RadView Software Ltd. (RDVWF)

[midastouch017]

Form 10-K for RADVIEW SOFTWARE LTD

14-Apr-2006

Annual Report

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as "believe," "anticipates," "expects," "intends," "plans," "will," "may," and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in Item 1A. Risk Factors. Our business may have changes since the date hereof, and we undertake no obligation to update these forward-looking statements.

Overview

We develop, market and support software that enables companies to assure the scalability, performance, efficiency and reliability of web applications. In May 2004, we introduced the TestView suite of products, which provides a comprehensive test management solution for test automation and reporting for web applications. The TestView suite efficiently integrates test management and automation with the functionality of our existing stand-alone products to include functional testing, load testing, and root-cause analysis.

We derive the majority of our software license revenues from perpetual licenses of our load testing products and, to a lesser extent, our functional testing and root-cause analysis products. We derive the majority of our services revenues from support and maintenance arrangements and, to a lesser extent, from training and consulting services. Substantially all of our revenues are denominated in U.S. dollars.

A portion of our software license revenues, and to a lesser extent our services revenues, was derived from royalty fees, license fees and engineering service fees from technology license transactions. Revenues recognized under such arrangements totaled $213,000 in 2003, $730,000 in 2004 and $928,000 in 2005. While we expect to recognize a portion of our revenues from technology arrangements in 2006, we expect that the impact of future technology license transactions, if any, will not represent a material portion of our total revenues.

We measure our operating success using both financial and non-financial metrics. The financial metrics include revenue, gross profit, operating expenses, and loss from operations, as well as cash position and operating cash flow. Other key metrics include product orders by industry segment, average deal size, repeat customer orders, and the portion of revenue that is generated by indirect channels.

We have incurred net losses since our inception. Our net loss was $5.1 million in 2003, $3.8 million in 2004 and $2.5 million in 2005. Net losses have declined as a result of significant cost reductions achieved through restructuring actions undertaken in response to a decline in our revenues in previous years. In 2005, the decrease in our net loss was primarily attributable to an increase in revenues and, to a lesser extent, lower operating expenses. If we are to achieve future profitability, we must continue to increase our revenues while maintaining lower operating expenses.

Cash used in operating activities was $4.6 million in 2003, $2.7 million in 2004 and $2.1 million in 2005, attributable primarily to our net losses, partially offset by noncash charges such as depreciation expense and stock-based compensation along with changes in current assets and liabilities. We expect that operating expenses will constitute a material use of our cash resources.

On April 4, 2006, we signed definitive agreements for a financing lead by Fortissimo Capital Funds, or Fortissimo, along with several co-investors including one of our directors and two existing shareholders, to provide for a minimum initial investment of $1.5 million and up to $2.25 million of additional investments,



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at the election of the investors, over 18 months. The completion of the proposed financing is subject to approval by a majority of our shareholders. See Note 1(b) in the Notes to Consolidated Financial Statements for further information related to the proposed financing. Prior to signing the definitive agreements for the financing, in January 2006, we executed a bridge loan agreement with Fortissimo to provide us with interim funding for up to $500,000, subject to compliance by the Company with an approved budget, of which we have borrowed $280,000 as of April 5, 2006 and have $220,000 available for future borrowings. Borrowings under the bridge loan will become part of the minimum investment at closing.

Our cash balance was $166,000 as of December 31, 2005. We believe that our existing cash and cash equivalents, along with the proceeds available under the bridge loan and the expected proceeds from the initial investment from the financing, assuming the approval by a majority our shareholders and completion of the financing, will be sufficient to meet our anticipated needs for working capital and capital expenditures for at least the next 12 months.

Critical Accounting Policies and Estimates

General

We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. To fully understand and evaluate our reported financial results, we believe it is important to understand the significant estimates and judgments applied as they relate to our policies for revenue recognition, software development costs, and accounting for stock options. More detailed descriptions of these policies are provided in Note 2 to the Consolidated Financial Statements.

Revenue Recognition

Our revenue recognition approach requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) is based on management's judgments regarding the fixed nature of the fee charged for services rendered and products delivered, and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

Software Development Costs

Software development costs incurred from the point of reaching technological feasibility until the time of general product release are normally capitalized. We define technological feasibility as the completion of a working model. The determination of technological feasibility requires the exercise of judgment by our management. Because we sell our products in a market that is subject to rapid technological change, new product development and changing customer needs, we have concluded that technological feasibility is not established until the development stage of the product is nearly complete. For us, the period in which we can capitalize software development costs is very short, so the amounts that could be capitalized are not material to our financial statements. Therefore, we have charged all such costs to research and development expense in the period incurred.



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Accounting for Stock Options

Effective January 1, 2005, we have accounted for stock options issued to employees in accordance with SFAS No. 123R (Revised 2004), or SFAS 123(R), Share-Based Payment and SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure. Under this approach all share-based payments to employees, including grants of employee stock options, are required to be recognized in the financial statements based on their fair values, instead of providing the information in a pro forma disclosure in the notes to the financial statements. We have elected to use the modified prospective method of adoption as permitted under SFAS 123(R), which requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123(R). We have determined the fair value of share-based payments issued after January 1, 2005 using the Black-Scholes option valuation model. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect management's best estimates.

For reporting periods before January 1, 2005, we accounted for stock options using the intrinsic method in accordance with Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees. Under this approach we did not record any expense at the time the options were granted unless the exercise price of a granted option was below the fair market price of our ordinary shares on the date of grant. For reporting periods before January 1, 2005, we have provided pro forma disclosures of impact to our reported net loss and net loss per share if we had applied the fair value method.

The determination of fair value of stock options, whether for actual expense reporting under SFAS 123(R) or for pro forma disclosures, requires the application of estimates, such as estimated expected life of the options and estimated market volatility for our ordinary shares. These estimates are based on management's review of historical option lives and computations of market volatility for our ordinary shares.



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Results of Operations

The following table sets forth the consolidated statement of operations data as a percentage of total revenues for the periods indicated:


For the Year Ended December 31,
2003 2004 2005
Revenues:
Software licenses 52.7 % 52.7 % 55.6 %
Services 47.3 % 47.3 % 44.4 %
Total revenues 100.0 % 100.0 % 100.0 %
Cost of revenues:
Software licenses 3.0 % 1.8 % 2.6 %
Services 8.8 % 7.0 % 4.5 %
Total cost of revenues 11.8 % 8.9 % 7.1 %
Gross profit 88.2 % 91.1 % 92.9 %
Operating expenses:
Sales and marketing 87.9 % 75.9 % 58.2 %
Research and development 61.0 % 56.4 % 39.5 %
General and administrative 38.9 % 39.3 % 35.5 %
Restructuring charges 5.1 % 0.0 % 0.0 %
Total operating expenses 192.9 % 171.6 % 133.2 %
Loss from operations (104.7 )% (80.5 )% (40.3 )%
Other income (expense), net:
Interest income (expense), net 0.7 % 0.4 % (3.2 )%
Other expense, net (1.1 )% (1.0 )% (0.2 )%
Net loss (105.1 )% (81.1 )% (43.7 )%




Years Ended December 31, 2004 and 2005

Revenues

Total Revenues. Total revenues were $4.7 million in 2004 and $5.6 million in 2005. Total revenues increased $982,000, or 21%, due to a $682,000 increase in product revenues and a $300,000 increase in services revenues.

Software Licenses. Software licenses revenues consist primarily of revenues from the license of our software products to end-users, resellers, and technology partners. Software license revenues were $2.5 million in 2004 and $3.1 million in 2005. Software license revenues increased $682,000, or 28%, due to a $416,000 increase in revenues attributable to the expansion of our product offerings following the introduction of TestView suite and new versions of WebLOAD Analyzer, and $266,000 of incremental software license fees from technology license transactions.

Services. Services revenues consist primarily of revenue from annual support and maintenance contracts and, to a lesser extent, training and consulting services. Services revenues were $2.2 million in 2004 and $2.5 million in 2005. Services revenues increased $300,000, or 14%, primarily due to $149,000 of incremental service revenues in 2005 attributable to engineering services provided under technology transactions with OPNET and IXIA, and an $82,000 increase maintenance services revenue derived from new customers and renewal orders.



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Cost of Revenues

Cost of Software Licenses. Cost of software licenses consists principally of direct product costs, such as product media and packaging, as well as royalties due to third parties. Cost of software licenses was $86,000 in 2004, or 3.5% of software license revenue, compared to $147,000 in 2005, or 4.7% of software license revenue. The increase in cost of software licenses resulted from third-party royalties attributable to increased revenues from royalty-bearing products in 2005.

Cost of Services. Cost of services consists principally of personnel related costs associated with customer support and training. Cost of services was $327,000 in 2004, or 14.8% of services revenues, compared to $255,000 in 2005, or 10.2% of services revenue. This decrease was due to lower personnel costs for support and maintenance services resulting from staff reallocations made in late 2004 and through reductions in personnel and salary-related costs in July 2005.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist principally of salaries and commissions for sales personnel, recruiting costs, trade show costs, travel and other marketing costs such as lead generation activities, advertising and product promotion. Sales and marketing expenses were $3.5 million in 2004, or 75.9% of total revenues, compared to $3.3 million in 2005, or 58.2% of total revenues. The decrease in sales and marketing costs relate primarily to personnel reductions and lower marketing program spending. We expect that our sales and marketing expenses will decrease in 2006 as a result of cost reduction measures taken in July 2005.

Research and Development. Research and development expenses consist principally of salaries and related expenses required to develop and enhance our products. Research and development expenses were $2.6 million in 2004, or 56.4% of total revenues, compared to $2.2 million in 2005, or 39.5% of total revenues. These decreases resulted primarily as a result of cost reductions in July 2005 achieved through reductions in personnel and salary-related costs. We expect that our research and development expenses will decrease in 2006 as a result of cost reduction measures taken in July 2005 and March 2006.

General and Administrative. General and administrative expenses consist principally of executive, finance and administrative salaries and related expenses, and costs of being a publicly held company. General and administrative expenses were $1.8 million in 2004, or 39.3% of total revenues, compared to $2.0 million in 2005, or 35.5% of total revenues. The increase in general and administrative costs in absolute dollars resulted primarily from increased professional fees incurred in 2005 arising from the exploration of strategic alternatives, including the potential sale of our business. We expect that our general and administrative expenses will decrease in 2006 as a result of cost reduction measures taken in March 2006.

Interest Income (Expense), Net. Interest income, net was $19,000 in 2004 resulting primarily from interest earned on invested cash balances. Interest expense, net was $177,000 in 2005 resulting primarily from interest expense arising from borrowings under a revolving line of credit facility entered into in 2005, including amortization of deferred debt issuance costs, partially offset by interest income from lower invested cash balances in 2005 as compared to 2004. We expect that our interest expense, net may increase in 2006 as a result of interest and amortization of warrants and debt issuance costs in connection with the proposed financing we expect to complete in 2006.

Other Expense, Net. Other income (expense), net consists principally of currency translation gains and losses. Other expense, net was $45,000 in 2004 and $11,000 in 2005. The decrease resulted from exchange rate fluctuations.



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Income Taxes. We have estimated net operating loss carry forwards for Israeli tax purposes totaling approximately $17.2 million through December 31, 2005 that would reduce future Israeli income taxes, if any. These net operating losses may be carried forward indefinitely and offset against future taxable business income. We expect that during the period these losses are utilized, our income would be substantially tax exempt.

Our U.S. subsidiary has net operating loss carry forwards for U.S. Federal and state tax purposes totaling approximately $34.6 million through December 31, 2005. These losses are available to offset any future U.S. taxable income of the U.S. subsidiary and will expire between 2012 and 2025.

We have recorded a full valuation allowance against all of our deferred tax assets since we believe it is not likely that those deferred taxes will be realized in the foreseeable future.

Years Ended December 31, 2003 and 2004

Revenues

Total Revenues. Total revenues were $4.8 million in 2003 and $4.7 million in 2004. Total revenues decreased $173,000, or 3.6%, due to a $234,000 decrease in total revenues from international customers, partially offset by a $61,000 increase in total revenues from customers in the U.S. The decreases in total revenues are attributable to lower unit volume sales of software licenses and, to a lesser extent, a decline in related services revenues.

Software Licenses. Software license revenues were $2.5 million in 2003 and $2.5 million in 2004. Software license revenues from U.S. customers increased $138,000 from $1.8 million in 2003 to $1.9 million in 2004, due primarily to the increase in software license revenue attributable to the technology license arrangement with Ixia. Software license revenues from international customers decreased $230,000 from $777,000 in 2003 to $546,000 in 2004, attributable to a decrease in orders from our Asia Pacific distributors and lower sales resulting from employee turnover in our Europe sales operation in 2004.

Services. Services revenues were $2.3 million in 2003 and $2.2 million in 2004. Services revenues from U.S. customers decreased $77,000 from $1.6 million in 2003 to $1.5 million in 2004, with services revenues from international customers remaining relatively the same. This decrease in U.S. services revenues was primarily a result of a decline in training and consulting revenues due to lower customer demand for consulting services.

Cost of Revenues

Cost of Software Licenses. Cost of software licenses was $147,000 in 2003, or 5.8% of software license revenue, compared to $86,000 in 2004, or 3.5% of software license revenue. The decrease in cost of software licenses resulted from lower spending on product packaging in addition to lower royalty costs as a result of a decline in orders for our products that result in third-party royalties.

Cost of Services. Cost of services was $426,000 in 2003, or 18.6% of services revenues, compared to $327,000 in 2004, or 14.8% of services revenue. This decrease was due to reduced personnel costs to provide support and maintenance services resulting from the headcount reductions taken in the first half of 2003.



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Operating Expenses

Sales and Marketing. Sales and marketing expenses were $4.3 million in 2003, or 87.9% of total revenues, compared to $3.5 million in 2004, or 75.9% of total revenues. These decreases were due primarily to headcount reductions of sales and marketing personnel during the first half of 2003.

Research and Development. Research and development expenses were $3.0 million in 2003, or 61.0% of total revenues, compared to $2.6 million in 2004, or 56.4% of total revenues. These decreases were due primarily to headcount reductions of research and development personnel during the first half of 2003.

General and Administrative. General and administrative expenses were $1.9 million in 2003, or 38.9% of total revenues, compared to $1.8 million in 2004, or 39.3% of total revenues.

Restructuring Expenses. Restructuring expenses were $245,000 in 2003. There were no restructuring expenses in 2004. The restructuring expenses in 2003 consisted of severance costs for terminated employees of $207,000, lease termination costs of $26,000, and vendor contract termination fees and other costs of $12,000. A total of 20 employees were terminated, or approximately 27% of the then current workforce, of whom 6 employees were from sales and marketing, 11 employees were from research and development, and three employees were from general and administrative.

Interest Income (Expense), Net. Interest income, net consists principally of interest earned on cash investments. Interest income, net was $32,000 in 2003 compared to $19,000 in 2004. The decrease resulted from lower invested cash balances and lower interest rates in 2004 as compared to 2003.

Other Expense, Net. Other expense, net consists principally of currency translation gains and losses. Other expense, net was $51,000 in 2003 and $45,000 in 2004. The decrease resulted from exchange rate fluctuations.

Liquidity and Capital Resources

Cash and cash equivalents totaled $2.2 million as of December 31, 2004 and $166,000 as of December 31, 2005. Restricted cash totaled $40,000 as of December 31, 2005.

Cash used in operating activities was $4.6 million in 2003, $2.7 million in 2004 and $2.1 million in 2005. Cash used in operating activities have resulted substantially from our reported net losses partially reduced by noncash items such as depreciation and stock-based compensation, and changes in current assets and liabilities.

Cash used in operating activities in 2003 was due primarily to a net loss of $5.1 million, a decrease of $514,000 in accrued expenses and a decrease of $292,000 in accrued restructuring charge, partially offset by noncash items and a decrease of $348,000 in accounts receivable. Accrued expenses decreased as a result of additional reductions of operating expenses in 2003. Accrued restructuring charge decreased as a result of the lease payments made in 2003. Accounts receivable decreased as a result of decreased order volume and favorable collection activities.

Cash used in operating activities in 2004 was due primarily to a net loss of $3.8 million, a decrease of $128,000 in accounts payable and a decrease of $291,000 in accrued restructuring charge, partially offset by noncash items and a decrease of $73,000 in accounts receivable. The accounts payable decreased as a result of lower operating expenditures. The accrued restructuring charge decreased as a result of the payments made in 2004. Accounts receivable decreased as a result of decreased order volume and favorable collection activities.

Cash used in operating activities in 2005 was due primarily to a net loss of $2.5 million, an increase of $74,000 in accounts receivable, a decrease of $174,000 in accrued severance pay, and a decrease of $246,000 in deferred revenue, partially offset by noncash items, a decrease of $196,000 in prepaid expenses



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and other current assets and an increase of $331,000 in accounts payable. Accounts receivable increased as a result of incremental amounts to be collected under a technology license agreement entered into in December 2005. Accrued severance pay decreased due to the termination of several employees in Israel during 2005. Deferred revenues decreased due primarily to the recognition of deferred technology license fees during 2005. Prepaid expenses and other current assets decreased as a result of lower prepayments of insurance policies and vendor maintenance contracts. Accounts payable increased due to increased professional costs incurred at end of 2005 and slower payments to vendors.

Cash used in investing activities was $43,000 in 2003 and $29,000 in 2004. Cash provided by investing activities was $105,000 in 2005. Cash used in investing activities in 2003 was for the purchase of $83,000 in property and equipment offset by a decrease of $40,000 in other assets. Cash used in investing activities in 2004 was for the purchase of $65,000 in property and equipment partially offset by a decrease of $36,000 in other assets. Cash provided by investing activities in 2005 was due to the decrease of $224,000 in other assets partially offset by the purchase of $79,000 in property and equipment and investment in restricted cash of $40,000. Other assets decreased as a result of the release to terminated employees of deposits maintained for severance pay obligations in 2003, 2004 and 2005 and reductions in security deposits for expiring office space leases in 2004 and 2005.

Cash provided by financing activities was $183,000 in 2003 and consisted of proceeds from exercise of stock options. Cash provided by financing activities was $1.8 million in 2004 consisting primarily of the net proceeds from a private placement in March 2004 of 3,333,331 of our ordinary shares, plus warrants and additional investment rights for an aggregate purchase price of $2.0 million. There was no net cash provided by financing activities in 2005 attributable to the issuance of warrants for $52,000 and borrowings of $1.3 million under the revolving line of credit, entirely offset by repayments totaling $1.3 million under the revolving line of credit and payment of debt issuance costs of $70,000.

In May 2005, we entered into a one-year revolving line of credit facility with Comerica Bank for borrowings of up to $2.0 million. Advances under the facility were limited to the lesser of $2.0 million or the sum of 75% of eligible accounts receivables plus $1.0 million. In December 2005, our borrowings under the credit facility exceeded the collateral base and, as a result, we triggered an event of default. We agreed upon a repayment plan with Comerica Bank to repay the outstanding borrowings under the facility in installments through January 2006. As of December 31, 2005, we had an outstanding balance under the facility of $70,000. In January 2006, all outstanding borrowings under the credit facility were fully repaid and the revolving line of credit facility was terminated.

On April 4, 2006, we signed definitive agreements for a financing with Fortissimo Capital Fund GP LP on behalf of several limited partnerships in which it serves as general partner and other potential co-investors including one of our directors and two existing shareholders, or the Investors. The initial investment of the financing would be for a minimum of $1.5 million consisting of $750,000 to purchase 25,000,000 of convertible preferred shares, or Preferred . . .

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