filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) includes the following: a business overview that provides a high-level summary of our strategies and initiatives, financial results and bookings trends that affect our business; a more detailed analysis of our results of operations; our liquidity and capital resources, which discusses key aspects of our statements of cash flows, changes in our balance sheets and our financial commitments; and a summary of our critical accounting policies and estimates we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Our MD&A should be read in conjunction with Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ from those referred to herein due to a number of factors, including but not limited to risks described in Item 1A, Risk Factors, in this Annual Report on Form 10-K.
BUSINESS OVERVIEW
Strategies and Initiatives
During fiscal 2018, our growth initiatives continued to generate significant free cash flow. We utilized our cash to enhance stockholder value through investments in long-term growth initiatives and our stock repurchase programs.
We continued to transform our business from on-premises to recurring revenue associated with our cloud-based solutions in our Applications and Decision Management Software segments. Our continued product innovation provides growth opportunities with customers that can benefit from the affordability and simplicity of these solutions. The majority of our software solutions are available through the FICO® Analytic Cloud, and starting fiscal 2017 we added AWS as our primary cloud infrastructure provider. We have migrated several core applications, including the Decision Management Suite, to AWS and will migrate additional applications over the next couple of years. Our cloud bookings accounted for 35% and 24% of our total bookings during fiscal 2018 and 2017, respectively, directly demonstrating the willingness among our customers to engage our cloud-based solutions.
For our Scores segment, our industry leading business-to-business FICO® Scores has achieved a multi-year expansion in the growing U.S. consumer market. We have launched numerous new FICO® Score based products, and continue to grow our partnership with Experian, a leading global information services provider. This partnership provides consumers the FICO® Score that lenders most commonly use in evaluating credit when determining applicant eligibility for new credit cards, car loans, mortgages or other lines of credit and can be accessed through Experian.com. The FICO® Score Open Access program launched in 2014, which allows our participating clients to provide their customers with a free FICO® Score along with content to help them understand the FICO® Score their lender uses, has more than 310 million consumer accounts with access to their free FICO® Scores. During fiscal 2017, we announced the FICO Financial Inclusion Initiative, a global effort to increase access to affordable credit for consumers and businesses with limited or no credit history, through the use of alternative data. We continue to pursue additional partners to distribute FICO® Scores with their product offerings sold directly to consumers. In addition, we are pursuing opportunities to make FICO® Scores available to third-parties for affinity, white-labeled programs to further penetrate and expand the markets where our scores are available.
We continue to enhance stockholder value by returning cash to stockholders through our stock repurchase program. During fiscal 2018, we repurchased approximately 1.9 million shares at a total repurchase price of $336.9 million. As of September 30, 2018, we had $199.3 million remaining under our current stock repurchase program.
Overview of Financial Results
Total revenues for fiscal 2018 were $1.03 billion, an increase of 11% from $932.2 million in fiscal 2017. We continue to drive growth in our Scores segment. Scores revenue increased 29% to $342.6 million in fiscal 2018 from $266.4 million in fiscal 2017, and Scores operating income increased 32% to $279.2 million in fiscal 2018 from $211.9 million in fiscal 2017. For our Applications and Decision Management Software segments, our cloud business continues to grow both in the absolute dollar value and as a percentage of revenues as we pursue our cloud-first strategy. During fiscal 2018, cloud revenues accounted for $241.5 million, or 35% of non-Scores revenues, compared to $202.7 million, or 30% during fiscal 2017.
We derive a significant portion of revenues internationally, and 34% and 36% of total consolidated revenues were derived from clients outside the U.S. during fiscal 2018 and 2017, respectively. A significant portion of our revenues are derived from the sale of products and services within the banking (including consumer credit) industry, and 86% and 74% of our revenues were derived from within this industry during fiscal 2018 and 2017, respectively. In addition, we derive a significant share of revenues from transactional or unit-based software license fees, transactional fees derived under credit scoring, data processing, data management and SaaS subscription services arrangements, and annual software maintenance fees. Arrangements with transactional or unit-based pricing accounted for 74% and 70% of our revenues during fiscal 2018 and 2017, respectively. Revenue fluctuations in our business are primarily driven by changes in the transactional volume and license fees.
Operating income for fiscal 2018 was $206.4 million, an increase of 16% from $177.2 million in fiscal 2017. Operating margin was 20% and 19% for fiscal 2018 and 2017, respectively. Net income increased 11% to $142.4 million in fiscal 2018 from $128.3 million in fiscal 2017 primarily due to an increase in operating income, partially offset by the income tax expense related to enactment of the Tax Cuts and Jobs Act. Diluted earnings per share for fiscal 2018 was $4.57, an increase of 15% from $3.98 in fiscal 2017.
Bookings
Management regards the volume of bookings achieved as an important indicator of future revenues, but they are not comparable to nor a substitute for an analysis of our revenues. Bookings represent contracts signed in the current reporting period that generate current and future revenue streams. We estimate bookings as of the end of the period in which a contract is signed and initial booking estimates are not updated in future periods for changes between estimated and actual results. Our calculations have varying degrees of certainty depending on the revenue type and individual contract terms. They are subject to a number of risks and uncertainties concerning timing and contingencies affecting product delivery and performance, and estimates consider contract terms, knowledge of the marketplace and experience with our customers, among other factors. Actual revenue and the timing thereof could differ materially from our initial estimates.
Although many of our contracts contain non-cancelable terms, most of our bookings are transactional or service related that depend upon estimates such as volume of transactions, number of active accounts, or number of hours incurred. Since these estimates cannot be considered fixed or firm, we do not believe it is appropriate to characterize bookings as backlog. The following paragraphs discuss the key assumptions used to calculate bookings and the susceptibility of these assumptions to variability for each revenue type.
Transactional and Maintenance Bookings
We calculate transactional bookings as the total estimated volume of transactions or number of accounts under contract, multiplied by the contractual rate. Transactional contracts generally span multiple years and require estimates of future transaction volumes or number of active accounts. We develop estimates from discussions with our customers and examinations of historical data from similar products and customer arrangements. Differences between estimated bookings and actual results occur due to variability in the volume of transactions or number of active accounts estimated. This variability is primarily caused by the economic trends in our customers’ industries; individual performance of our customers relative to their competitors; and regulatory and other factors that affect the business environment in which our customers operate.
We calculate maintenance bookings directly from the terms stated in the contract.
Professional Services Bookings
We calculate professional services bookings as the estimated number of hours to complete a project multiplied by the rate per hour. We estimate the number of hours based on our understanding of the project scope, conversations with customer personnel and our experience in estimating professional services projects. Estimated bookings may differ from actual results primarily due to differences in the actual number of hours incurred.
License Bookings
Licenses are sold on a perpetual or term basis and bookings generally equal the fixed amount stated in the contract.
Bookings Trend Analysis
| Bookings | Bookings Yield (1) | Number of Bookings over $1 Million | Weighted- Average Term (2) | |||||||||
| (In millions) | (months) | |||||||||||
| Quarter ended September 30, 2018 | $ | 133.5 | 11 | % | 24 | 31 | ||||||
| Quarter ended September 30, 2017 | $ | 145.9 | 16 | % | 32 | 29 | ||||||
| Year ended September 30, 2018 | $ | 437.3 | 29 | % | 80 | NM(a) | ||||||
| Year ended September 30, 2017 | $ | 429.0 | 36 | % | 88 | NM(a) |
| (1) | Bookings yield represents the percentage of revenue recognized from bookings for the periods indicated. |
| (2) | Weighted-average term of bookings measures the average term over which bookings are expected to be recognized as revenue. |
| (a) | NM - Measure is not meaningful as our estimate of bookings is as of the end of the period in which a contract is signed, and we do not update our initial booking estimates in future periods for changes between estimated and actual results. |
Transactional and maintenance bookings were 46% and 41% of total bookings for the years ended September 30, 2018 and 2017, respectively. Professional services bookings were 43% and 43% of total bookings for the years ended September 30, 2018 and 2017, respectively. License bookings were 11% and 16% of total bookings for the years ended September 30, 2018 and 2017, respectively.
RESULTS OF OPERATIONS
We are organized into the following three reportable segments: Applications, Scores and Decision Management Software. Although we sell solutions and services into a large number of end user product and industry markets, our reportable business segments reflect the primary method in which management organizes and evaluates internal financial information to make operating decisions and assess performance. Segment revenues, operating income, and related financial information, including geographic information, for the years ended September 30, 2018, 2017 and 2016 are set forth in Note 16 to the accompanying consolidated financial statements.
Revenues
The following tables set forth certain summary information on a segment basis related to our revenues for fiscal 2018, 2017 and 2016:
| Revenues Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| Segment | 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | ||||||||||||||||||
| (In thousands) | (In thousands) | ||||||||||||||||||||||||
| Applications | $ | 585,571 | $ | 553,167 | $ | 532,642 | $ | 32,404 | $ | 20,525 | 6 | % | 4 | % | |||||||||||
| Scores | 342,648 | 266,354 | 241,059 | 76,294 | 25,295 | 29 | % | 10 | % | ||||||||||||||||
| Decision Management Software | 104,256 | 112,648 | 107,655 | (8,392 | ) | 4,993 | (7 | )% | 5 | % | |||||||||||||||
| Total | $ | 1,032,475 | $ | 932,169 | $ | 881,356 | 100,306 | 50,813 | 11 | % | 6 | % |
| Percentage of Revenues Year Ended September 30, | ||||||||
| Segment | 2018 | 2017 | 2016 | |||||
| Applications | 57 | % | 59 | % | 61 | % | ||
| Scores | 33 | % | 29 | % | 27 | % | ||
| Decision Management Software | 10 | % | 12 | % | 12 | % | ||
| Total | 100 | % | 100 | % | 100 | % |
Applications
| Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | |||||||||||||||||||
| (In thousands) | (In thousands) | ||||||||||||||||||||||||
| Transactional and maintenance | $ | 381,109 | $ | 348,861 | $ | 328,472 | $ | 32,248 | $ | 20,389 | 9 | % | 6 | % | |||||||||||
| Professional services | 142,908 | 141,857 | 138,775 | 1,051 | 3,082 | 1 | % | 2 | % | ||||||||||||||||
| License | 61,554 | 62,449 | 65,395 | (895 | ) | (2,946 | ) | (1 | )% | (5 | )% | ||||||||||||||
| Total | $ | 585,571 | $ | 553,167 | $ | 532,642 | 32,404 | 20,525 | 6 | % | 4 | % |
Applications segment revenues increased $32.4 million in fiscal 2018 from 2017 primarily due to an $11.2 million increase in our customer communication services, a $9.4 million increase in our originations solutions, a $6.0 million increase in our compliance solutions, and a $4.4 million increase in our customer management solutions. The increase in customer communication services was primarily attributable to an increase in transactional revenue as a result of our continued growth in the mobile communication market. The increase in originations solutions was primarily attributable to an increase in transactional and services revenues from our SaaS products. The increase in compliance solutions was attributable to an increase in all revenue types. The increase in customer management solutions was primarily attributable to an increase in license and transactional revenues.
Applications segment revenues increased $20.5 million in fiscal 2017 from 2016 primarily due to a $10.9 million increase in our originations solutions and a $10.5 million increase in our customer communication services. The increase in originations solutions was primarily attributable to an increase in services and transactional revenues from our SaaS products. The increase in customer communication services was primarily attributable to an increase in transactional revenue as a result of our continued growth in the mobile communication market.
Scores
| Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | |||||||||||||||||||
| (In thousands) | (In thousands) | ||||||||||||||||||||||||
| Transactional and maintenance | $ | 337,530 | $ | 259,780 | $ | 233,655 | $ | 77,750 | $ | 26,125 | 30 | % | 11 | % | |||||||||||
| Professional services | 1,751 | 2,849 | 4,185 | (1,098 | ) | (1,336 | ) | (39 | )% | (32 | )% | ||||||||||||||
| License | 3,367 | 3,725 | 3,219 | (358 | ) | 506 | (10 | )% | 16 | % | |||||||||||||||
| Total | $ | 342,648 | $ | 266,354 | $ | 241,059 | 76,294 | 25,295 | 29 | % | 10 | % |
Scores segment revenues increased $76.3 million in fiscal 2018 from 2017 due to an increase of $60.8 million in our business-to-business scores revenue and $15.4 million in our business-to-consumer services revenue. The increase in business-to-business scores was primarily attributable to a $48.1 million increase in transactional scores in originations, primarily driven by a higher unit price in mortgage activities; in addition, transactional scores in account management and prescreen increased $13.1 million driven by higher transactional volume. The increase in business-to-consumer services was primarily attributable to an increase in royalties derived from scores sold indirectly to consumers through credit reporting agencies.
Scores segment revenues increased $25.3 million in fiscal 2017 from 2016 due to a $14.2 million increase in our business-to-business scores revenues and an $11.1 million increase in our business-to-consumer services revenue. The increase in business-to-business scores was primarily attributable to an increase in our transactional scores driven by new originations, prescreen and account management. The increase in business-to-consumer services was primarily attributable to an increase in royalties derived from scores sold indirectly to consumers through credit reporting agencies.
During fiscal 2018, 2017 and 2016, revenues generated from our agreements with Experian accounted for 11%, 9% and 8%, respectively, of our total revenues, and revenues generated from our agreements with Equifax and TransUnion together accounted for 14%, 11% and 11%, respectively, of our total revenues. Revenues from these customers included amounts recorded in our other segments.
Decision Management Software
| Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | |||||||||||||||||||
| (In thousands) | (In thousands) | ||||||||||||||||||||||||
| Transactional and maintenance | $ | 47,420 | $ | 44,019 | $ | 43,792 | $ | 3,401 | $ | 227 | 8 | % | 1 | % | |||||||||||
| Professional services | 32,145 | 34,863 | 26,778 | (2,718 | ) | 8,085 | (8 | )% | 30 | % | |||||||||||||||
| License | 24,691 | 33,766 | 37,085 | (9,075 | ) | (3,319 | ) | (27 | )% | (9 | )% | ||||||||||||||
| Total | $ | 104,256 | $ | 112,648 | $ | 107,655 | (8,392 | ) | 4,993 | (7 | )% | 5 | % |
Decision Management Software segment revenues decreased $8.4 million in fiscal 2018 from 2017 primarily attributable to a decrease in license revenue related to our FICO® Blaze Advisor®.
Decision Management Software segment revenues increased $5.0 million in fiscal 2017 from 2016 primarily attributable to an increase in services revenue related to our FICO® Decision Optimizer, partially offset by a decrease in license revenue related to our FICO® Blaze Advisor®.
Operating Expenses and Other Income (Expense), Net
The following tables set forth certain summary information related to our consolidated statements of income and comprehensive income for the fiscal 2018, 2017 and 2016:
| Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | |||||||||||||||||||
| (In thousands, except employees) | (In thousands, except employees) | ||||||||||||||||||||||||
| Revenues | $ | 1,032,475 | $ | 932,169 | $ | 881,356 | $ | 100,306 | $ | 50,813 | 11 | % | 6 | % | |||||||||||
| Operating expenses: | |||||||||||||||||||||||||
| Cost of revenues | 310,699 | 287,123 | 265,173 | 23,576 | 21,950 | 8 | % | 8 | % | ||||||||||||||||
| Research and development | 128,383 | 110,870 | 103,669 | 17,513 | 7,201 | 16 | % | 7 | % | ||||||||||||||||
| Selling, general and administrative | 380,362 | 339,796 | 328,940 | 40,566 | 10,856 | 12 | % | 3 | % | ||||||||||||||||
| Amortization of intangible assets | 6,594 | 12,709 | 13,982 | (6,115 | ) | (1,273 | ) | (48 | )% | (9 | )% | ||||||||||||||
| Restructuring and acquisition-related | — | 4,471 | — | (4,471 | ) | 4,471 | (100 | )% | — | % | |||||||||||||||
| Total operating expenses | 826,038 | 754,969 | 711,764 | 71,069 | 43,205 | 9 | % | 6 | % | ||||||||||||||||
| Operating income | 206,437 | 177,200 | 169,592 | 29,237 | 7,608 | 16 | % | 4 | % | ||||||||||||||||
| Interest expense, net | (31,311 | ) | (25,790 | ) | (26,633 | ) | (5,521 | ) | 843 | 21 | % | (3 | )% | ||||||||||||
| Other income (expense), net | 12,884 | (86 | ) | 1,610 | 12,970 | (1,696 | ) | (15,081 | )% | (105 | )% | ||||||||||||||
| Income before income taxes | 188,010 | 151,324 | 144,569 | 36,686 | 6,755 | 24 | % | 5 | % | ||||||||||||||||
| Provision for income taxes | 45,595 | 23,068 | 35,121 | 22,527 | (12,053 | ) | 98 | % | (34 | )% | |||||||||||||||
| Net income | $ | 142,415 | $ | 128,256 | $ | 109,448 | 14,159 | 18,808 | 11 | % | 17 | % | |||||||||||||
| Number of employees at fiscal year-end | 3,668 | 3,299 | 3,088 | 369 | 211 | 11 | % | 7 | % |
| Percentage of Revenues Year Ended September 30, | ||||||||
| 2018 | 2017 | 2016 | ||||||
| Revenues | 100 | % | 100 | % | 100 | % | ||
| Operating expenses: | ||||||||
| Cost of revenues | 30 | % | 31 | % | 30 | % | ||
| Research and development | 12 | % | 12 | % | 12 | % | ||
| Selling, general and administrative | 37 | % | 36 | % | 37 | % | ||
| Amortization of intangible assets | 1 | % | 1 | % | 2 | % | ||
| Restructuring and acquisition-related | — | % | 1 | % | — | % | ||
| Total operating expenses | 80 | % | 81 | % | 81 | % | ||
| Operating income | 20 | % | 19 | % | 19 | % | ||
| Interest expense, net | (3 | )% | (3 | )% | (3 | )% | ||
| Other income (expense), net | 1 | % | — | % | — | % | ||
| Income before income taxes | 18 | % | 16 | % | 16 | % | ||
| Provision for income taxes | 4 | % | 2 | % | 4 | % | ||
| Net income | 14 | % | 14 | % | 12 | % |
Cost of Revenues
Cost of revenues consists primarily of employee salaries and benefits for personnel directly involved in developing, installing and supporting revenue products; travel costs; overhead costs; outside services; internal network hosting costs; software royalty fees; and credit bureau data and processing services.
The fiscal 2018 over 2017 increase of $23.6 million in cost of revenues expenses was primarily attributable to a $13.4 million increase in facilities and infrastructure costs and a $7.7 million increase in personnel and labor costs. The increase in facilities and infrastructure costs was primarily attributable to increased resource requirement due to expansion in our cloud infrastructure operations. The increase in personnel and labor costs was primarily attributable to an increase in incentive cost and share-based compensation costs. Cost of revenues as a percentage of revenues was 30% during fiscal 2018, materially consistent with that incurred during fiscal 2017.
Cost of revenues as a percentage of revenues increased to 31% during fiscal 2017 from 30% during fiscal 2016. The $22.0 million increase was primarily attributable to a $14.6 million increase in personnel and labor costs and a $7.4 million increase in allocated facilities and infrastructure costs. The increase in personnel and labor costs was primarily attributable to an increase in professional services delivery cost driven by higher services revenue and an increase in salaries and benefit costs as a result of our increased headcount. The increase in allocated facilities and infrastructure costs was primarily attributable to increased resource requirements due to our expanded investment in product delivery, support and infrastructure operations.
In fiscal 2019, we expect cost of revenues as a percentage of revenues will be consistent with those incurred during fiscal 2018.
Research and Development
Research and development expenses include the personnel and related overhead costs incurred in the development of new products and services, including the research of mathematical and statistical models and the development of new versions of our products.
The fiscal 2018 over 2017 increase of $17.5 million in research and development expenses was primarily attributable to a $14.8 million increase in personnel and labor costs as a result of our continued investment in the areas of cloud computing and SaaS, as well as new products. Research and development expenses as a percentage of revenues were 12% during fiscal 2018, consistent with those incurred during fiscal 2017.
The fiscal 2017 over 2016 increase of $7.2 million in research and development expenses was primarily attributable to a $5.0 million increase in personnel and labor costs and a $2.6 million increase in facilities and infrastructure costs, mainly driven by our continued investment in the areas of cloud computing and SaaS, as well as new products primarily in the Decision Management Software segment. Research and development expenses as a percentage of revenues were 12% during fiscal 2017, consistent with those incurred during fiscal 2016.
In fiscal 2019, we expect that research and development expenditures as a percentage of revenues will be consistent with or slightly higher than those incurred during fiscal 2018.
Selling, General and Administrative
Selling, general and administrative expenses consist principally of employee salaries and benefits; travel costs; overhead costs; advertising and other promotional expenses; corporate facilities expenses; legal expenses; business development expenses and the cost of operating computer systems.
The fiscal 2018 over 2017 increase of $40.6 million was primarily attributable to a $27.4 million increase in personnel and labor costs as a result of increased headcount, higher share-based compensation and incentive costs; as well as a $10.1 million increase in marketing and travel costs, primarily driven by a company-wide marketing event during fiscal 2018. Selling, general and administrative expenses as a percentage of revenues was 37% during fiscal 2018, materially consistent with those incurred during fiscal 2017.
The fiscal 2017 over 2016 increase of $10.9 million was primarily attributable to a $21.0 million increase in labor and personnel costs, partially offset by a $4.0 million decrease in marketing expenses and a $6.6 million decrease in outside services. The increase in personnel costs was primarily attributable to an increase in salaries and benefits as a result of our increased headcount, an increase in commission cost driven by revenue growth, and an increase in stock-based compensation cost. The decrease in marketing expenses was primarily attributable to a company-wide marketing event during our fiscal 2016. The decrease in outside services was primarily attributable to a one-time settlement during fiscal 2017. Selling, general and administrative expenses as a percentage of revenues was 36% during fiscal 2017, materially consistent with those incurred during fiscal 2016.
In fiscal 2019, we expect that selling, general and administrative expenses as a percentage of revenues will be consistent with those incurred during fiscal 2018.
Amortization of Intangible Assets
Amortization of intangible assets consists of expense related to intangible assets recorded in connection with our acquisitions. Our finite-lived intangible assets consist primarily of completed technology and customer contracts and relationships, which are being amortized using the straight-line method over periods ranging from five to fifteen years.
The fiscal 2018 over 2017 decrease in amortization expense of $6.1 million was primarily attributable to certain intangible assets associated with our Adeptra and HNC acquisitions becoming fully amortized in fiscal 2017.
The fiscal 2017 over 2016 decrease in amortization expense of $1.3 million was primarily attributable to certain intangible assets associated with our Adeptra, HNC and Entiera acquisitions becoming fully amortized in fiscal 2017 and 2016.
In fiscal 2019, we expect amortization expense will be slightly lower than that incurred in fiscal 2018.
Restructuring and Acquisition-Related
There were no restructuring or acquisition-related expenses incurred during fiscal 2018.
During fiscal 2017, we incurred net charges totaling $4.5 million consisting of $1.7 million in facilities charges associated with vacating excess leased space in San Rafael, California and $2.8 million in employee separation costs due to the elimination of 79 positions throughout the Company. Cash payments for all the facilities charges will be paid by the end of fiscal 2020. Cash payments for all the employee separation costs were paid before the end of the second quarter of fiscal 2018. There were no acquisition-related expenses incurred during fiscal 2017.
There were no restructuring or acquisition-related expenses incurred during fiscal 2016.
Interest Expense, Net
Interest expense includes primarily interest on the senior notes issued in May 2008, July 2010 and May 2018, as well as interest and credit facility fees on the revolving line of credit. On our consolidated statements of income and comprehensive income, interest expense is netted with interest income, which is derived primarily from the investment of funds in excess of our immediate operating requirements.
The fiscal 2018 over 2017 increase in net interest expense of $5.8 million was primarily attributable to a higher average outstanding debt balance during fiscal 2018, as well as a higher average interest rate on our 2018 Senior Notes (as discussed below) compared to that on our revolving line of credit.
The fiscal 2017 over 2016 decrease in net interest expense of $0.8 million was primarily attributable to the $72.0 million and $60.0 million principal payments in July 2017 and July 2016, respectively, on the senior notes issued in July 2010, resulting in lower average debt balances for fiscal 2017, partially offset by a higher average outstanding balance on our revolving line of credit.
In fiscal 2019, we expect net interest expense will be higher than what we incurred during fiscal 2018.
Other Income (Expense), Net
Other income (expense), net consists primarily of realized investment gains/losses and unrealized gains/losses on certain investments classified as trading securities, exchange rate gains/losses resulting from re-measurement of foreign-currency-denominated receivable and cash balances held by our various reporting entities into their respective functional currencies at period-end market rates, net of the impact of offsetting foreign currency forward contracts, and other non-operating items.
The fiscal 2018 over 2017 change in other income (expense), net of $13.0 million was primarily attributable to a non-operating gain related to the divestiture of an investment in which we had a minority interest, as well as an increase in foreign currency exchange gain during fiscal 2018.
The fiscal 2017 over 2016 change in other income (expense), net of $1.7 million was primarily attributable to an increase in foreign currency exchange loss during fiscal 2017.
Provision for Income Taxes
Our effective tax rates were 24.3%, 15.2% and 24.3% in fiscal 2018, 2017 and 2016, respectively.
The increase in our income tax provision in fiscal 2018 compared to fiscal 2017 is primarily due to recording the impact related to the enactment of the Tax Act in fiscal 2018. This includes re-measurement to our deferred tax assets and liabilities for the tax rate changes, the one-time Transition Tax, and a provisional charge related to the loss of deductibility of performance-based compensation for certain employees.
The decrease in our effective tax rate in fiscal 2017 compared to fiscal 2016 was due primarily to the adoption of ASU 2016-09 on October 1, 2016. We no longer record excess tax benefits as an increase to additional paid-in capital, but record such excess tax benefits on a prospective basis as a reduction of income tax expense.
Prior to the enactment of the Tax Act we had not made a provision for U.S. income or additional foreign withholding taxes on the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries as we intended to reinvest the earnings of our non-U.S. subsidiaries in those operations indefinitely, except where we were able to repatriate these earnings to the U.S. without material incremental tax provision. As of September 30, 2018, we have approximately $79.7 million of unremitted earnings of non-U.S. subsidiaries, of which $57.9 million was included in our current year provision for income taxes due to the one-time Transition Tax on the deemed repatriation of deferred foreign income under the Tax Act. The Company generates substantial cash flow in the U.S. and does not have a current need for the cash to be returned to the U.S. from the foreign entities. While the Transition Tax resulted in the reduction of the excess of the amount for financial reporting over the tax basis in our foreign subsidiaries such that a repatriation may not result in additional U.S. income tax, an actual repatriation from our non-US subsidiaries could still be subject to additional foreign withholding taxes and U.S. state taxes.
Operating Income
The following tables set forth certain summary information on a segment basis related to our operating income for the fiscal 2018, 2017 and 2016:
| Year Ended September 30, | Period-to-Period Change | Period-to-Period Percentage Change | |||||||||||||||||||||||
| Segment | 2018 | 2017 | 2016 | 2018 to 2017 | 2017 to 2016 | 2018 to 2017 | 2017 to 2016 | ||||||||||||||||||
| (In thousands) | (In thousands) | ||||||||||||||||||||||||
| Applications | $ | 164,576 | $ | 159,500 | $ | 168,271 | $ | 5,076 | $ | (8,771 | ) | 3 | % | (5 | )% | ||||||||||
| Scores | 279,171 | 211,918 | 185,084 | 67,253 | 26,834 | 32 | % | 14 | % | ||||||||||||||||
| Decision Management Software | (30,647 | ) | (10,818 | ) | (3,660 | ) | (19,829 | ) | (7,158 | ) | 183 | % | 196 | % | |||||||||||
| Unallocated corporate expenses | (125,255 | ) | (104,998 | ) | (110,612 | ) | (20,257 | ) | 5,614 | 19 | % | (5 | )% | ||||||||||||
| Total segment operating income | 287,845 | 255,602 | 239,083 | 32,243 | 16,519 | 13 | % | 7 | % | ||||||||||||||||
| Unallocated share-based compensation | (74,814 | ) | (61,222 | ) | (55,509 | ) | (13,592 | ) | (5,713 | ) | 22 | % | 10 | % | |||||||||||
| Unallocated amortization expense | (6,594 | ) | (12,709 | ) | (13,982 | ) | 6,115 | 1,273 | (48 | )% | (9 | )% | |||||||||||||
| Unallocated restructuring and acquisition-related | — | (4,471 | ) | — | 4,471 | (4,471 | ) | (100 | )% | — | % | ||||||||||||||
| Operating income | $ | 206,437 | $ | 177,200 | $ | 169,592 | 29,237 | 7,608 | 16 | % | 4 | % |
Applications
| Year Ended September 30, | Percentage of Revenues | |||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||
| (In thousands) | ||||||||||||||||||||
| Segment revenues | $ | 585,571 | $ | 553,167 | $ | 532,642 | 100 | % | 100 | % | 100 | % | ||||||||
| Segment operating expenses | (420,995 | ) | (393,667 | ) | (364,371 | ) | (72 | )% | (71 | )% | (68 | )% | ||||||||
| Segment operating income | $ | 164,576 | $ | 159,500 | $ | 168,271 | 28 | % | 29 | % | 32 | % |
Scores
| Year Ended September 30, | Percentage of Revenues | |||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||
| (In thousands) | ||||||||||||||||||||
| Segment revenues | $ | 342,648 | $ | 266,354 | $ | 241,059 | 100 | % | 100 | % | 100 | % | ||||||||
| Segment operating expenses | (63,477 | ) | (54,436 | ) | (55,975 | ) | (19 | )% | (20 | )% | (23 | )% | ||||||||
| Segment operating income | $ | 279,171 | $ | 211,918 | $ | 185,084 | 81 | % | 80 | % | 77 | % |
Decision Management Software
| Year Ended September 30, | Percentage of Revenues | |||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||
| (In thousands) | ||||||||||||||||||||
| Segment revenues | $ | 104,256 | $ | 112,648 | $ | 107,655 | 100 | % | 100 | % | 100 | % | ||||||||
| Segment operating expenses | (134,903 | ) | (123,466 | ) | (111,315 | ) | (129 | )% | (110 | )% | (103 | )% | ||||||||
| Segment operating loss | $ | (30,647 | ) | $ | (10,818 | ) | $ | (3,660 | ) | (29 | )% | (10 | )% | (3 | )% |
The fiscal 2018 over 2017 increase in operating income of $29.2 million was attributable to a $100.3 million increase in segment revenues, a $6.1 million decrease in amortization expense and a $4.5 million decrease in restructuring and acquisition-related expenses, partially offset by a $47.8 million increase in segment operating expenses, a $20.3 million increase in unallocated corporate expenses and a $13.6 million increase in share-based compensation expense.
At the segment level, the $32.2 million increase in segment operating income was the result of a $67.2 million increase in our Scores segment operating income and a $5.1 million increase in our Applications segment operating income, partially offset by a $20.3 million increase in unallocated corporate expenses primarily driven by an increase in unallocated incentive cost and a one-time settlement during fiscal 2017, and a $19.8 million increase in our Decision Management Software segment operating loss.
The $5.1 million increase in Applications segment operating income was attributable to a $32.4 million increase in segment revenue, partially offset by a $27.3 million increase in segment operating expenses. Segment operating income as a percentage of segment revenue for Applications was 28%, materially consistent with fiscal 2017.
The $67.2 million increase in Scores segment operating income was attributable to a $76.3 million increase in segment revenue, partially offset by a $9.1 million increase in segment operating expenses. Segment operating income as a percentage of segment revenue for Scores was 81%, materially consistent with fiscal 2017.
The $19.8 million increase in Decision Management Software segment operating loss was attributable to an $11.4 million increase in segment operating expenses and an $8.4 million decrease in segment revenue. Segment operating margin for Decision Management Software decreased to a negative 29% from a negative 10% mainly due to a decrease in sales of our higher-margin software products, as well as our continued investment in cloud infrastructure operations and new products.
The fiscal 2017 over 2016 increase in operating income of $7.6 million was attributable to a $50.8 million increase in segment revenues, a $5.6 million decrease in unallocated corporate expenses and a $1.3 million decrease in amortization expense, partially offset by a $39.9 million increase in segment operating expenses, a $5.7 million increase in share-based compensation expense and a $4.5 million increase in restructuring and acquisition-related expenses.
At the segment level, the $16.5 million increase in segment operating income was the result of a $26.8 million increase in our Scores segment operating income and a $5.6 million decrease in unallocated corporate expenses, partially offset by an $8.8 million decrease in our Applications segment operating income and a $7.1 million increase in our Decision Management Software segment operating loss.
The $8.8 million decrease in Applications segment operating income was attributable to a $29.3 million increase in segment operating expenses, partially offset by a $20.5 million increase in segment revenue. Segment operating income as a percentage of segment revenue for Applications decreased to 29% from 32% primarily due to a decrease in sales of our higher-margin software products and an increase in professional services delivery cost.
The $26.8 million increase in Scores segment operating income was attributable to a $25.3 million increase in segment revenue and a $1.5 million decrease in segment operating expenses. Segment operating income as a percentage of segment revenue for Scores increased to 80% from 77% mainly due to an increase in sales of our higher-margin score products.
The $7.1 million increase in Decision Management Software segment operating loss was attributable to a $12.1 million increase in segment operating expenses, partially offset by a $5.0 million increase in segment revenue. Segment operating margin for Decision Management Software decreased to a negative 10% from a negative 3% mainly due to a decrease in sales of our higher-margin software products, our continued investment in sales distribution, and expanded investment in cloud infrastructure operations.
CAPITAL RESOURCES AND LIQUIDITY
Outlook
As of September 30, 2018, we had $90.0 million in cash and cash equivalents, which included $75.9 million held off-shore by our foreign subsidiaries. We believe these balances, as well as available borrowings from our $400 million revolving line of credit and anticipated cash flows from operating activities, will be sufficient to fund our working and other capital requirements as well as the $28.0 million principal payment due in July 2019 on our senior notes issued in July 2010. Under our current financing arrangements, we have no other significant debt obligations maturing over the next twelve months. Additionally, though we do not anticipate the need to repatriate any undistributed earnings from our foreign subsidiaries for the foreseeable future, we may take advantage of opportunities where we are able to repatriate these earnings to the U.S. without material incremental tax provision.
In the normal course of business, we evaluate the merits of acquiring technology or businesses, or establishing strategic relationships with or investing in these businesses. We may elect to use available cash and cash equivalents to fund such activities in the future. In the event additional needs for cash arise, or if we refinance our existing debt, we may raise additional funds from a combination of sources, including the potential issuance of debt or equity securities. Additional financing might not be available on terms favorable to us, or at all. If adequate funds were not available or were not available on acceptable terms, our ability to take advantage of unanticipated opportunities or respond to competitive pressures could be limited.
Summary of Cash Flows
| Year Ended September 30, | |||||||||||
| 2018 | 2017 | 2016 | |||||||||
| (In thousands) | |||||||||||
| Cash provided by (used in): | |||||||||||
| Operating activities | $ | 223,052 | $ | 225,644 | $ | 210,268 | |||||
| Investing activities | (14,119 | ) | (20,605 | ) | (27,615 | ) | |||||
| Financing activities | (218,627 | ) | (180,625 | ) | (190,015 | ) | |||||
| Effect of exchange rate changes on cash | (5,901 | ) | 5,278 | (2,832 | ) | ||||||
| Increase (decrease) in cash and cash equivalents | $ | (15,595 | ) | $ | 29,692 | $ | (10,194 | ) |
Cash Flows from Operating Activities
Our primary method for funding operations and growth has been through cash flows generated from operating activities. Net cash provided by operating activities totaled $223.1 million in fiscal 2018 compared to $225.6 million in fiscal 2017. The $2.5 million decrease was mainly attributable to a $43.8 million decrease that resulted from timing of receipts and payments in our ordinary course of business, partially offset by a $26.9 million increase in non-cash items, including a $31.8 million increase in non-cash deferred income taxes and $10 million non-operating gain related to the divestiture of a cost-method investment; as well a $14.2 increase in net income.
Net cash provided by operating activities totaled $225.6 million in fiscal 2017 compared to $210.3 million in fiscal 2016. The $15.3 million increase was mainly attributable to a $20.0 million decrease in our deferred income tax provision and an $18.8 million increase in net income, partially offset by a $24.2 million excess tax benefit related to share-based payments that was recorded as an increase to additional paid-in capital in the prior year but was recorded as a reduction of income tax expense in the current year as a result of our early adoption of ASU 2016-09 effective October 1, 2016.
Cash Flows from Investing Activities
Net cash used in investing activities totaled $14.1 million in fiscal 2018 compared to $20.6 million in fiscal 2017. The $6.5 million decrease was primarily attributable to a $20.0 million increase in proceeds from the sale of cost method investment, partially offset by an $11.5 million increase in net cash used for purchases of property and equipment as well as a $2.8 million increase in purchases, net of proceeds from sale, of marketable securities.
Net cash used in investing activities totaled $20.6 million in fiscal 2017 compared to $27.6 million in fiscal 2016. The $7.0 million decrease was primarily attributable to a $5.7 million decrease in net cash used for acquisitions and a $2.1 million decrease in net cash used for purchases of property and equipment.
Cash Flows from Financing Activities
Net cash used in financing activities totaled $218.6 million in fiscal 2018 compared to $180.6 million in fiscal 2017. The $38.0 million increase was primarily due to a $210.0 million increase in payments, net of proceeds, on our revolving line of credit, a $155.0 million increase in net cash used for repurchases of common stock and a $7.8 million increase in debt issuance cost, partially offset by a $341.0 million increase in proceeds, net of payments, from our senior notes.
Net cash used in financing activities totaled $180.6 million in fiscal 2017 compared to $190.0 million in fiscal 2016. The $9.4 million decrease was primarily due to an $83.0 million increase in proceeds, net of payments from our revolving line of credit, partially offset by a $49.2 million increase in net cash used for repurchases of common stock, a $12.0 million increase in payment on our senior notes, and a $10.3 million increase in taxes paid related to net share settlement of equity awards.
Repurchases of Common Stock
In October 2017, our Board of Directors approved a stock repurchase program following the completion of the previously authorized program. This program is open-ended and authorizes repurchases of shares of our common stock up to an aggregate cost of $250.0 million in the open market or in negotiated transactions. In July 2018, our Board of Directors approved a new stock repurchase program following the completion of the October 2017 program. This program is open-ended and authorizes repurchases of shares of our common stock up to an aggregate cost of $250.0 million in the open market or in negotiated transactions. As of September 30, 2018, we had $199.3 million remaining under this authorization. During fiscal 2018, 2017 and 2016, we expended $336.9 million, $193.3 million and $138.4 million, respectively, under these and previously authorized stock repurchase programs.
Dividends
We paid dividends of $0.02 per share on a quarterly basis during each of fiscal 2015 and 2016, and the first two quarters of our fiscal 2017. In May 2017, our Board of Directors discontinued cash dividend payments in favor of using our excess cash flow for share repurchases.
Revolving Line of Credit
On May 8, 2018, we amended our credit agreement with a syndicate of banks, extending the maturity date of the unsecured revolving line of credit from December 30, 2019 to May 8, 2023, while reducing our borrowing capacity to $400 million with an option to increase it by another $100 million. Proceeds from the credit facility can be used for working capital and general corporate purposes and may also be used for the refinancing of existing debt, acquisitions and the repurchase of our common stock. Interest on amounts borrowed under the credit facility is based on (i) a base rate, which is the greater of (a) the prime rate, (b) the Federal Funds rate plus 0.500% and (c) the one-month LIBOR rate plus 1.000%, plus, in each case, an applicable margin, or (ii) an adjusted LIBOR rate plus an applicable margin. The applicable margin for base rate borrowings ranges from 0% to 0.875% and for LIBOR borrowings ranges from 1.000% to 1.875%, and is determined based on our consolidated leverage ratio. In addition, we must pay credit facility fees. The credit facility contains certain restrictive covenants including maintaining a maximum consolidated leverage ratio of 3.25, subject to a step up to 3.75 following certain permitted acquisitions; and a minimum fixed charge ratio of 2.50 through the maturity of our 2010 Senior Notes in July 2020, upon which maintaining a minimum interest coverage ratio of 3.00. The credit agreement also contains other covenants typical of unsecured facilities. As of September 30, 2018, we had $257.0 million in borrowings outstanding at a weighted average interest rate of 3.555% and were in compliance with all financial covenants under this credit facility.
Senior Notes
On May 7, 2008, we issued $275 million of senior notes in a private placement to a group of institutional investors, the outstanding aggregate principal amount of which was paid in full at maturity on May 7, 2018. On July 14, 2010, we issued $245 million of senior notes in a private placement to a group of institutional investors (the “2010 Senior Notes”). The 2010 Senior Notes were issued in four series with maturities ranging from 6 to 10 years. The outstanding 2010 Senior Notes’ weighted average interest rate is 5.6% and the weighted average maturity is 9.8 years. The 2010 Senior Notes require interest payments semi-annually and contain certain restrictive covenants, including the maintenance of a maximum consolidated net debt to consolidated EBITDA ratio of 3.00 and a minimum fixed charge coverage ratio of 2.50. On May 8, 2018, we issued $400 million of senior notes in a private offering to qualified institutional investors (the “2018 Senior Notes”, and with the 2010 Senior Notes, the “Senior Notes”). The 2018 Senior Notes require interest payments semi-annually at a rate of 5.25% per annum and will mature on May 15, 2026. The purchase agreement for the 2010 Senior Notes and the indenture for the 2018 Senior Notes contain certain covenants typical of unsecured obligations. As of September 30, 2018, the carrying value of the Senior Notes was $513.0 million and we were in compliance with all financial covenants under the purchase agreement and the indenture, respectively.
Contractual Obligations
The following table presents a summary of our contractual obligations at September 30, 2018:
| Year Ending September 30, | Thereafter | Total | |||||||||||||||||||||||||
| 2019 | 2020 | 2021 | 2022 | 2023 | |||||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||||||
| Senior notes (1) | $ | 28,000 | $ | 85,000 | $ | — | $ | — | $ | — | $ | 400,000 | $ | 513,000 | |||||||||||||
| Interest due on debt obligations (2) | 27,677 | 25,752 | 21,000 | 21,000 | 21,000 | 63,000 | 179,429 | ||||||||||||||||||||
| Operating lease obligations | 24,224 | 15,694 | 15,768 | 14,151 | 12,866 | 33,030 | 115,733 | ||||||||||||||||||||
| Unrecognized tax benefits (3) | — | — | — | — | — | — | 6,113 | ||||||||||||||||||||
| Total commitments | $ | 79,901 | $ | 126,446 | $ | 36,768 | $ | 35,151 | $ | 33,866 | $ | 496,030 | $ | 814,275 |
| (1) | Represents the unpaid principal amount of the Senior Notes. |
| (2) | Represents interest payments on the Senior Notes. |
| (3) | Represents unrecognized tax benefits related to uncertain tax positions. As we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time, the related balances have not been reflected in the section of the table showing payment by fiscal year. |
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make certain judgments and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, goodwill and other intangible assets resulting from business acquisitions, share-based compensation, income taxes and contingencies and litigation. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements:
Revenue Recognition
Software Licenses
Software license fee revenue is recognized when persuasive evidence of an arrangement exists, software is made available to our customers, the fee is fixed or determinable and collection is probable. The determination of whether fees are fixed or determinable and collection is probable involves the use of assumptions. If at the outset of an arrangement we determine that the arrangement fee is not fixed or determinable, revenue is deferred until the arrangement fee becomes fixed or determinable, assuming all other revenue recognition criteria have been met. If at the outset of an arrangement we determine that collectability is not probable, revenue is deferred until the earlier of when collectability becomes probable or the receipt of payment. If there is uncertainty as to the customer’s acceptance of our deliverables, revenue is not recognized until the earlier of receipt of customer acceptance, expiration of the acceptance period, or when we can demonstrate we meet the acceptance criteria. We evaluate contract terms and customer information to ensure that these criteria are met prior to our recognition of license fee revenue.
We use the residual method to recognize revenue when a software arrangement includes one or more elements to be delivered at a future date provided the following criteria are met: (i) vendor-specific objective evidence (“VSOE”) of the fair value does not exist for one or more of the delivered items but exists for all undelivered elements, (ii) all other applicable revenue recognition criteria are met and (iii) the fair value of all of the undelivered elements is less than the arrangement fee. VSOE of fair value is based on the normal pricing practices for those products and services when sold separately by us and customer renewal rates for post-contract customer support services. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence of the fair value of one or more undelivered elements does not exist, the revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and change to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue.
Revenues from post-contract customer support services, such as software maintenance, are recognized on a straight-line basis over the term of the support period. The majority of our software maintenance agreements provide technical support as well as unspecified software product upgrades and releases when and if made available by us during the term of the support period.
Transactional-Based Revenues
Transactional-based revenue is recognized when persuasive evidence of an arrangement exists, fees are fixed or determinable, and collection is probable. Revenues from our credit scoring, data processing, data management and SaaS subscription services are recognized as these services are performed. Revenues from transactional or unit-based license fees under software license arrangements, credit scoring, data processing, data management and SaaS subscription services agreements are recognized based on minimum contractual amounts or on system usage that exceeds minimum contractual amounts. Certain of our transactional-based revenues are based on transaction or active account volumes as reported by our clients. In instances where volumes are reported to us in arrears, we estimate volumes based on preliminary customer transaction information or average actual reported volumes for an immediate trailing period. Differences between our estimates and actual final volumes reported are recorded in the period in which actual volumes are reported. We have not experienced significant variances between our estimates and actual reported volumes in the past and anticipate that we will be able to continue to make reasonable estimates in the future. If for some reason we were unable to reasonably estimate transaction volumes in the future, revenue may be deferred until actual customer data is received, and this could have a material impact on our consolidated results of operations.
Consulting Services
We provide consulting, training, model development and software integration services under both hourly-based time and materials and fixed-priced contracts. Revenues from these services are generally recognized as the services are performed. For fixed-price service contracts, we use a proportionate performance model with hours as the input method of attribution to determine progress towards completion, with consideration also given to output measures, such as contract milestones, when applicable. In such instances, management is required to estimate the total estimated hours of the project. Adjustments to estimates are made in the period in which the facts requiring such revisions become known and, accordingly, recognized revenues and profits are subject to revisions as the contract progresses to completion. Estimated losses, if any, are recorded in the period in which current estimates of total contract revenue and contract costs indicate a loss. If substantive uncertainty related to customer acceptance of services exists, we defer the associated revenue until the contract is completed. We have not experienced significant variances between our estimates and actual hours in the past and anticipate that we will be able to continue to make reasonable estimates in the future. If for some reason we are unable to accurately estimate the input measures, revenue would be deferred until the contract is complete, and this could have a material impact on our consolidated results of operations.
Services that are sold in connection with software license arrangements generally qualify for separate accounting from the license element because they do not involve significant production, modification or customization of our products and are not otherwise considered to be essential to the functionality of our software. In arrangements where the professional services do not qualify for separate accounting from the license element, the combined software license and professional services revenue are recognized based on contract accounting using either the percentage-of-completion or completed-contract method.
Multiple-Deliverable Arrangements including Non-Software
When we enter into a multiple-deliverable arrangement that includes non-software, each deliverable is accounted for as a separate unit of accounting if the following criteria are met: (i) the delivered item or items have value to the customer on a standalone basis and (ii) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. We consider a deliverable to have standalone value if we sell this item separately or if the item is sold by another vendor or could be resold by the customer; for example, we conclude professional services offered along with our SaaS subscription services typically have standalone value using this criteria. Further, our revenue arrangements generally do not include a general right of return relative to delivered products. Revenue for multiple element arrangements is allocated to the software and non-software deliverables based on a relative selling price. We use VSOE in our allocation of arrangement consideration when it is available. We define VSOE as a median price of recent standalone transactions that are priced within a narrow range, as defined by us. If a product or service is seldom sold separately, it is unlikely that we can determine VSOE. In circumstances when VSOE does not exist, we then assess whether we can obtain third-party evidence (“TPE”) of the selling price. It may be difficult for us to obtain sufficient information on competitor pricing to substantiate TPE and therefore we may not always be able to use TPE. When we are unable to establish selling price using VSOE or TPE, we use estimated selling price (“ESP”) in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact if the product or service were sold by us on a standalone basis. Our determination of ESP involves weighting several factors based on the specific facts and circumstances of each arrangement. The factors include, but are not limited to, geographies, market conditions, gross margin objectives, pricing practices and controls, customer segment pricing strategies and the product lifecycle. Historically, there have been no significant changes in our ESP used in allocation of arrangement consideration. We do not believe there is a reasonable likelihood there will be a material change in the future estimates.
If a deliverable does not have standalone value because the aforementioned criteria are not met, we combine it with the other applicable undelivered item(s) within the arrangement and account for the multiple deliverables as one combined unit of accounting. For example, for hosting arrangements requiring a highly specialized and unique set of initial implementation and setup services prior to the commencement of hosting services, we typically conclude that these implementation or setup services do not have value to the customer on a stand-alone basis; therefore, we combine them with the hosting services as a combined unit of accounting. Revenue is recognized upon commencement of our hosting services over the expected life of the customer relationship.
Gross vs. Net Revenue Reporting
We apply accounting guidance to determine whether we report revenue for certain transactions based upon the gross amount billed to the customer, or the net amount retained by us. In accordance with the guidance we record revenue on a gross basis for sales in which we have acted as the principal and on a net basis for those sales in which we have in substance acted as an agent or broker in the transaction.
Business Combinations
Accounting for our acquisitions requires us to recognize, separately from goodwill, the assets acquired and the liabilities assumed at their acquisition-date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred and the net of the acquisition-date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statements of income and comprehensive income.
Accounting for business combinations requires our management to make significant estimates and assumptions, especially at the acquisition date, including our estimates for intangible assets, contractual obligations assumed, pre-acquisition contingencies and contingent consideration, where applicable. If we cannot reasonably determine the fair value of a pre-acquisition contingency (non-income tax related) by the end of the measurement period, we will recognize an asset or a liability for such pre-acquisition contingency if: (i) it is probable that an asset existed or a liability had been incurred at the acquisition date and (ii) the amount of the asset or liability can be reasonably estimated. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Subsequent to the measurement period, changes in our estimates of such contingencies will affect earnings and could have a material effect on our consolidated results of operations and financial position.
Examples of critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: (i)future expected cash flows from software license sales, support agreements, consulting contracts, other customer contracts and acquired developed technologies and patents; (ii) expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed; and (iii) the acquired company’s brand and competitive position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Historically, there have been no significant changes in our estimates or assumptions. To the extent a significant acquisition is made during a fiscal year, as appropriate we will expand the discussion to include specific assumptions and inputs used to determine the fair value of our acquired intangible assets.
In addition, uncertain tax positions and tax-related valuation allowances assumed in connection with a business combination are initially estimated as of the acquisition date. We reevaluate these items quarterly based upon facts and circumstances that existed as of the acquisition date with any adjustments to our preliminary estimates being recorded to goodwill provided that we are within the measurement period. Subsequent to the measurement period or our final determination of the tax allowance’s or contingency’s estimated value, whichever comes first, changes to these uncertain tax positions and tax-related valuation allowances will affect our provision for income taxes in our consolidated statements of income and comprehensive income and could have a material impact on our consolidated results of operations and financial position. Historically, there have been no significant changes in our valuation allowances or uncertain tax positions as it relates to business combinations. We do not believe there is a reasonable likelihood there will be a material change in the future estimates.
Goodwill, Acquisition Intangibles and Other Long-Lived Assets - Impairment Assessment
Goodwill represents the excess of cost over the fair value of identifiable assets acquired and liabilities assumed in business combinations. We assess goodwill for impairment for each of our reporting units on an annual basis during the fourth quarter using a July 1 measurement date unless circumstances require a more frequent measurement. We have determined that our reporting units are the same as our reportable segments. When evaluating goodwill for impairment, we may first perform an assessment qualitatively whether it is more likely than not that a reporting unit's carrying amount exceeds its fair value, referred to as a “step zero” approach. If, based on the review of the qualitative factors, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, we would bypass the two-step impairment test. Events and circumstances we consider in performing the “step zero” qualitative assessment include macro-economic conditions, market and industry conditions, internal cost factors, share price fluctuations, and the operational stability and the overall financial performance of the reporting units. If we conclude that it is more likely than not that a reporting unit's fair value is less than its carrying amount, we would perform the first step (“step one”) of the two-step impairment test and calculate the estimated fair value of the reporting unit by using discounted cash flow valuation models and by comparing our reporting units to guideline publicly-traded companies. These methods require estimates of our future revenues, profits, capital expenditures, working capital, and other relevant factors, as well as selecting appropriate guideline publicly-traded companies for each reporting unit. We estimate these amounts by evaluating historical trends, current budgets, operating plans, industry data, and other relevant factors. Using assumptions that are different from those used in our estimates, but in each case reasonable, could produce significantly different results and materially affect the determination of fair value and/or goodwill impairment for each reporting unit. For example, if the economic environment impacts our forecasts beyond what we have anticipated, it could cause the fair value of a reporting unit to fall below its respective carrying value.
For fiscal 2016, we performed a step zero qualitative analysis for our annual assessment of goodwill impairment. After evaluating and weighing all relevant events and circumstances, we concluded that it is not more likely than not that the fair value of any of our reporting units was less their carrying amounts. Consequently, we did not perform a step one quantitative analysis. For fiscal 2017, we elected to proceed directly to the step one quantitative analysis for all of our reporting units, as three years had elapsed since the date of our previous quantitative valuation. There was a substantial excess of fair value over carrying value for each of our reporting units and we determined goodwill was not impaired for any of our reporting units for fiscal 2017. For fiscal 2018, we performed a step zero qualitative analysis for our annual assessment of goodwill impairment. After evaluating and weighing all relevant events and circumstances, we concluded that it is not more likely than not that the fair value of any of our reporting units was less their carrying amounts. Consequently, we did not perform a step one quantitative analysis and determined goodwill was not impaired for any of our reporting units for fiscal 2018.
Our intangible assets that have finite useful lives and other long-lived assets are assessed for potential impairment when there is evidence that events and circumstances related to our financial performance and economic environment indicate the carrying amount of the assets may not be recoverable. When impairment indicators are identified, we test for impairment using undiscounted cash flows. If such tests indicate impairment, then we measure and record the impairment as the difference between the carrying value of the asset and the fair value of the asset. Significant management judgment is required in forecasting future operating results used in the preparation of the projected cash flows. Should different conditions prevail, material write downs of our intangible assets or other long-lived assets could occur. We review the estimated remaining useful lives of our acquired intangible assets at each reporting period. A reduction in our estimate of remaining useful lives, if any, could result in increased annual amortization expense in future periods. We did not recognize any impairment charges on intangible assets that have finite useful lives or other long-lived assets in fiscal 2018, 2017 and 2016.
As discussed above, while we believe that the assumptions and estimates utilized were appropriate based on the information available to management, different assumptions, judgments and estimates could materially affect our impairment assessments for our goodwill, acquired intangibles with finite lives and other long-lived assets. Historically, there have been no significant changes in our estimates or assumptions that would have had a material impact for our goodwill or intangible assets impairment assessment. We believe our projected operating results and cash flows would need to be significantly less favorable to have a material impact on our impairment assessment. However, based upon our historical experience with operations, we do not believe there is a reasonable likelihood of a significant change in our projections.
Share-Based Compensation
We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the stock award (generally three to four years). We use the Black-Scholes valuation model to determine the fair value of our stock options and a Monte Carlo valuation model to determine the fair value of our market share units. Our valuation models and generally accepted valuation techniques require us to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the volatility of our stock price, expected dividend yield, employee turnover rates and employee stock option exercise behaviors. Historically, there have been no material changes in our estimates or assumptions. We do not believe there is a reasonable likelihood there will be a material change in the future estimates or assumptions. See Note 14 to the accompanying consolidated financial statements for further discussion of our share-based employee benefit plans.
Income Taxes
We estimate our income taxes based on the various jurisdictions where we conduct business, which involves significant judgment in determining our income tax provision. We estimate our current tax liability using currently enacted tax rates and laws and assess temporary differences that result from differing treatments of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities recorded on our balance sheet using the currently enacted tax rates and laws that will apply to taxable income for the years in which those tax assets are expected to be realized or settled. We then assess the likelihood our deferred tax assets will be realized and to the extent we believe realization is not more likely than not, we establish a valuation allowance. When we establish a valuation allowance or increase this allowance in an accounting period, we record a corresponding income tax expense in our consolidated statements of income and comprehensive income. In assessing the need for the valuation allowance, we consider future taxable income in the jurisdictions we operate; our ability to carry back tax attributes to prior years; an analysis of our deferred tax assets and the periods over which they will be realizable; and ongoing prudent and feasible tax planning strategies. An increase in the valuation allowance would have an adverse impact, which could be material, on our income tax provision and net income in the period in which we record the increase. We have historically had minimal changes in our valuation allowances related to deferred tax assets, as described in Note 13 to the accompanying consolidated financial statements.
The Tax Cuts and Jobs Act of 2017 (the “Tax Act”), as signed by the U.S. President on December 22, 2017, significantly revises U.S. tax law. The legislation reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were indefinitely reinvested and creates new taxes on certain foreign sourced earnings. The Tax Act adds many new provisions including changes to bonus depreciation, the deduction for executive compensation and interest expense, a tax on global intangible low taxed income (“GILTI”), the base erosion anti-abuse tax, a deduction for foreign derived intangible income, and the repeal of the deduction for domestic production activities. Some of these provisions, such as tax on GILTI, the repeal of the deduction for domestic production activities, and executive compensation, may not apply to the Company with full effect until future years. The Company is assessing the impact of the provisions of the Tax Act that do not apply until later years. The items that impact the Company for fiscal 2018 include, but are not limited to, 1) reduction of the U.S. federal corporate income tax rate; (2) a one-time transition tax on certain un-repatriated earnings of foreign subsidiaries; and (3) repeal of the performance-based compensation exception to the $1 million deduction limitation.
The SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) in December 2017, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under FASB Accounting Standards Codification (“ASC”) 740, “Accounting for Income Taxes” (“ASC 740”). In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.
The Tax Act was effective in the first quarter of fiscal 2018. As of September 30, 2018, we have not completed our accounting for the estimated tax effects for the Transition Tax nor the excessive employee remuneration. During fiscal 2018, we recorded a provisional net charge of $9.6 million related to the Tax Act based on reasonable estimates for those tax effects and $14.0 million for the re-measurement of the deferred tax assets and liabilities, in which accounting is now complete. Due to the timing of the enactment and the complexity in applying the provisions of the Tax Act, the provisional net charge is subject to revisions as we continue to complete our analysis, collect and prepare necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, Internal Revenue Service (“IRS”), FASB, and other standard-setting and regulatory bodies. Adjustments may materially impact our provision for income taxes and effective tax rate in the period in which the adjustments are made. Our accounting for the estimated tax effects of the Tax Act will be completed during the measurement period, which is not expected to extend beyond one year from the enactment date.
We recognize and measure benefits for uncertain tax positions using a two-step approach. The first step is to evaluate the tax position taken or expected to be taken in a tax return by determining if the technical merits of the tax position indicate it is more likely than not the tax position will be sustained upon audit, including resolution of any related appeals or litigation processes. For tax positions more likely than not of being sustained upon audit, the second step is to measure the tax benefit as the largest amount more than 50% likely of being realized upon settlement. Significant judgment is required to evaluate uncertain tax positions and they are evaluated on a quarterly basis. Our evaluations are based upon a number of factors, including changes in facts or circumstances, changes in tax law, correspondence with tax authorities during the course of audits and effective settlement of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in our income tax expense in the period in which we make the change, which could have a material impact on our effective tax rate and operating results. Historically, settlements related to our unrecognized tax benefits have been minimal as described in Note 13 to the accompanying consolidated financial statements.
A description of our accounting policies associated with tax-related contingencies and valuation allowances assumed as part of a business combination is provided under “Business Combinations” above.
Contingencies and Litigation
We are subject to various proceedings, lawsuits and claims relating to products and services, technology, labor, stockholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. If the potential loss is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. If the potential loss is considered less than probable or the amount cannot be reasonably estimated, disclosure of the matter is considered. The amount of loss accrual or disclosure, if any, is determined after analysis of each matter, and is subject to adjustment if warranted by new developments or revised strategies. Due to uncertainties related to these matters, accruals or disclosures are based on the best information available at the time. Significant judgment is required in both the assessment of likelihood and in the determination of a range of potential losses. Revisions in the estimates of the potential liabilities could have a material impact on our consolidated financial position or consolidated results of operations. Historically, there have been no material changes in our estimates or assumptions. We do not believe there is a reasonable likelihood there will be a material change in the future estimates.
New Accounting Pronouncements
Recent Accounting Pronouncements Not Yet Adopted
In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2018-02, “Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” (“ASU 2018-02”). ASU 2018-02 allows reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Act and requires certain disclosures about stranded tax effects. The guidance is effective for fiscal years and interim periods beginning after December 15, 2018, which means it will be effective for our fiscal year beginning October 1, 2019. ASU 2018-02 should be applied either in the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Act is recognized. We do not believe that adoption of ASU 2018-02 will have a significant impact on our consolidated financial statements.
In October 2016, the FASB issued ASU No. 2016-16, “Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory” (“ASU 2016-16”). ASU 2016-16 requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. The guidance is effective for fiscal years and interim periods beginning after December 15, 2017, which means it will be effective for our fiscal year beginning October 1, 2018. ASU 2016-16 should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings at the beginning of the period of adoption. Early adoption is permitted as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued. We do not believe that adoption of ASU 2016-16 will have a significant impact on our consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which requires lessees to put most leases on their balance sheets but recognize the expenses on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. ASU 2016-02 is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2018, which means it will be effective for our fiscal year beginning October 1, 2019. Early adoption is permitted. We are currently evaluating the impact of our pending adoption of Topic 842 on our consolidated financial statements. We expect that most of our operating leases will be recognized as right-of-use assets and corresponding lease liabilities on our consolidated balance sheets, which will increase our total assets and total liabilities upon adoption.
In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”). The standard’s core principle is that a reporting entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from the contracts with customers.
The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method method), or the retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method). We have adopted the standard using the full retrospective method.
The standard is effective for us beginning October 1, 2018. In preparation for adoption of the new standard, we have implemented internal controls and key system functionality to enable the preparation of financial information and have reached conclusions on key accounting assessments related to the standard, including our assessment of the impact of accounting for costs incurred to obtain a contract.
The most significant impact of the standard relates to the timing of revenue recognition for term licenses and transactional revenue on guaranteed minimum fees related to our on-premises software products. Under the new standard, we expect to recognize revenue when control of the license transfers to the customer, rather than at the date payments become due and payable when there are extended payment terms, or ratably over the term of the contract as required under the current standard. In addition, revenue attributable to a software license renewal will be recognized at the beginning of the applicable renewal period, rather than at the signing of the renewal agreement as required under the current standard. Finally, when we enter into non-cancellable contracts that provide unconditional rights to payment from our customers for services we have not yet completed, or services we will provide in the near future, we expect to present the unconditional rights as receivables regardless of whether cash has been received from customers.
In addition, Accounting Standards Codification Subtopic 340-40, “Other Assets and Deferred Costs - Contracts with Customers” (“ASC 340”), requires us to recognize an asset for the incremental costs of obtaining a contract with a customer if our sales incentive programs meet requirements for capitalization. Previously we recorded these incremental costs of obtaining a contract, primarily commission expense, when we booked a sales transaction, whereas under ASC 340, we record an asset for the incremental cost to obtain a contract and recognize the cost over the expected revenue recognition period.
We estimate the adoption of the standard will result in a revenue reduction of approximately $32.3 million and an increase of approximately $2.8 million during our fiscal years 2018 and 2017, respectively. This is primarily due to change in timing of recognition of license revenue — when control of license transfers versus when fees became due and payable, and only at the beginning of the renewal period when applicable — from arrangements entered into during fiscal years 2018 and 2017, as well as arrangements entered into prior to fiscal 2017. In addition, while we continue to evaluate other impacts Topic 606 will have on our consolidated financial statements, including those related to our commission costs and receivables accounts as mentioned above, we do not expect the impact will be material to our consolidated financial statements.
In future periods, the new standard will require us to disclose additional information in the notes to our consolidated financial statements, including disaggregation of our revenue, remaining performance obligations, and other quantitative and qualitative information about our contracts with customers.
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