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GUID > SEC Filings for GUID > Form 10-Q on 8-May-2013All Recent SEC Filings

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Form 10-Q for GUIDANCE SOFTWARE, INC.


8-May-2013

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, 2012 under "Risk Factors" and in other parts of this Quarterly Report.

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-


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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. 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.

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, 2012 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. There have been no significant changes in those critical accounting policies and estimates during the three months ended March 31, 2013.

With the acquisition of CaseCentral in February 2012, we now also generate revenue from cloud-based document review and production SaaS 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.


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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 that of 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 were 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 months
ended March 31, 2013 and 2012, respectively, expressed as a percentage of total
revenues:



                                            Three Months Ended
                                                 March 31,
                                             2013         2012
Revenues:
Product revenue                                27.9 %       40.4 %
Subscription revenue                            9.6          4.7
Services and maintenance revenue               62.5         54.9
Total revenues                                100.0        100.0

Cost of revenues:
Cost of product revenue                         6.6          6.5
Cost of subscription revenue                    4.2          2.3
Cost of services and maintenance revenue       24.3         20.9
Total cost of revenues                         35.1         29.7

Gross profit                                   64.9         70.3

Operating expenses:
Selling and marketing                          35.0         33.2
Research and development                       28.0         20.3
General and administrative                     19.6         23.9
Depreciation and amortization                   6.3          6.2
Total operating expenses                       88.9         83.6

Operating loss                                (24.0 )      (13.3 )

Other income and expense:
Interest income                                 0.0          0.0
Interest expense                                0.0          0.0
Other income, net                               0.0          0.0
Loss before income taxes                      (24.0 )      (13.3 )
Income tax provision                            0.2          0.5
Net loss                                      (24.2 )%     (13.8 )%

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

                                               Three Months Ended
                                                   March 31,
                                                2013         2012
Non-Cash Share-Based Compensation Data(1):
Cost of product revenue                      $       32    $     23
Cost of subscription revenue                         44          22
Cost of services and maintenance revenue            322         216
Selling and marketing                               442         377
Research and development                            461         290
General and administrative                          438         369
Total non-cash share-based compensation      $    1,739    $  1,297



(1) Non-cash share-based compensation recorded in the three-month periods ended March 31, 2013 and 2012 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 Months Ended March 31, 2013 and 2012

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 March 31,
(Dollars in thousands)                       2013        Change %       2012
Product revenues                          $     7,530      (28 )%     $ 10,509

Subscription revenue                            2,582      111 %         1,225

Services and maintenance revenues:
Professional services                           5,383       61 %         3,353
Training                                        2,166       (6 )%        2,295
Maintenance                                     9,283        7 %         8,637
Total services and maintenance revenues        16,832       18 %        14,285

Total revenues                            $    26,944        4 %      $ 26,019

Product Revenues

We generate product revenues principally from two product categories: Enterprise products and Forensic products. Our Enterprise products include perpetual licenses 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 for the three months ended March 31, 2013 were $7.5 million, a decrease of $3.0 million, or 28%, from $10.5 million for the same period in the prior year. The decrease in product revenues was due to a decrease in Enterprise revenue of $1.6 million, or 38%, from $4.1 million in the first quarter 2012 and a decrease in Forensic revenue of $1.1 million, or 28%, from $3.8 million for the same period in the prior year. The decrease in Enterprise revenue was principally due to delays in spending by our corporate customers, and the decrease in Forensic revenue was due to significantly reduced spending by our government customers impacted by the federal budget sequestration. During the three months ended March 31, 2013 we added 65 new EnCase® Enterprise customers, as compared to 64 for the comparable period in the prior year. During the three months ended March 31, 2013, 61% of Enterprise product revenues were the result of sales to existing customers, compared to 68% in the comparable period in the prior 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 for the three months ended March 31, 2013 were $2.6 million, an increase of $1.4 million, or 111%, from $1.2 million for the same period in the prior year. The three months ended March 31, 2012 included only a partial quarter of subscription revenues, since we only started to earn subscription revenues in February 2012 as a result of our acquisition of CaseCentral.


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Services and Maintenance Revenues

Services and maintenance revenues are comprised of our professional services revenue, training revenue and maintenance revenues. Services and maintenance revenues increased $2.5 million, or 18%, from $14.3 million to $16.8 million for the three months ended March 31, 2013, as compared to the same period in the prior year

Services revenues increased $1.9 million, or 34% from $5.6 million to $7.5 million for the three months ended March 31, 2013, as compared to the same period in the prior year, primarily due to an increase of approximately $0.6 million in professional services related to the timing of our acquisition of CaseCentral in February, 2012 and an increase of $1.3 million related to case work and incident response work for existing customers of our EnCase Enterprise products.

Maintenance revenues increased $0.6 million, or 7%, from $8.6 million to $9.3 million for the three months ended March 31, 2013 as compared to the same period in the prior year. The increase was 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. Our installed product base increased primarily through the addition of 359 new EnCase Enterprise customers and sales of 86 new EnCase eDiscovery and EnCase Cybersecurity modules to existing EnCase Enterprise customers during the twelve-month period ending March 31, 2013.

Cost of Revenues



                                                     Three Months Ended March 31,
(Dollars in thousands)                               2013        Change %      2012
Cost of product revenues                          $     1,768        5 %      $ 1,683

Cost of subscription revenues                           1,126       92 %          586

Cost of services and maintenance revenues:
Professional services                                   4,400       28 %        3,435
Training                                                1,680       14 %        1,480
Maintenance                                               481      (10 )%         535
Total cost of services and maintenance revenues         6,561       20 %        5,450

Total cost of revenues                            $     9,455       22 %      $ 7,719
Share-based compensation included above:
Cost of product revenues                          $        32                 $    22
Cost of subscription revenues                     $        44                 $    23
Cost of services and maintenance revenues         $       322                 $   216

Gross Margin Percentages
Products                                                 76.5 %                  84.0 %
Subscriptions                                            56.4 %                  52.2 %
Services and maintenance                                 61.0 %                  61.8 %
Total                                                    64.9 %                  70.3 %

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 revenues 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 $0.1 million, or 5%, from $1.7 million to $1.8 million for the three months ended March 31, 2013, as compared to the same period in the prior year, primarily as a result of an increase in the cost of certain of our forensic hardware products. Product gross margin decreased to 76.5% in the three months ended March 31, 2013, from 84.0% in the same period in the prior year. The decrease was primarily due to forensic hardware product revenues comprising 28% of product revenues


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in the three months ended March 31, 2013, as compared to 23% of product revenues in the same period of the prior year. Forensic hardware products 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 revenues increased $0.5 million, or 92%, from $0.6 million to $1.1 million for the three months ended March 31, 2013, as compared to the same period in the prior year. 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 is largely comprised of employee compensation costs, including share-based compensation and related overhead, travel and facilities costs. The cost of maintenance revenues includes employee compensation costs for customer technical support and related overhead costs. Total cost of services and maintenance revenues increased $1.1 million, or 20%, from $5.5 million to $6.6 million in the three months ending March 31, 2013, as compared to the same period in the prior year, primarily due to a $1.0 million increase in the cost of services. This increase was primarily due to an increase in costs of $0.7 million as a result of the acquisition of CaseCentral in February, 2012 and higher compensation and related expenses, associated with higher revenues and higher utilization rates in our professional services organization.

Services and maintenance gross margin was 61.0% for the three months ended March 31, 2013, compared to 61.8% in the same period in the prior year. The decrease in gross margin was primarily due to higher compensation and related expenses, associated with higher revenues and higher utilization rates in our professional services organization.

Operating Expenses



                                              Three Months Ended March 31,
(Dollars in thousands)                        2013        Change %      2012
Selling and marketing expenses             $     9,453        9 %      $ 8,637
Research and development expenses          $     7,544       43 %      $ 5,290
General and administrative expenses        $     5,269      (15 )%     $ 6,220
Depreciation and amortization expenses     $     1,697        4 %      $ 1,626

Share-based compensation included above:
Selling and marketing expenses             $       442                 $   377
Research and development expenses          $       461                 $   290
General and administrative expenses        $       438                 $   369

As a percentage of revenue:
Selling and marketing expenses                    35.0 %                  33.2 %
Research and development expenses                 28.0 %                  20.3 %
General and administrative expenses               19.6 %                  23.9 %
Depreciation and amortization expenses             6.3 %                   6.2 %

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 $0.8 million, or 9%, from $8.6 million to $9.5 million, for the three months ended March 31, 2013 as compared to the same period in the prior year. The increase was due primarily to a $0.9 million increase in compensation and other employee-related expenses due to an increase in headcount and a $0.3 million increase in expenses for other marketing activities, offset by a decrease of $0.3 million in sales commissions due to lower revenues for the three months ended March 31, 2013 as compared to the same period in the prior year.


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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 the three months ended March 31, 2013 compared to the same period in 2012.

Research and development expenses increased $2.3 million, or 43%, from $5.3 million to $7.5 million during the three months ended March 31, 2013, as compared to the same period in the prior year. Approximately $0.6 million of the increase was due to increases in compensation and other-employee related expenses due to an increase in headcount in connection with the acquisition of CaseCentral in February of 2012. Approximately $1.7 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.

General and Administrative Expenses

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