Datawatch Corporation
DATAWATCH CORP (Form: 10-K, Received: 12/21/2012 16:48:45)


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

FORM 10-K
 
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2012 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)
 
 
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:  
 
Common Stock $0.01 PAR VALUE
NASDAQ
(Title of Class)
(Name of Exchange on which Registered)
   
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:  NONE
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o    No   ý
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No   ý
 
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    ý     No    o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     ý
 
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 the definitions 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 aggregate market value of voting stock held by non-affiliates of the registrant, based on the closing price of the registrant’s common stock on March 31, 2012, the last business day of the Company’s most recently completed second fiscal quarter, as reported by the NASDAQ Capital Market was $58,723,579.       
 
The number of shares of the registrant’s common stock, $.01 par value, outstanding as of December 10, 2012 was 6,396,386. 
 
Documents Incorporated By Reference 
 
Registrant intends to file a definitive Proxy Statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended September 30, 2012.  Portions of such Proxy Statement are incorporated by reference in Part III of this report.
 


 
 
 
 
DATAWATCH CORPORATION 
ANNUAL REPORT ON FORM 10-K 
 
TABLE OF CONTENTS 
 
Page
     
Part I
 
     
Item 1.
Business
3
Item 1A.
Risk Factors
11
Item 1B.
Unresolved Staff Comments
17
Item 2.
Properties
17
Item 3.
Legal Proceedings
18
Item 4.
Mine Safety Disclosures
18
     
   
Part II
 
     
Item 5.
Market for Registrant’s Common Equity and Related Shareholder Matters
19
Item 6.
Selected Consolidated Financial Data
19
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
20
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
33
Item 8.
Financial Statements and Supplementary Data
34
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
59
Item 9A.
Controls and Procedures
59
Item 9B.
Other Information
60
     
   
Part III
 
     
Item 10.
Directors and Executive Officers of the Registrant
61
Item 11.
Executive Compensation
62
Item 12.
Security Ownership of Certain Beneficial Owners and Management
62
Item 13.
Certain Relationships and Related Transactions
62
Item 14.
Principal Accountant Fees and Services
62
     
   
Part IV
 
     
Item 15.
Exhibits and Financial Statement Schedules
63
     

  
 
 
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PART I
 
Item 1.  BUSINESS
 
GENERAL
 
Datawatch Corporation (the “Company” or “Datawatch”) (NASDAQ-CM: DWCH ) is a leader in providing information optimization products and software solutions that allow organizations to deliver an extensive variety of data into their Big Data and analytic applications. Datawatch provides organizations the ability to integrate structured, unstructured and semi-structured sources such as reports, machine data, PDF files, HTML and EDI streams into these applications to provide a 360 degree perspective of the issues and opportunities that exist in their businesses. More than 40,000 organizations worldwide use Datawatch products and services, including 99 of the Fortune 100. Founded in 1985, Datawatch is headquartered in Chelmsford, Massachusetts with offices in London, Munich, Singapore, Sydney and Manila, and with partners and customers in more than 100 countries worldwide. 
 
Datawatch is a Delaware corporation with executive offices located at 271 Mill Road, Quorum Office Park, Chelmsford, MA 01824 and our telephone number is (978)441-2200. Periodic reports, proxy statements and other information are available to the public, free of charge, on our website, www.datawatch.com , as soon as reasonably practicable after they have been filed with the SEC and through the SEC’s website, www.sec.gov . Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, N.E., Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. 
 
OUR INDUSTRY

We believe that the information analytics industry is on the verge of a major change that is being driven by the convergence of several major trends from existing and emerging market segments. This change is being driven from the desire organizations have to better understand their businesses by making use of all of the data sources they have available to them, regardless of their format or point of origin. This means using data that is not in traditional sources such as relational databases and data warehousing solutions but resides in sources that are less structured, harder to access, and often times outside the direct control of the receiving organization. The ability to collect and analyze data from these semi-structured and unstructured sources, which include machine data, log files, EDI streams, PDF files, report spools, XBRL, and other sources and formats, offer organizations a better perspective on their businesses and often lead to improvements in the actual business processes that drive organizations. As companies look to fulfill this need, they are trying to solve the problems of how to store this information, how to harvest the value that is held within these sources, and finally how to effectively deliver this information to the business users in a flexible manner. We believe that the market dynamics that are shaping this industry revolve around delivering greater data variety through Big Data and Business Intelligence solutions and moving beyond simple search within content management systems.

The Big Data Dynamic

To deliver a better perspective on their businesses, organizations are starting to deploy what this industry is calling Big Data solutions. The Big Data market has focused its attention on trying to solve the problems that are inherent to offering all sources of data to organizations. These problems are typically categorized into dealing with the data volume, velocity and variety associated with these types of applications. While the first two issues are important to deploying Big Data solutions, we believe that delivering a greater variety of information is the key to providing the improved insights and operations that is the promise of Big Data to the market. Datawatch, with our ability to access and harvest information from structured, semi-structured and unstructured sources, plays an important role in delivering variety to Big Data applications. We believe that our position in this dynamic market segment provides us substantial partnering opportunities. With over twenty years of experience in deriving valuable information assets from semi-structured and unstructured sources, Datawatch can enhance the loading of Big Data stores as well as offer users of this information the ability to decompose and restructure data accessed in the creation of analytical applications.

 
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The Business Intelligence Dynamic

Business intelligence (“BI”) solutions have been the delivery mechanism for analytics over the past fifteen years, but as organizations look to extend their perspective to include information that exists beyond traditional databases and allow users to personalize their data discovery applications, these BI solutions are undergoing a change. As BI vendors retool to provide Big Data solutions and deliver a greater variety of information to their users’ technologies, organizations like Datawatch are becoming increasingly important. By deploying Datawatch alongside every BI seat in an organization, customers can empower users to deliver a self-service capability against unstructured and semi-structured information sources to conduct personal data discovery tasks. By deploying Datawatch’s complete Information Optimization platform, organizations can integrate traditional BI with Big Data variety to deliver all types of data to their users.

The Content Management Dynamic

For years organizations have stored vast amounts of content in a variety of unstructured and semi-structured sources in enterprise content management (“ECM”) systems. While some of this data was stored originally out of compliance requirements, many organizations are now looking to do more with that information to better understand their businesses or to provide Big Data sources to drive decisions within their businesses. Traditional enterprise content management systems are ill equipped to do much more than search and retrieve documents.  Their inability to take any action against the returned information is a significant limitation. By including Datawatch as part of their solution, ECM systems can be transformed from simple search technologies into “search-to-action” Information Optimization solutions providing better information to users.

The desire for organizations to leverage every source of information that exists in their organizations has given rise to a new market – the Information Optimization market. With major initiatives such as Big Data acting as a catalyst, companies of every size are reevaluating their approach to analyzing business issues and revamping business processes through the inclusion of all data regardless of type. We believe that Datawatch is uniquely positioned to allow these companies to deliver greater data variety to the key applications that are at the forefront of this change such as BI, ECM and Big Data, ensuring that these organizations get a complete picture of what drives their businesses.

OUR PRODUCTS
 
Datawatch is a leading provider of products that allow organizations to optimize the use of information inside and outside the walls of their organization to improve business processes and increase the visibility into a greater variety of information for analytical purposes. To deliver this functionality, we offer a complete product portfolio to allow companies to model, ingest, store, distribute, and analyze structured, semi-structured, and unstructured information. This portfolio is comprised of two primary product groupings: our Information Optimization products and our Unified Information Management products. With these products, Datawatch can deliver information optimization capabilities to individual desktops inside the organization throughout the entire enterprise, and with our newly released cloud offering, we can deliver these capabilities without the typical barriers of entry associated with on-premise solutions.









 
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Datawatch Information Optimization Products

Datawatch is a leader in providing information optimization products that allow organizations to get the whole story about their businesses by leveraging structured, unstructured, and semi-structured content such as reports, machine data, PDF files, HTML and EDI streams. Our Information Optimization suite of products allows companies to utilize data from a wide variety of sources to deliver a complete model of their business and then manage, secure, and deliver that information to transform business processes and increase visibility to critical business intelligence and Big Data sources to improve business processes and offer broader analytical capabilities. The Datawatch Information Optimization Suite, which represented approximately 95% of total revenues for fiscal year 2012, includes:

Modeling Information – Monarch Professional
 
The ability to leverage all the information that a customer needs to understand its business is the key to remaining competitive in a world where data comes from a wide variety of sources in a wide variety of formats. With Monarch Professional, a customer can bring all the data that it needs to manage its business to life, whether that information is stored in structured sources like databases, or in less conventional places like unstructured or semi-structured EDI streams, machine data, PDF files, reports, or text files. With Monarch Professional's mapping engine, information can be evaluated, organized, and integrated to provide users with a 360 degree view of business issues and opportunities. Additionally, Monarch Professional has the versatility to deliver value to the individual user and extend that knowledge to the entire enterprise by deploying it with the Datawatch Information Optimization suite.

Monarch Professional – For the Individual
 
When deployed as a stand-alone desktop information optimization client, Monarch Professional allows users to model their own information and perform personal analysis of structured and semi-structured information from a wide variety of sources. We believe this capability to operate in a personal deployment model makes Monarch Professional an ideal data discovery solution to empower individual analysts to work with reports, PDF files and other sources of data to gain a better understanding of what drives their day-to-day jobs. Monarch Professional’s desktop deployment capability also helps users with mobile deployment needs to take their information optimization capabilities “on the road.” Users like auditors and sales teams can take this tool with them into off-site situations and work directly with their clients’ information to gain a greater understanding of their businesses.

 
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Monarch Professional – For the Enterprise
 
Monarch Professional provides the ability for data and IT professionals involved in delivering Big Data and information optimization applications to model a wide variety of data sources. Structured, unstructured and semi-structured information can be modeled, transformed, and shared through the combination of Monarch Professional and Datawatch’s Information Optimization suite. This ability to leverage models created in Monarch Professional means that every user who is using an individual copy of a model can ensure that, if needed, their applications can become part of a compliant corporate environment and that the investment made in those copies can be expanded across the entire organization allowing everyone to understand their business better.

Automating and Transforming Information – Datawatch Data Pump
 
Once organizations have their various information sources, structured, semi-structured, and unstructured, modeled using Monarch Professional, and ready to optimize, they need to make these processes repeatable and dynamic so that information can be shared across the organization faster and more efficiently. With Datawatch Data Pump, organizations can move their individual information optimization systems into a high performance production environment that allows them to process larger amounts of data, schedule and automate these processes, and distribute this data to other users throughout the organization. Datawatch Data Pump is an integral part of the Datawatch Information Optimization Platform, and when combined with Datawatch Enterprise Server, provides a complete enterprise solution. Using Datawatch Data Pump, companies can deliver larger volumes of data to more users in a variety of formats.

Managing and Analyzing Information – Datawatch Enterprise Server
 
To fully exploit the value of optimized information, organizations must ensure that information is easily available to users of all types. With Datawatch Enterprise Server or Datawatch Enterprise Server - Cloud, companies of all sizes can allow every user to access information through a web browser and provide them the ability to analyze and understand this information more effectively.
 
With the ability to manage and secure this content, users of all levels can be provided the information they need, whether that information is stored in structured, unstructured, or semi-structured sources like PDF files, machine data, EDI streams, or reports, to gain a complete understanding of their business. By using the models developed in Datawatch Monarch Professional, and managing and securing them in a high availability server that works directly with Datawatch’s high performance Data Pump product, organizations can make their Big Data solutions available to every user.

Eliminating the Barriers – Datawatch Enterprise Server - Cloud
 
With Datawatch Enterprise Server - Cloud, companies of all sizes can allow users to access the information they need to transform their business processes and improve their analytical capabilities. With Datawatch Enterprise Server – Cloud, an organization gets the capabilities of Datawatch’s complete information optimization solution deployed faster than the on-premise Datawatch Enterprise Server and with less expense and overhead. We launched the Datawatch Enterprise Server – Cloud offering in October 2012.
 
Datawatch Enterprise Server - Cloud provides the ability for organizations to transform, integrate, manage, secure, and analyze information of all types whether it resides in structured, unstructured, or semi-structured sources like PDF files, machine data, EDI streams, or reports. By using existing models developed in Monarch Professional or through the use of Datawatch’s cloud-based modeling service, organizations can rapidly deploy applications that allow every user to have a 360 degree view of their business opportunities.

To fully optimize an organization’s information, users must be able to access and interact with information stored in a wide variety of applications. Enterprise content management stores are a rich source of this type of information. As part of our Information Optimization suite, Datawatch’s Unified Information Management products allow users to leverage the power of information optimization technologies against a wide variety of content stores from companies like IBM, EMC, Microsoft and Open Text. In addition, for companies looking to manage high volume semi-structured sources such as print spools and PDFs, Datawatch can provide that functionality with its Unified Information Management products.
 
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Unlocking the Power of Content - Datawatch RMS

Datawatch’s RMS (Report Mining Server) is a web-based report analytics solution that integrates with any existing enterprise content management system such as Monarch Report Manager on Demand, IBM Content Manager OnDemand, Microsoft SharePoint, Hyland OnBase, ASG Mobius ViewDirect and others. Monarch RMS opens up the corporate data locked in content management systems, static reports and business documents, enabling dynamic business-driven analysis of information in users’ web browsers or favorite productivity tools with no user programming.

Managing Content - Datawatch Report Manager on Demand

In today's accelerated global business environment, information must be rapidly available to users. On-demand access to critical business documents can significantly improve customer service response time, drive more efficient operations, and expedite audits and legal discovery. To support this expanded use of data and manage the volumes of print and electronic information generated by its business, a company needs a flexible, scalable system.
 
Datawatch Report Manager on Demand (RMOD) helps an enterprise meet its growing information needs by offering centralized management of document images, reports, customer correspondence, statements and more. Datawatch's experience in highly regulated markets - including financial services and healthcare - gives an enterprise a trusted solution that supports its regulatory compliance initiatives. In addition, RMOD readily integrates with CRM and call center applications to give customer service teams real-time access to invoices, statements, checks, policies and any other customer documents.
 
RMOD can also be integrated with web portals, giving customers, agents and brokers the option of secure, self-service access to their statements, trade confirmations, reports and other account documents. On-demand access to information means fewer call-backs, decreased costs and improved customer satisfaction. This ensures that organizations can keep track of the information they need in their businesses.

Datawatch Dashboards ™ - Datawatch Dashboards is a fully interactive dashboard solution that gives all levels of users a visual overview of operational performance as well as the ability to monitor specific business processes and events. Utilizing information from existing databases (in real time if so desired) and other sources of data including Excel and reports, Datawatch Dashboards allows users to visualize data in more than 60 graphical chart types in a web browser. Users from senior level executives to operational staff can easily assess results, identify trends, reveal issues and rapidly initiate appropriate actions with Datawatch Dashboards. 
 
iMergence iStore is a report management solution which manages computer-generated reports, mines the data contained in them, and allows users to interactively merge and transform them into new reports. We receive subscription license fees for our iMergence iStore product primarily from a provider of services to the financial services industry.
 
Business Service Management Solutions 
 
Staying ahead of the competition requires dramatically improving operating efficiency while delivering service efficiency at the lowest cost. Datawatch’s service management and workflow solutions enable customers to improve user service satisfaction, manage an organization’s infrastructure and use support resources effectively and efficiently. Business Service Management solutions, including the enabled IT service management system Visual QSM™ and the enterprise-wide support solution Visual Help Desk™, represented approximately 5% of total revenues for fiscal year 2012. 
 
 

 
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OUR SERVICES

Datawatch complements its core products with a range of services to ensure successful deployment and usage of the Datawatch Information Optimization platform. This includes educational services for customers and partners implementing and learning about the platform, maintenance and support, and professional services to provide in-depth technical assistance for software implementations.

Educational Services - Datawatch Educational Services offers a number of training choices to customers and partners to support the knowledge and skills development needed to take advantage of investment in the Information Optimization platform. We offer an array of live and virtual classroom instruction, including private onsite classes. Courses include training on all aspects of our platform, from beginning model building basics to the deployment of sophisticated dashboards sourced from data harvested by our platform.

Professional Services - To assist customers in achieving rapid time-to-value, Datawatch has established a professional services team. This team supports customers and partners with more in-depth technical consulting and best practices about our platform including advanced modeling, application design, implementation and configuration and process optimization.

Customer Support – Datawatch’s customers receive one year of software maintenance and support as part of their initial license of our software platform and have the option to annually renew their maintenance agreements. These annual maintenance agreements provide customers the right to receive unspecified software updates on a when and if available basis, maintenance releases and patches, and access to telephone support services. The maintenance agreement also allows access to an on-line user forum, where experienced users from around the world can share their tips and tricks.

Datawatch has determined that it has only one operating segment. See Note 9 to our Consolidated Financial Statements for information about our revenue by product line and geographic operations. 

MARKETING, SALES AND DISTRIBUTION STRATEGY
 
Datawatch markets and sells its products and services through its direct sales force, a distribution channel and an indirect sales channel comprised of a global partner network. Our direct sales force consists of professional sales and pre-sales personnel who typically have many years of experience selling and demonstrating enterprise software solutions. Our distribution channel is predominantly for our Monarch Professional product and consists of a two-tier reselling network in North America and single tier resellers in the rest of the world. Our global partner network brings significant technological and industry expertise, as well as added geographic presence, that enables us to reach customer organizations around the world. These indirect sales channels often help to shorten sales cycles with prospective customers.

Datawatch’s global partner network includes geographic resellers and product-specific resellers. These partners are typically authorized to sell licenses and implement and provide first line support for our software products. Additionally, we work with global, national and local system integrators, implementation partners and referral partners who may sell licenses and provide complementary skills, domain or industry experience, as well as geographic coverage.

Datawatch’s global partner network also includes OEM partners and VAR partners who use our technologies as an embedded or bundled add-on feature in their products and services. Typically, OEM and VAR partners include software companies, SaaS vendors and information providers. More broadly, this category includes any organization seeking to leverage Datawatch products to access and analyze semi-structured and unstructured data for use in an existing or new product or in a service offering. We invest both development and business resources to ensure that Datawatch is optimized and certified for leading technology platforms, allowing our customers to benefit from these expanded solutions with seamless integration.

 
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Datawatch supports its global partner network based on three fundamental principles:

·  
enable partners through sales training, demonstration training, technical support and education;
·  
market with and for partners through lead generation programs, customer marketing and awareness;
·  
and, position and sell Datawatch products with effective sales tools and sales support.

As of September 30, 2012, our global partner network was comprised of more than 100 partners in over 75 countries. Two distribution partners accounted for the following percentages of total revenue for the periods indicated:

   
Percentage of total revenue
   
for the fiscal year ended
   
September 30,
   
2012
 
2011
 
2010
             
Ingram Micro, Inc.
 
4%
 
13%
 
11%
             
Lifeboat Distribution
 
17%
 
15%
 
12%
             

 No other customer accounted for more than 10% of our total revenue in fiscal 2012, 2011 or 2010. In fiscal 2012, we consolidated our use of indirect distribution channels under a single distributor (Lifeboat Distribution) and terminated our arrangement with Ingram Micro, Inc. effective March 2012. 

We offer Lifeboat Distribution the ability to return obsolete versions of our products and slow-moving products for credit. Based on our historical experience relative to products sold to distributors, we believe that our exposure to such returns is minimal. We record a provision for such estimated returns in our financial statements.
 
Our software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. We also offer a 30 day money-back guarantee on our Monarch Professional product sold directly to end-users. To date, we have not experienced any significant product returns under our money-back guarantee. 
 
We focus our marketing efforts on generating qualified sales leads for our direct sales force and our global partners, increasing brand awareness, communicating our positioning in the market and promoting product advantages. We rely on a variety of marketing initiatives including internet-based marketing campaigns, user group meetings, trade shows, our website, industry research, public relations and advertising. In addition, we work closely with a number of our global partners on co-marketing and lead generation initiatives in an effort to broaden our marketing reach.
    
 Our revenues from outside of the U.S. are primarily the result of sales through the direct sales force of our wholly-owned subsidiary, Datawatch International Limited which is located in the U.K. and its subsidiaries which are located in Germany, Singapore and Australia, as well as through international resellers. Such international sales represented approximately 15%, 23% and 25% of our total revenue for fiscal 2012, 2011 and 2010, respectively.   
 
 
OUR RESEARCH AND DEVELOPMENT OPERATIONS
 
We believe that timely development of new products and enhancements to our existing products is essential to maintain strong positions in our markets. We intend to continue to invest significant amounts in research and product development to ensure that our products meet the current and future demands of our markets as well as to take advantage of evolving technology trends. 
 
Our product development efforts are conducted through in-house software development engineers and by external developers. External developers are compensated under contracts based on services provided. We have established long-term relationships with several development engineering firms, providing flexibility, stability and reliability in our development process. 
 
 
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Our product managers work closely with developers, whether independent or in-house, to define product specifications. The initial concept for a product originates from this cooperative effort.  The developer is generally responsible for coding the development project. Our product managers maintain close technical control over the products, giving us the freedom to designate which modifications and enhancements are most important and when they should be implemented. The product managers and their staff work in parallel with the developers to produce printed documentation, on-line help files, tutorials and installation software. In some cases, we may choose to subcontract a portion of this work on a project basis to third-party suppliers under contracts. Our personnel also perform extensive quality assurance testing for all products and coordinate external beta test programs. 
 
Prior to March 30, 2012, we licensed certain intellectual property incorporated by Datawatch in its Monarch, Monarch Data Pump and certain other products from Math Strategies. On March 30, 2012, we acquired this intellectual property from Math Strategies for a purchase price of approximately $8.5 million. The purchase was funded in part through the issuance by Datawatch of a $4.0 million subordinated note and warrants for 185,000 shares of Datawatch common stock to Massachusetts Capital Resource Company and through the borrowing of $1.5 million under a $2.0 million revolving credit facility with Silicon Valley Bank. We believe the purchase of the intellectual property from Math Strategies provides us with the financial, marketing and technological flexibility to best pursue our business strategy going forward. See Notes 2 and 4 to our Consolidated Financial Statements for information about our acquisition of this intellectual property and financing arrangements.
  
Datawatch products have been developed through in-house software development or by offshore software development companies hired under contract. Datawatch maintains source code and full product control for these products, which include Monarch Professional, Datawatch Enterprise Server, Datawatch RMS, Datawatch Report Manager On Demand, Visual QSM, and Visual HD products. Datawatch Report Manager On Demand, Datawatch Enterprise Server, Visual QSM, and Visual HD are trademarks of Datawatch Corporation. 
 
Our total engineering and product development expense was approximately $2,790,000, $2,502,000 and $2,658,000 for fiscal years 2012, 2011 and 2010, respectively. 
 
  
OUR COMPETITION
 
The differentiated technology underlying Datawatch’s Information Optimization software platform helps us compete within the broader, highly competitive, business analytics market. While we believe that there is no single competitor that addresses the full range of our Information Optimization platform, Datawatch faces competition from several companies that are offering, or soon may offer, products that compete with portions or aspects of its software platform.

To date, Datawatch has generally faced competitors in sub-sectors of the broader Information Optimization market, including independent vendors that focus on specific data formats or sources such as machine data, data in content management systems, EDI, XBRL, HTML and PDFs. These competitors include Splunk, Actuate (Xenos), Informatica and Nuance, among others. We also compete with in-house systems that provide one or more capabilities competitive with our products. We believe that we generally compete favorably with respect to these competitors and competitive offerings; however, some of our current competitors and potential competitors have advantages over us, such as:

·  
longer operating histories,
·  
significantly greater financial, technical, marketing or other resources,
·  
stronger brand and business user recognition, and
·  
broader global distribution and presence.

Competition in our industry is likely to intensify as current competitors expand their product lines and as new competitors enter the market.

 

 
 
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OUR EMPLOYEES
 
As of December 10, 2012, we had 124 full-time and 6 contract, temporary or part-time employees, including 48 engaged in marketing and sales; 25 engaged in product consulting, training and technical support; 29 engaged in product management, development and quality assurance; and 22 providing general, administrative, accounting, IT and software production and warehousing functions.
 

OTHER BUSINESS CONSIDERATIONS

Product Protection  
 
We rely on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements, and technical measures to protect our rights in our products. Despite these precautions, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. We believe that, because of the rapid pace of technological change in the software industry, the legal protections for our products are less significant than the knowledge, ability and experience of our employees and developers, the frequency of product enhancements and the timeliness and quality of our support services. We believe that none of our products, trademarks, patents, and other proprietary rights infringes on the proprietary rights of third parties, but there can be no assurance that third parties will not assert infringement claims against us or our developers in the future or that products developed by third parties do not infringe on other parties’ proprietary rights. 
 
Product Production
 
Production of our products involves the duplication of compact disks and the printing of user manuals, packaging and other related materials. High volume compact disk duplication is performed by non-affiliated subcontractors, while low volume compact disk duplication is performed in-house. Printing work is also performed by non-affiliated subcontractors. To date, we have not experienced any material difficulties or delays in production of our software and related documentation and believe that, if necessary, alternative production sources could be secured at a commercially reasonable cost. 
 
Backlog
 
Our software products are generally shipped within three business days of receipt of an order. Accordingly, we do not believe that backlog for our products is a meaningful indicator of future business. Datawatch does maintain a backlog of services commitments primarily related to its Datawatch Enterprise Server, Datawatch Report Manager On Demand and Visual QSM business. While this services backlog will provide future revenue to Datawatch, we believe that it is not a meaningful indicator of future business. 
  
 
Item 1A.  RISK FACTORS 

We do not provide forecasts of our future financial performance. However, from time to time, information provided by us or statements made by our employees may contain “forward looking” information that involves risks and uncertainties. In particular, statements contained in this Annual Report on Form 10-K that are not historical facts (including, but not limited to statements contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part II of this Annual Report on Form 10-K relating to liquidity and capital resources) may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. We caution readers not to place undue reliance on any such forward looking statements, which speak only as of the date they are made. We disclaim 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 our 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. Our 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 below and within this Annual Report on Form 10-K, as well as the accuracy of our internal estimates of revenue and operating expense levels. The following discussion of our risk factors should be read in conjunction with the financial statements contained herein and related notes thereto. Such factors, among others, may have a material adverse effect upon our business, results of operations and financial condition. 
 
 
- 11 -

 
A Weak Global Economy and Softening in the Computer Software Market May Result in Decreased Revenues or Lower Revenue Growth Rates 
 
The profitability of our business depends on the overall demand for computer software and services, particularly in the financial services markets and other markets in which we compete. Tighter credit and negative financial news resulting from the recent worldwide recession and, in the U.S, from the potential combination of federal income tax increases and government spending restrictions that may occur at the end of calendar year 2012 in the absence of Congressional action to delay or offset these actions (commonly referred to as the “fiscal cliff”), may continue to have an adverse affect on the market for computer software and result in significant fluctuations in the value of foreign currencies. If ultimately realized, the fiscal cliff would likely negatively impact global economic activity, including possibly sending the U.S. into a new recession. Because our sales are primarily to major corporate customers, poor economic conditions may soften the demand for computer software and services which may result in decreased revenues, lower revenue growth rates and reduced profitability. In addition, a weak global economy may result in longer sales cycles, reduced, deferred or cancelled orders, or greater than anticipated uncollectible accounts receivables. In a weakened economy, we cannot be assured that we will be able to effectively promote future growth in our software and services revenues or maintain profitability. 
 
Our Dependence on our Principal Products and our Failure to Develop Enhanced or New Products May Have a Material Adverse Effect on our Business, Financial Condition or Results of Operations 
 
In the year ended September 30, 2012, our Information Optimization products accounted for approximately 95% of our total revenue. We are primarily dependent on our Information Optimization products. As a result, any factor adversely affecting sales of any of these products could have a material adverse effect on us. Our future financial performance will depend in part on the successful introduction of new and enhanced versions of these products and development of new versions of these and other products and subsequent customer acceptance of such new and enhanced products. In addition, competitive pressures or other factors may result in significant price erosion that could have a material adverse effect on our business, financial condition, results of operations, or cash flows. 
 
Fluctuations in Quarterly Operating Results Could Have a Material Adverse Effect on our Business, Financial Condition or Results of Operations 
 
Our future operating results could vary substantially from quarter-to-quarter because of uncertainties and/or risks associated with such matters as current economic conditions, technological change, competition, delays in the introduction of new products or product enhancements and general market trends. In addition, as we focus on increasing enterprise sales, the timing of significant orders may cause fluctuations in quarterly operating results. Large enterprise sales arrangements often involve multiple elements and may require more complex accounting than the sales transactions we have entered into in the past, which also makes projecting future operating results more difficult. Historically, we have operated with minimal backlog of orders because our software products are generally shipped as orders are received. As a result, net sales in any quarter are substantially dependent on orders booked and shipped in that quarter. Further, any increases in sales under our subscription sales model or cloud offering could result in decreased revenues over the short term. Because our staffing and operating expenses are based on anticipated revenue levels and a high percentage of our costs are fixed in the short-term, small variations in the timing of revenues can cause significant variations in operating results from quarter-to-quarter. Because of these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. We can give no assurance that we will not experience such variations in operating results in the future or that such variations will not have a material adverse effect on our business, financial condition or results of operations. 
 
 
 
 
 
 
- 12 -

 
The Sales Cycle for our Enterprise Products is Long and Unpredictable, Particularly with Respect to Large Customers, and our Sales Efforts Require Considerable Time and Expense
 
Our operating results may fluctuate, in part, because of the resource intensive nature of our sales efforts, the length and variability of the sales cycle of our enterprise software licensing offerings and the short-term difficulty in adjusting our operating expenses. Our operating results depend in part on sales to large customers and conversions of users that have downloaded the desktop version of our Monarch Professional software into enterprise customers. The length of our sales cycle, from initial evaluation to delivery of and payment for the software license, varies substantially from customer to customer. It is difficult to predict exactly when, or even if, we will make a sale with a potential customer or if a user that has licensed desktop versions of our Monarch Professional software will upgrade to a larger enterprise license. As a result, large individual sales may, in some cases, occur in quarters subsequent to those we anticipate, or not at all. The loss or delay of one or more large transactions in a quarter could impact our operating results for that quarter and any future quarters for which revenue from that transaction is delayed. As a result of these factors, it is difficult for us to forecast our revenues accurately in any quarter. Because a substantial portion of our expenses are relatively fixed in the short-term, our operating results will suffer if revenues fall below our expectations in a particular quarter, which could cause the price of our common stock to decline.

The Market for our Information Optimization Products is Emerging and May Not Grow
 
The market for our Information Optimization products that allow organizations to analyze their businesses at an enterprise level by leveraging structured, unstructured, and semi-structured data is still emerging. It is difficult to predict customer adoption and renewal rates, customer demand for our enterprise software licenses, the size and growth rate of this market, the entry of competitive products or the success of existing competitive products. Any expansion in our market depends on a number of factors, including the cost, performance and perceived value associated with such software licenses. If the market for our enterprise software licenses does not achieve widespread adoption or there is a reduction in demand for software in this market caused by a lack of customer acceptance, technological challenges, competing technologies and products, decreases in corporate spending, weakening economic conditions, or otherwise, it could result in reduced customer orders, early terminations, reduced renewal rates or decreased revenues, any of which would adversely affect our business operations and financial results.

Dependence on New Product Introductions and New Product Delays or Defects Could Have a Material Adverse Effect on our Business 
 
The market for Information Optimization products is newly emerging and evolving rapidly. Growth in our business depends in substantial part on the continuing introduction of new products to address the emerging needs of this market. The length of product life cycles depends in part on end-user demand for new or additional functionality in our products and our ability to update our products to meet such demands. If we fail to accurately anticipate the demand for, or encounter any significant delays in developing or introducing, new products or additional functionality in our products, there could be a material adverse effect on our business. Product life cycles can also be affected by suppliers of operating systems introducing new or changed functionality within their products. Our failure to anticipate the introduction of additional functionality in products developed by such suppliers could have a material adverse effect on our business. In addition, our competitors may introduce products with more features and lower prices than our products. Such increase in competition could adversely affect the life cycles of our products, which in turn could have a material adverse effect on our business. 
 
Software products, whether developed internally or licensed from third parties, may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by us and by current and potential end-users, errors will not be found in new products after commencement of commercial shipments, resulting in loss of or delay in market acceptance. Any failure by us to anticipate or respond adequately to changes in technology and customer preferences, or any significant delays in product development or introduction, could have a material adverse effect on our business. 
 
 
- 13 -

 
The Market Price of our Stock Has Been and May Continue to Be Volatile 
 
As seen recently with the turmoil in the financial markets, and is frequently the case with the stocks of high technology companies, the market price of our common stock has been, and may continue to be, volatile. In addition, insiders presently hold a significant percentage of our stock, and our shares are thinly traded in the public market. Factors such as quarterly fluctuations in results of operations, increased competition, the introduction of new products by us or our competitors, expenses or other difficulties associated with assimilating companies acquired by us, changes in the mix of sales channels, the timing of significant customer orders, and macroeconomic conditions generally, may have a significant impact on the market price of our stock. Even though we do not presently provide forecasts of our future financial performance, any shortfall in revenue or earnings from the levels anticipated by securities analysts or investors could have an immediate and significant adverse effect on the market price of our common stock in any given period. In addition, the stock market has from time to time experienced extreme price and volume fluctuations, which have particularly affected the market price for many high technology companies and which, on occasion, have appeared to be unrelated to the operating performance of such companies. Finally, to maintain our stock listing with NASDAQ, we must be in compliance with NASDAQ Marketplace Rules. If we are not able to maintain compliance with these rules, and if our common stock does not qualify for, or is subsequently delisted from, the NASDAQ Capital Market, investors may have difficulty converting their investment into cash efficiently. The price of our common stock and the ability of holders to sell such stock would be adversely affected. 
 
A Significant Percentage of our Total Revenue is Subject to Risks Associated with International Sales 
 
In the years ended September 30, 2012, 2011 and 2010, international sales accounted for approximately 15%, 23% and 25%, respectively, of our total revenue. We have recently expanded our presence in Europe and in Asia-Pacific, including the opening of an office in Singapore, and we anticipate that international sales will continue to account for a significant percentage of our total revenue. A significant portion of our total revenue will therefore be subject to risks associated with international sales, including further deterioration of international economic conditions, unexpected changes in legal and regulatory requirements, changes in tariffs, currency exchange rates and other barriers, political and economic instability, possible effects of war and acts of terrorism, difficulties in accounts receivable collection, difficulties in managing distributors or representatives, difficulties in staffing and managing international operations, difficulties in protecting our intellectual property overseas, seasonality of sales and potentially adverse foreign tax consequences. 
 
Past and Future Acquisitions may be Difficult to Integrate, Disrupt our Business, Dilute Stockholder Value or Divert Management Attention 
 
Historically, we have acquired certain technology or businesses to supplement and expand our product offerings. In the future, we could acquire additional products, technologies or businesses, or enter into joint venture arrangements, for the purpose of complementing or expanding our business and to address the need to develop new products. Acquisitions involve numerous risks including difficulties in the assimilation of the operations, technologies and products of the acquired companies, the diversion of management’s attention from other business concerns, risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions, and the potential loss of key employees of the acquired company. Achieving and maintaining the anticipated benefits of an acquisition will depend in part upon whether the integration of the companies’ business is accomplished in an efficient and effective manner, and there can be no assurance that this will occur. The successful combination of companies in the high technology industry may be more difficult to accomplish than in other industries. 
 
There may be Limitations on the Effectiveness of our Controls 
 
Our management does not expect that our internal controls will prevent all errors. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and no assurance can be given that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or intentional conduct may occur and not be detected. 
 
 
- 14 -

 
We Face Significant Competition in the Software Industry 
 
The software market is highly competitive and characterized by continual change and improvement in technology. Several of our existing and potential competitors, including Splunk, Actuate (Xenos), Informatica, Nuance and others, have substantially greater financial, marketing and technological resources than we do. No assurance can be given that we will have the resources required to compete successfully in the future. 
 
Our Success is Dependent on Proprietary Software Technology 
 
Our success is dependent upon proprietary software technology. We do not own patents on any such technology and we rely principally on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect our rights to such proprietary technology. Despite such precautions, there can be no assurance that such steps will be adequate to deter misappropriation of such technology. 
 
We May Not be Able to Hire and Retain Highly Skilled Employees, Which Could Affect our Ability to Compete Effectively Because our Business is Technology-Based 
 
Qualified personnel are in great demand throughout the software industry. Our success depends, in large part, upon our ability to attract, train, motivate and retain highly skilled employees, particularly technical personnel and product development and professional services personnel, sales and marketing personnel and other senior personnel. Our failure to attract and retain the highly trained technical personnel that are integral to our product development, professional services and sales and marketing teams may limit the rate at which we can generate sales and develop new products or product enhancements. We have hired a number of key executives during the past two years, including our Chief Executive Officer and key executives in sales and marketing functions. A loss of these personnel or other changes in key management could have a material adverse effect on our business, operating results and financial condition. 
 
Evolving Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses and Continuing Uncertainty 
 
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Sarbanes-Oxley Act of 2002 and related SEC regulations as well as the listing standards of the NASDAQ Stock Market, have created and are continuing to create uncertainty for public companies. We continually evaluate and monitor developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs incurred or the timing of such costs. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we have invested resources to comply with evolving laws, regulations and standards. This investment has and may continue to result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and we may be harmed. 
 
 
 
 
 
 
 
 
- 15 -

 
The Failure of Indirect Distribution Channels Could Have a Material Adverse Effect on our Operating Results 
 
We sell a significant portion of our products through distributors and resellers, none of which are under our direct control. The loss of major distributors or resellers of our products, or a significant decline in their sales, could have a material adverse effect on our operating results. We have terminated our arrangement with Ingram Micro, Inc. effective in March 2012 and we consolidated our use of indirect distribution channels with a single distributor, Lifeboat Distribution, which accounted for 17%, 15% and 12% of our total revenue for fiscal 2012, 2011 and 2010, respectively. Ingram accounted for 4%, 13% and 11% of our total revenue for fiscal 2012, 2011 and 2010, respectively. There can be no assurance that we will be able to attract or retain qualified distributors or resellers or that Lifeboat Distribution or any other distributors or resellers will be able to effectively sell our products, including the volume of products previously sold by Ingram Micro, Inc. We seek to select and retain distributors and resellers on the basis of their business credentials and their ability to add value through expertise in specific vertical markets or application programming expertise. In addition, we may rely on resellers to provide post-sales service and support, and any deficiencies in such service and support could adversely affect our business. 
 
Failure to Maintain an Adequate Sales Returns Reserve Could Have a Material Adverse Effect on our Financial Position and Results of Operations 
 
Revenue from the sale of all our software products (when separately sold) is generally recognized at the time of shipment. We estimate and maintain reserves for potential future product returns from distributors based on our experience and history with our various distributors and resellers as well as by monitoring inventory levels at such companies. While actual returns have historically been within the range estimated by management, future actual results could differ from the reserve for sales returns recorded, and this difference could have a material effect on our financial position and results of operations. 
 
Our Subscription Sales Model for our Enterprise Products Could Result in Decreased or Delayed Revenues and Cash Flows 
 
We sell our enterprise products through the sale of perpetual licenses and through a subscription pricing model. The subscription pricing model allows customers to use our products at a lower initial cost of software acquisition when compared to the more traditional perpetual license sale. Although the subscription sales model is designed to increase the number of enterprise solutions sold and also reduce dependency on short-term sales by building a recurring revenue stream, it introduces increased risks for us primarily associated with the timing of revenue recognition and reduced cash flows. The subscription model delays revenue recognition when compared to the typical perpetual license sale and also, as we allow termination of certain subscriptions with 90 days notice, it could result in decreased revenue for solutions sold under the model if we experience a high percentage of subscription cancellations following the first 12 months of the subscription. Further, as amounts due from customers are invoiced over the life of the subscription, there are delayed cash flows from subscription sales when compared to perpetual license sales. 
 
If our Security Measures are Breached or Other Unauthorized Access to Customer Data is Otherwise Obtained, our Software May be Perceived as not being Secure, Customers May Reduce the Use of or Stop Using our Software, and we May Incur Significant Liabilities
 
Our software may involve the storage and transmission of customer data, and security breaches could result in the loss of this information, litigation, indemnity obligations and other liability. While we have taken steps to protect the confidential information that we have access to, including confidential information we may obtain through our customer support services or customer usage of our products, we do not have the ability to monitor or review the content that our customers store, and therefore, we have no direct control over the substance of that content. Therefore, if customers use our software for the transmission or storage of personally identifiable information and our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise, our reputation could be damaged, our business may suffer, and we could incur significant liability. Because techniques used to obtain unauthorized access or sabotage systems change frequently and generally are not identified until they are launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any or all of these issues could negatively impact our ability to attract new customers and increase engagement by existing customers, cause existing customers to elect to not renew their subscriptions, or subject us to third-party lawsuits, regulatory fines or other action or liability, thereby adversely affecting our financial results.

 
- 16 -

 
We May Require Additional Capital to Grow our Business, and Our Financing Arrangements Expose us to Interest Rate Risk

Our business may require additional capital to operate and expand. We have historically relied upon cash generated from operations and bank credit lines to satisfy our capital needs and finance growth. If we determine in the future to make significant investments in our business, including by acquiring assets or businesses from third parties, we may attempt to raise additional funds by securing additional debt financing or selling equity securities in either the public or the private markets. As the financial markets change and new regulations come into effect, the cost of acquiring financing and the methods of financing may change. We may not be able to obtain additional debt or equity financing on favorable terms, if at all. If we raise additional equity financing, our security holders may experience significant dilution of their ownership interests and the value of shares of our common stock could decline. If we engage in debt financing, we may be required to accept terms that restrict our ability to incur additional indebtedness, force us to maintain specified liquidity or other ratios or restrict our ability to make acquisitions. Our inability to do any of the foregoing could reduce our ability to compete successfully and adversely affect our results of operations. Changes in our credit rating or other market factors may increase our interest expense or other costs of capital, or capital may not be available to us on acceptable terms to fund our needs. Our current credit facilities contain various financial and other covenants that may limit our ability to borrow or limit our flexibility in responding to business opportunities or conditions. These financing instruments involve variable rate debt, thus exposing us to risk of fluctuations in interest rates. Such fluctuations in interest rates could have an adverse effect on our business.

Catastrophic Events May Adversely Affect Our Business 
 
Our company is a highly automated business which relies on its network infrastructure and enterprise applications, internal technology systems and website for development, marketing, operational, support and sales activities. A disruption or failure of these systems in the event of a major storm, earthquake, fire, telecommunications failure, cyber-attack, terrorist attack or other catastrophic event could cause system interruptions, reputational harm, delays in our product development and loss of critical data and could affect our ability to sell and deliver products and services and other critical functions of our business. 
 

Item 1B.  UNRESOLVED STAFF COMMENTS 

Not applicable.
  

Item 2.  PROPERTIES
 
The Company is currently headquartered in 14,683 square feet of leased office space in Chelmsford, Massachusetts pursuant to a sublease agreement executed on June 17, 2011. The sublease expires in June 2016. The aggregate rent for the remaining term of the sublease is approximately $606,000. In addition to rent, the sublease requires the Company to pay certain taxes, insurance and operating costs related to the leased facility based on the Company’s pro-rata share of such costs.  
 
The Company also maintains sales offices in the U.S, and international sales and administrative offices in the United Kingdom, Germany, Singapore and Australia. In addition, the Company maintains a software development and testing facility in the Philippines.
  




 
- 17 -

 
Item 3.  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 4.  MINE SAFETY DISCLOSURES

Not applicable
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
  

 
 
 
 
 
 
 
- 18 -

 
PART II
 
Item 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
 
The Registrant’s common stock is listed and traded on the NASDAQ Capital Market (formerly the NASDAQ SmallCap Market) under the symbol DWCH.  The range of high and low closing prices during each fiscal quarter for the last two fiscal years is set forth below: 
 
For the Year Ended
 
Common Stock
 
September 30, 2012
 
High ($)
 
Low ($)
 
           
4th Quarter
 
20.27
 
11.96
 
3rd Quarter
 
14.85
 
10.80
 
2nd Quarter
 
14.03
 
5.50
 
1st Quarter
 
5.62
 
5.10
 


For the Year Ended
 
Common Stock
 
September 30, 2011
 
High ($)
 
Low ($)
 
           
4th Quarter
 
5.96
 
4.90
 
3rd Quarter
 
5.97
 
4.85
 
2nd Quarter
 
5.59
 
3.08
 
1st Quarter
 
3.59
 
2.71
 

 
There were 75 shareholders of record as of December 4, 2012.  The Company believes that the number of beneficial holders of common stock is approximately 1,900. The last reported sale of the Company’s common stock on December 4, 2012 was at $14.89. 
 
The Company has not paid any cash dividends and it is anticipated that none will be declared in the foreseeable future. The Company intends to retain future earnings, if any, to provide funds for the operation, development and expansion of its business. 
 
The information set forth under the caption “Equity Compensation Plans” appearing in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders for the fiscal year ended September 30, 2012 is incorporated herein by reference.
  

Item 6.   SELECTED CONSOLIDATED FINANCIAL DATA
 
The following table sets forth selected consolidated financial data of the Company for the periods indicated.  The selected consolidated financial data for and as of the end of the years in the five-year period ended September 30, 2012 are derived from the Consolidated Financial Statements of the Company.  The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and notes which appear elsewhere in this Annual Report on Form 10-K. 

 
- 19 -

 
Statements of Operations Data:
                             
Years Ended September 30,
 
2012
   
2011
   
2010
   
2009
   
2008
 
   
(In thousands, except per share data)
 
                               
Revenue
  $ 26,006     $ 17,885     $ 17,674     $ 19,618     $ 23,030  
Costs and Expenses
    24,463       17,818       17,283       24,912       22,531  
Income (Loss) from Operations
    1,543       67       391       (5,294 )     499  
Net Income (Loss) (1)
  $ 1,034     $ 132     $ 380     $ (4,940 )   $ 717  
                                         
Earnings (Loss) per Common Share:
                                       
Basic (1)
  $ 0.17     $ 0.02     $ 0.06     $ (0.83 )   $ 0.12  
Diluted (1)
  $ 0.15     $ 0.02     $ 0.06     $ (0.83 )   $ 0.12  
                                         
 
 
Balance Sheet Data:
                             
September 30,
 
2012
   
2011
   
2010
   
2009
   
2008
 
   
(In thousands)
 
                               
Total Assets
  $ 22,805     $ 13,134     $ 11,487     $ 12,043     $ 18,169  
Working Capital
    4,041       5,423       4,186       2,627       1,130  
Long-term Obligations
    3,448       288       302       482       627  
Shareholders’ Equity
    9,694       6,342       5,679       5,166       10,082  
                                         
                                         
___________________
(1)   Net income (loss) and earnings (loss) per common share for 2009 include the impact of the full impairment of goodwill and   an indefinite lived trademark totaling $6,401,000. See Note 1. Nature of Business and Summary of Significant Accounting Policies,  of Notes to Consolidated Financial Statements in the Company's Form 10-K for the fiscal year ended September 30, 2010.
 

 
Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
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, 201 1 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, 2010

Total 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 than
 
Contractual 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.

 
- 32 -

 
Item 7(A).  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments 
 
At September 30, 2012, 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. International revenues and expenses are generally transacted by the Company’s foreign subsidiaries and are denominated in local currency. Approximately 15%, 23% and 25% of the Company’s revenues for 2012, 2011 and 2010, respectively, were from foreign subsidiaries. In addition, approximately 17%, 19% and 20% of the Company’s operating expenses for fiscal 2012, 2011 and 2010, respectively, were from foreign subsidiaries. 
 
The Company is exposed to foreign currency exchange rate risk inherent in conducting business globally in several currencies, of which the most significant to our operations has historically been the British Pound. 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 foreign currency transaction (losses) gains in the consolidated statements of operations. Foreign currency transaction loss for the fiscal year ended September 30, 2012 was $126,000. Foreign currency transaction gains for the fiscal years ended September 30, 2011 and 2010 were $89,000 and $24,000, respectively. Currently, the Company does not engage in foreign currency hedging activities.
  
 
















 
- 33 -

 
Item 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 
 
The following consolidated financial statements and the related notes thereto of Datawatch Corporation and the Report of Independent Registered Public Accounting Firm thereon are filed as part of this Annual Report on Form 10-K. 

   
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
35
   
CONSOLIDATED FINANCIAL STATEMENTS AS OF SEPTEMBER 30, 2012 AND 2011 AND FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED SEPTEMBER 30, 2012:
 
   
Consolidated Balance Sheets
36
   
Consolidated Statements of Operations
37
   
Consolidated Statements of Shareholders’ Equity and Comprehensive Income
38
   
Consolidated Statements of Cash Flows
39
   
Notes to Consolidated Financial Statements
40

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
- 34 -

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
To the Board of Directors and Shareholders of Datawatch Corporation
Chelmsford, Massachusetts 
 
We have audited the accompanying consolidated balance sheets of Datawatch Corporation and subsidiaries (the “Company”) as of September 30, 2012 and 2011, and the related consolidated statements of operations, shareholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended September 30, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. 
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. 
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Datawatch Corporation and subsidiaries as of September 30, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2012, in conformity with accounting principles generally accepted in the United States of America. 
 
/s/ Marcum LLP 
Marcum LLP 
 
Boston, Massachusetts 
December 21, 2012
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
- 35 -

 
DATAWATCH CORPORATION  
CONSOLIDATED BALANCE SHEETS 
(In thousands, except share and per share amounts) 
 
   
September 30,
 
   
2012
   
2011
 
ASSETS
           
CURRENT ASSETS:
           
Cash and equivalents
  $ 8,722     $ 8,384  
Accounts receivable, less allowance for doubtful accounts and sales returns
    4,391       2,966  
   of $212 in 2012 and $148 in 2011
               
Inventories
    59       49  
Prepaid expenses
    532       528  
Total current assets
    13,704       11,927  
                 
Property and equipment
               
Office furniture and equipment
    1,296       1,232  
Software
    492       477  
Leasehold improvements
    551       509  
      2,339       2,218  
Less accumulated depreciation and amortization
    (2,058 )     (1,948 )
Net property and equipment
    281       270  
                 
Acquired intellectual property, net
    7,745        
Other intangible assets, net
    792       878  
Other long-term assets
    283       59  
Total assets
  $ 22,805     $ 13,134  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
CURRENT LIABILITIES:
               
Line of credit
  $ 900     $  
Accounts payable
    676       879  
Accrued expenses
    1,792       1,802  
Deferred revenue
    6,295       3,823  
Total current liabilities
    9,663       6,504  
                 
LONG-TERM LIABILITIES:
               
Note payable, net of unamortized debt discount of $1,017
    2,983        
Deferred revenue, long-term
    265       113  
Other liabilities
    200       175  
Total long-term liabilities
    3,448       288  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
SHAREHOLDERS’ EQUITY:
               
Common stock, par value $.01; 20,000,000 shares authorized;
    64       62  
   issued, 6,372,465 shares and 6,175,978 shares, respectively;
               
   outstanding, 6,358,219 shares and 6,161,732 shares, respectively
               
Additional paid-in capital
    26,710       24,476  
Accumulated deficit
    (15,824 )     (16,858 )
Accumulated other comprehensive loss
    (1,116 )     (1,198 )
      9,834       6,482  
Less treasury stock, at cost, 14,246 shares
    (140 )     (140 )
Total shareholders’ equity
    9,694       6,342  
                 
Total liabilities and shareholders' equity
  $ 22,805     $ 13,134  
                 
 See notes to consolidated financial statements.
    
 
- 36 -

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

                   
                   
   
Year Ended September 30,
 
   
2012
   
2011
   
2010
 
REVENUE:
                 
Software licenses
  $ 16,800     $ 9,858     $ 9,563  
Maintenance
    7,902       6,219       6,322  
Professional services
    1,304       1,808       1,789  
Total revenue
    26,006       17,885       17,674  
                         
COSTS AND EXPENSES:
                       
Cost of software licenses
    2,270       2,237       2,382  
Cost of maintenance and services
    2,530       2,537       2,893  
Sales and marketing
    12,263       6,268       5,786  
Engineering and product development
    2,790       2,502       2,658  
General and administrative
    4,610       4,274       3,564  
Total costs and expenses
    24,463       17,818       17,283  
                         
INCOME FROM OPERATIONS
    1,543       67       391  
Interest income and other income (expense), net
    (333 )     11       2  
Foreign currency transaction (losses) gains
    (126 )     89       24  
                         
INCOME FROM OPERATIONS BEFORE INCOME TAXES
    1,084       167       417  
Provision for income taxes
    (50 )     (35 )     (37 )
                         
NET INCOME
  $ 1,034     $ 132     $ 380  
                         
Net income per share - basic:
  $ 0.17     $ 0.02     $ 0.06  
Net income per share - diluted:
  $ 0.15     $ 0.02     $ 0.06  
                         
Weighted-average shares outstanding - basic
    6,252       6,039       5,936  
Weighted-average shares outstanding - diluted
    6,730       6,235       6,061  
 
 
 
 
 
 
See notes to consolidated financial statements.
  
 
- 37 -

 
DATAWATCH CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME 
 
Years Ended September 30, 2012, 2011 and 2010 
(In thousands, except share amounts) 
 

                           
Accumulated
                         
               
Additional
         
Other
                         
   
Common Stock
   
Paid-In
   
Accumulated
   
Comprehensive
   
Comprehensive
   
Treasury Stock
       
   
Shares
   
Amount
   
Capital
   
Deficit
   
Loss
   
Income
   
Shares
   
Amount
   
Total
 
                                                       
BALANCE,
                                                     
  OCTOBER 1, 2009
    5,940,085     $ 59     $ 23,634     $ (17,370 )   $ (1,017 )           (14,246 )   $ (140 )   $ 5,166  
  Stock options exercised/
                                                                     
       vesting of restricted
                                                                     
       stock units
    18,152       1                                                     1  
  Share-based compensation
                                                                     
       expense
                    192                                             192  
  Comprehensive income:
                                                                     
  Translation adjustments
                                    (60 )     (60 )                     (60 )
       Net income
                            380               380                       380  
                                                                         
Total comprehensive income
                                          $ 320                          
                                                                         
BALANCE,
                                                                       
  SEPTEMBER 30, 2010
    5,958,237       60       23,826       (16,990 )     (1,077 )             (14,246 )     (140 )     5,679  
  Stock options exercised/
                                                                       
       vesting of restricted
                                                                       
       stock units
    217,741       2       386                                               388  
  Share-based compensation
                                                                       
       expense
                    264                                               264  
  Comprehensive income:
                                                                       
  Translation adjustments
                                    (121 )     (121 )                     (121 )
       Net income
                            132               132                       132  
                                                                         
Total comprehensive income
                                          $ 11                          
                                                                         
BALANCE,
                                                                       
  SEPTEMBER 30, 2011
    6,175,978       62       24,476       (16,858 )     (1,198 )             (14,246 )     (140 )     6,342  
  Stock options exercised/
                                                                       
       vesting of restricted
                                                                       
       stock units
    196,487       2       259                                               261  
  Share-based compensation
                                                                       
       expense
                    879                                               879  
  Fair value of warrants
                    1,096                                               1,096  
  Comprehensive income:
                                                                       
  Translation adjustments
                                    82       82                       82  
       Net income
                            1,034               1,034                       1,034  
                                                                         
Total comprehensive income
                                          $ 1,116                          
                                                                         
BALANCE,