24.8 million for the year ended December 31, 2012 from 2011, primarily due to an increase in the number of new EnCase® Enterprise customers resulting from additional functionality made available in our Enterprise products and an increase in sales to existing customers. During the year ended December 31, 2012 we added 358 new EnCase® Enterprise customers, as compared to 285 for the year ended December 31, 2011. During 2012, 74% of Enterprise product revenues were the result of sales to existing customers, compared to 61% in 2011. Forensic hardware revenue increased by $3.7 million, or 44%, from $8.4 million for the year ended December 31, 2012 from 2011, primarily due to increased sales of new versions of our hardware products that were made available during the year. The increases in Enterprise product revenues and Forensic hardware revenues were offset by a decrease in Forensic software revenues of $5.4 million, or 28%, from $19.0 million for the year ended December 31, 2012 from 2011. The decrease in Forensic software revenues was due to the initial release of the latest version of our EnCase® Forensic product in June 2011, which generated increased demand for that product in 2011 as compared to 2012.

Product revenues increased by $8.4 million, or 19%, from $43.9 million for the year ended December 31, 2011 from 2010, primarily due to a $6.3 million, or 30%, increase in Forensic product revenues. The increase in Forensic product revenues was due to a $3.1 million, or 19%, increase in forensic software revenues and a $3.2 million, or 62%, increase in forensic hardware revenues. The increase in forensic software revenues was primarily due to increased sales volume of the latest version of our EnCase® Forensic software product released in June 2011. The increase in forensic hardware revenues was primarily due to the inclusion of a full twelve months of sales in 2011 of the forensic hardware products that we acquired through our acquisition of Tableau in May 2010 as compared to our forensic hardware revenues in 2010, which included only approximately eight months of such sales. Enterprise product revenues increased $2.1 million, or 9%, for the year ended December 31, 2011 from 2010. This increase was primarily attributable to increased sales to our customers resulting from additional functionality made available in our Enterprise products during the year.

Subscription Revenues

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, which are determined monthly, are recognized when incurred.

Subscription revenues were $9.2 million for the year ended December 31, 2012, compared with none 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 $11.9 million, or 23%, from $52.3 million for the year ended December 31, 2012, from 2011. Services revenues increased $5.1 million, or 23% from $22.8 million, for the year ended December 31, 2012, from 2011, primarily due to an increase of $3.0 million in professional services revenues related to our acquisition of CaseCentral in February 2012 and a $2.1 million increase in training revenue. The increase in training revenue was primarily due to increased demand for training courses related to new product releases. Maintenance revenues increased $6.8 million, or 23%, from $29.5 million for the year ended December 31, 2012, from 2011 primarily as a result of sustained increases in our installed product base and high annual renewal rates by customers desiring continuing maintenance support on our products. In 2012 our installed product base increased primarily through the addition of 358 new EnCase Enterprise customers and sales of 106 new EnCase e-Discovery and EnCase Cybersecurity modules to existing EnCase Enterprise customers.

Services and maintenance revenues increased $4.3 million, or 9%, from $48.0 million for the year ended December 31, 2011, from 2010. Services revenues increased $0.4 million, or 3%, for the year ended December 31, 2011, from 2010, primarily due to revenue from certain significant one-time consulting engagements performed during the first six months of 2011. Maintenance revenues increased $3.9 million, or 15%, from $25.6 million for the year ended December 31, 2011, from 2010, primarily as a result of sustained increases in our installed product base and high annual renewal rates by customers desiring continuing maintenance support on our products. In 2011 our installed product base increased primarily through the addition of 285 new EnCase Enterprise customers and sales of 106 new EnCase e-Discovery and EnCase Cybersecurity modules to existing EnCase Enterprise customers.

Cost of Revenues



                                                   Year Ended December 31,
(Dollars in thousands)             2012       Change %      2011       Change %      2010
Cost of product revenues         $   7,982      34%       $   5,973      21%       $   4,937
Cost of subscription revenue         3,722      100%              -       -                -
Cost of services and
maintenance revenues:
Professional services               16,681      18%          14,179      19%          11,903
Training                             6,095       6%           5,735       5%           5,474
Maintenance                          1,957     (23)%          2,539       2%           2,497
Total cost of services and
maintenance revenues                24,733      10%          22,453      13%          19,874
Total cost of revenues           $  36,437      28%       $  28,426      15%       $  24,811
Share-based compensation
included above:
Cost of product revenue          $     101                $      82                $      54
Cost of subscription revenue     $     142                $       -                $       -
Cost of services and
maintenance revenues             $   1,041                $     898                $     847
Gross Margin Percentage
Products                              85.8 %                   88.6 %                   88.8 %
Subscription                          59.5 %                      - %                      - %
Services and maintenance              61.4 %                   57.0 %                   58.6 %
Total                                 71.9 %                   72.8 %                   73.0 %

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 by $2.0 million, or 34%, from $6.0 million for the year ended December 31, 2012, from 2011. The increase was primarily a result of an increase in forensic hardware product revenues. Product gross margin decreased slightly to 85.8% in 2012 from 88.6% in 2011 primarily due to a $3.7 million increase in sales of forensic hardware products to $12.1 million, or 21.6% of product sales. Forensic hardware sales have lower gross margins than our software products.

Cost of product revenues increased by $1.0 million, or 21%, from $4.9 million, for the year ended December 31, 2011, from 2010. The increase was primarily a result of an increase in forensic hardware product revenues due to our acquisition of certain of the assets of Tableau in May 2010. Product gross margin decreased slightly to 88.6% in 2011 from 88.8% in 2010 primarily due to a $3.2 million increase in sales of forensic hardware products to $8.4 million, or 16.1% of product revenues. Forensic hardware sales have lower gross margins than our software products.

Cost of Subscription Revenues

The cost of subscription revenues 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 $3.7 million for the year ended December 31, 2012, compared with none 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.

The cost of services and maintenance revenues increased $2.3 million, or 10%, from $22.5 million for the year ended December 31, 2012, from 2011. The increase in the cost of services and maintenance revenues for the year ended December 31, 2012 from 2011 was due primarily to an increase in costs added as a result of the acquisition of CaseCentral in February 2012. We added 10 employees to cost of services and maintenance from the CaseCentral acquisition. Services and maintenance gross margin was 61.4% in 2012, compared to 57.0% in 2011. The higher services and maintenance gross margin for the year ended December 31, 2012, from 2011, was a result of higher gross margins on our services revenue due the addition of higher-margin services through our acquisition of CaseCentral.

The cost of services and maintenance revenues increased $2.6 million, or 13%, from $19.9 million for the year ended December 31, 2011, from 2010. The increase in the cost of services and maintenance revenues in 2011 from 2010 was due primarily to increases in compensation and related expenses, associated with higher revenues and higher utilization rates in our professional services organization, as well as an increase in third-party consultants on certain engagements. Third-party consultants, which are generally more expensive than our own professional services consultants, are used mostly when the demand for our own consultants exceeds our internal capacity.

Services and maintenance gross margin was 57.0% in 2011, compared to 58.6% in 2010. The lower services and maintenance gross margin in 2011 was primarily a result of lower margins on services revenue in 2011, compared to 2010, which was primarily due to an increase in the number of third-party consultants used on certain professional engagements.

Operating Expenses



                                                 Year Ended December 31,
(Dollars in thousands)             2012      Change %      2011      Change %      2010
Selling and marketing
expenses                         $ 42,278      14%       $ 36,992       3%       $ 35,947
Research and development
expenses                         $ 24,458      30%       $ 18,882      11%       $ 17,012
General and administrative
expenses                         $ 21,224      29%       $ 16,432      18%       $ 13,985
Depreciation and amortization
expense                          $  6,859      26%       $  5,424      15%       $  4,700
As a percent of revenue:
Selling and marketing
expenses                             32.8 %                  35.4 %                  39.1 %
Research and development
expenses                             18.9 %                  18.1 %                  18.5 %
General and administrative
expenses                             16.4 %                  15.7 %                  15.2 %
Depreciation and amortization
expense                               5.3 %                   5.2 %                   5.1 %
Share-based compensation
included above:
Selling and marketing
expenses                         $  1,639                $  1,613                $  1,601
Research and development
expenses                         $  1,428                $  1,373                $  1,192
General and administrative
expenses                         $  1,500                $  1,566                $  1,493

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 $5.3 million, or 14%, from $37.0 million for the year ended December 31, 2012, from 2011. Approximately $3.7 million of the increase was due to higher compensation costs and other employee-related expenses associated with increased product revenues, while approximately $1.6 million of the increase was due to higher compensation and other employee-related expenses due to an increase in headcount in connection with the acquisition of CaseCentral in February 2012.

Selling and marketing expenses increased $1.0 million, or 3%, from $35.9 million for the year ended December 31, 2011, from 2010. The increase was primarily due to higher compensation costs and related expenses associated with increased product revenues.

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 product offerings, continue developing existing products and improve quality assurance, and incorporate personnel to support our new cloud-based subscription offerings we increased the number of research and development personnel that we employed during 2012 compared to 2011 and 2010.

Research and development expenses increased $5.6 million, or 30%, from $18.9 million for the year ended December 31, 2012, from 2011. Approximately $3.6 million of the increase was due to compensation and other employee-related expenses increasing due to an increase in headcount in connection with the acquisition of CaseCentral in February of 2012. Approximately $2.0 million of the increase was due to higher compensation costs and other employee-related expenses associated with increased headcount due to the number of products in development.

Research and development expenses increased $1.9 million, or 11%, from $17.0 million for the year ended December 31, 2011, from 2010. Approximately $1.5 million of the increase was driven by increased compensation and related expenses resulting from an increase in headcount during the year due to the number of products in development, and approximately $0.4 million of the increase was due to the acquisition of Tableau in May 2010.

General and Administrative Expenses

General and administrative expenses consist of personnel and related costs for accounting, legal, information systems, human resources and other administrative functions. In addition, general and administrative expenses include professional service fees, bad debt expense, and other corporate expenses and related overhead.

General and administrative expenses increased by $4.8 million, or 29%, from $16.4 million, for the year ended December 31, 2012, from 2011. Approximately $2.5 million of the increase was due to acquisition and integration-related expenses incurred in connection with the acquisition of CaseCentral in February, 2012, approximately $1.3 million of the increase was due to an increase in legal fees primarily due to legal fees incurred in connection with patent infringement complaints filed in 2011,and approximately $2.3 million of the increase was due to increased compensation costs and other employee and facility-related expenses of which approximately $0.7 million was due to the CaseCentral acquisition. These increases were partially offset by a charge in the first quarter of 2011 of $1.3 million related to certain state sales tax obligations including related interest and penalties.

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