News Column

GUIDEWIRE SOFTWARE, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

June 3, 2014

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and the notes thereto included elsewhere in this document and the Risk Factors included in Item 1A of Part II of this Quarterly Report on Form 10-Q. All information presented herein is based on our fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to our fiscal years ended in July and the associated quarters of those fiscal years. We do not undertake, and specifically disclaim, any obligation to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements except as required by law. Overview We are a leading provider of core system software to the global property and casualty ("P&C") insurance and reinsurance industry. Our solutions serve as the transactional systems-of-record for, and enable the key functions of, a P&C insurance carrier's business: underwriting and policy administration, claims management and billing. Since our inception, our mission has been to empower P&C insurance carriers to transform and improve their businesses by replacing their legacy core systems with our software platform. We derive our revenues from licensing our software applications, providing maintenance support and providing professional services to the extent requested by our customers. Our license revenues are primarily generated through annual license fees that recur during the term of our multi-year contracts. These multi-year contracts have an average term of approximately five years and are renewed on an annual or multi-year basis. In certain cases, when required by a customer, we license our software on a perpetual license basis. In addition, certain of our multi-year term licenses provide the customer with the option to purchase a perpetual license at the end of the initial contract term. We generally price our licenses based on the amount of direct written premiums ("DWP") that will be managed by our solutions. We typically invoice our customers annually in advance and quarterly in certain cases, for both term license and maintenance fees, and we invoice our perpetual license customers either in full at contract signing or on an installment basis and invoice related maintenance fees annually, in advance. To extend our technology leadership position in our market, we intend to continue to focus on product innovation through research and development and aggressively pursue new customers and up-sell additional products within our existing customer base. This will require us to make continued investment in our research and development and sales and marketing functions to capitalize on opportunities for growth. We expect research and development, sales and marketing and general and administrative expenses to continue to increase in absolute dollars for the foreseeable future to support this strategy. Research and development and sales and marketing expenses are also expected to increase as a percentage of revenues in future periods as we focus on expanding our technological leadership. We face a number of risks in the execution of our strategy, including reliance on sales to a relatively small number of large customers, variances in the mix amongst our components of revenues, which could result in lower gross margin from services revenues as compared to license and maintenance revenues, and the overall impact of weakening economic conditions on the insurance industry. We believe that our focus on continued product innovation and customer wins and renewals will support the expansion of our license sales and reduce the impact from weakened economic conditions. We sell our core system software primarily through our direct sales force. Our sales cycle for new customers is typically 12 to 24 months. Product implementations, the primary driver of our services revenues, typically last 6 to 24 months and may take longer. Opportunities, Challenges, & Risks Since August 2010, our license revenues from new orders and subsequent annual and, in some cases, quarterly payments have generally been recognized when payment is due from our customers. Historically, and to a lesser extent during fiscal years 2013, 2012 and 2011, our license revenues from existing orders have been recognized under three methods: under the residual method when payment is due and payable from our customers, under the percentage-of-completion method as we complete customer implementations of our software, or under the zero-gross-margin method as we complete customer implementations of our software. During the three months ended April 30, 2014 and 2013, our license revenues accounted for 39% and 34% of our total revenues, respectively, and our recurring term license revenues accounted for 88% and 78% of our total license revenues, respectively. During the nine months ended April 30, 2014 and 2013, our license revenues accounted for 37% and 36% of our total revenues, respectively, and our recurring term license revenues accounted for 94% and 91% of our total license revenues, respectively. 21



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Our maintenance revenues are generally recognized annually over the committed maintenance term. Our maintenance fees are typically priced as a fixed percentage of the associated license fees and generate lower gross margins than our license revenues. Our maintenance revenues accounted for 13% and 13% of our total revenues during the three months ended April 30, 2014 and 2013, respectively, and 13% and 14% of our total revenues during the nine months ended April 30, 2014 and 2013, respectively. We generally charge services fees on a time and materials basis and revenues are typically recognized upon delivery of our services. In certain offerings sold as fixed fee arrangements, we recognize services revenues on a proportional performance basis as performance obligations are completed by using the ratio of labor hours to date as an input measure compared to total estimated labor hours for the consulting services. We derive our services revenues primarily from implementation services performed for our customers, revenues related to reimbursable travel expenses and training fees. Our services revenues generate lower gross margins than our license and maintenance revenues and accounted for 48% and 53% of our total revenues during the three months ended April 30, 2014 and 2013, respectively. Our services revenues accounted for 50% and 50% of our total revenues during the nine months ended April 30, 2014 and 2013, respectively. We enter into multi-year renewable contracts to license our software. Regardless of contract length, we typically invoice our customers for annual or quarterly amounts at the beginning of the corresponding period. Our deferred revenues consist only of amounts that have been invoiced, but not yet recognized as revenues. As a result, deferred revenues and change in deferred revenues are incomplete measures of the strength of our business and are not necessarily indicative of our future performance. Further, we expect to recognize our current deferred services revenue into income but do not expect significant deferrals of services revenue in future periods. Deferred license and service revenues related to projects under contract accounting as of April 30, 2014 were $1.3 million and $1.9 million, respectively, while deferred license and service revenues related to projects under contract accounting as of July 31, 2013 were $2.2 million and $2.0 million, respectively. Such deferral is in accordance with our Revenue Recognition policy as described in Note 1 to the condensed consolidated financial statements. We have historically experienced seasonal variations in our revenues as a result of increased customer orders in our second and fourth fiscal quarters and subsequent annual fees. We generally see increased orders in our second fiscal quarter, which is the quarter ended January 31, due to customer buying patterns. We also see increased orders in our fourth fiscal quarter due to efforts by our sales team to achieve annual incentives. As a result, a significantly higher percentage of our annual license fees are invoiced and recognized as revenues during those quarters at contract inception or in the subsequent quarter when the annual license payment is due and in subsequent years upon the anniversary of the contract date. We generally expect these seasonal trends to continue in the future, which may cause quarterly fluctuations in our results of operations and certain financial metrics. Our quarterly growth in license revenues may not match up to new orders we receive in a given quarter. This mismatch is primarily due to the following reasons: for the initial year of a multi-year term license, we generally recognize revenues when payment is due and payment may not be due until a subsequent fiscal quarter; we may enter into license agreements with specified terms for product upgrades or functionality, which may require us to delay revenue recognition until the period in which the upgrade or



functionality is

delivered; and



we may enter into license agreements with other contractual terms that

may affect the timing of revenue recognition. Our revenue seasonality may fluctuate versus comparable prior periods or prior quarters within the same fiscal year based upon when new orders are executed in the quarter and the payment terms of each order. Additionally, our revenue may fluctuate if our customers make an early payment or change payment terms during or after the end of the contract term for up-sell of additional products or renewals. Our ability to renew existing contracts for multiple year terms versus annual automatic renewals may impact revenue recognition. We generally charge annual software license fees for our multi-year term licenses and price our licenses based on the amount of direct written premiums ("DWP") that will be managed by our solutions. However, in rare circumstances, our customers desire the ability to purchase our products on a perpetual license basis, resulting in an acceleration of license revenue recognition. Milestone payments in a perpetual license order also cause seasonal variations. Our perpetual license revenues are not consistent from period to period. In addition, a few of our multi-year term licenses provide the customer with the option to purchase a perpetual license at the end of the initial contract term, which we refer to as a perpetual buyout right. The mix of our contract terms for our licenses and the exercise of perpetual buyout rights at the end of the initial contract term by our customers may lead to variability in our results of operations. Increases in perpetual license sales and exercises of perpetual buyout rights by our customers may affect our ability to show consistent growth in license revenues in subsequent periods. Reductions in perpetual licenses in future periods could cause adverse period-to-period comparisons of our financial results. 22



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In addition, because we price our products based on the amount of DWP that will be managed by our solutions, license revenues from each customer may fluctuate up or down based upon insurance policies sold by the customer in the preceding year. If we enter into a new territory, our revenue recognition pattern may change depending on the contractual terms and local laws and regulations. We generated revenues of $82.0 million and $68.3 million in the three months ended April 30, 2014 and 2013, respectively and revenues of $232.0 million and $203.7 million in the nine months ended April 30, 2014 and 2013, respectively. We generate the majority of our revenues in the United States and Canada. Our revenues from outside the United States and Canada as a percentage of total revenues were 30% and 29% in the three months ended April 30, 2014 and 2013, respectively, and 33% and 30% in the nine months ended April 30, 2014 and 2013, respectively. We generated a net loss of $1.4 million and $2.7 million in the three months ended April 30, 2014 and 2013, respectively, and a net loss of $12.9 million and net income of $3.3 million in the nine months ended April 30, 2014 and 2013, respectively. No customer accounted for 10% or more of our revenues for the three and nine months ended April 30, 2014 or 2013. Our ten largest customers accounted for 38% and 39% of our total revenues for the three months ended April 30, 2014 and 2013, respectively, and 37% and 34% of our total revenues for the nine month periods ended April 30, 2014 and 2013, respectively. We count as customers distinct buying entities, which may include multiple national or regional subsidiaries of large, global P&C insurance carriers. Key Business Metrics We use certain key metrics to evaluate and manage our business, including rolling four-quarter recurring revenues from term licenses and maintenance. In addition, we present select GAAP and non-GAAP financial metrics that we use internally to manage the business and that we believe are useful for investors. These metrics include operating cash flow and non-GAAP measures such as Adjusted EBITDA. Four-Quarter Recurring Revenues We measure four-quarter recurring revenues by adding the total term license revenues and maintenance revenues recognized in the preceding four quarters ended in the stated period and excluding perpetual license revenues, revenues from perpetual buyout rights and services revenues. This metric allows us to better understand the trends in our recurring revenues because it typically reduces the variations in any particular quarter caused by seasonality, the effects of the annual invoicing of our term licenses, the effects of differences in timing of payments, and certain effects of contractual provisions that may accelerate or delay revenue recognition in some cases. Our four-quarter recurring revenues for each of the eight periods presented were:



Four quarters ended

4/30/2014 1/31/2014 10/31/2013



7/31/20134/30/20131/31/201310/31/20127/31/2012

(in thousands) Term license revenues $ 125,485$ 115,144$ 110,640$ 112,863$ 95,303$ 92,792$ 83,114$ 74,869 Maintenance revenues 39,836 38,510

37,830 37,561 35,548 34,207 31,802 29,538



Total four-quarter recurring revenues $ 165,321$ 153,654$ 148,470$ 150,424$ 130,851$ 126,999$ 114,916$ 104,407

Adjusted EBITDA We believe Adjusted EBITDA, a non-GAAP measure, is useful, in addition to other financial measures presented in accordance with GAAP, in evaluating our operating performance compared to that of other companies in our industry, as this metric generally eliminates the effects of certain items that may vary for different companies for reasons unrelated to overall operating performance. We believe that: Adjusted EBITDA provides investors and other users of our financial



information consistency and comparability with our past financial

performance, facilitates period-to-period comparisons of operations and

facilitates comparisons with other companies, many of which use similar non-GAAP financial measures to supplement their GAAP results; and it is useful to exclude non-cash charges, such as depreciation and amortization, stock-based compensation and one-time cash or non-cash



charges because the amount of such expenses in any specific period may

not directly correlate to the underlying performance of our business operations and these expenses can vary significantly between periods. 23



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We use Adjusted EBITDA in conjunction with traditional GAAP measures as part of our overall assessment of our performance, including the preparation of our annual operating budget and quarterly forecasts, to evaluate the effectiveness of our business strategies and to communicate with our board of directors regarding our financial performance. Adjusted EBITDA should not be considered as a substitute for other measures of financial performance reported in accordance with GAAP. There are limitations to using non-GAAP financial measures, including that other companies may calculate these measures differently than we do. We compensate for the inherent limitations associated with using Adjusted EBITDA through disclosure of these limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure, net income. The following table provides a reconciliation of net income (loss) to Adjusted EBITDA: Three Months Ended April 30,



Nine Months Ended April 30,

2014 2013 2014 2013 (in thousands) Reconciliation of Adjusted EBITDA: Net income (loss) $ (1,358 )$ (2,670 )$ (12,865 )$ 3,278 Non-GAAP adjustments: Benefit from income taxes (1,435 ) (1,823 ) (9,670 ) (2,366 ) Other expense (income), net (190 ) 268 (372 ) 104 Interest income, net (415 ) (137 ) (919 ) (359 ) Depreciation and amortization 1,770 1,137 4,978 3,182 Total stock-based compensation 13,913 8,272 47,520 28,430 Adjusted EBITDA $ 12,285$ 5,047$ 28,672$ 32,269 Operating Cash Flows We monitor our cash flows from operating activities, or operating cash flows, as a key measure of our overall business performance, which enables us to analyze our financial performance without the effects of certain non-cash items such as depreciation and amortization and stock-based compensation expenses. Additionally, operating cash flows takes into account the impact of changes in deferred revenues, which reflects the receipt of cash payment for products before they are recognized as revenues. Our operating cash flows are significantly impacted by changes in deferred revenues, timing of bonus payments and collections of accounts receivable. As a result, our operating cash flows fluctuate significantly on a quarterly basis. Cash provided by operations was $26.1 million and $8.1 million for the nine months ended April 30, 2014 and 2013, respectively. For a further discussion of our operating cash flows, see "Liquidity and Capital Resources-Cash Flows from Operating Activities." Results of Operations The following tables set forth our results of operations for the periods presented (in thousands, except per share data, and as a percentage of our total revenues) for those periods. The data have been derived from the unaudited Condensed Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q which, in the opinion of our management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations for the interim periods presented. The operating results for any period should not be considered indicative of results for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K filed with the SEC on September 27, 2013. 24



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Table of Contents Three Months Ended April 30, Nine Months Ended April 30, 2014 2013 2014 2013 Revenues: (in thousands) License $ 31,927$ 22,918$ 86,012$ 74,482 Maintenance 10,440 9,110 29,969 27,690 Services 39,668 36,222 116,058 101,567 Total revenues 82,035 68,250 232,039 203,739 Cost of revenues: License 845 139 3,394 436 Maintenance 2,238 2,079 6,192 5,430 Services 34,259 33,774 106,397 89,071 Total cost of revenues 37,342 35,992 115,983 94,937 Gross profit: License 31,082 22,779 82,618 74,046 Maintenance 8,202 7,031 23,777 22,260 Services 5,409 2,448 9,661 12,496 Total gross profit 44,693 32,258 116,056 108,802 Operating expenses: Research and development 20,634 16,854 58,444 47,503 Sales and marketing 17,968 11,915 53,871 36,680 General and administrative 9,489 7,851 27,567 23,962 Total operating expenses 48,091 36,620 139,882 108,145 Income (loss) from operations (3,398 ) (4,362 ) (23,826 ) 657 Interest income, net 415 137 919 359 Other income (expense), net 190 (268 ) 372 (104 ) Income (loss) before benefit from income taxes (2,793 ) (4,493 ) (22,535 ) 912 Benefit from income taxes (1,435 ) (1,823 ) (9,670 ) (2,366 ) Net income (loss) $ (1,358 )$ (2,670 )$ (12,865 )$ 3,278 Three Months Ended April 30, Nine Months Ended April 30, 2014 2013 2014 2013 Revenues: License 39 % 34 % 37 % 36 % Maintenance 13 % 13 % 13 % 14 % Services 48 % 53 % 50 % 50 % Total revenues 100 % 100 % 100 % 100 % Total cost of revenues 46 % 52 % 50 % 47 % Total gross profit 54 % 48 % 50 % 53 % Operating expenses: Research and development 25 % 25 % 25 % 23 % Sales and marketing 22 % 17 % 23 % 18 % General and administrative 12 % 12 % 12 % 12 % Total operating expenses 59 % 54 % 60 % 53 % Income (loss) from operations (5 )% (6 )% (10 )% - % Interest income, net 1 % - % - % 1 % Other income (expense), net - % (1 )% - % - % Income (loss) before benefit from income taxes (4 )% (7 )% (10 )% 1 % Benefit from income taxes (2 )% (3 )% (4 )% (1 )% Net income (loss) (2 )% (4 )% (6 )% 2 % 25



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Comparison of the Three and Nine Months Ended April 30, 2014 and 2013 Revenues Please refer to Note 1 of Notes to Condensed Consolidated Financial Statements for a description of our accounting policy related to revenue recognition. Three Months Ended April 30, 2014 2013 % of total % of total Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) Revenues: License $ 31,927 39 % $ 22,918 34 % $ 9,009 39 % Maintenance 10,440 13 % 9,110 13 % 1,330 15 % Services 39,668 48 % 36,222 53 % 3,446 10 % Total revenues $ 82,035 100 % $ 68,250 100 % $ 13,785 20 % Nine Months Ended April 30, 2014 2013 % of total % of total Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) Revenues: License $ 86,012 37 % $ 74,482 36 % $ 11,530 15 % Maintenance 29,969 13 % 27,690 14 % 2,279 8 % Services 116,058 50 % 101,567 50 % 14,491 14 % Total revenues $ 232,039 100 % $ 203,739 100 % $ 28,300 14 % License Revenues License revenues for the three and nine month periods were primarily driven by ClaimCenter, continued adoption of our PolicyCenter software, adoption of our BillingCenter and an increase in customer purchases of our product suite, and expansion of our international reach. Three Months Ended April 30, 2014 2013 % of license % of license Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) License revenues: Term $ 28,213 88 % $ 17,877 78 % $ 10,336 58 % Perpetual 3,714 12 % 5,041 22 % (1,327 ) (26 )% Total license revenues $ 31,927 100 % $ 22,918 100 % $ 9,009 39 % 26



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Table of Contents Nine Months Ended April 30, 2014 2013 % of license % of license Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) License revenues: Term $ 80,598 94 % $ 67,981 91 % $ 12,617 19 % Perpetual 5,414 6 % 6,501 9 % (1,087 ) (17 )% Total license revenues $ 86,012 100 % $ 74,482 100 % $ 11,530 15 % The $10.3 million increase in term license revenues during the three month period ended April 30, 2014, was primarily driven by $2.8 million of revenues recognized from new orders or expanded orders from existing customers, $7.1 million of revenues recognized due to timing of invoicing and corresponding due dates, early payments made by our customers or other contractual terms that affected license revenue recognition from customer contracts. The $12.6 million increase in term license revenues during the nine month period ended April 30, 2014, was primarily driven by $12.9 million of revenues recognized from new orders or expanded orders from existing customers offset by a net $0.3 million of revenues due to timing of invoicing and corresponding due dates, early payments made by our customers or other contractual terms that affected license revenue recognition from customer contracts. The $1.3 million decrease in perpetual license revenues during the three month period ended April 30, 2014, was primarily driven by new customers' increasingly signing term license agreements. This decrease was net of a $1.0 million increase in revenues for one customer who exercised a perpetual buyout option in the current period. The $1.1 million decrease in perpetual license revenues during the nine month period ended April 30, 2014, was primarily driven by new customers' increasingly signing term license agreements. This decrease was net of a $1.0 million increase in revenues for one customer who exercised a perpetual buyout option in the current period. Maintenance Revenues



The $1.3 million increase in maintenance revenues during the three month period ended April 30, 2014, was primarily driven by new and existing orders.

The $2.3 million increase in maintenance revenues during the nine month period ended April 30, 2014, was primarily driven by new and existing orders.

Services Revenues

The $3.4 million increase in services revenues during three month period ended April 30, 2014, was primarily driven by an additional $2.9 million of revenues related to implementation of our software. Also, an additional $0.5 million in revenues were recognized related to training and reimbursable travel costs. The $14.5 million increase in services revenues during the nine month period ended April 30, 2014, was primarily driven by an additional $13.1 million of revenues related to implementation of our software and $1.4 million of revenues related to training and reimbursable travel costs. This increase is net of $1.9 million of services billings that were deferred due to certain contractual terms and $0.9 million of services revenues were deferred due to specified terms for future product functionality during the nine months ended April 30, 2014. 27



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Table of Contents Deferred Revenues As of April 30, 2014 July 31, 2013 Change Amount Amount ($) (%) (in thousands, except percentages) Deferred revenues: Deferred license revenues $ 24,907$ 14,435$ 10,472 73 % Deferred maintenance revenues 25,157 22,017 3,140 14 % Deferred services revenues 8,234 4,744 3,490 74 % Total deferred revenues $ 58,298$ 41,196$ 17,102 42 % The $10.5 million increase in deferred license revenues compared to the prior year end was primarily driven by $4.7 million of deferred license billings for new deals during nine months ended April 30, 2014, and remaining deferred revenues related to billings on existing orders as of April 30, 2014. The $3.1 million increase in deferred maintenance revenues compared to the prior year end was primarily driven by revenues deferred from new and existing orders during the nine months ended April 30, 2014. This increase reflects the seasonal nature of the billing of maintenance revenues. The $3.5 million increase in deferred services revenues compared to the prior year end was primarily driven by $1.9 million of services billings deferred due to certain contractual terms and $0.9 million of services revenues deferred due to specified terms for future product functionality during the nine months ended April 30, 2014. Included in our deferred license revenues as of April 30, 2014, is $4.0 million of deferred revenue for one customer that is subject to refund in the event of nonperformance of certain project implementation milestones. Our deferred revenues consist only of amounts that have been invoiced, but not yet recognized as revenues. As a result, deferred revenues and change in deferred revenues are incomplete measures of the strength of our business and are not necessarily indicative of our future performance. Cost of Revenues and Gross Profit Three Months Ended April 30, 2014 2013 Change Amount Amount ($) (%) (in thousands, except percentages) Cost of revenues: License $ 845 $ 139 $ 706 508 % Maintenance 2,238 2,079 159 8 % Services 34,259 33,774 485 1 % Total cost of revenues $ 37,342$ 35,992$ 1,350 4 % Includes stock-based compensation of:

Cost of license revenues: $ 41 $ - $

41 Cost of maintenance revenues: 309 313 (4 ) Cost of services revenues: 3,927 3,150 777 Total $ 4,277 $ 3,463$ 814 28



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Table of Contents Nine Months Ended April 30, 2014 2013 Change Amount Amount ($) (%) (in thousands, except percentages) Cost of revenues: License $ 3,394 $ 436 $ 2,958 678 % Maintenance 6,192 5,430 762 14 % Services 106,397 89,071 17,326 19 % Total cost of revenues $ 115,983$ 94,937$ 21,046 22 % Includes stock-based compensation of: Cost of license revenues: 245 - $ 245 Cost of maintenance revenues: 932 914 18 Cost of services revenues: 13,869 9,205 4,664 Total $ 15,046$ 10,119$ 4,927 The $1.4 million increase in cost of revenues during the three month period was primarily driven by an increase of $1.1 million in personnel-related expenses as a result of 9 additional employees hired during the last twelve months primarily to provide implementation services to our customers, a $0.8 million increase in stock-based compensation, and a $0.4 million increase in royalties and amortization of acquired intangible assets, which was offset by a $0.9 million decrease in third-party consultant costs and billable expenses. The $21.0 million increase in cost of revenues during the nine month period was primarily driven by an increase of $8.0 million in personnel-related expenses as a result of 9 additional employees hired during the last twelve months primarily to provide implementation services to our customers, a $4.9 million increase in stock-based compensation, a $4.1 million increase in third-party consultant costs and billable expenses, a $2.0 million increase in royalties and amortization of acquired intangible assets, a $1.2 million increase in operating expenses, and a $0.8 million increase in non-billable travel and professional services. We expect our cost of revenues in future periods to trend in-line with implementation services provided to our customers. Three Months Ended April 30, 2014 2013 Change Amount Margin % Amount Margin % ($) (%) (in thousands, except percentages) Gross profit: License $ 31,082 97 % $ 22,779 99 % $ 8,303 36 % Maintenance 8,202 79 % 7,031 77 % 1,171 17 % Services 5,409 14 % 2,448 7 % 2,961 121 % Total gross profit $ 44,693 55 % $ 32,258 48 % $ 12,435 39 % Nine Months Ended April 30, 2014 2013 Change Amount Margin % Amount Margin % ($) (%) (in thousands, except percentages) Gross profit: License $ 82,618 96 % $ 74,046 99 % $ 8,572 12 % Maintenance 23,777 79 % 22,260 80 % 1,517 7 % Services 9,661 8 % 12,496 12 % (2,835 ) (23 )% Total gross profit $ 116,056 50 % $ 108,802 53 % $ 7,254 7 % 29



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The $12.4 million increase in gross profit during the three month period was primarily due to increases in services and license revenues that were partially offset by increases in corresponding costs of revenues. License margins decreased to 97% in the three month period ended April 30, 2014, from 99% in the three month period ended April 30, 2013, due to amortization of acquired intangibles and royalties owed on third-party licensed technology. Service margin increased to 14% when compared to the three month period ended April 30, 2013, primarily due to increased services revenues, while cost of revenues for services remain flat. Gross margin increased to 55% from 48% for the three month periods ended April 30, 2014 and 2013, respectively, primarily due to the increase in maintenance and service margin, as well as a greater percentage of revenues from services. The $7.3 million increase in gross profit during the nine month period was primarily due to increases in license and services revenues that were partially offset by increases in corresponding costs of revenues. Service margin decreased to 8% in the nine month period ended April 30, 2014, from 12% in the nine month period ended April 30, 2013, primarily due to an increase in cost related to 9 additional employees hired during the last twelve months to support expected growth, as well as increases in stock-based compensation and third-party consultant costs. License margins decreased to 96% in the nine month period ended April 30, 2014, from 99% in the nine month period ended April 30, 2013, due to amortization of acquired intangibles and royalties owed on our acquired technology. Gross margin decreased to 50% from 53% for the nine month periods ended April 30, 2014 and 2013, respectively, primarily due to a higher proportion of revenues being attributed to services, which have lower margins than license and maintenance revenues, as well as a decrease in services and license margins. Operating Expenses Three Months Ended April 30, 2014 2013 % of total % of total Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) Operating expenses: Research and development $ 20,634 25 % $ 16,854 25 % $ 3,780 22 % Sales and marketing 17,968 22 % 11,915 17 % 6,053 51 % General and administrative 9,489 12 % 7,851 12 % 1,638 21 % Total operating expenses $ 48,091 59 % $ 36,620 54 % $ 11,471 31 % Includes stock-based compensation of: Research and development $ 3,075$ 2,056$ 1,019 Sales and marketing 3,440 676 2,764 General and administrative 3,121 2,077 1,044 Total $ 9,636$ 4,809$ 4,827 30



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Table of Contents Nine Months Ended April 30, 2014 2013 % of total % of total Change Amount revenues Amount revenues ($) (%) (in thousands, except percentages) Operating expenses: Research and development $ 58,444 25 % $ 47,503 23 % $ 10,941 23 % Sales and marketing 53,871 23 % 36,680 18 % 17,191 47 % General and administrative 27,567 12 % 23,962 12 % 3,605 15 % Total operating expenses $ 139,882 60 % $ 108,145 53 % $ 31,737 29 % Includes stock-based compensation of: Research and development $ 10,147$ 6,544$ 3,603 Sales and marketing 12,153 4,269 7,884 General and administrative 10,174 7,498 2,676 Total $ 32,474$ 18,311$ 14,163 The $11.5 million increase in operating expenses during the three month period was primarily driven by a $5.0 million increase in personnel-related expenses as a result of 101 additional employees during the last twelve months, a $4.8 million increase in stock-based compensation, a $1.2 million increase in travel and marketing expenses, and $0.5 million increase in other operational expenses. The $31.7 million increase in operating expenses during the nine month period was primarily driven by a $14.6 million increase in personnel-related expenses as a result of 101 additional employees during the last twelve months, a $14.2 million increase in stock-based compensation, a $1.5 million increase in travel and marketing expenses, and $1.4 million increase in other operational expenses.



We expect all of our operating expense line items to increase in absolute dollars in future periods to support our future growth strategy.

Research and Development

The $3.8 million increase in research and development expenses during the three month period was primarily due to an increase of $1.7 million in personnel-related expenses as a result of 34 additional employees during the last twelve months to support our continued development of new products and services and product improvements, a $1.1 million increase in other operational expenses, and a $1.0 million increase in stock-based compensation. The $10.9 million increase in research and development expenses during the nine month period was primarily due to an increase of $5.5 million in personnel-related expenses as a result of 34 additional employees during the last twelve months to support our continued development of new products and services and product improvements, a $3.6 million increase in stock-based compensation, a $1.3 million increase in other operational expenses, and a $0.5 million increase in travel and marketing expenses.



Sales and Marketing

The $6.1 million increase in sales and marketing expenses during the three month period was primarily due to a $2.8 million increase in stock-based compensation, an increase of $2.0 million in personnel-related expenses as a result of 46 additional employees during the last twelve months to support our sales growth and marketing new products and services, a $0.8 million increase in employee travel costs and marketing programs, and a $0.5 million increase in other operational expenses. The $17.2 million increase in sales and marketing expenses during the nine month period was primarily due to a $7.9 million increase in stock-based compensation, an increase of $6.0 million in personnel-related expenses as a result of 46 31



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additional employees during the last twelve months to support our sales growth and marketing new products and services, a $1.9 million increase in employee travel costs and marketing programs, and a $1.4 million increase in other operational expenses.



General and Administrative

The $1.6 million increase in general and administrative expenses during the three month period was primarily due to a $1.2 million increase in personnel-related expenses as a result of 21 additional employees during the last twelve months to support investment in our infrastructure and general administrative functions, and a $1.0 million increase in stock-based compensation, offset by a decrease of $0.6 million in other operational expenses.

The $3.6 million increase in general and administrative expenses during the nine month period was primarily due to a $3.1 million increase in personnel-related expenses as a result of 21 additional employees during the last twelve months to support investment in our infrastructure and general administrative functions, and a $2.7 million increase in stock-based compensation, offset by a decrease of $0.9 million in professional services costs, including legal and consultant expenses, and a decrease of $1.3 million in other operational expenses. Other Income (Expense) Three Months Ended April 30, 2014 2013 Change Amount Amount ($) (%) (in thousands, except percentages) Interest income, net $ 415$ 137$ 278 * Other income (expense), net 190 (268 ) 458 * Total $ 605$ (131 )$ 736 * * Not meaningful Nine Months Ended April 30, 2014 2013 Change Amount Amount ($) (%) (in thousands, except percentages) Interest income, net $ 919 $ 359$ 560 * Other income (expense), net 372 (104 ) 476 * Total $ 1,291 $ 255$ 1,036 * * Not meaningful Interest Income, Net Interest income increased $0.3 million and $0.6 million during the three and nine month periods ended April 30, 2014, primarily due to higher interest income on our cash, cash equivalents, and investments due to higher balances.



Other Income (Expense), Net

Other income remained insignificant for the three and nine month periods ended April 30, 2014, when compared to the three and nine month periods ended April 30, 2013.

Provision for (Benefit from) Income Taxes

We recognized an income tax benefit of $1.4 million and $9.7 million for the three and nine month periods ended April 30, 2014, respectively, and an income tax benefit of $1.8 million and $2.4 million for the three and nine month periods ended April 30, 2013, respectively. The decrease in tax benefit recognized in the three month period is primarily due to an 32



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increase in profitability in the current period. The increase in tax benefit recognized in the nine month period is primarily due to a decrease in profitability in the nine month period. Our effective income tax rate of 51.4% and 42.9% for the three and nine month periods ended April 30, 2014, respectively, increased compared to the three and nine month periods ended April 30, 2013 of 40.6% and (259.4)%, respectively, due to a tax benefit on a projected worldwide pretax loss for the three and nine month periods ended April 30, 2014, as compared to the tax benefit on a projected worldwide pretax income for the three and nine month periods ended April 30, 2013, the benefit from permanent differences related to stock-based compensation, the impact of state income taxes, and the tax rate differences between the United States and foreign countries, and tax credits. Liquidity and Capital Resources On October 28, 2013, we received proceeds of approximately $389.9 million from our follow-on offering of common stock, net of underwriters' discounts and commissions, but before deduction of offering costs of approximately $0.4 million payable by the Company. Cash flows provided by operating activities were $26.1 million and $8.1 million during the nine months ended April 30, 2014 and 2013, respectively. We had capital expenditures of $3.7 million and $7.1 million for the nine months ended April 30, 2014 and 2013, respectively. Our capital expenditures consisted of purchases of property and equipment, primarily consisting of computer hardware, software and leasehold improvements. Additionally, cash paid for employee withholding taxes on RSU awards vested was $25.7 million and $14.7 million during the nine months ended April 30, 2014 and 2013, respectively. As of April 30, 2014 and July 31, 2013, we had $600.1 million and $207.7 million of cash, cash equivalents and investments, respectively, and working capital of $414.7 million and $135.3 million, respectively. Our cash flows from operations are significantly impacted by timing of revenues, bonus payments and collections of accounts receivable, as well as by changes in deferred taxes. We expect that we will continue to generate positive cash flows from operations on an annual basis, although this may fluctuate significantly on a quarterly basis. In particular, we typically use more cash during the first fiscal quarter ended October 31, as we generally pay cash bonuses to our employees for the prior fiscal year during that period and pay seasonally higher sales commissions from increased orders in our fourth fiscal quarter. As such, we believe that our existing cash and cash equivalents and sources of liquidity will be sufficient to fund our operations for at least the next 12 months. Our long-term capital requirements will depend on many factors, including our rate of revenues growth, the expansion of our sales and marketing activities and the timing and extent of our spending to support our research and development efforts and expansion into other markets. We may also seek to invest in, or acquire complementary businesses, applications or technologies for which we may need to raise additional funds through public or private equity or debt financing. Additional funds may not be available on terms favorable to us or at all. As of April 30, 2014, approximately $14.1 million of our cash and cash equivalents were domiciled in foreign tax jurisdictions. While we have no plans to repatriate these funds to the United States in the short term, if we choose to do so, we would be required to accrue and pay additional taxes on any portion of the repatriation where no United States income tax had been previously provided. Cash Flows The following summary of cash flows for the periods indicated has been derived from our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q: Nine Months Ended April 30, 2014 2013 (in thousands) Net cash provided by operating activities $ 26,053$ 8,112 Net cash used in investing activities (318,785 ) (116,798 ) Net cash provided by (used in) financing activities 371,739



(6,408 )

Cash Flows from Operating Activities Cash flows provided by operating activities increased $17.9 million for the nine month period ended April 30, 2014 when compared to the comparable period ended April 30, 2013, primarily due to current year revenue deferrals where the prior year included significant release from deferrals upon attainment of revenue recognition criteria and a $19.1 million increase in 33



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stock-based compensation due to increases in stock prices and number of awards granted. These increases were partially offset by a decrease in net income of $16.1 million and an increase in deferred tax assets which was $5.9 million greater than the increase in the comparable period of the prior year primarily due to the increase in stock-based compensation. Additionally, accounts receivable increased $1.9 million more in the current period than in the comparable period of the prior year due primarily to an increase in billings. Cash Flows from Investing Activities Our investing activities consist primarily of investment of excess cash and cash equivalents into short-term and long-term investments, as well as capital expenditures to purchase property and equipment and changes in our restricted cash. Cash used in investing activities increased $202.0 million for the nine month period ended April 30, 2014 when compared to the comparable period ended April 30, 2013, primarily due to the investment of excess cash into available-for-sale securities from our stock issuance in October 2013, as seen in increased net purchases of available-for-sale securities. The prior year included the release of restricted cash related to secured lines of credit. This decrease was partially offset by a $3.4 million decrease in capital expenditures compared to the comparable period of the prior year, as the prior year included payments for our corporate headquarters move. Cash Flows from Financing Activities Cash flows from financing activities increased by $378.1 million for the nine month period ended April 30, 2014 when compared to the comparable period ended April 30, 2013. During the three months ended October 31, 2013, we received $389.9 million in net proceeds from our follow-on offering of common stock, after deducting underwriters' discounts and commissions. These proceeds were offset by a $10.9 million increase in taxes remitted related to the vesting of RSUs held by employees. Additionally, proceeds from stock options exercises decreased by $0.6 million as we have granted more RSUs than stock options in recent years to employees. Application of Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP"). Accounting policies, methods and estimates are an integral part of the preparation of consolidated financial statements in accordance with U.S. GAAP and, in part, are based upon management's current judgments. Those judgments are normally based on knowledge and experience with regard to past and current events and assumptions about future events. Certain accounting policies, methods and estimates are particularly sensitive because of their significance to the consolidated financial statements and because of the possibility that future events affecting them may differ markedly from management's current judgments. While there are a number of accounting policies, methods and estimates affecting our consolidated financial statements, areas that are particularly significant include: Revenue recognition policies;



Stock-based compensation; and

Income taxes.

There were no significant changes in our critical accounting policies and estimates during the nine months ended April 30, 2014. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K filed on September 27, 2013 for a more complete discussion of our critical accounting policies and estimates. Contractual Obligations Our primary contractual obligations are from operating leases for office space and letters of credit related to those leases. See Note 5 to the Condensed Consolidated Financial Statements for a discussion of our lease commitments and letters of credit. Other than the lease commitments and letters of credit discussed in Note 5 to the Condensed Consolidated Financial Statements, we do not have commercial commitments under lines of credit, standby repurchase obligations or other such debt arrangements. We do not have any material non-cancellable purchase commitments as of April 30, 2014. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements or transactions with unconsolidated limited purpose entities, nor do we have any undisclosed material transactions or commitments involving related persons or entities. 34



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Anticipated Cash Flows We expect to incur significant operating costs, particularly related to services delivery costs, sales and marketing, and research and development for the foreseeable future in order to execute our business plan. We anticipate that such operating costs, as well as planned capital expenditures will constitute a material use of our cash resources. As a result, our net cash flows will depend heavily on the level of future sales, changes in deferred revenues and our ability to manage infrastructure costs. ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Sensitivity Our exposure to market risk for changes in interest rates relates primarily to our cash, cash equivalents and short-term and long-term investments as of April 30, 2014 and July 31, 2013. Our cash, cash equivalents and short-term and long-term investments as of April 30, 2014 were $600.1 million and consisted primarily of cash, money market funds, commercial paper, agency debt securities, corporate bonds, U.S. government bonds and municipal debt securities with maturities of up to two years from the date of purchase. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of the interest rates in the United States. However, because of the short-term nature of our interest bearing securities, a 10% change in market interest rates would not be expected to have a material impact on our consolidated financial condition or results of operations. Foreign Currency Exchange Risk Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the exchange rates for the Canadian dollar, Australian dollar, EU Euro, British pound, and Japanese yen. The volatility of exchange rates depends on many factors that we cannot forecast with reliable accuracy. We believe our operating activities act as a natural hedge for a substantial portion of our foreign currency exposure because we typically collect revenues and incur costs in the currency in the location in which we provide our application. Although we have experienced and will continue to experience fluctuations in our net income as a result of transaction gains (losses) related to transactions denominated in currencies other than the U.S. dollar, we believe that a 10% change in foreign exchange rates would not have a material impact on our results of operations. To date, we have entered into one foreign currency hedging contract, but may consider entering into more such contracts in the future. As our international operations grow, we will continue to reassess our approach to manage our risk relating to fluctuations in currency rates. Fair Value of Financial Instruments We do not have material exposure to market risk with respect to investments in financial instruments, as our investments consist primarily of highly liquid investments purchased with a remaining maturity of two years or less. We do not use derivative financial instruments for speculative or trading purposes. However, this does not preclude our adoption of specific hedging strategies in the future.


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