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TMCNet:  DATAWATCH CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[December 21, 2012]

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

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis is qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements of Datawatch and its subsidiaries which appear elsewhere in this Annual Report on Form 10-K.



GENERAL Introduction 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; - 20 ---------------------------------------------------------------------------------· 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.

The Company offers its enterprise products through perpetual licenses and subscription pricing models. Subscriptions automatically renew unless terminated with 90 days notice following the first year of the subscription term. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The subscription renewal rate is the same as the initial subscription rate. During fiscal years 2012, 2011 and 2010, subscription revenues were approximately $301,000, $299,000 and $313,000, respectively.

CRITICAL ACCOUNTING POLICIES In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on judgments 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 described below.

Revenue Recognition, Allowance for Bad Debts and Returns Reserve The Company licenses its software products directly to end-users, through value added resellers and through distributors. Sales to distributors and resellers accounted for approximately 31%, 41% and 43%, of total sales for fiscal years 2012, 2011 and 2010, respectively. Revenue from the sale of all software products (when separately sold) is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed or determinable, collectability is reasonably assured, persuasive evidence of the arrangement exists and there are no significant obligations remaining.

Both types of the Company's software product offerings are "off-the-shelf" as such term is customarily defined. The Company's software products can be installed and used by customers on their own with little or no configuration required. Multi-user licenses marketed by the Company are sold as a right to use the number of licenses, and the license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations to the Company.

- 21 - -------------------------------------------------------------------------------- Datawatch software products are generally sold in multiple element arrangements which may include software licenses, professional services and post-contract customer support. In such multiple element arrangements, the Company applies the residual method in determining revenue to be allocated to the software license.

In applying the residual method, the Company deducts from the sale proceeds the vendor specific objective evidence ("VSOE") of fair value of the professional services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and do not involve modification or customization of the software or any other unusual acceptance clauses or terms. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis. Revenue from post-contract customer support services is deferred and recognized ratably over the period of support (generally one year). Such deferred amounts are recorded as part of deferred revenue in the Company's Consolidated Balance Sheets included herein.

The Company also licenses its enterprise software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided.

The customer is then invoiced every 90 days and revenue is recognized ratably over the period of the subscription. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades when and if available. The subscription renewal rate is the same as the initial subscription rate. Subscriptions can be cancelled by the customer at any time by providing 90 days written notice following the first year of the subscription term.

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.

The Company also offers a 30 day money-back guarantee on its Monarch product sold directly to end-users. Additionally, the Company provides its distributors with stock-balancing rights. Revenue from the sale of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company's experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at, and the returns history with, the various distributors and resellers, which the Company monitors frequently. Once the estimates of potential future returns from all sources are made, the Company determines if it has adequate returns reserves to cover anticipated returns and the returns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by the Company. The Company's returns reserves were $105,000 and $70,000 as of September 30, 2012 and 2011, respectively.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company analyzes accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends, foreign currency exchange rate fluctuations and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the collectability of its accounts receivable, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on the Company's financial position and results of operations. The Company's allowance for doubtful accounts was $107,000 and $78,000 as of September 30, 2012 and 2011, respectively.

- 22 ---------------------------------------------------------------------------------Income Taxes The Company has deferred tax assets primarily related to net operating loss carryforwards and tax credits that expire at different times through and until 2031. At September 30, 2012, the Company had U.S. federal tax loss carryforwards of approximately $6.9 million, expiring at various dates through 2031, including $182,000 resulting from the Mergence acquisition undertaken during 2004 which are subject to additional annual limitations as a result of the changes in Mergence's ownership, and had approximately $1.7 million in state tax loss carryforwards, which also expire at various dates through 2031. An alternative minimum tax credit of approximately $154,000 is available to offset future regular federal taxes. Research and development credits of approximately $778,000 expire beginning in 2019. In addition, the Company has the following foreign net operating loss carryforwards: United Kingdom losses of $7.4 million with no expiration date, Australia losses of $3.7 million with no expiration date and Germany losses of $691,000 with no expiration date.

Significant judgment is required in determining the Company's provision for income taxes, the carrying value of deferred tax assets and liabilities and the valuation allowance recorded against net deferred tax assets. Factors such as future reversals of deferred tax assets and liabilities, projected future taxable income, changes in enacted tax rates and the period over which the Company's deferred tax assets will be recoverable are considered in making these determinations. Management does not believe the deferred tax assets are more likely than not to be realized and therefore a full valuation allowance has been provided against the deferred tax assets at September 30, 2012 and 2011.

Management evaluates the realizability of the deferred tax assets quarterly and, if current economic conditions change or future results of operations are better than expected, future assessments may result in the Company concluding that it is more likely than not that all or a portion of the deferred tax assets are realizable. If this conclusion were reached, the valuation allowance against deferred tax assets would be reduced resulting in a tax benefit being recorded for financial reporting purposes. Total net deferred tax assets subject to the full valuation allowance were approximately $7.6 million as of September 30, 2012.

The Company follows the accounting guidance for uncertain tax positions. The comprehensive model addresses the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. In accordance with these requirements, the Company first determines whether a tax authority would "more likely than not" sustain its tax position if it were to audit the position with full knowledge of all the relevant facts and other information. For those tax positions that meet this threshold, the Company measures the amount of tax benefit based on the largest amount of tax benefit that the Company has a greater than 50% chance of realizing in a final settlement with the relevant authority. Those tax positions failing to qualify for initial recognition are recognized in the first interim period in which they meet the more likely than not standard, or are resolved through negotiation or litigation with the taxing authority, or upon expiration of the statute of limitations. The Company maintains a cumulative risk portfolio relating to all of its uncertainties in income taxes in order to perform this analysis, but the evaluation of the Company's tax positions requires significant judgment and estimation in part because, in certain cases, tax law is subject to varied interpretation, and whether a tax position will ultimately be sustained may be uncertain. The actual outcome of the Company's tax positions, if significantly different from its estimates, could materially impact the financial statements.

At October 1, 2010, the Company had a cumulative tax liability of $150,000 related to foreign tax exposure. During each of the fiscal years ended September 30, 2010, 2011 and 2012, the Company increased its tax liability by $25,000, resulting in a cumulative tax liability of $200,000 at September 30, 2012. These amounts have been recorded as an increase to other long-term liabilities on the Company's Consolidated Balance Sheets.

Capitalized Software Development Costs The Company capitalizes certain software development costs as well as purchased software upon achieving technological feasibility of the related products.

Software development costs incurred and software purchased prior to achieving technological feasibility are charged to engineering and product development expense as incurred. Commencing upon initial product release, capitalized costs are amortized to cost of software licenses using the straight-line method over the estimated life of the product (which approximates the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product), which is generally 18 to 24 months. The net amount of capitalized software development costs was approximately $30,000 and $14,000 at September 30, 2012 and 2011. During fiscal 2012, the Company capitalized approximately $54,000 of software development costs related to products developed in fiscal year 2012.

- 23 - --------------------------------------------------------------------------------Valuation of Intangible Assets and Other Long-Lived Assets On March 30, 2012, the Company acquired the intellectual property underlying its Monarch Professional and Datawatch Data Pump products for a purchase price of $8,541,000 and capitalized approximately $75,000 in closing costs and adjustments. The intellectual property assets are being amortized to cost of software licenses using the straight-line method over the estimated life of the asset, which is five years. Other intangible assets consist of internally developed software, patents and customer lists acquired through business combinations. The values allocated to these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset.

The Company reviews all of its intangible assets and other long-lived assets whenever an indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Should the fair value of the Company's long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary. No impairment charges were taken for intangible assets during fiscal year 2012.

Accounting for Share-Based Compensation The Company recognizes share-based compensation expense in accordance with generally accepted accounting principles which require that all share-based awards, including grants of employee stock options, be recognized in the financial statements based on their fair value at date of grant.

The Company recognizes the fair value of share-based awards over the requisite service period of the individual awards, which generally equals the vesting period. For the fiscal year ended September 30, 2012, the Company recorded share-based compensation expense of approximately $879,000. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates.

The Company uses an expected stock-price volatility assumption that is based on historical volatilities of the underlying stock which are obtained from public data sources. The Company believes this approach results in a reasonable estimate of volatility. No stock options were granted during the fiscal year ended September 30, 2012. For the most recent stock option grants issued during the fiscal year ended September 30, 2011, the Company used an expected stock-price volatility of 67% based upon the historical volatility at the time of issuance.

With regard to the expected option life assumption, the Company considers the exercise behavior of past grants and models the pattern of aggregate exercises.

Patterns are determined on specific criteria of the aggregate pool of optionees including the reaction to vesting, realizable value and short-time-to-maturity effect. For the most recent stock option grants issued during the year ended September 30, 2011, the Company used an expected option life assumption of 5 years.

With regard to the forfeiture rate assumption, the Company reviews historical voluntary turnover rates. For the most recent stock option grants issued during the fiscal year ended September 30, 2011, the Company used an annual estimated forfeiture rate of 10%. Additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior expense will be recorded if the actual forfeiture rate is higher than estimated.

- 24 - -------------------------------------------------------------------------------- The Company also periodically grants awards of restricted stock units ("RSU") to each of its non-employee directors and some of its employees on a discretionary basis pursuant to its stock compensation plans. Each RSU entitles the holder to receive, at the end of each vesting period, a specified number of shares of the Company's common stock. Each RSU vests at the rate of 33.33% on each of the first through third anniversaries of the grant date. Additionally, some of the RSUs are subject to a further vesting condition that the Company's common stock must trade at prices greater than certain minimum per share prices on a national securities exchange for a period of twenty consecutive days prior to the fourth or fifth anniversary of the grant date depending on the grant. For such RSUs, the Company applies the Monte Carlo option-pricing model for determining the fair value on the date of grant.

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 Company's consolidated financial statements. The operating results for any period should not be considered indicative of the results expected for any future period.

Year Ended September 30, 2012 2011 2010 REVENUE: Software licenses 65 % 55 % 54 % Maintenance 30 35 36 Professional Services 5 10 10 Total revenue 100 100 100 COSTS AND EXPENSES: Cost of software licenses 9 13 14 Cost of maintenance and services 10 14 16 Sales and marketing 47 35 33 Engineering and product development 11 14 15 General and administrative 17 24 20 Total costs and expenses 94 100 98 INCOME FROM OPERATIONS 6 - 2 Other (expense) income, net (2) 1 - INCOME BEFORE INCOME TAXES 4 1 2 Provision for income taxes - - - NET INCOME 4 % 1 % 2 % Fiscal Year Ended September 30, 2012 as Compared to Fiscal Year Ended September 30, 2011 Total Revenues The following table presents revenue, revenue increase (decrease) and percentage change in revenue for the years ended September 30, 2012 and 2011: Year Ended September 30, Increase Percentage 2012 2011 (Decrease) Change (In thousands) Software licenses $ 16,800 $ 9,858 $ 6,942 70 % Maintenance 7,902 6,219 1,683 27 % Professional services 1,304 1,808 (504 ) (28 )% Total revenue $ 26,006 $ 17,885 $ 8,121 45 % - 25 --------------------------------------------------------------------------------- Revenue for the fiscal year ended September 30, 2012 was $26,006,000 which represents an increase of $8,121,000 or 45% from revenue of $17,885,000 for the fiscal year ended September 30, 2011. For fiscal 2012, 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) revenue accounted for 95% and 5% of total revenue, respectively, as compared to 91% and 9%, respectively, for fiscal 2011.

Software license revenue for the fiscal year ended September 30, 2012 was $16,800,000 or approximately 65% of total revenue, as compared to $9,858,000 or approximately 55% of total revenue for the fiscal year ended September 30, 2011.

This represents an increase of $6,942,000 or approximately 70% from fiscal 2011.

The increase in software license revenue consists of a $7,013,000 increase in Information Optimization Solutions which was partially offset by a $71,000 decrease in Business Service Management Solutions. 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 resulted in both increased desktop and enterprise license sales during the year.

Maintenance revenue for the fiscal year ended September 30, 2012 was $7,902,000 or approximately 30% of total revenue, as compared to $6,219,000 or approximately 35% of total revenue for the fiscal year ended September 30, 2011.

This represents an increase of $1,683,000 or approximately 27% from fiscal 2011.

The increase in maintenance revenue consists of a $1,788,000 increase in Information Optimization Solutions which was partially offset by a $105,000 decrease in Business Service Management Solutions. The Company attributes the overall increase in maintenance revenue to higher overall sales and higher renewal rates of Monarch Professional.

Professional services revenue for the fiscal year ended September 30, 2012 was $1,304,000 or approximately 5% of total revenue, as compared to $1,808,000 or approximately 10% of total revenue for the fiscal year ended September 30, 2011.

This represents a decrease of $504,000 or approximately 28% from fiscal 2011.

The decrease in professional services revenue consists of a $392,000 decrease in Information Optimization Solutions and a $112,000 decrease in Business Service Management Solutions. This decrease is due to lower consulting services primarily within 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 years ended September 30, 2012 and 2011: Year Ended September 30, Increase / Percentage 2012 2011 (Decrease) Change (in thousands) Cost of software licenses $ 2,270 $ 2,237 $ 33 1 % Cost of maintenance and services 2,530 2,537 (7 ) - % Sales and marketing 12,263 6,268 5,995 96 % Engineering and product development 2,790 2,502 288 12 % General and administrative 4,610 4,274 336 8 % Total costs and operating expenses $ 24,463 $ 17,818 $ 6,645 37 % Cost of software licenses for the fiscal year ended September 30, 2012 was $2,270,000 or approximately 14% of software license revenues, as compared to $2,237,000 or approximately 23% of software license revenues for the fiscal year ended September 30, 2011. The increase in cost of software licenses is primarily due to higher software amortization costs 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 lower royalty expense. As a result of this acquisition, the Company is no longer charging 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 2 to the Company's consolidated financial statements.

- 26 - -------------------------------------------------------------------------------- Cost of maintenance and services for the fiscal year ended September 30, 2012 was $2,530,000 or approximately 27% of maintenance and services revenue, as compared to $2,537,000 or approximately 32% of maintenance and services revenue for the fiscal year ended September 30, 2011.

Sales and marketing expenses for the fiscal year ended September 30, 2012 were $12,263,000, or 47% of total revenue as compared to $6,268,000, or approximately 35% of total revenue for fiscal 2011. The increase in sales and marketing expenses of $5,995,000, or approximately 96%, is due to increased commissions, higher wages and employee-related costs attributable to increased headcount and increased promotional, lead generation and consulting costs as compared to last year. The increases reflect the Company's significant investment in a new sales and marketing team during the most recent fiscal year to accelerate revenue generation. The Company does not expect increases of this magnitude to continue.

Engineering and product development expenses were $2,790,000, or 11% of total revenue for the fiscal year ended September 30, 2012 as compared to $2,502,000, or 14% of total revenue in fiscal 2011. The increase in engineering and product development expenses of $288,000, or approximately 12%, is primarily attributable to higher wages and other employee-related costs due to increased headcount offset by lower external consulting costs as compared to last year.

General and administrative expenses were $4,610,000, or 17% of total revenue for the fiscal year ended September 30, 2012 as compared to $4,274,000 or 24% of total revenue in fiscal 2011. The increase in general and administrative expenses of $336,000, or approximately 8%, is primarily attributable to higher external consulting costs as well as higher stock compensation and employee-related costs as compared to last year.

Interest income and other income (expense) for the fiscal year ended September 30, 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 fiscal year ended September 30, 2011 included interest income of $4,000 and miscellaneous income representing old accounts receivable write-offs in the United Kingdom of $7,000.

Gain (loss) on foreign currency transactions for the fiscal year ended September 30, 2012 was a loss of $126,000 as compared to a gain of $89,000 for the fiscal year ended September 30, 2011. The foreign currency loss for the fiscal year ended September 30, 2012 was attributable to the settlement of intercompany account balances due to the dissolution of one of the Company's foreign subsidiaries and the repatriation of international funds to the US required by the Company's line of credit facility which was entered into on March 30, 2012.

The foreign currency gain for the fiscal year ended September 30, 2011 is partially attributable to the repayment of intercompany loans between the Australian and UK subsidiaries. Additionally, the foreign currency gains (losses) recorded in both periods were partially due to foreign currency rate volatility between the Euro and British pound during these periods.

Income tax expense for the years ended September 30, 2012 and 2011 was $50,000 and $35,000, respectively. Income tax expense for both years includes a provision for uncertain tax positions relative to foreign taxes of $25,000. In addition, income tax expense includes minimum state tax liabilities and federal alternative minimum taxes totaling $25,000 and $10,000 for the years ended September 30, 2012 and 2011, respectively.

Net income for the year ended September 30, 2012 was $1,034,000, or $0.15 per diluted share, as compared to $132,000, or $0.02 per diluted share, for the year ended September 30, 2011.

- 27 --------------------------------------------------------------------------------- Fiscal Year Ended September 30, 2011 as Compared to Fiscal Year Ended September 30, 2010Total Revenues The following table presents total revenue, total revenue increase (decrease) and percentage change in total revenue for the years ended September 30, 2011 and 2010: Year Ended September 30, Increase Percentage 2011 2010 (Decrease) Change (In thousands) Software licenses $ 9,858 $ 9,563 $ 295 3 % Maintenance 6,219 6,322 (103 ) (2 )% Professional services 1,808 1,789 19 1 % Total revenue $ 17,885 $ 17,674 $ 211 1 % Revenue for the fiscal year ended September 30, 2011 was $17,885,000, which represents an increase of $211,000 or approximately 1% from revenue of $17,674,000 for the fiscal year ended September 30, 2010. For fiscal 2011, Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence), and Business Service Management Solutions (including Visual QSM and Visual HD) revenue accounted for 91% and 9% of total revenue, respectively, as compared to 90% and 10%, respectively, for fiscal 2010.

Software license revenue for the fiscal year ended September 30, 2011 was $9,858,000 or approximately 55% of total revenue, as compared to $9,563,000, or approximately 54% of total revenue for the fiscal year ended September 30, 2010.

This represents an increase of $295,000 or approximately 3% from fiscal 2010.

The overall increase in software license revenue consists of a $361,000 increase in Report Analytics Solutions which was partially offset by a $66,000 decrease in Business Service Management Solutions. The Company attributes the overall 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 increased enterprise license sales during the year.

Maintenance revenue for the fiscal year ended September 30, 2011 was $6,219,000 or approximately 35% of total revenue, as compared to $6,322,000 or approximately 36% of total revenue for the fiscal year ended September 30, 2010.

This represents a decrease of $103,000 or approximately 2% from fiscal 2010. The decrease in maintenance revenue consists of a $74,000 decrease in Business Service Management Solutions and a $29,000 decrease in Report Analytics Solutions. The Company attributes the overall decrease in maintenance revenue to lower renewal rates of enterprise product customers which was partially offset by maintenance on the Monarch product line.

Professional services revenue for the fiscal year ended September 30, 2011 was $1,808,000 or approximately 10% of total revenue, as compared to $1,789,000 or approximately 10% of total revenue for the fiscal year ended September 30, 2010.

This represents an increase of $19,000 or approximately 1% from fiscal 2010. The increase in professional services revenue consists of a $197,000 increase in Report Analytics Solutions and a $178,000 decrease in Business Service Management Solutions.

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 years ended September 30, 2011 and 2010: - 28 --------------------------------------------------------------------------------- Year Ended September 30, Increase / Percentage 2011 2010 (Decrease) Change (in thousands) Cost of software licenses $ 2,237 $ 2,382 $ (145 ) (6 )% Cost of maintenance and services 2,537 2,893 (356 ) (12 )% Sales and marketing 6,268 5,786 482 8 % Engineering and product development 2,502 2,658 (156 ) (6 )% General and administrative 4,274 3,564 710 20 % Total costs and operating expenses $ 17,818 $ 17,283 $ 535 3 % Cost of software licenses for the fiscal year ended September 30, 2011 was $2,237,000 or approximately 23% of software license revenues, as compared to $2,382,000 or approximately 25% of software license revenues for the fiscal year ended September 30, 2010. The percentage and dollar decrease in cost of software licenses is primarily due to lower software amortization costs associated with new products released during fiscal 2009.

Cost of maintenance and services for the fiscal year ended September 30, 2011 was $2,537,000 or approximately 32% of maintenance and services revenue, as compared to $2,893,000 or approximately 36% of maintenance and services revenue for the fiscal year ended September 30, 2010. The decrease in cost of maintenance and services is primarily due to lower wages and other employee-related costs due to decreased headcount as well as lower use of external consultants in 2011 as compared to fiscal 2010.

Sales and marketing expenses for the fiscal year ended September 30, 2011 were $6,268,000, or 35% of total revenue as compared to $5,786,000, or approximately 33% of total revenue for fiscal 2010. The increase in sales and marketing expenses of $482,000, or approximately 8%, is primarily due to increased promotional, lead generation and consulting costs as well as higher wages and employee-related costs attributable to increased headcount as compared to the same period last year.

Engineering and product development expenses were $2,502,000, or 14% of total revenue for the fiscal year ended September 30, 2011 as compared to $2,658,000, or 15% of total revenue in fiscal 2010. The decrease in engineering and product development expenses of $156,000, or approximately 6%, is primarily attributable to lower external consulting costs as well as lower employee related costs as compared to the same period last year.

General and administrative expenses were $4,274,000, or 24% of total revenue for the fiscal year ended September 30, 2011 as compared to $3,564,000, or 20% of total revenue in fiscal 2010. The increase in general and administrative expenses of $710,000, or approximately 20%, is primarily attributable to $641,000 of severance costs incurred in connection with a restructuring by the Company to align the sales and marketing operations with the Company's new business strategy and higher external consulting costs as compared to the same period last year.

Interest income and other income (expense) includes primarily the following two components: interest income and miscellaneous income. Interest income for the fiscal year ended September 30, 2011 was approximately $4,000 as compared to $2,000 for fiscal 2010. The increase in interest income is primarily the result of higher balances in interest-bearing cash and equivalents. Miscellaneous income for the fiscal year ended September 30, 2011 was approximately $7,000 and consisted primarily of old accounts receivable write-offs in the United Kingdom.

There was no miscellaneous income in the fiscal year ended September 30, 2010.

Gain on foreign currency transactions for the fiscal year ended September 30, 2011 was $89,000 as compared to $24,000 for the fiscal year ended September 30, 2010. The foreign currency gain for the fiscal year ended September 30, 2011 is partially attributable to the repayment of intercompany loans between the Australian and UK subsidiaries. The foreign currency gains for both fiscal years were also the result of foreign currency rate volatility between the Euro and the British Pound during these periods.

- 29 - -------------------------------------------------------------------------------- Income tax expense for the years ended September 30, 2011 and 2010 was $35,000 and $37,000, respectively. Income tax expense for both years includes a provision for uncertain tax positions relative to foreign taxes of $25,000. In addition, income tax expense includes minimum state tax liabilities, provision-to-return adjustments and foreign tax liabilities totaling $10,000 and $12,000 for the years ended September 30, 2011 and 2010, respectively.

Net income for the year ended September 30, 2011 was $132,000, or $0.02 per diluted share, as compared to $380,000, or $0.06 per diluted share, for the year ended September 30, 2010. Net income for fiscal 2011 includes $641,000 of severance costs incurred in connection with a restructuring by the Company to align the sales and marketing operations with the Company's new business strategy. Excluding the effects of the severance charge, non-GAAP net income for the year ended September 30, 2011 would have been $773,000, or $0.12 per diluted share.

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 $454,000, $352,000 and $301,000 for fiscal years 2012, 2011 and 2010, respectively.

As of September 30, 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 More thanContractual Obligations: Total 1 Year 1-3 Years 3-5 Years 5 Years Operating Lease Obligations $ 880 $ 404 $ 351 $ 125 $ - Long-term Debt Obligations $ 4,000 $ - $ 1,267 $ 1,600 $ 1,133 Other Liabilities $ 200 $ - $ - $ - $ 200 Prior to the acquisition of intellectual property disclosed in Note 2 to the Company's 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. Royalty expense included in cost of software licenses was approximately $1,161,000, $1,630,000 and $1,436,000, respectively, for the years ended September 30, 2012, 2011 and 2010. 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. Minimum royalty obligations were insignificant for fiscal years 2012, 2011 and 2010.

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 September 30, 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 September 30, 2012.

- 30 - -------------------------------------------------------------------------------- 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 September 30, 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 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 September 30, 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 September 30, 2012, the Company had $8,722,000 of cash and equivalents, an increase of $338,000 from September 30, 2011.

At September 30, 2012, the Company had working capital of approximately $4,041,000 as compared to $5,423,000 as of September 30, 2011. 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 net income of approximately $1,034,000 for the year ended September 30, 2012 as compared to net income of approximately $132,000 for the year ended September 30, 2011 and $380,000 for the year ended September 30, 2010. During the years ended September 30, 2012, 2011 and 2010, approximately $3,956,000, $1,147,000 and $1,569,000, respectively, of cash was provided by the Company's operations. During fiscal year 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 deferred revenue.

Net cash used in investing activities for the year ended September 30, 2012 of $8,819,000 is primarily related to the acquisition of intellectual property from Math Strategies as well as the purchase of property and equipment and capitalized software development costs.

- 31 - -------------------------------------------------------------------------------- Net cash provided by financing activities for the year ended September 30, 2012 of $5,089,000 is primarily related to cash received from the issuance of a $4.0 million long-term subordinated note and the borrowing of $1.5 million under a $2.0 million revolving credit facility as well as 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 September 30, 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 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 September 30, 2012, the Company was in compliance with the covenants under the Loan Agreement.

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

RECENT ACCOUNTING PRONOUNCEMENTS In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2011-04, "Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S.

GAAP and IFRSs" ("ASU 2011-04"). ASU 2011-04 changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between U.S. GAAP and IFRS. This standard also expands the disclosure requirements particularly for level 3 fair value measurements. This standard is effective on a prospective basis for reporting periods beginning on or after December 15, 2011. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, "Comprehensive Income (Topic 220): Presentation of Comprehensive Income" ("ASU 2011-05"). ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in equity. Under this standard, an entity can elect to present items of net income and other comprehensive income in one continuous statement of comprehensive income or in two separate but consecutive statements.

This new guidance is to be applied retrospectively for interim and annual periods beginning after December 15, 2011. The Company is currently evaluating what impact, if any, this standard will have on its consolidated financial statements.

In December 2011, the FASB issued ASU No. 2011-12, "Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05" ("ASU 2011-12"). ASU 2011-12 supersedes certain paragraphs in ASU 2011-05 which pertain to how, when and where reclassification adjustments out of accumulated other comprehensive income are presented. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating what impact, if any, this standard will have on its condensed consolidated financial statements.

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