Datawatch Corporation
DATAWATCH CORP (Form: 10-Q, Received: 05/11/2011 16:41:35)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2011

OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM             TO

Commission File Number: 000-19960

DATAWATCH CORPORATION
( Exact name of registrant as specified in its charter )

DELAWARE
 
02-0405716
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

271 MILL ROAD
QUORUM OFFICE PARK
CHELMSFORD, MASSACHUSETTS 01824
(978) 441-2200
(Address and telephone number of principal executive office)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes    ý      No    o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).       Yes    o      No    o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer   o     Accelerated filer o
Non-accelerated filer    o (Do not check if a smaller reporting company)
Smaller reporting company   ý

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).   Yes    o     No   ý

The number of shares of the registrant’s common stock, $.01 par value, outstanding as of May 3, 2011 was 6,008,719.
 


 
 
 
 
DATAWATCH CORPORATION
QUARTERLY REPORT ON FORM 10-Q
For the Quarterly Period Ended March 31, 2011


TABLE OF CONTENTS

  Page #      
PART I.
FINANCIAL INFORMATION
 
       
Item 1.
 
Financial Statements (Unaudited)
 
       
a)
 
Condensed Consolidated Balance Sheets:
 
   
March 31, 2011 and September 30, 2010
3
       
b)
 
Condensed Consolidated Statements of Operations:
 
   
Three and Six Months Ended March 31, 2011 and 2010
4
       
c)
 
Condensed Consolidated Statements of Cash Flows:
 
   
Six Months Ended March 31, 2011 and 2010
5
       
d)
 
Notes to Condensed Consolidated Financial Statements
6
       
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
       
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
23
       
Item 4.
 
Controls and Procedures
23
       
     
PART II.
OTHER INFORMATION
 
       
Item 1.
 
Legal Proceedings
24
Item 1A.
 
Risk Factors
24
Item 6.
 
Exhibits
24
       
SIGNATURES
25
   
CERTIFICATIONS
26
   


 
2

 
PART I. FINANCIAL INFORMATION
 
Item 1:  FINANCIAL STATEMENTS

DATAWATCH CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(In thousands, except share and per share amounts)

 
   
March 31,
   
September 30,
 
   
2011
   
2010
 
ASSETS
           
CURRENT ASSETS:
           
Cash and equivalents
  $ 7,752     $ 7,053  
Accounts receivable, less allowance for doubtful accounts and sales returns
    2,394       2,228  
   of $167 at March 31, 2011 and $164 at September 30, 2010
               
Inventories
    65       39  
Prepaid expenses
    444       283  
Restricted cash
    71       89  
Total current assets
    10,726       9,692  
                 
Property and equipment, net
    281       340  
Intangible assets, net
    1,049       1,434  
Other long-term assets
    25       21  
Total assets
  $ 12,081     $ 11,487  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
                 
CURRENT LIABILITIES:
               
Accounts payable
  $ 495     $ 473  
Accrued expenses
    2,209       1,606  
Deferred revenue
    3,583       3,427  
Total current liabilities
    6,287       5,506  
                 
LONG-TERM LIABILITIES:
               
Deferred revenue - long-term
    131       152  
Other liabilities
    163       150  
Total long-term liabilities
    294       302  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
SHAREHOLDERS’ EQUITY:
               
Common stock, par value $.01; 20,000,000 shares authorized;
    60       60  
   issued, 6,022,565 shares and 5,958,237 shares, respectively;
               
   outstanding, 6,008,319 shares and 5,943,991 shares, respectively
               
Additional paid-in capital
    23,981       23,826  
Accumulated deficit
    (17,272 )     (16,990 )
Accumulated other comprehensive loss
    (1,129 )     (1,077 )
      5,640       5,819  
Less treasury stock, at cost, 14,246 shares
    (140 )     (140 )
Total shareholders’ equity
    5,500       5,679  
                 
Total liabilities and shareholders' equity
  $ 12,081     $ 11,487  
 
 
See notes to condensed consolidated financial statements.

 
3

 
DATAWATCH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share amounts)
 

 
   
Three Months Ended March 31,
   
Six Months Ended March 31,
 
   
2011
   
2010
   
2011
   
2010
 
REVENUE:
                       
   Software licenses
  $ 2,552     $ 2,593     $ 4,662     $ 4,759  
   Maintenance and services
    1,902       1,978       3,972       4,047  
          Total revenue
    4,454       4,571       8,634       8,806  
                                 
COSTS AND EXPENSES:
                               
   Cost of software licenses
    587       648       1,131       1,222  
   Cost of maintenance and services
    606       747       1,287       1,506  
   Sales and marketing
    1,479       1,588       2,705       3,135  
   Engineering and product development
    648       710       1,283       1,419  
   General and administrative
    1,638       970       2,515       1,806  
          Total costs and expenses
    4,958       4,663       8,921       9,088  
                                 
LOSS FROM OPERATIONS
    (504 )     (92 )     (287 )     (282 )
                                 
Interest income and other income (expense), net
    34       1       57       (1 )
                                 
LOSS BEFORE INCOME TAXES
    (470 )     (91 )     (230 )     (283 )
Provision for income taxes
    41       6       52       14  
                                 
NET LOSS
  $ (511 )   $ (97 )   $ (282 )   $ (297 )
                                 
                                 
Net loss per share—Basic
  $ (0.09 )   $ (0.02 )   $ (0.05 )   $ (0.05 )
                                 
Net loss per share—Diluted
  $ (0.09 )   $ (0.02 )   $ (0.05 )   $ (0.05 )
                                 
                                 
Weighted-Average Shares Outstanding—Basic
    5,972       5,930       5,960       5,928  
                                 
Weighted-Average Shares Outstanding—Diluted
    5,972       5,930       5,960       5,928  
 

 
See notes to condensed consolidated financial statements.

 
4

 
DATAWATCH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 (In thousands)
 
   
Six Months Ended
 
   
March 31,
 
   
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net loss
  $ (282 )   $ (297 )
Adjustments to reconcile net loss to cash provided by
               
   operating activities:
               
     Depreciation and amortization
    491       653  
     Provision for doubtful accounts and sales returns
    2       176  
     Stock-based compensation
    65       102  
     Changes in current assets and liabilities:
               
          Accounts receivable
    (159 )     345  
          Inventories
    (26 )     4  
          Prepaid expenses and other assets
    (161 )     (124 )
          Accounts payable, accrued expenses and other liabilities
    631       (127 )
          Deferred revenue
    120       86  
               Cash provided by operating activities
    681       818  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
     Purchases of equipment and fixtures
    (47 )     (47 )
     Decrease in restricted cash
    18       18  
     Increase in other assets
    (2 )     (2 )
               Cash used in investing activities
    (31 )     (31 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
     Proceeds from exercise of stock options
    90        
               Cash provided by financing activities
    90        
                 
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND EQUIVALENTS
    (41 )     (99 )
                 
INCREASE IN CASH AND EQUIVALENTS
    699       688  
CASH AND EQUIVALENTS, BEGINNING OF PERIOD
    7,053       5,649  
CASH AND EQUIVALENTS, END OF PERIOD
  $ 7,752     $ 6,337  
                 
SUPPLEMENTAL INFORMATION:
               
     Income taxes paid
  $ 28     $ 27  
 

See notes to condensed consolidated financial statements.
 
 
5

 
DATAWATCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


Note 1 - Summary of Significant Accounting Policies

Basis of Presentation and Principles of Consolidation
 
The accompanying condensed consolidated financial statements include the accounts of Datawatch Corporation (the “Company”) and its wholly-owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) regarding interim financial reporting.  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2010 filed with the SEC. All intercompany accounts and transactions have been eliminated.

In the opinion of management, the accompanying condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements for the fiscal year ended September 30, 2010, and include all adjustments necessary for fair presentation of the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year. The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure.

The preparation of financial statements in conformity with GAAP requires management to make estimates and judgments, which are evaluated on an on-going basis, that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates and judgments. In particular, significant estimates and judgments include those related to revenue recognition, allowance for doubtful accounts, sales returns reserve, useful lives of property and equipment, valuation of net deferred tax assets, business combinations, valuation of intangible assets and valuation of share-based awards.

Revenue Recognition
 
Revenue allocated to software products, specified upgrades and enhancements is recognized upon delivery of the related product, upgrades or enhancements. Revenue is allocated by vendor specific objective evidence (“VSOE”) of fair value to post-contract customer support (primarily maintenance) and is recognized ratably over the term of the support, and revenue allocated using VSOE to service elements (primarily training and consulting) is recognized as the services are performed. The residual method of revenue recognition is used for multi-element arrangements when the VSOE of the fair value does not exist for one of the delivered elements. Under the residual method, the arrangement fee is recognized as follows: (1) the total fair value of the undelivered elements, as supported by VSOE, is deferred and subsequently recognized as such items are delivered or completed and (2) the difference between the total arrangement fee and the amount allocated to the undelivered elements is recognized as revenue related to the delivered elements.

The Company has two types of software product offerings: (1) Enterprise Software and (2) Desktop and Server Software. Enterprise Software products are sold directly to end-users and through value added resellers. The Company sells its Desktop and Server Software products directly to end-users and through distributors and resellers.  Sales to distributors and resellers accounted for approximately 40% and 42%, respectively, of total sales for the three months ended March 31, 2011 and 2010, and 41% and 44%, respectively, of total sales for the six months ended March 31, 2011 and 2010. Revenue from the sale of all software products (when separately sold) is
 
6

 
 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 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.

Desktop and Server Software products are generally not sold in multiple element arrangements. Enterprise Software sales are generally 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 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 condensed consolidated balance sheets.

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. Certain software products, including desktop versions of Monarch and Monarch Data Pump sold directly to end-users, include a guarantee under which such customers may return products within 30 days for a full refund. 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 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.

Stock-Based Compensation
 
All share-based awards, including grants of employee stock options, are recognized in the financial statements based on their fair value.

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. All of the Company’s share-based awards are accounted for as equity instruments and there have been no liability awards granted. See additional stock-based compensation disclosure in Note 4 to the Company’s condensed consolidated financial statements.

Concentration of Credit Risks and Major Customers
 
The Company sells its products and services to U.S. and non-U.S. dealers and other software distributors, as well as to end users, under customary credit terms. Two customers, Ingram Micro, Inc. and Lifeboat Distribution, individually accounted for the following percentages of total revenue and accounts receivable for the periods indicated:
 
7

 
   
Percentage of total
 
Percentage of total
       
   
revenue for the three
 
revenue for the six
 
Percentage of total
   
months ended
 
months ended
 
accounts receivable at
   
March 31,
 
March 31,
 
March 31,
 
September 30,
   
2011
 
2010
 
2011
 
2010
 
2011
 
2010
                         
Ingram Micro, Inc.
 
17%
 
11%
 
15%
 
13%
 
24%
 
11%
                         
Lifeboat Distribution
 
10%
 
13%
 
13%
 
10%
 
14%
 
21%
 

The Company sells to Ingram Micro, Inc. and Lifeboat Distribution under separate distribution agreements which automatically renew for successive one-year terms unless terminated. Other than these two customers, no other customer constitutes a significant portion (more than 10%) of revenues or accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are provided for anticipated doubtful accounts and sales returns based on management’s review of receivables, inventory and historical trends.

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 research and 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 and purchased software was approximately $98,000 and $396,000 at March 31, 2011 and September 30, 2010, respectively. The Company did not capitalize any software development costs during the six months ended March 31, 2011 or March 31, 2010.

Intangible Assets
 
Intangible assets consist of internally developed software, acquired technology, patents and customer lists acquired through business combinations. The values allocated to the majority of these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in cost of software licenses and subscriptions. The values allocated to customer relationships are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in sales and marketing expenses. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable and an impairment loss is recognized when it is probable that the estimated cash flows are less than the carrying amount of the asset.

Income Taxes
 
Deferred income taxes are provided for the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and operating loss carryforwards and credits. Valuation allowances are recorded to reduce the net deferred tax assets to amounts the Company believes are more likely than not to be realized.

Cash and Equivalents
 
Cash and equivalents include cash on hand, cash deposited with banks and highly liquid securities consisting of money market investments with original maturities of 90 days or less. The Company’s cash equivalents are carried at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company classifies the inputs used to measure fair value into the following hierarchy:
 
 
8

 
·  
Level 1 – Observable inputs such as quoted prices in active markets;
·  
Level 2 – Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
·  
Level 3 – Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The following table represents information about the Company’s cash equivalents measured at fair value on a recurring basis at March 31, 2011 (in thousands):
 
       
Quoted Prices
       
       
in Active
 
Significant
   
       
Markets for
 
Other
 
Significant
       
Identical
 
Observable
 
Unobservable
       
Assets
 
Inputs
 
Inputs
   
Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
                 
Money market funds
 
 $          2,233
 
 $            2,233
 
 $                  
 
 $                 —
 

Recent Accounting Pronouncements
 
In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2009-13, “Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”). ASU 2009-13 provides principles for allocation of consideration among its multiple-elements, allowing more flexibility in identifying and accounting for separate deliverables under an arrangement. This ASU introduces an estimated selling price method for valuing the elements of a bundled arrangement if vendor-specific objective evidence or third-party evidence of selling price is not available, and significantly expands related disclosure requirements. This standard is effective on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Alternatively, adoption may be on a retrospective basis, and early application is permitted. The adoption of this standard did not have a material effect on the Company’s condensed consolidated financial statements or disclosures.

In April 2010, the FASB issued ASU No. 2010-17, “Revenue Recognition — Milestone Method (Topic 605): Milestone Method of Revenue Recognition” . This ASU provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. The updated guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Entities may elect to adopt the amendments in the ASU retrospectively for all prior periods. The adoption of this standard did not have a material effect on the Company’s condensed consolidated financial statements.

Note 2 – Intangible Assets, Net

Intangible assets, net, were comprised of the following as of March 31, 2011 and September 30, 2010:

 
9

 
   
Weighted
   
March 31, 2011
   
September 30, 2010
 
   
Average
   
Gross
         
Net
   
Gross
         
Net
 
Identified Intangible
 
Useful Life
   
Carrying
   
Accumulated
 
Carrying
   
Carrying
   
Accumulated
 
Carrying
 
Asset
 
in Years
   
Amount
   
Amortization
 
Amount
   
Amount
   
Amortization
 
Amount
 
         
(in thousands)
 
                                           
Capitalized software
    2     $ 2,662     $ 2,567     $ 95     $ 2,662     $ 2,287     $ 375  
Purchased software
    5       700       697       3       700       679       21  
Patents
    20       160       53       107       160       49       111  
Customer lists
    10       1,790       946       844       1,790       863       927  
                                                         
Total
          $ 5,312     $ 4,263     $ 1,049     $ 5,312     $ 3,878     $ 1,434  
 
For the three months ended March 31, 2011 and 2010, amortization expense related to intangible assets was $191,000 and $277,000, respectively. For the six months ended March 31, 2011 and 2010, amortization expense related to intangible assets was $385,000 and $522,000, respectively.

The estimated future amortization expense related to intangible assets as of March 31, 2011 is as follows:
 
Fiscal Years Ended September 30,
 
(In thousands)
 
       
Remainder of fiscal 2011
  $ 171  
2012
    188  
2013
    174  
2014
    174  
2015
    174  
2016
    105  
Thereafter
    63  
         
Total estimated future amortization expense
  $ 1,049  
 
 
Note 3 – Income Taxes

During the three and six months ended March 31, 2011, the Company recorded $41,000 and $52,000, respectively, related to estimated state taxes, estimated federal alternative minimum taxes and uncertain tax positions relative to foreign taxes. During the three and six months ended March 31, 2010, the Company recorded $6,000 and $14,000, respectively, related to estimated alternative minimum taxes and uncertain tax positions relative to foreign taxes.

Deferred Tax Assets
 
The Company’s deferred tax assets include net operating loss carry forwards and tax credits that expire at different times through and until 2030. 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 a full valuation allowance has been provided against the deferred tax assets at March 31, 2011 and September 30, 2010. 

Provision for Uncertain Tax Positions
 
At September 30, 2010, the Company had a $150,000 tax liability related to tax exposures that could result in cash payments, of which approximately $6,000 and $12,000, respectively, were recorded during the three and six months ended March 31, 2010. The Company increased its tax liability by $6,000 during each of the three
 
10

 
month periods ended December 31, 2010 and March 31, 2011. The Company also recorded additional uncertain tax positions of approximately $1,000 and $3,000, respectively, during the three and six months ended March 31, 2011 which were recorded as a reduction of the Company’s deferred tax asset and its valuation allowance. The Company does not expect its tax liability to change significantly during the next twelve months. The Company’s policy is to recognize interest and penalties related to uncertain tax positions as a component of income tax expense in its consolidated statements of operations. To date, the Company has not accrued any amounts for interest and penalties associated with this liability as such amounts have been de minimis.

The Company’s unrecognized tax benefits (before consideration of any valuation allowance) represent differences between tax positions taken by the Company in its various consolidated and separate worldwide tax returns and the benefits recognized and measured. This amount also represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. The change in the unrecognized tax benefits during the six months ended March 31, 2011 was as follows:
       
Balance at October 1, 2010
 
$
826
 
Additions for prior year tax positions
 
16
 
Balance at March 31, 2011
 
$
842
 

In the normal course of business, the Company is subject to examination by taxing authorities throughout the world, including such jurisdictions as the United Kingdom, Australia, and the United States, and as a result, files numerous consolidated and separate income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The fiscal years ended September 30, 2007 through September 30, 2009 are generally still open to examination in the jurisdictions listed above.

Note 4 – Shareholders’ Equity

Stock-based compensation expense for the three months ended March 31, 2011 and 2010 was $36,000 and $50,000, respectively, and $65,000 and $102,000 for the six months ended March 31, 2011 and 2010, respectively, as included in the following expense categories:

   
Three months ended March 31,
   
Six months ended March 31,
 
   
2011
   
2010
   
2011
   
2010
 
   
(In thousands)
 
                         
Sales and marketing
  $ 4     $ 11     $ 12     $ 23  
Engineering and product development
    1       3       3       7  
General and administrative
    31       36       50       72  
    $ 36     $ 50     $ 65     $ 102  

The Company’s stock compensation plans provide for the granting of restricted stock units and either incentive or non-qualified stock options to employees and non-employee directors. Options and restricted stock units are subject to terms and conditions determined by the Compensation and Stock Committee of the Board of Directors. Options generally vest over a three year period beginning three months from the date of grant and expire either seven or ten years from the date of grant. Restricted stock units vest annually over a three year period.

Stock Options
 
The Company uses the Black-Scholes option-pricing model to calculate the fair value of options. The key assumptions for this valuation method include the expected life of the option, stock price volatility, risk-free interest rate and dividend yield. The weighted-average fair value of options granted under the stock option plans for the three months ended March 31, 2011 was $1.97. No options were granted under the stock option plans for the three months ended March 31, 2010. The weighted-average fair values of options granted under the stock option plans for the six months ended March 31, 2011 and 2010 were $1.90 and $1.43, respectively. The total
 
 
11

 
intrinsic value of options exercised during the three and six months ended March 31, 2011 was approximately $121,000 and $125,000, respectively. No options were exercised during the three or six months ended March 31, 2010. Total cash received from option exercises during the three and six months ended March 31, 2011 was $80,000 and $90,000, respectively. As of March 31, 2011, there was $311,000 of total unrecognized compensation cost related to non-vested stock option arrangements, which is expected to be recognized over a weighted-average period of 2.93 years.

Many of the assumptions used in the determination of compensation expense are judgmental and highly volatile. The table below indicates the key assumptions used in the option valuation calculations for options granted in the six months ended March 31, 2011 and 2010:
 
  2011 2010
Expected life
5 years
5 years
Expected volatility
66.26 -67.32%
75.33%
Weighted-average volatility
66.43%
75.33%
Risk free interest rate
1.49 – 2.38%
1.28%
Dividend yield
0.0%
0.0%
 

The expected option life is based on historical trends and data. 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. 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 risk-free interest rate is equal to the historical U.S. Treasury zero-coupon bond rate with a remaining term equal to the expected life of the option. The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Based on the Company’s historical voluntary turnover rates, an annualized estimated forfeiture rate of 10% has been used in calculating the estimated cost. 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.

The following table summarizes information about the Company’s stock option plans for the six months ended March 31, 2011.
 
   
Number of Options
Outstanding
   
Weighted-Average
Exercise Price
   
Weighted-Average Remaining Contractual Term
   
 
Aggregate Intrinsic Value $(000)
 
                         
Outstanding, October 1, 2010
    545,010     $ 2.89              
                             
Granted
    179,000       3.35              
Canceled
    (119,600 )     3.67              
Exercised
    (44,668 )     2.02              
Outstanding, March 31, 2011
    559,742     $ 2.93       4.11     $ 1,317  
                                 
Vested or expected to vest, March 31, 2011
    542,576     $ 2.92       3.90     $ 1,284  
                                 
Exercisable, March 31, 2011
    388,086     $ 2.76       2.76     $ 988  

Restricted Stock Units
 
The Company periodically grants awards of restricted stock units (“RSU”) to each of its non-employee directors and some of its management team on a discretionary basis pursuant to its 2006 Equity Compensation and Incentive Plan. 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. The total number of RSUs unvested at March 31, 2011 was 49,677.
 
 
12

 
Each RSU vests at the rate of 33.33% on each of the first through third anniversaries of the grant date with final vesting of the most recent grants scheduled to occur in February 2014. Included in the total number of RSUs unvested at March 31, 2011 are 25,000 RSUs which were awarded to the Company’s Chief Executive Officer and are subject to a further vesting condition that the Company’s common stock must trade at a price greater than $10 per share on a national securities exchange for a period of twenty consecutive days on or prior to February 14, 2016. The fair value related to the RSUs was calculated based primarily on the average stock price of the Company’s common stock on the date of the grant and is being amortized evenly on a pro-rata basis over the vesting period to general and administrative expense. The fair value of the RSUs granted in the six months ended March 31, 2011 and 2010, respectively, was approximately $120,000 (or $3.24 weighted-average fair value per share) and $59,000 (or $2.39 weighted-average fair value per share). The Company recorded compensation expense related to RSUs of approximately $16,000 and $13,000 for the three months ended March 31, 2011 and 2010, respectively, and $29,000 and $26,000 for the six months ended March 31, 2011 and 2010, respectively. These amounts are included in the total stock-based compensation expense disclosed above. As of March 31, 2011, there was $161,000 of total unrecognized compensation cost related to RSUs, which is expected to be recognized over a weighted average period of 2.48 years.

The following table presents RSU information for the six months ended March 31, 2011:

   
Number of
 
   
RSUs
 
   
Outstanding
 
       
Outstanding, October 1, 2010
 
45,841
 
Granted
 
37,000
 
Canceled
 
(13,504
)
Vested
 
(19,660
)
Outstanding, March 31, 2011
 
49,677
 

Note 5 - Comprehensive Income (Loss)

The following table sets forth the reconciliation of net loss to comprehensive loss:
 
   
Three Months Ended March 31,
   
Six Months Ended March 31,
 
   
2011
   
2010
   
2011
   
2010
 
   
(In thousands)
 
                         
Net loss
  $ (511 )   $ (97 )   $ (282 )   $ (297 )
Other comprehensive loss:
                               
    Foreign currency translation adjustments
    (22 )     (32 )     (52 )     (49 )
                                 
Comprehensive loss
  $ (533 )   $ (129 )   $ (334 )   $ (346 )

 
Accumulated other comprehensive loss reported in the condensed consolidated balance sheets consists solely of foreign currency translation adjustments.

Note 6 - Basic and Diluted Net Income (Loss) Per Share

Basic net income (loss) per common share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share reflects the impact, when dilutive, of the exercise of stock options and RSUs using the treasury stock method. Diluted net loss per share for the three and six months ended March 31, 2011 is the same as basic net loss per share as the potentially dilutive securities are all anti-dilutive.

 
13

 
Potentially dilutive common stock options aggregating 129,998 and 304,990 shares for the three months ended March 31, 2011 and 2010, respectively, and 158,478 and 305,711 shares for the six months ended March 31, 2011 and 2010, respectively, have been excluded from the computation of diluted net income per share because their inclusion would be anti-dilutive. There were no potentially dilutive restricted stock units for the three or six months ended March 31, 2011. Potentially dilutive restricted stock units aggregating 6,672 shares and 5,830 shares for the three and six months ended March 31, 2010, respectively, have been excluded from the computation of diluted net income per share because their inclusion would be anti-dilutive.

Note 7 - Commitments and Contingencies

The Company is 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 $374,000 and $382,000, respectively, for the three months ended March 31, 2011 and 2010 and $713,000 and $727,000, respectively, for the six months ended March 31, 2011 and 2010. The Company is not obligated to pay any minimum amounts for royalties.

From time to time, the Company is subject to claims and may be party to actions that arise in the normal course of business. The Company is not party to any litigation that management believes will have a material adverse effect on the Company’s consolidated financial condition or results of operations.

Note 8 - Segment Information

The Company has determined that it has only one reportable segment. The Company’s chief operating decision maker, its Chief Executive Officer, does not manage any part of the Company separately, and the allocation of resources and assessment of performance is based solely on the Company’s consolidated operations and operating results.

The following table presents information about the Company’s revenue by product lines:
 
 
Three Months Ended
 
Six Months Ended
 
March 31,
 
March 31,
 
2011
 
2010
 
2011
 
2010
Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence)
75%
 
70%
 
73%
 
70%
Report Management and Archive Solutions (including Datawatch BDS)
17%
 
18%
 
18%
 
18%
Business Service Management Solutions (including Visual QSM and Visual HD)
8%
 
12%
 
9%
 
12%
               
Total
100%
 
100%
 
100%
 
100%
 

The Company conducts operations in the U.S. and internationally (principally in the United Kingdom). The following table presents information about the Company’s geographic operations:
 
14

 
 
         
International
             
         
(Principally
   
Intercompany
       
   
Domestic
   
U.K.)
   
Eliminations
   
Total
 
   
(In thousands)
 
                         
Total Revenue
                       
   Three months ended  March 31, 2011
  $ 3,676     $ 986     $ (208 )   $ 4,454  
   Three months ended  March 31, 2010
  $ 3,682     $ 1,105     $ (216 )   $ 4,571  
                                 
   Six months ended  March 31, 2011
  $ 6,994     $ 2,060     $ (420 )   $ 8,634  
   Six months ended  March 31, 2010
  $ 7,072     $ 2,168     $ (434 )   $ 8,806  
                                 
Total Operating Loss
                               
   Three months ended  March 31, 2011
  $ (414 )   $ (90 )   $     $ (504 )
   Three months ended  March 31, 2010
  $ (55 )   $ (37 )   $     $ (92 )
                                 
   Six months ended  March 31, 2011
  $ (299 )   $ 12     $     $ (287 )
   Six months ended  March 31, 2010
  $ (130 )   $ (152 )   $     $ (282 )
                                 
Non-current Assets
                               
   At March 31, 2011
  $ 1,293     $ 62     $     $ 1,355  
   At September 30, 2010
  $ 1,741     $ 54     $     $ 1,795  
 


Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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, 2010, as well as the accuracy of the Company’s internal estimates of revenue and operating expense levels. 

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

The Company’s principal products are Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence), Report Management and Archive Solutions (including Datawatch BDS) and Business Service Management Solutions (including Visual QSM and Visual HD). Included in the above categories are:
 
15

 

·  
Monarch, 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;
·  
Monarch 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;
·  
Monarch RMS, a web-based report activation and analysis solution that integrates with any existing Enterprise Report Management document or content management archiving solution;
·  
Monarch Enterprise Server, an enterprise operational report activation and business intelligence system 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 decision support;
·  
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;
·  
Datawatch BDS, a system for high-volume document capture, archiving, and online presentation;
·  
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 described below.

·  
Revenue Recognition, Allowance for Bad Debts and Returns Reserve
·  
Income Taxes
·  
Capitalized Software Development Costs
·  
Valuation of Intangible Assets and Other Long-Lived Assets
·  
Accounting for Stock-Based Compensation

During the six months ended March 31, 2011, 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, 2010 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, 2010.
 
16

 
   
Three Months Ended
 
Six Months Ended
   
March 31,
 
March 31,
   
2011
 
2010
 
2011
 
2010
REVENUE:
               
  Software licenses
 
57%
 
57%
 
54%
 
54%
  Maintenance and services
 
43%
 
43%
 
46%
 
46%
           Total revenue
 
100%
 
100%
 
100%
 
100%
                 
COSTS AND EXPENSES:
               
  Cost of software licenses
 
13%
 
14%
 
13%
 
14%
  Cost of maintenance and services
 
14%
 
16%
 
15%
 
17%
  Sales and marketing
 
33%
 
35%
 
31%
 
36%
  Engineering and product development
 
15%
 
16%
 
15%
 
16%
  General and administrative
 
37%
 
21%
 
29%
 
20%
           Total costs and expenses
 
112%
 
102%
 
103%
 
103%
LOSS FROM OPERATIONS
 
-12%
 
-2%
 
-3%
 
-3%
Interest income and other income (expense), net
 
1%
 
0%
 
1%
 
0%
LOSS BEFORE INCOME TAXES
 
-11%
 
-2%
 
-2%
 
-3%
Provision for income taxes
 
1%
 
0%
 
1%
 
0%
NET LOSS
 
-12%
 
-2%
 
-3%
 
-3%


Three Months Ended March 31, 2011 Compared to
Three Months Ended March 31, 2010

Total Revenues

The following table presents total revenue, total revenue decrease and percentage change in total revenue for the three months ended March 31, 2011 and 2010:
 
   
Three Months Ended
             
   
March 31,
   
Increase
   
Percentage
 
   
2011
   
2010
   
(Decrease)
   
Change
 
   
(In thousands)
 
                         
Software licenses
  $ 2,552     $ 2,593     $ (41 )     -2%  
Maintenance and services
    1,902       1,978       (76 )     -4%  
                                 
Total revenue
  $ 4,454     $ 4,571     $ (117 )     -3%  

 
The decrease in software license revenue of $41,000 for the three months ended March 31, 2011 consists of an $85,000 decrease in Report Management and Archive Solutions (including Datawatch BDS), a $21,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products) and a $65,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence).

The decrease in maintenance and services revenue of $76,000 consists of a $140,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products), a $47,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence), and a $17,000 increase in Report Management and Archive Solutions (including Datawatch BDS).  Maintenance revenue decreased $43,000 which included a $65,000 decrease in Report Management and Archive Solutions, a $30,000 decrease in Business Service Management Solutions and a $52,000 increase in Report Analytics Solutions. Services revenue decreased $33,000 which included a $110,000 decrease in Business Service Management Solutions, a $5,000 decrease in Report Analytics Solutions and an $82,000 increase in Report Management and Archive Solutions.
 
17

 
Costs and Operating Expenses

The following table presents costs and operating expenses, increase (decrease) in costs and operating expenses and percentage changes in costs and operating expenses for the three months ended March 31, 2011 and 2010:
 
   
Three Months Ended
             
   
March 31,
   
Increase
   
Percentage
 
   
2011
   
2010
   
(Decrease)
   
Change
 
   
(In thousands)
 
                         
Cost of software licenses
  $ 587     $ 648     $ (61 )     -9%  
Cost of maintenance and services
    606       747       (141 )     -19%  
Sales and marketing
    1,479       1,588       (109 )     -7%  
Engineering and product development
    648       710       (62 )     -9%  
General and administrative
    1,638       970       668       69%  
                                 
Total costs and operating expenses
  $ 4,958     $ 4,663     $ 295       6%  
 

The decrease in cost of software licenses of $61,000, or 9%, is primarily due to lower software amortization costs associated with previously acquired software and lower royalty costs as compared to the same period last year.
 
The decrease in cost of maintenance and services of $141,000, or approximately 19%, is primarily due to lower wages, travel costs and other employee-related costs due to decreased headcount as compared to the same period last year.

The decrease in sales and marketing expenses of $109,000, or approximately 7%, is attributable to lower external consulting costs, lower amortization costs related to fully amortized intangible assets and lower wages and employee-related costs due to decreased headcount as compared to the same period last year.

The decrease in engineering and product development expenses of $62,000, or approximately 9%, is primarily attributable to lower headcount and other employee-related costs and lower external consulting costs as compared to the same period last year.

The increase in general and administrative expenses of $668,000, or 69%, 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. The increase in general and administrative expenses also includes higher external consulting costs related to IT managed services as compared to the same period last year.

Interest income and other income (expense), net includes primarily the following two components: interest income; and gains (losses) on foreign currency transactions. Interest income for the three months ended March 31, 2011 and March 31, 2010 was less than $1,000. Gain (loss) on foreign currency transactions for the three months ended March 31, 2011 was a gain of approximately $33,000 as compared to a gain of $1,000 for the three months ended March 31, 2010. The foreign currency gains (losses) recorded in the three months ended March 31, 2011 and 2010 were the result of foreign currency rate volatility between the Euro and the British Pound during these periods.

Income tax expense for the three months ended March 31, 2011 was $41,000 as compared to $6,000 for the three months ended March 31, 2010. Income tax expense for the three months ended March 31, 2011 includes estimated state taxes and federal alternative minimum taxes totaling $35,000. Income tax expense for both periods includes a $6,000 provision for uncertain tax positions relative to foreign taxes.
 
18

 
Net loss for the three months ended March 31, 2011 was $511,000 as compared to net loss of $97,000 for the three months ended March 31, 2010.

Six months Ended March 31, 2011 Compared to
Six Months Ended March 31, 2010

Total Revenues
 
The following table presents total revenue, total revenue decrease and percentage change in total revenue for the six months ended March 31, 2011 and 2010:
 
   
Six Months Ended
             
   
March 31,
   
Increase
   
Percentage
 
   
2011
   
2010
   
(Decrease)
   
Change
 
   
(In thousands)
 
                         
Software licenses
  $ 4,662     $ 4,759     $ (97 )     -2%  
Maintenance and services
    3,972       4,047       (75 )     -2%  
                                 
Total revenue
  $ 8,634     $ 8,806     $ (172 )     -2%  
                                 

 
The decrease in software license revenue of $97,000 for the six months ended March 31, 2011 consists of a 78,000 decrease in Report Management and Archive Solutions (including Datawatch BDS), a $73,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD) and a $54,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence).

The decrease in maintenance and services revenue of $75,000 consists of a $234,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD), a $110,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch Enterprise Server, Datawatch Dashboards and iMergence) and a $49,000 increase in Report Management and Archive Solutions (including Datawatch BDS). Maintenance revenue decreased $118,000 which included a $122,000 decrease in Report Management and Archive Solutions, a $92,000 decrease in Business Service Management Solutions and a $96,000 increase in Report Analytics Solutions. Services revenue increased $43,000 which included a $171,000 increase in Report Management and Archive Solutions, a $14,000 increase in Report Analytics Solutions and a $142,000 decrease in Business Service Management Solutions.

Costs and Operating Expenses

The following table presents costs and operating expenses, increase (decrease) in costs and operating expenses and percentage changes in costs and operating expenses for the six months ended March 31, 2011 and 2010:
 
 
19

 
   
Six Months Ended
             
   
March 31,
   
Increase
   
Percentage
 
   
2011
   
2010
   
(Decrease)
   
Change
 
   
(In thousands)
 
                         
Cost of software licenses
  $ 1,131     $ 1,222     $ (91 )     -7%  
Cost of maintenance and services
    1,287       1,506       (219 )     -15%  
Sales and marketing
    2,705       3,135       (430 )     -14%  
Engineering and product development
    1,283       1,419       (136 )     -10%  
General and administrative
    2,515       1,806       709       39%  
                                 
Total costs and operating expenses
  $ 8,921     $ 9,088     $ (167 )     -2%  
 

The decrease in cost of software licenses of $91,000, or approximately 7%, is primarily due to lower software amortization costs associated with previously acquired software and lower royalty costs as compared to the same period last year.

The decrease in cost of maintenance and services of $219,000, or approximately 15%, is primarily due to lower wages and other employee-related costs due to decreased headcount as compared to the same period last year and lower consulting and travel costs.

The decrease in sales and marketing expenses of $430,000, or approximately 14%, is attributable to lower external consulting costs, a reduction in travel-related costs, lower wages and employee-related costs due to decreased headcount and lower amortization costs as compared to the same period last year.

The decrease in engineering and product development expenses of $136,000, or approximately 10%, is primarily due to lower external consulting costs as compared to the same period last year and lower wages and other employee-related costs.

The increase in general and administrative expenses of $709,000, or approximately 39%, 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. The increase in general and administrative expenses also includes higher external consulting costs related to IT managed services as compared to the same period last year.

Interest income and other income (expense) includes primarily the following two components: interest income; and gains (losses) on foreign currency transactions. Interest income for the six months ended March 31, 2011 and 2010 was approximately $2,000 and $1,000, respectively.  Gain (loss) on foreign currency transactions for the six months ended March 31, 2011 was a gain of approximately $55,000 as compared to a loss of $2,000 for the six months ended March 31, 2010. The foreign currency gains (losses) recorded in the six months ended March 31, 2011 and 2010 were the result of foreign currency rate volatility between the Euro and the British Pound during these periods.

Income tax expense for the six months ended March 31, 2011 was $52,000 as compared to $14,000 for the six months ended March 31, 2010. Income tax expense for the six months ended March 31, 2011 includes estimated state taxes totaling $30,000. Income tax expense for both periods includes estimated federal alternative minimum taxes of $9,000 and $1,000, respectively, and a provision for uncertain tax positions relative to foreign taxes of $13,000 during each period.

Net loss for the six months ended March 31, 2011 was $282,000 as compared to net loss of $297,000 for the six months ended March 31, 2010.
 
20

 
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 $83,000 and $76,000 for the three months ended March 31, 2011 and 2010, respectively, and $164,000 and $149,000 for the six months ended March 31, 2011 and 2010, respectively.

As of March 31, 2011, the Company’s contractual obligations include minimum rental commitments under non-cancelable operating leases and other liabilities related to uncertain tax positions as follows:
 
Contractual Obligations:
 
Total
   
Less than 1 Year
   
1-3 Years
   
3-5 Years
   
More than 5 Years
 
   
(in thousands)
 
                               
   Operating Lease Obligations
  $ 211     $ 148     $ 43     $ 20     $  
                                         
   Other Liabilities
  $ 163     $     $     $     $ 163  


The Company is 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 $374,000 and $382,000, respectively, for the three months ended March 31, 2011 and 2010, and $713,000 and $727,000 for the six months ended March 31, 2011 and 2010, respectively. The Company is not obligated to pay any minimum amounts for royalties.

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 the estimated fair value of these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of March 31, 2011.

The Company is required by a sublease agreement related to its Chelmsford, Massachusetts facility to provide a letter of credit originally in the amount of approximately $125,000 as a security deposit to the landlord of amounts due under the lease. In accordance with the terms of its sublease agreement, the Company is allowed to reduce its letter of credit by approximately $18,000 annually following the completion of the first three years of its lease arrangement, which occurred during the first quarter of fiscal year 2009. Cash on deposit providing security in the amount of this letter of credit was $71,000 and $89,000 as of March 31, 2011 and September 30, 2010, respectively, and is classified as restricted cash in the Company’s condensed consolidated balance sheets.

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 the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of March 31, 2011.

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
 
 
21

 
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 the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of March 31, 2011.

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 the estimated fair value of these indemnification agreements is minimal. The Company has no liabilities recorded for these potential obligations as of March 31, 2011.

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 March 31, 2011, the Company had $7,752,000 of cash and equivalents, an increase of $699,000 from September 30, 2010.

At March 31, 2011, the Company had working capital of approximately $4,439,000 as compared to working capital of $4,186,000 at September 30, 2010. 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 further reductions to its operating expenses. The Company does not anticipate additional cash requirements to fund significant growth or the acquisition of complementary technology or businesses. However, if in the future, such expenditures are anticipated or required, the Company may need to 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 credit facility at attractive prices or rates, or at all.

The Company had a net loss of approximately $282,000 for the six months ended March 31, 2011 as compared to a net loss of approximately $297,000 for the six months ended March 31, 2010. During the six months ended March 31, 2011 and 2010, approximately $681,000 and $818,000, respectively, of cash was provided by the Company’s operations. During the six months ended March 31, 2011, the main source of cash from operations was net loss adjusted for depreciation and amortization as well as an increase in accounts payable, accrued expenses and other liabilities.

Net cash used in investing activities for the six months ended March 31, 2011 of $31,000 is primarily related to the purchase of property and equipment which was partially offset by a reduction in the Company’s letter of credit pursuant to its sublease agreement for its Chelmsford, Massachusetts facility.

Net cash provided by financing activities for the six months ended March 31, 2011 of $90,000 is related to proceeds from the exercise of stock options.

An existing agreement between Datawatch and Math Strategies grants the Company exclusive worldwide rights to use and distribute through April 30, 2015 certain intellectual property owned by Math Strategies and incorporated by the Company in its Monarch, Monarch Data Pump and certain other products. The Company has also entered into an Option Purchase Agreement with Math Strategies giving the Company the option to purchase these intellectual property rights for a formula price based on a multiple of the aggregate royalties paid to Math Strategies by the Company for the four fiscal quarters preceding the exercise of the option. This option, if exercised, would provide the Company with increased flexibility to utilize the purchased technology in the future.
 
22

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


Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments
 
At March 31, 2011, the Company did not participate in or hold any derivative financial instruments or commodity instruments. The Company holds no investment securities that possess significant market risk.

Primary Market Risk Exposures
 
The Company’s primary market risk exposure is foreign currency exchange rate risk. The Company’s exposure to currency exchange rate fluctuations has been and is expected to continue to be modest due to the fact that the operations of its international subsidiaries are almost exclusively conducted in their respective local currencies, and dollar advances to the Company’s international subsidiaries, if any, are usually considered to be of a long-term investment nature. Accordingly, the majority of currency movements are reflected in the Company’s other comprehensive income (loss). There are, however, certain situations where the Company will invoice customers in currencies other than its own. Such gains or losses from operating activity, whether realized or unrealized, are reflected in interest income and other income (expense), net in the condensed consolidated statements of operations. Currently, the Company does not engage in foreign currency hedging activities.


Item 4.  CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.
 
The principal executive officer and principal financial officer, with the participation of the Company’s management, evaluated the effectiveness of the Company’s disclosure controls and procedures as of March 31, 2011. The term “disclosure controls and procedures,” as defined in Rules 13a−15(e) and 15d−15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives. Based upon that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in enabling the Company to record, process, summarize and report information required to be included in the Company’s periodic SEC filings within the required time period.
 
(b) Changes in Internal Controls.
 
No changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
23

 
PART II. OTHER INFORMATION


Item 1.   Legal Proceedings

The Company is occasionally involved in legal proceedings and other claims arising out of its operations in the normal course of business. The Company is not party to any litigation that management believes will have a material adverse effect on the Company’s consolidated financial condition, results of operations, or cash flows.


Item 1A.   Risk Factors

In addition to the other information set forth in this report, the reader should carefully consider the factors discussed in Part I, Item 1A under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended September 30, 2010, which could materially affect its business, financial condition or future results. The risks described in the Company’s Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known or that it currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results. 


Item 6.   Exhibits
 
 
31.1
  Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2
  Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
32.1
  Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
32.2
  Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 

 
24

 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on May 11, 2011.


 
DATAWATCH CORPORATION
 
     
     
     
 
/s/ Michael A. Morrison
 
 
Michael A. Morrison
 
 
President, Chief Executive Officer, and
 
 
Director (Principal Executive Officer)
 
     
     
 
/s/ Murray P. Fish
 
 
Murray P. Fish
 
 
Chief Financial Officer,
 
(Principal Financial Officer)
 













 
25

 
















Exhibit 31.1
 
 
CERTIFICATIONS

I, Michael A. Morrison, certify that:

1.      I have reviewed this quarterly report on Form 10-Q of Datawatch Corporation;

2.      Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.      Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.      The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 
(c)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 
(d)
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

5.      The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 11, 2011
 
/s/ Michael A. Morrison
 
 
Michael A. Morrison
 
 
President, Chief Executive Officer
 
 
and Director
 
 
 
Exhibit 31.2
 
 
CERTIFICATIONS

I, Murray P. Fish, certify that:

1.      I have reviewed this quarterly report on Form 10-Q of Datawatch Corporation;

2.      Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.      Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.      The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 
(c)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 
(d)
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

5.      The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 11, 2011
     
 
/s/ Murray P. Fish
 
 
Murray P. Fish
 
 
Chief Financial Officer
 
Exhibit 32.1
 
 

 
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Datawatch Corporation (the “Company”) on Form 10-Q for the period ending March 31, 2011 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Michael A. Morrison, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that:

 
(1)
The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

 
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.


 
/s/ Michael A. Morrison
 
 
Michael A. Morrison
 
Chief Executive Officer
 
May 11, 2011



Exhibit 32.2
 
 
 

 
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Datawatch Corporation (the “Company”) on Form 10-Q for the period ending March 31, 2011 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Murray P. Fish, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that:

 
(1)
The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

 
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.


 
/s/ Murray P. Fish
 
 
Murray P. Fish
 
 
Chief Financial Officer
 
 
May 11, 2011