DATAWATCH CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) GENERAL The Company does not provide forecasts of its future financial performance. However, from time to time, information provided by the Company or statements made by its employees may contain "forward looking" information that involves risks and uncertainties. In particular, statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. The Company cautions readers not to place undue reliance on any such forward looking statements, which speak only as of the date they are made. The Company disclaims any obligation, except as specifically required by law and the rules of the Securities and Exchange Commission, to publicly update or revise any such statements to reflect any change in the Company's expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward looking statements. The Company's actual results of operations and financial condition have varied and may in the future vary significantly from those stated in any forward looking statements. Factors that may cause such differences include, without limitation, the risks, uncertainties and other information discussed in Item 1A of the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2012, as well as the accuracy of the Company's internal estimates of revenue and operating expense levels.

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

The Company's principal product lines are Information Optimization Solutions (including Monarch Professional, Datawatch Data Pump, Datawatch Enterprise Server, Datawatch Enterprise Server - Cloud, Datawatch RMS, Datawatch Report Manager on Demand, Datawatch Dashboards, and iMergence) and Business Service Management Solutions (including Visual QSM and Visual HD). Included in the above categories are: · Monarch Professional, a desktop reporting and data analysis application that lets users extract and manipulate data from ASCII report files, PDF files or HTML files produced on any mainframe, midrange, client/server or PC system; · Datawatch Data Pump, a data replication and migration tool that offers a shortcut for populating and refreshing data marts and data warehouses, for migrating legacy data into new applications and for providing automated delivery of reports in a variety of formats, such as Excel, via email; · Datawatch Enterprise Server, an enterprise solution that provides web-enabled report storage, transformation and distribution including data analysis, visualization and MS Excel integration for easy to use and cost effective self-serve reporting and analytics; · Datawatch Enterprise Server - Cloud, a cloud-based application that provides the same functionality as Datawatch Enterprise Server and which allows faster deployment with less expense and overhead; · Datawatch RMS, a web-based report analysis solution that integrates with any existing enterprise report management or content management archiving solution; · Datawatch Report Manager on Demand, a system for high-volume document capture, archiving, and online presentation; · Datawatch Dashboards, an interactive dashboard solution that provides a visual overview of operational performance as well as the ability to monitor specific business processes and events; · iMergence, an enterprise report mining system; · Visual QSM, a fully internet-enabled IT service management solution that incorporates workflow and network management capabilities and provides web access to multiple databases via a standard browser; and · Visual Help Desk or Visual HD, a web-based help desk and call center solution operating on the IBM Lotus Domino platform.

CRITICAL ACCOUNTING POLICIES In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on choices made by management, can result in different outcomes. In order for a reader to understand the following information regarding the financial performance and condition of the Company, an understanding of those accounting policies is important. Certain of those policies are comparatively more important to the Company's financial results and condition than others. The policies that the Company believes are most important for a reader's understanding of the financial information provided in this report are identified below: · Revenue Recognition, Allowance for Bad Debts and Returns Reserve · Income Taxes · Capitalized Software Development Costs 19 -------------------------------------------------------------------------------- · Valuation of Intangible Assets and Other Long-Lived Assets · Accounting for Share-Based Compensation During the three months ended December 31, 2012, there were no significant changes in the Company's critical accounting policies. See Note 1 to the Company's condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and in its Annual Report on Form 10-K for the year ended September 30, 2012 for additional information about these critical accounting policies, as well as a description of the Company's other significant accounting policies.

RESULTS OF OPERATIONS The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q. The operating results for any period should not be considered indicative of the results expected for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2012.

Three Months Ended December 31, 2012 2011 REVENUE: Software licenses 64 % 67 % Maintenance 34 27 Professional Services 2 6 Total revenue 100 100 COSTS AND EXPENSES: Cost of software licenses 8 9 Cost of maintenance and services 8 11 Sales and marketing 55 45 Engineering and product development 13 10 General and administrative 17 15 Total costs and expenses 101 90 INCOME (LOSS) FROM OPERATIONS (1) 10 Interest (expense) income and other income, net (2) - INCOME (LOSS) BEFORE INCOME TAXES (3) 10 Provision for income taxes - - NET INCOME (LOSS) (3) % 10 % 20 -------------------------------------------------------------------------------- Three Months Ended December 31, 2012 Compared to Three Months Ended December 31, 2011 Total Revenues The following table presents total revenue, revenue increase (decrease) and percentage change in revenue for the three months ended December 31, 2012 and 2011: Three Months Ended December 31, Increase Percentage 2012 2011 (Decrease) Change (In thousands) Software licenses $ 4,330 $ 4,208 $ 122 3 % Maintenance 2,333 1,717 616 36 Professional services 158 346 (188) -54 Total revenue $ 6,821 $ 6,271 $ 550 9 % Software license revenue for the three months ended December 31, 2012 was $4,330,000 or approximately 64% of total revenue, as compared to $4,208,000, or approximately 67% of total revenue for the three months ended December 31, 2011.

The increase in software license revenue of $122,000 for the three months ended December 31, 2012 consists of a $163,000 increase in Information Optimization Solutions (including Monarch Professional, Datawatch Data Pump, Datawatch Enterprise Server, Datawatch Enterprise Server - Cloud, Datawatch RMS, Datawatch Report Manager on Demand, Datawatch Dashboards, and iMergence products) offset by a $41,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products). The Company attributes the increase in software license revenue to its new product positioning and the investments the Company has made in its sales and marketing organization which has resulted in both increased desktop and enterprise license sales during the quarter.

Maintenance revenue for the three months ended December 31, 2012 was $2,333,000 or approximately 34% of total revenue, as compared to $1,717,000, or approximately 27% of total revenue for the three months ended December 31, 2011.

The increase in maintenance revenue of $616,000 consists of a $633,000 increase in Information Optimization Solutions offset by a $17,000 decrease in Business Service Management Solutions. The Company attributes the increase in maintenance revenue to higher overall sales and higher renewal rates of Monarch Professional.

Professional services revenue for the three months ended December 31, 2012 was $158,000 or approximately 2% of total revenue, as compared to $346,000, or approximately 6% of total revenue for the three months ended December 31, 2011.

The decrease in professional services revenue of $188,000 consists of a $129,000 decrease in Information Optimization Solutions and a $59,000 decrease in Business Service Management Solutions. The decrease is due to lower consulting services primarily related to the Company's Report Manager on Demand and Visual QSM product offerings.

Costs and Operating Expenses The following table presents costs of sales and operating expenses, increase (decrease) in costs of sales and operating expenses and percentage changes in costs of sales and operating expenses for the three months ended December 31, 2012 and 2011: Three Months Ended December 31, Increase / Percentage 2012 2011 (Decrease) Change (in thousands) Cost of software licenses $ 521 $ 575 $ (54 ) (9 )% Cost of maintenance and services 530 668 (138 ) (21 ) Sales and marketing 3,776 2,801 975 35 Engineering and product development 853 628 225 36 General and administrative 1,191 967 224 23 Total costs and operating expenses $ 6,871 $ 5,639 $ 1,232 22 % 21 -------------------------------------------------------------------------------- The decrease in cost of software licenses and subscriptions of $54,000, or approximately 9%, is primarily due to a decrease in royalty expense attributable to the acquisition of intellectual property underlying the Company's Monarch Professional and Datawatch Data Pump products on March 30, 2012 which was partially offset by higher software amortization costs. As a result of this acquisition, the Company is no longer incurring royalty expense to cost of software licenses but is amortizing the purchase price of the intellectual property to cost of software licenses. See additional information regarding the amortization of the intellectual property in Note 1 to the Company's condensed consolidated financial statements.

The decrease in cost of maintenance and services of $138,000, or approximately 21%, is primarily due to lower commissions and other employee-related costs attributable to lower professional services revenue during the three months ended December 31, 2012.

The increase in sales and marketing expenses of $975,000, or approximately 35%, is due to higher wages and employee-related costs, including share-based compensation, attributable to increased headcount and increased promotional and lead generation costs as compared to last year. These increases reflect the Company's significant investment in a new sales and marketing team during the last several quarters to accelerate revenue generation. The Company does not expect increases of this magnitude to continue beyond fiscal year 2013.

The increase in engineering and product development expenses of $225,000, or approximately 36%, is primarily attributable to higher wages and other employee-related costs due to increased headcount offset by lower external consulting costs.

The increase in general and administrative expenses of $224,000, or 23%, is primarily attributable to higher external consulting costs as well as higher share-based compensation costs as compared to last year.

Interest (expense) income and other income, net for the three months ended December 31, 2012 represents primarily interest expense related to both the Company's $4.0 million subordinated note with a private investment company and borrowings under a $2.0 million revolving credit facility with a bank. Both of these financings were issued in connection with the Company's acquisition of the intellectual property underlying its Monarch Professional and Datawatch Data Pump product offerings. Interest income and other income (expense) for the three months ended December 31, 2011 included interest income of $2,000 and gains on foreign currency transactions of approximately $7,000.

Income tax expense for the three months ended December 31, 2012 and 2011 was $9,000 and $38,000, respectively. Income tax expense for the three months ended December 31, 2012 includes $5,000 related to estimated federal alternative minimum taxes and a $2,000 credit related to state income tax adjustments.

Income tax expense for the three months ended December 31, 2011 includes $19,000 related to estimated state taxes and $13,000 related to estimated federal alternative minimum taxes. Income tax expense for both periods also includes a $6,000 provision for uncertain tax positions relative to foreign taxes. At December 31, 2012, the Company had U.S. federal tax loss carryforwards of approximately $6.7 million which expire at various dates through and until 2031 as well as significant state and foreign net operating loss carry forwards.

Net loss for the three months ended December 31, 2012 was $222,000 as compared to net income of $603,000 for the three months ended December 31, 2011.

OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS The Company leases various facilities and equipment in the U.S. and overseas under non-cancelable operating leases that expire through 2016. The lease agreements generally provide for the payment of minimum annual rentals, pro rata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $143,000 and $113,000 for the three months ended December 31, 2012 and 2011, respectively.

22 -------------------------------------------------------------------------------- As of December 31, 2012, the Company's contractual obligations include minimum rental commitments under non-cancelable operating leases, long-term debt obligations and other liabilities related to uncertain tax positions as follows (in thousands): Less than 1 More than Contractual Obligations: Total Year 1-3 Years 3-5 Years 5 Years Operating Lease Obligations $ 821 $ 370 $ 369 $ 82 $ - Long-term Debt Obligations $ 4,000 $ - $ 1,467 $ 1,600 $ 933 Other Liabilities $ 206 $ - $ - $ - $ 206 Prior to the acquisition of intellectual property on March 30, 2012, as disclosed in Note 1 to the condensed consolidated financial statements, the Company was obligated to pay royalties ranging from 7% to 50% on revenue generated by the sale of certain licensed software products. Additionally, the Company pays royalties under arrangements with vendors related to sales of its Datawatch Report Manager on Demand and Datawatch Dashboards products. Royalty expense included in cost of software licenses was approximately $35,000 and $511,000, respectively, for the three months ended December 31, 2012 and 2011.

The Company is not obligated to pay any minimum amounts for royalties. As a result of the acquisition of the intellectual property, the Company is no longer required to pay royalties related to its Monarch Professional and Datawatch Data Pump products.

The Company's software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase.

If necessary, the Company would provide for the estimated cost of warranties based on specific warranty claims and claim history. However, the Company has never incurred significant expense under its product or service warranties. As a result, the Company believes its exposure related to these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of December 31, 2012.

The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company generally agrees to indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company's products.

The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of December 31, 2012.

Certain of the Company's agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable it to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of December 31, 2012.

As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company's request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company's director and officer insurance policy would enable it to recover a portion of any future amounts paid. As a result of its 23 -------------------------------------------------------------------------------- insurance policy coverage, the Company believes its exposure related to these indemnification agreements is minimal. The Company has no liabilities recorded for these potential obligations as of December 31, 2012.

LIQUIDITY AND CAPITAL RESOURCES Management believes that its current cash balances and cash generated from operations will be sufficient to meet the Company's cash needs for working capital and anticipated capital expenditures for at least the next twelve months. At December 31, 2012, the Company had $8,937,000 of cash and equivalents, an increase of $215,000 from September 30, 2012.

At December 31, 2012, the Company had working capital of approximately $5,054,000 as compared to $4,041,000 at September 30, 2012. The Company expects cash flows from operations to remain positive as it anticipates profitability in the future. However, if the Company's cash flow from operations were to decline significantly, it may need to consider reductions to its operating expenses. The Company does not anticipate additional cash requirements to fund growth or the acquisition of additional complementary technology or businesses. However, if in the future, such expenditures are anticipated or required, the Company may seek additional financing by issuing equity or obtaining credit facilities to fund such requirements. There can be no assurance that the Company will be able to issue additional equity or obtain a new or expanded credit facility at attractive prices or rates, or at all.

The Company had a net loss of approximately $222,000 for the three months ended December 31, 2012 as compared to net income of approximately $603,000 for the three months ended December 31, 2011. During the three months ended December 31, 2012 and 2011, approximately $130,000 and $1,419,000, respectively, of cash was provided by the Company's operations. During the three months ended December 31, 2012, the main source of cash from operations was net income adjusted for depreciation and amortization and share-based compensation expense, as well as an increase in accounts receivable.

Net cash used in investing activities for the three months ended December 31, 2012 of $19,000 is related to the purchase of property and equipment.

Net cash provided by financing activities for the three months ended December 31, 2012 of $119,000 is related to proceeds from the exercise of stock options.

On March 30, 2012, the Company entered into a Note and Warrant Purchase Agreement with a private investment company. The terms of the Note and Warrant Purchase Agreement include a $4.0 million subordinated note and warrants for 185,000 shares of the Company's common stock. The subordinated note has a maturity date of February 28, 2019, with interest due monthly on the unpaid principal amount of the note at the rate of 10% per annum in arrears.

Additionally, beginning on March 31, 2014 and on the last day of each month thereafter until the maturity date, the Company will make principal payments totaling $66,667. The Company is required under this agreement to maintain certain interest coverage and leverage ratios. As of December 31, 2012, the Company was in compliance with the covenants under the Note and Warrant Purchase Agreement.

On March 30, 2012, the Company entered into a Loan and Security Agreement ("Loan Agreement") with a bank which established a $2.0 million revolving line of credit facility and borrowed $1.5 million under the Loan Agreement on that date.

The Company repaid $600,000 under the line of credit in September 2012. The Loan Agreement terminates on March 29, 2014. On that date, the principal amount of all advances under the revolving line and all unpaid interest thereon will become due and payable. The principal amount outstanding under the revolving line accrues interest at a floating rate per annum equal to 1.5% above the prime rate, with the prime rate having a floor of 3.25%. The Company can borrow under the revolving line of credit based on a formula percentage of its accounts receivable balance. Additionally, the Loan Agreement requires that the Company maintain certain net asset and net income ratios. The Company's obligations under the line of credit facility are secured by substantially all of the Company's assets other than intellectual property. As of December 31, 2012, the Company was in compliance with the covenants under the Loan Agreement.

24 --------------------------------------------------------------------------------Management believes that the Company's current operations have not been materially impacted by the effects of inflation.

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