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RALY > SEC Filings for RALY > Form 10-Q on 13-Jun-2013All Recent SEC Filings

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Form 10-Q for RALLY SOFTWARE DEVELOPMENT CORP


13-Jun-2013

Quarterly Report


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

The following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended January 31, 2013 included in our prospectus dated April 11, 2013, filed with the SEC on April 12, 2013 pursuant to Rule 424(b)(4) under the Securities Act (File No. 333-187173). This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements are often identified by the use of words such as "anticipate," "believe," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "will," "would" or the negative or plural of these words or similar expressions or variations. Such forward-looking statements are subject to a number of risks, uncertainties, assumptions and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled "Risk Factors", set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q and in our other SEC filings. You should not rely upon forward-looking statements as predictions of future events. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

Rally Software is a leading global provider of cloud-based solutions for managing Agile software development. Agile is a software development methodology characterized by short, iterative and highly-adaptable development cycles. Our platform transforms the way organizations manage the software development lifecycle by enabling close alignment of software development and strategic business objectives, facilitating collaboration, increasing transparency, and automating manual processes. Organizations use our solutions to accelerate the pace of innovation, improve productivity and more effectively adapt to rapidly-changing customer needs and competitive dynamics. Our enterprise-class platform is extensible, cost-effective and designed to be easy to use.

Our operating results in a given period can fluctuate based on the mix of subscription and support, perpetual license and professional services revenue. In the three months ended April 30, 2013, subscription and support revenue accounted for 83% of total revenue. Our subscription contracts are typically sold on a per-seat basis with a one-year term, paid upfront and provide us with revenue visibility over a number of quarters. We typically negotiate the total number of seats a customer is entitled to provision as part of their subscription, but these seats may not be fully utilized over the term of the agreement. However, we have recently, and may in the future, enter into multi-year contracts in which the fees are paid upfront and the customer is entitled to an unlimited number of seats. These contracts may lead to significant fluctuations in cash flow from operations and will positively impact cash flow from operations in the period in which the cash is received. To a lesser extent, we sell perpetual licenses, which are also paid upfront and include support agreements, which are one year in duration and entitle the customer to support and upgrades. In the three months ended April 30, 2013, perpetual license revenue accounted for 4% of total revenue. We also offer professional services, which include training on Agile software development methodologies and the use of our solutions. In the three months ended April 30, 2013, professional services accounted for 13% of total revenue.

We have achieved significant growth since inception. From the three months ended April 30, 2012 to the three months ended April 30, 2013, our subscription and support revenue grew from $9.5 million to $13.4 million, representing a 40% period-over-period growth rate. From the three months ended April 30, 2012 to the three months ended April 30, 2013, our total revenue grew from $13.0 million to $16.0 million, representing a 24% period-over-period growth rate. We expect to continue to make significant expenditures to support and grow our business, including investing in our data center infrastructure, expanding our sales force and increasing our international presence. In addition, as a public company we will incur significant legal, accounting and other expenses that we did not incur as a private company. We expect to incur losses for the foreseeable future and we may not be able to achieve or sustain profitability. We increased our overall employee headcount to 378 as of April 30, 2013 from 296 as of April 30, 2012.

On April 17, 2013, we issued and sold 6,900,000 shares of common stock in our IPO. The net offering proceeds to us, after deducting underwriting discounts and commissions totaling approximately $6.8 million and offering expenses totaling approximately $2.9 million, were approximately $87.0 million.


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Key Metrics

We regularly review the following key metrics to evaluate our business, measure our performance, identify trends in our business, prepare financial projections and make strategic decisions.

Total paid seats. We believe total paid seats are a key indicator of our market penetration, growth and future revenue. We define a paid seat as a seat with a subscription or support contract as of the measurement date. Our total paid seats were 184,145 and 128,787 as of April 30, 2013 and, 2012, respectively. In the case of a contract that allows a customer to provision an unlimited number of seats, total paid seats includes an estimate of the total number of seats to be provisioned during the term of the contract. Total paid seats as of April 30, 2013 includes 13,731 in aggregate seat upgrades pursuant to such contracts with four different enterprise customers entered into between July 2012 and April 2013.

Renewal rate. We believe our renewal rate is an important metric to measure the long-term value of customer agreements and our ability to upsell or expand in our existing customer base. We calculate our renewal rate by comparing the number of paid seats of all of our existing customers at the beginning of a twelve-month period to the number of paid seats for those same customers at the end of such period, taking into account nonrenewals, upgrades and downgrades. We exclude seats sold to new customers. For the twelve months ended April 30, 2013 and 2012, the renewal rate was 126% and 123%, respectively.

Components of Operating Results

Revenue

Subscription and support revenue. We derive our subscription revenue from fees paid to us by our customers for access to our cloud-based solutions. We recognize the revenue associated with subscription agreements ratably on a straight-line basis over the term of the agreement, provided all criteria required for revenue recognition have been met.

Our support revenue consists of maintenance associated with our perpetual licenses and hosting fees paid to us by our customers. Typically, when purchasing a perpetual license, a customer also purchases maintenance for which we charge a fee, priced as a percentage of the perpetual license fee. Maintenance agreements include the right to support and unspecified product upgrades. We recognize the revenue associated with maintenance ratably, on a straight-line basis, over the term of the contract. In limited instances, at the customer's option, we may host the software purchased by a customer under a perpetual license on systems at our third-party data centers. For hosting, we charge a fee, priced as a percentage of the perpetual license fee, and we recognize the revenue associated with hosting ratably on a straight-line basis over the associated hosting period.

Perpetual license revenue. Perpetual license revenue reflects the revenue recognized from sales of perpetual licenses to new customers and additional licenses to existing customers. We generally recognize the license fee portion of the arrangement upfront, provided all revenue recognition criteria are satisfied.

Professional services revenue. Professional services revenue consists primarily of fees related to the instruction of customers in Agile software development methodologies and training on our solutions, as well as reimbursable expenses. We generally recognize the revenue associated with these professional services on a time-and-materials basis as we deliver the services or provide the training to our customers.

Cost of Revenue

Cost of product revenue. Cost of product revenue consists primarily of personnel and related costs of our support and operations teams, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and allocated overhead, as well as software license fees, hosting costs, Internet connectivity and depreciation expenses directly related to delivering our solutions. As we add data center capacity and support personnel in advance of anticipated growth, our cost of product revenue will increase and if such anticipated revenue growth does not occur, our product gross profit will be adversely affected. In February 2013, we purchased Flowdock Oy, a company based in Helsinki, Finland, for approximately $4.4 million. Our purchase accounting allocation is not yet complete; however, we expect a meaningful portion of the purchase consideration will be allocated to intangible assets that will be capitalized and amortized over time to cost of product revenue, thereby increasing our cost of product revenue. Our cost of product revenue is generally expensed as the costs are incurred.

Cost of professional services revenue. Cost of professional services revenue consists primarily of personnel and related costs, including salaries, benefits, bonuses, payroll taxes, stock-based compensation, the costs of contracted third-party vendors, reimbursable expenses and allocated overhead. As most of our personnel are employed on a full-time basis, our cost of professional services is largely


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fixed in the short-term, while our professional services revenue may fluctuate, leading to fluctuations in professional services gross profit. Our cost of professional services revenue is generally expensed as costs are incurred.

Operating Expenses

Our operating expenses are classified into three categories: sales and marketing, research and development and general and administrative. For each category, the largest expense component is personnel and related costs, which includes salaries, employee benefit costs, bonuses, commissions, stock-based compensation and payroll taxes. Operating expenses also include allocated overhead costs for facilities and depreciation of equipment, which are allocated to each department based on relative department headcount. Operating expenses are generally recognized as incurred.

Sales and marketing. Sales and marketing expenses primarily consist of personnel and related costs for our sales and marketing staff, including salaries, benefits, commissions, bonuses, payroll taxes, stock-based compensation and costs of promotional events, corporate communications, online marketing, product marketing and other brand-building activities, in addition to allocated overhead. We expense sales commissions when the initial customer contract is signed and upon any renewal as our obligation to pay a sales commission arises at these times. We expect that sales and marketing expenses will continue to increase in absolute dollars, partially as a result of our international expansion, and will continue to be the largest expense component of our operating expenses. However, we expect sales and marketing expenses to be relatively constant as a percentage of revenue in the near term.

Research and development. Research and development expenses primarily consist of personnel and related costs of our research and development staff, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and costs of certain third-party contractors, as well as allocated overhead. Research and development costs related to the development of our software products are generally expensed as incurred as development costs that have qualified for capitalization are not significant. We have devoted our product development efforts primarily to enhancing the functionality and expanding the capabilities of our solutions. We expect that our research and development expenses will continue to increase in absolute dollars as we increase our research and development headcount to further strengthen and enhance our solutions. For example, in February 2013 we increased our research and development headcount by eight employees with the purchase of Flowdock Oy, a company based in Helsinki, Finland.

General and administrative. General and administrative expenses primarily consist of personnel and related costs for our executive, administrative, finance, information technology, legal, accounting and human resource staffs, including salaries, benefits, bonuses, payroll taxes and stock-based compensation, professional fees, other corporate expenses and allocated overhead. We have recently incurred, and expect to continue to incur, additional expenses as we grow our operations and transition to operating as a public company, including higher legal, corporate insurance, accounting and auditing expenses, and the additional costs of enhancing and maintaining our internal control environment through the adoption of new corporate policies. We also expect that general and administrative expenses will continue to increase in absolute dollars as we expand our operations, including internationally.

Other Income (Expense)

Other income (expense) consists primarily of interest income on our cash balances, changes in the estimated fair value of our preferred stock warrants, which are recorded as interest expense because the warrants were issued in conjunction with debt facilities, and foreign exchange gains (losses) that relate to expenses and transactions denominated in currencies other than our functional currency. Our functional currency is the U.S. dollar. On April 17, 2013, our preferred stock warrants converted to common stock warrants upon the closing of our IPO and, as such, we will no longer be required to present the warrants at fair value.

Provision for Income Taxes

Because we have generated net losses in all periods to date and recorded a full valuation allowance against our deferred tax assets, we have historically not recorded a provision for federal or state income taxes. Foreign income taxes prior to the three months ended April 30, 2013 have not been material. The tax provision for the three months ended April 30, 2013 is exclusively related to foreign income taxes and is a result of the cost-plus transfer pricing agreements we have in place with our foreign subsidiaries. Realization of any of our deferred tax assets depends upon future earnings, the timing and amount of which are uncertain. Utilization of our net operating losses may be subject to annual limitations due to the ownership change rules under the Internal Revenue Code of 1986, as amended, and similar state provisions. We completed an analysis covering the period through April 30, 2013 to determine whether an ownership change had occurred since our inception. The analysis indicated that although an ownership change had occurred in 2003, the net operating losses and research and development credits remained available to offset future taxable income, if any. However, in the event we have subsequent changes in ownership, the availability of net operating losses and research and development credit carryovers could be limited.


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Results of Operations

To enhance comparability, the following tables set forth our results of operations for the periods presented and as a percentage of our total revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods.

                                                                  Three Months Ended April 30,
                                                                    2013               2012
                                                                     (dollars in thousands)

Consolidated Statements of Operations Data:
Revenue:
Subscription and support                                       $        13,373    $         9,530
Perpetual license                                                          629              1,611
Total product revenue                                                   14,002             11,141
Professional services                                                    2,047              1,837
Total revenue                                                           16,049             12,978
Cost of revenue:
Product                                                                  1,684              1,153
Professional services                                                    1,873              1,586
Total cost of revenue                                                    3,557              2,739
Gross profit                                                            12,492             10,239
Operating expenses:
Sales and marketing                                                      8,835              7,005
Research and development                                                 5,079              3,041
General and administrative                                               3,854              2,302
Sublease termination income                                                  -               (839 )
Total operating expenses                                                17,768             11,509
Loss from operations                                                    (5,276 )           (1,270 )
Other (expense) income:
Interest and other income                                                   13                  2
Interest expense                                                          (462 )             (438 )
Loss on foreign currency transactions and other gain (loss)                (19 )              (15 )
Loss before provision for income taxes                                  (5,744 )           (1,721 )
Provision for income taxes                                                 (46 )                -
Net loss                                                       $        (5,790 )  $        (1,721 )




                                                                Three Months
                                                               Ended April 30,
                                                               2013       2012

Consolidated Statements of Operations Data:
Revenue:
Subscription and support                                          83 %       74 %
Perpetual license                                                  4         12
Total product revenue                                             87         86
Professional services                                             13         14
Total revenue                                                    100        100
Cost of revenue:
Product                                                           10          9
Professional services                                             12         12
Total cost of revenue                                             22         21
Gross profit                                                      78         79
Operating expenses:
Sales and marketing                                               55         54
Research and development                                          32         23
General and administrative                                        24         18
Sublease termination income                                        -         (6 )
Total operating expenses                                         111         89
Loss from operations                                             (33 )      (10 )
Other (expense) income:
Interest and other income                                          -          -
Interest expense                                                  (3 )       (3 )
Loss on foreign currency transactions and other gain (loss)        -          -
Loss before provision for income taxes                           (36 )      (13 )
Provision for income taxes                                         -          -
Net loss                                                         (36 )%     (13 )%


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Comparison of the Three Months Ended April 30, 2013 and 2012



Revenue



                               Three Months Ended
                                   April 30,
                                2013           2012     % Change
                             (dollars in thousands)
Revenue:
Subscription and support   $       13,373    $  9,530         40 %
Perpetual license                     629       1,611        (61 )%
Total product revenue              14,002      11,141         26 %
Professional services               2,047       1,837         11 %
Total revenue              $       16,049    $ 12,978         24 %
Percentage of revenue:
Subscription and support               83 %        74 %
Perpetual license                       4          12
Total product revenue                  87          86
Professional services                  13          14
Total                                 100 %       100 %

Subscription and support revenue increased $3.8 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. Of the total increase in subscription and support revenue, approximately $1.5 million, or 38.1%, represented revenue from new customers acquired after April 30, 2012, and approximately $2.3 million, or 61.9%, represented revenue from existing customers at or prior to April 30, 2012. The increase in revenue from existing customers was due primarily to sales of additional seats, which we believe is attributable to increased adoption of Agile practices by our customers.

Perpetual license revenue decreased $1.0 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The overall decrease in perpetual license revenue was primarily the result of three large transactions totaling approximately $0.9 million that were recognized as revenue in the three months ended April 30, 2012 and were not offset or replaced by the sale of additional perpetual license seats to different new or existing customers in the three months ended April 30, 2013.

Professional services revenue increased $0.2 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The increase was driven by higher demand for our services to help companies implement Agile software development methodologies.


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Cost of Revenue and Gross Profit Percentage



                            Three Months Ended
                                April 30,
                            2013            2012     % Change
                          (dollars in thousands)
Cost of revenue:
Product                 $       1,684     $  1,153         46 %
Professional services           1,873        1,586         18 %
Total cost of revenue   $       3,557     $  2,739
Gross profit:
Product                            88 %         89 %
Professional services               9 %         14 %
Total gross profit                 78 %         79 %

Cost of product revenue increased $0.5 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The increase was primarily comprised of a $0.2 million increase in personnel and related expenses, a $0.1 million increase in depreciation expense as a result of computer equipment purchases and amortization of intangible assets acquired in business combinations and a $0.1 million increase in additional software licenses.

Cost of professional services revenue increased $0.3 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The increase was primarily due to an increase of $0.1 million in personnel and related expenses and an increase of $0.1 million in third-party consulting services.

Operating Expenses



Sales and Marketing



                                  Three Months Ended
                                      April 30,
                                  2013            2012     % Change
                                (dollars in thousands)
Sales and marketing           $       8,835     $  7,005         26 %
Percentage of total revenue              55 %         54 %

Sales and marketing expenses increased $1.8 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The increase was primarily due to an increase of $1.4 million in personnel and related expenses. Our sales and marketing headcount increased from 113 as of April 30, 2012 to 145 as of April 30, 2013. Rent expense increased $0.1 million as a result of an increase in allocated rent expense and an increase associated with opening new foreign sales offices. Travel and entertainment expenses increased $0.2 million as a result of our larger sales and marketing teams and an increase in travel related to our international expansion and an increased number of marketing events.

Research and Development



                                  Three Months Ended
                                      April 30,
                                  2013            2012     % Change
                                (dollars in thousands)
Research and development      $       5,079     $  3,041         67 %
Percentage of total revenue              32 %         23 %

Research and development expenses increased $2.0 million from the three months ended April 30, 2012 to the three months ended April 30, 2013. The increase was primarily due to an increase of $1.5 million in personnel and related expenses to enhance existing solutions and add new functionality to our solutions, an increase of $0.2 million for third-party consulting services and a $0.1


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million increase in allocated rent expense. Our research and development headcount increased from 94 as of April 30, 2012 to 123 as of April 30, 2013.

General and Administrative



                                  Three Months Ended
                                      April 30,
. . .
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