SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-Q





| | (Mark One)
| | ----------




| | x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. FOR THE QUARTERLY PERIOD ENDED SEPTEMBER
30, 2000
| | - | ------------------------------------------------------------------------------------------------------------------------------------------




OR





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




COMMISSION FILE NUMBER 000-22647





PERITUS SOFTWARE SERVICES, INC.


(Exact Name of Registrant as Specified in Its Charter)





|Massachusetts
(State or Other Jurisdiction of
Incorporation or Organization) |  | 04-3126919
(I.R.S. Employer Identification No.) | 
|---------------------------------------------------------------------------- |  | ----------------------------------------------- | 




|112 Turnpike Road, Suite 111
Westborough, Massachusetts
(Address of Principal Executive Offices) |  | 01581-2860
(Zip Code) | 
|------------------------------------------------------------------------------------------------ |  | --------------------- | 




(508) 870-0963


(Registrants Telephone Number, Including Area Code)





Not Applicable


(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)





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





Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:





|Title of Class               |  | Shares outstanding at

November 9, 2000
|---------------------------- |  | ---------------------------------------
|Common Stock, $.01 par value |  | 27,319,903                             







PERITUS SOFTWARE SERVICES INC.





FORM 10-Q





For The Quarterly Period Ended September 30, 2000





TABLE OF CONTENTS





|                                                                                                                                |  | Page
|------------------------------------------------------------------------------------------------------------------------------- |  | ----
|Part I.    Financial Information                                                                                                |  |     
|Item 1.    Financial Statements                                                                                                 |  |     
|Consolidated Balance Sheet as of September 30, 2000 and December 31, 1999                                                       |  | 3   
|Consolidated Statement of Operations for the Three and Nine Months Ended September 30,

                         
2000 and 1999 |  | 4   
|Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2000 and

                         
1999           |  | 5   
|Notes to Unaudited Consolidated Financial Statements                                                                            |  | 6   
|Item 2.    Managements Discussion and Analysis of Financial Condition and Results of

               
Operations               |  | 8   
|Item 3.    Quantitative and Qualitative Disclosures about Market Risk                                                           |  | 23  
|                                                                                                                                | 
|
|Part II.    Other Information                                                                                                   |  |     
|Item 1.    Legal Proceedings                                                                                                    |  | 24  
|Item 6.    Exhibits and Reports on Form 8-K                                                                                     |  | 24  
|Signatures                                                                                                                      |  | 25  




From time to time, information provided by the Company or statements made by its employees may contain fo
rward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements.
Without limiting the foregoing, the words believes, anticipates, plans, expects, and similar expressions are intended to identify forward-looking statements.





This Quarterly Report on Form 10-Q may contain forward looking statements which involve risks and uncertainties. The
Companys actual results could differ materially from the results discussed in such statements. Certain factors that could cause such a difference include, without limitation, the risks specifically described in the Companys Annual Report on
Form 10-K for the year ended December 31, 1999 and other public documents filed by the Company with the Securities and Exchange Commission (the Commission), which factors are incorporated herein by reference, the factors listed below in 
Factors That May Affect Future Results and other factors such as product or services demand and market acceptance risks, product development and services capacity, commercialization and technological difficulties, capacity and supply constraints or
difficulties and the effect of general business or economic conditions. The Companys forward-looking statements do not reflect the impact of any future transactions or strategic alliances or alternatives. From time to time, the Company may also
provide oral or written forward-looking statements in other materials it releases to the public. The Company does not assume any obligation to update any of the forward-looking statements it makes.





PART I. FINANCIAL INFORMATION





Item 1.    Financial Statements





PERITUS SOFTWARE SERVICES, INC.





CONSOLIDATED BALANCE SHEET


(In thousands, except share-related data)





|                                                                                                                                                                                                              |  | September 30,

2000 |   | December 31,

1999
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------- | - | ------------------
|
|ASSETS                                                                                                                                                                                                        |  |                     |   |                   
|Current Assets:                                                                                                                                                                                               |  |                     |   |                   
|Cash and cash equivalents                                                                                                                                                                                     |  | $      2,754        |   |                   
|Short-term investments                                                                                                                                                                                        |  | 1,411               |   |                   
|Accounts receivable, net of allowance for doubtful accounts of $25 and $25,

               respectively, and including amounts from related parties of $39 and $0,

               respectively              |  | 338                 |   |                   
|Costs and estimated earnings in excess of billings on uncompleted contracts                                                                                                                                   |  | 83                  |   |                   
|Prepaid expenses and other current assets                                                                                                                                                                     |  | 289                 |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total Current Assets                                                                                                                                                                                          |  | 4,875               |   |                   
|Long-term investments                                                                                                                                                                                         |  | 2,000               |   |                   
|Property and equipment                                                                                                                                                                                        |  | 290                 |   |                   
|Intangible and other assets, net                                                                                                                                                                              |  | 42                  |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total Assets                                                                                                                                                                                                  |  | $      7,207        |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                          |  |                     |   |                   
|Current Liabilities:                                                                                                                                                                                          |  |                     |   |                   
|Current portion of capital lease obligations                                                                                                                                                                  |  | $          13       |   |                   
|Accounts payable                                                                                                                                                                                              |  | 29                  |   |                   
|Customer advances                                                                                                                                                                                             |  | 296                 |   |                   
|Billings in excess of costs and estimated earnings on uncompleted contracts                                                                                                                                   |  | 135                 |   |                   
|Deferred revenue                                                                                                                                                                                              |  | 6                   |   |                   
|Other accrued expenses and current liabilities                                                                                                                                                                |  | 517                 |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total Current
Liabilities                                                                                                                                                                                     |  | 996                 |   |                   
|Capital lease obligations                                                                                                                                                                                     |  | 15                  |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total Liabilities                                                                                                                                                                                             |  | $      1,011        |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Stockholders Equity:                                                                                                                                                                                         |  |                     |   |                   
|Common stock, $.01 par value; 50,000,000 shares authorized; 27,319,903 and

               17,173,975 shares issued and outstanding at September 30, 2000 and

               December 31, 1999, respectively |  | 273                 |   |                   
|Additional paid-in capital                                                                                                                                                                                    |  | 113,208             |   |                   
|Accumulated deficit                                                                                                                                                                                           |  | (107,273            | ) |                   
|Accumulated other comprehensive loss                                                                                                                                                                          |  | (12                 | ) |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total
Stockholders Equity                                                                                                                                                                                    |  | 6,196               |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   
|Total Liabilities
and Stockholders Equity                                                                                                                                                                    |  | $      7,207        |   |                   
|                                                                                                                                                                                                              |  |                     |   |                   




The accompanying notes are an integral part of these unaudited consolidated financial statements.





PERITUS SOFTWARE SERVICES, INC.





CONSOLIDATED STATEMENT OF OPERATIONS


(In thousands, except per share related data)


(unaudited)





|                                                                                                          |  | Three Months

Ended

September 30, |   | Nine Months

Ended

September 30,
|--------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | - | ---------------------------------
|
|Revenue:                                                                                                  |  |                                    |   |                                  
|Outsourcing services                                                                                      |  | $  582                             |   |                                  
|License                                                                                                   |  | 375                                |   |                                  
|Other services, including $69, $0, $69, and $0 from related parties,

               respectively         |  | 90                                 |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Total Revenue                                                                                             |  | 1,047                              |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Cost of Revenue:                                                                                          |  |                                    |   |                                  
|Cost of outsourcing services                                                                              |  | 278                                |   |                                  
|Cost of license                                                                                           |  |                                   |   |                                  
|Cost of other services, including $53, $0, $53, and $0 from related

               parties, respectively |  | 91                                 |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Total Cost of Revenue                                                                                     |  | 369                                |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Gross Profit                                                                                              |  | 678                                |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Operating Expenses:                                                                                       |  |                                    |   |                                  
|Sales and marketing                                                                                       |  | 100                                |   |                                  
|Research and development                                                                                  |  | 318                                |   |                                  
|General and administrative                                                                                |  | 336                                |   |                                  
|Impairment of long-lived assets                                                                           |  |                                   |   |                                  
|Restructuring charge                                                                                      |  |                                   |   |                                  
|Gain on sale of assets                                                                                    |  |                                   |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Total Operating
Expenses                                                                                  |  | 754                                |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Loss from Operations                                                                                      |  | (76                                | ) |                                  
|Interest income, net                                                                                      |  | 102                                |   |                                  
|Cost of Strategic Investment                                                                              |  |                                   |   |                                  
|Provision for income taxes                                                                                |  | (15                                | ) |                                  
|                                                                                                          |  |                                    |   |                                  
|Net Income (Loss)                                                                                         |  | $    41                            |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Net Income (Loss) per common share:                                                                       |  |                                    |   |                                  
|Basic                                                                                                     |  | $  0.00                            |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Diluted                                                                                                   |  | $  0.00                            |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Weighted average common shares outstanding:                                                               |  |                                    |   |                                  
|Basic                                                                                                     |  | 27,320                             |   |                                  
|                                                                                                          |  |                                    |   |                                  
|Diluted                                                                                                   |  | 27,682                             |   |                                  
|                                                                                                          |  |                                    |   |                                  




The accompanying notes are an integral part of these unaudited consolidated financial statements.





PERITUS SOFTWARE SERVICES, INC.





CONSOLIDATED STATEMENT OF CASH FLOWS


(In thousands)





|                                                                               |  | Nine Months Ended

September 30,
|------------------------------------------------------------------------------ |  | --------------------------------
|
|
|INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                               |  |                                 
|Cash flows from operating activities:                                          |  |                                 
|Net loss                                                                       |  | $(4,202                         
|Adjustments to reconcile net loss to net cash used for operating activities:   |  |                                 
|Depreciation and amortization                                                  |  | 384                             
|Gain on sale of assets                                                         |  | (24                             
|Cost of strategic investment                                                   |  | 4,000                           
|Impairment of long-lived assets                                                |  |                                
|Changes in assets and liabilities:                                             |  |                                 
|Accounts receivable                                                            |  | 194                             
|Costs and estimated earnings in excess of billings on uncompleted contracts    |  | 198                             
|Prepaid expenses and other current assets                                      |  | (41                             
|Other assets                                                                   |  | 13                              
|Accounts payable                                                               |  | 18                              
|Proceeds from customer advances                                                |  |                                
|Billings in excess of costs and estimated earnings on uncompleted contracts    |  | (118                            
|Deferred revenue                                                               |  | (189                            
|Other accrued expenses and current liabilities excluding accrued restructuring |  | (611                            
|Accrued restructuring                                                          |  |                                
|                                                                               |  |                                 
|Net cash used for
operating activities                                         |  | (378                            
|                                                                               |  |                                 
|Cash flows from investing activities:                                          |  |                                 
|Sale (Purchase) of short-term investments                                      |  | (1,411                          
|Purchase of long-term investments                                              |  | (2,000                          
|Proceeds from sale of property and equipment                                   |  | 57                              
|Purchases of property and equipment                                            |  | (5                              
|                                                                               |  |                                 
|Net cash provided by
(used for) investing activities                           |  | (3,359                          
|                                                                               |  |                                 
|Cash flows from financing activities:                                          |  |                                 
|Restricted cash                                                                |  |                                
|Principal payments on long-term debt                                           |  |                                
|Principal payments on capital lease obligations                                |  | (10                             
|Proceeds from exercise of stock options                                        |  | 30                              
|Proceeds from issuance of common stock net of issuance cost                    |  | 4,000                           
|                                                                               |  |                                 
|Net cash provided by
financing activities                                      |  | 4,020                           
|                                                                               |  |                                 
|Effects of exchange rates on cash and cash equivalents                         |  | (4                              
|                                                                               |  |                                 
|Net increase (decrease) in cash and cash equivalents                           |  | 279                             
|Cash and cash equivalents, beginning of period                                 |  | 2,475                           
|                                                                               |  |                                 
|Cash and cash equivalents, end of period                                       |  | $  2,754                        
|                                                                               |  |                                 
|Supplemental disclosure of cash flows:                                         |  |                                 
|Cash paid for income taxes                                                     |  |                                
|Cash paid for interest                                                         |  |                                




The accompanying notes are an integral part of these unaudited consolidated financial statements.





PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





1.    BASIS OF PRESENTATION AND CURRENT FINANCIAL CONDITION





The accompanying unaudited consolidated financial statements include the accounts of Peritus Software Services, Inc. and its
subsidiaries (the Company) and have been prepared by the Company without audit in accordance with the Companys accounting policies, as described in the Companys Annual Report on Form 10-K for the year ended December 31, 1999, as
filed with the Securities and Exchange Commission (SEC). In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, and consist only of those of a normal recurring nature, necessary for
a fair presentation of the Companys financial position, results of operations and cash flows at the dates and for the periods indicated. While the Company believes that the disclosures presented are adequate to make the information not misleading,
these financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Companys 1999 Annual Report on Form 10-K. The operating results for the nine months ended September 30, 2000 are
not necessarily indicative of the results to be expected for the full year ending December 31, 2000.





The Companys consolidated financial statements have been presented on the basis that it is a going concern, which
contemplates continuity of operations, realization of assets and the satisfaction of liabilities in the ordinary course of business. The Company experienced a net loss of $4,202,000 for the nine months ended September 30, 2000, and net losses of
$2,583,000 and $26,673,000 in the years ended December 31, 1999 and 1998, respectively.





On March 27, 2000, Rocket Software, Inc. (Rocket), a privately held company, invested $4,000,000 in the Company in
exchange for 10,000,000 shares ($0.40 per share) of restricted common stock (approximately 37% of the outstanding shares of common stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. The Company
recorded a $4,000,000 non-cash charge related to the investment in the quarter ended March 31, 2000. The charge represented the difference between the quoted market price on the commitment date and the price paid by Rocket. Under certain sections of the
Internal Revenue Code, a change in ownership of greater than 50% within a three-year period places an annual limitation on the Companys ability to utilize its existing net operating loss and research and development tax credit carry-forwards. The
investment by Rocket triggered the limitation. Based on the Companys current forecasted cash expenditures, its cash on hand prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance
its operations through the year 2001. The Companys future beyond the year 2001 is dependent upon its ability to achieve a break-even cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.





On October 16, 2000, the Company announced that it retained The Catalyst Group, LLC to render financial advisory and
investment banking services in connection with exploring strategic alternatives, including the potential sale of the Company.





2.    LEGAL PROCEEDINGS





On or about April 28, 1999, the Company filed a lawsuit in the United States District Court for the District of Massachusetts
against Micah Technology Services, Inc. and Affiliated Computer Services, Inc. (collectively, Micah). The lawsuit principally alleges that Micah breached its contract with the Company by failing to pay for services performed by the Company
under such contract. The lawsuit further alleges that since Micah was unjustly enriched by the services performed by the Company, the Company is entitled to recovery based on quantum meruit, and that Micah engaged in unfair and/or deceptive trade
practices or acts in violation of Massachusetts General Laws (M.G.L.) Chapter 93A by allowing the Company to perform services when Micah did not pay for such services. The lawsuit seeks unspecified damages on the breach of contract and quantum
meruit claims and double or triple damages on the Chapter 93A claim. Micah has denied the Companys
allegations and has filed a counterclaim against the Company principally alleging fraud, negligent misrepresentations, breach of contract and that the Company engaged in unfair and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by
its misrepresentations and breach of contract. The Company denied the allegations contained in Micahs counterclaim and intends to contest the counterclaim vigorously. A non-binding mediation hearing was held on March 17, 2000 and no settlement was
reached. The parties are in the discovery phase of the litigation and are presently engaged in discussions in order to attempt to settle the lawsuit.





In addition to the matters noted above, the Company is from time to time subject to legal proceedings and claims which arise
in the normal course of its business. In the opinion of management, the amount of ultimate liability with respect to these other actions, currently known, will not have a material adverse effect on the Companys financial position or results of
operations.





3.    INVESTMENTS





During the three months ended September 30, 2000, the Company made investments in debt securities of U.S. government agencies
and U.S. corporations. These investment grade securities are classified at purchase as held-to-maturity. Investments with remaining maturities of less than twelve months from the balance sheet date are classified as short-term investments. Investments
with remaining maturities of more than twelve months are classified as long-term investments.





4.    COMPREHENSIVE INCOME (LOSS)





Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other
events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.





For the three and nine months ended September 30, 2000 and 1999, the Companys comprehensive income (loss) consisted of
the following:





|                       |  | Three Months

Ended September 30, |   | Nine Months

Ended September 30,
|---------------------- |  | --------------------------------- | - | --------------------------------
|
|Net Income (Loss)      |  | $41,000                           |   |                                 
|Translation Adjustment |  | (2,000                            | ) |                                 
|                       |  |                                   |   |                                 
|                       |  | $39,000                           |   |                                 
|                       |  |                                   |   |                                 




5.    SEGMENT, GEOGRAPHIC, AND PRODUCT INFORMATION





The Company operates in one reportable segment under SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information, due to its centralized structure and single industry segment: software maintenance, tools and services. The Company currently derives its revenue from software maintenance outsourcing services, software and methodology licensing
and other services.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








Information by geographic area for the nine months ended September 30, 2000 and 1999 is summarized below (in thousands):





|                   |  | Outsourcing Services |  | License Revenue |  | Other Services Revenue |  | Long-lived Assets
|------------------ |  | -------------------- |  | --------------- |  | ---------------------- |  | -----------------
|September 30, 2000 |  |                      |  |                 |  |                        |  |                  
|United States      |  | $2,072               |  | $1,045          |  | $  421                 |  | $290             
|Foreign            |  |                     |  |                |  |                       |  |                 
|                   |  |                      |  |                 |  |                        |  |                  
|                   |  | $2,072               |  | $1,045          |  | $  421                 |  | $290             
|                   |  |                      |  |                 |  |                        |  |                  
|September 30, 1999 |  |                      |  |                 |  |                        |  |                  
|United States      |  | $4,846               |  | $1,937          |  | $2,957                 |  | $890             
|Foreign            |  |                     |  |                |  |                       |  | 37               
|                   |  |                      |  |                 |  |                        |  |                  
|                   |  | $4,846               |  | $1,937          |  | $2,957                 |  | $927             
|                   |  |                      |  |                 |  |                        |  |                  




The geographic classification of revenue is determined based on the country in which the legal entity providing the services
is located.





ITEM 2.    Managements Discussion and Analysis of Financial Condition and Results of Operations





OVERVIEW AND CURRENT FINANCIAL CONDITION





Peritus Software Services, Inc. (Peritus or the Company) was incorporated in Massachusetts in August
1991. The Company provides solutions consisting of software products and services that enable organizations to improve the productivity, quality and effectiveness of their information technology, systems maintenance, or software evolution
functions. The Company derives its revenue from software maintenance outsourcing services, software and methodology licensing and other services.





In the second half of 1998 and in 1999, the overall market for the year 2000 tools and services of Peritus contracted
dramatically, resulting in substantial financial losses. In response, the Company substantially reduced its workforce in September and December of 1998 and again in April of 1999. During the second and third quarters of 1999, the Company also settled its
leases for its facilities in Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other efforts to reduce its fixed costs. As a result of the Companys degraded financial condition, the Company began encountering major obstacles in
obtaining new outsourcing business. Since most outsourcing engagements are multi-year and involve critical applications, prospective new clients, although interested in the capabilities and technology of the Company, were reluctant or unwilling to commit
to contracts. Despite the significant reduction in the overall cost structure as a result of the foregoing actions, the Company was unable to achieve a cash flow break-even position in the year ended December 31, 1999.





On March 27, 2000, Rocket Software, Inc. (Rocket), a privately held company, invested $4,000,000 in the Company in
exchange for 10,000,000 shares ($.40 per share) of restricted common stock (approximately 37% of the outstanding shares of common stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. Based on the
Companys current forecasted cash expenditures, its cash on hand prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance its operations through the year 2001. The Companys
future beyond the year 2001 is dependent upon its ability to achieve a break-even cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.





The Companys current strategy is to continue to service its existing outsourcing customers and to renew expiring
contracts. At the same time, the Company is pursuing new business through (i) the licensing of, and
associated consulting and training for, its software maintenance methodology (technology transfer services) and SAM Relay tool, and (ii) the provision of various service offerings including, without limitation, contracted research and development, and
general software consulting. The Company plans to continue limited maintenance of and enhancements to its existing products and may selectively develop new products. The Company also may develop other service offerings. The Company has explored certain
extensions of its CodeNine tool beyond the field of application understanding and has concluded that such extensions are not feasible at this time.





On October 16, 2000, the Company announced that it retained The Catalyst Group, LLC to render financial advisory and
investment banking services in connection with exploring strategic alternatives, including the potential sale of the Company.





THREE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1999





Revenue





Total revenue decreased 46.6% to $1,047,000 in the three months ended September 30, 2000 from $1,960,000 in the three months
ended September 30, 1999. The decrease in total revenue was due to a decrease in outsourcing and other services revenues, partially offset by an increase in license revenue.





The Company anticipates that total revenue for the fourth quarter of 2000 will be substantially below the level achieved in
1999 for reasons that may include, without limitation, decreases in outsourcing revenues, other services revenues, and/or license revenues.





Outsourcing Services.Outsourcing services revenue decreased 57.0% to $582,000 in the three
months ended September 30, 2000 from $1,354,000 in the three months ended September 30, 1999. As a percentage of total revenue, outsourcing services revenue decreased to 55.6% in the three months ended September 30, 2000 from 69.1% for the three months
ended September 30, 1999. The decrease in outsourcing services revenue as a percentage of total revenue reflects the overall decrease in outsourcing services revenue in absolute dollars, as well as the increased contribution of license revenue to total
revenue during the three months ended September 30, 2000 when compared to the same period in the prior year. The decrease in outsourcing services revenue in absolute dollars in the three months ended September 30, 2000, compared to September 30, 1999, was
attributable to recording lower amounts of revenue under existing outsourcing engagements due to reduced workload or contract terminations. The Company did not sign any new outsourcing contracts during the third quarter of 2000.





License.License revenue increased 151.7% to $375,000 in the three months ended September 30,
2000, or 35.8% of total revenue, compared to $149,000 or 7.6% of total revenue, in the three months ended September 30, 1999. The increase in license revenue for 2000 in absolute dollars was attributable to a license of SAM Relay and the Peritus
methodology by a single customer. The increase in license revenue as a percentage of total revenue reflects the increase in license revenue in absolute dollars, as well as the overall decrease in outsourcing services and other services revenue. The
Company will continue to pursue licenses of its software maintenance methodology and SAM Relay tool and future license revenue is dependent on the success of such efforts.





Other Services.Other services revenue decreased 80.3% to $90,000 in the three months ended
September 30, 2000 from $457,000 in the three months ended September 30, 1999. As a percentage of total revenue, other services revenue decreased to 8.6% in the three months ended September 30, 2000 from 23.3% in the three months ended September 30, 1999.
The decreases in other services revenue both in absolute dollars and as a percentage of total revenue were primarily attributable to a decrease in direct delivery, consulting and client support services relating to the Companys year 2000 products
and services. Future revenue from other services is dependent on the Companys success in licensing its software maintenance methodology and its SAM Relay
tool, which would generate maintenance, consulting and training revenue. Future revenue from other services is also dependent on the development and sale of other successful service offerings.





Cost of Revenue





Cost of Outsourcing Services Revenue.Cost of outsourcing services revenue consists primarily of
salaries, benefits and overhead costs associated with delivering outsourcing services to clients. The cost of outsourcing services revenue decreased 70.8% to $278,000 in the three months ended September 30, 2000 from $951,000 for the three months ended
September 30, 1999. Cost of outsourcing services revenue as a percentage of outsourcing services revenue decreased to 47.8% in the three months ended September 30, 2000 from 70.2% in the three months ended September 30, 1999. The cost rate improvement in
the third quarter of 2000 resulted from the more effective utilization of outsourcing resources.





Cost of License Revenue.Cost of license revenue consists primarily of amortization of expense
of intangibles and salaries, benefits and related overhead costs associated with license-related materials, packaging and freight. Cost of license revenue was $0 in the three months ended September 30, 2000. Cost of license revenue was $15,000 or 10.1% of
license revenue in the three months ended September 30, 1999. The decrease in cost of license revenue was primarily related to the termination (in the fourth quarter of 1999) of amortization expense of intangibles related to the Companys December
1997 acquisition of Millennium Dynamics, Inc. (MDI).





Cost of Other Services Revenue.Cost of other services revenue consists primarily of salaries,
benefits and related overhead costs associated with delivering other services to clients. Cost of other services revenue decreased 42.8% to $91,000 in the three months ended September 30, 2000 from $159,000 in the three months ended September 30, 1999.
Cost of other services revenue as a percentage of other services revenue increased to 101.1% in the three months ended September 30, 2000 from 34.8% in the three months ended September 30, 1999. Costs decreased in absolute dollars in the three months
ended September 30, 2000 due to reduced staffing for the Companys client support, training and consulting organizations related to fewer customers for the Companys year 2000 products and services, including year 2000 renovations and RQE
services. The cost rate degradation in the third quarter of 2000 resulted primarily from the under utilization of resources associated with delivery of other services.





Operating Expenses





Sales and Marketing.Sales and marketing expenses consist primarily of salaries, commissions and
related overhead costs for sales and marketing personnel; sales referral fees to third parties; advertising programs; and other promotional activities. Sales and marketing expenses decreased 10.7% to $100,000 in the three months ended September 30, 2000
from $112,000 in the three months ended September 30, 1999 primarily due to reduced consulting and occupancy. As a percentage of total revenue, sales and marketing expenses increased to 9.6% in the three months ended September 30, 2000 from 5.7% in the
three months ended September 30, 1999 due to lower total revenue.





Research and Development.Research and development expenses consist primarily of salaries,
benefits and related overhead costs for engineering and technical personnel and outside engineering consulting services associated with developing new products and enhancing existing products. Research and development expenses increased 20.5% to $318,000
in the three months ended September 30, 2000 from $264,000 in the three months ended September 30, 1999. As a percentage of total revenue, research and development expenses increased to 30.4% in the three months ended September 30, 2000 from 13.5% in the
three months ended September 30, 1999 due to lower total revenue. The increase in research and development expenses in absolute dollars was primarily attributable to increased staff efforts in maintenance of and enhancements to the Companys CodeNine
and SAM Relay products. The Company plans to continue limited maintenance of and enhancements to its existing products and may selectively develop new products. The Company may also develop other service offerings.





General and Administrative.General and administrative expenses consist primarily of salaries
and related costs for the finance and accounting, human resources, legal services, information systems and other administrative departments of the Company, as well as contracted legal and accounting services. General and administrative expenses decreased
57.6% to $336,000 in the three months ended September 30, 2000 from $793,000 in the three months ended September 30, 1999. As a percentage of total revenue, general and administrative expenses decreased to 32.1% in the three months ended September 30,
2000 from 40.5% in the three months ended September 30, 1999. The decrease in general and administrative expenses in absolute dollars was primarily due to the reductions in staffing, a decrease in the cost of excess space as a result of the Companys
consolidation of its facilities to Westborough, MA, and an $80,000 insurance reimbursement of legal fees primarily incurred in 1999.





Impairment of Long-lived Assets





The Company periodically assesses whether any events or changes in circumstances have occurred that would indicate that the
carrying amount of a long-lived asset might not be recoverable. When such an event or change in circumstance occurs, the Company evaluates whether the carrying amount of such asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to such asset. If it is determined that the carrying amount is not recoverable, the Company recognizes an impairment loss equal to the excess of the carrying amount of the asset over
the estimated fair value of such asset.





The Company did not record an impairment charge in the three months ended September 30, 2000.





During the third quarter of 1999, the Company transferred the research and development responsibility for its CodeNine tool
from India to the United States. As a result of that decision, the personnel in India were no longer required and were transferred to another unrelated company at cost. In anticipation of completing the sale of all furniture and equipment in India prior
to the expiration of the lease in February, 2000, the Company recorded an impairment charge of $145,000 against assets having a net book value of $182,000 to write down assets to their estimated fair value (salvage value) of $37,000.





Also in the third quarter of 1999, the Company completed its review of CodeNine. It was determined that the Company would not
be able to afford to develop future products based upon its patented technology. In addition, the Company expected to receive minimal future revenue from its existing products that include the patented technology. Accordingly, the remaining patent book
value of $62,000 could no longer be supported and was written down to zero.





The combination of the $145,000 impairment charge against assets and $62,000 impairment charge for remaining patent book value
resulted in a total impairment charge of $207,000 for the three months ended September 30, 1999.





Restructuring Charges





The Company had no restructuring charges in the three months ended September 30, 2000.





In August 1999, the Company executed a lease termination agreement for its Lisle, Illinois facility. Under the agreement, the
Company paid $100,000 and relinquished its $16,000 security deposit. These amounts were charged against the accrued restructuring liability during the third quarter of 1999.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








During the third quarter of 1999, the Company developed a workable plan to relocate its headquarters from Billerica to its
existing facility in Westborough, Massachusetts. The plan, along with the Companys degraded financial condition, enabled the Company to negotiate a favorable settlement of its Billerica lease. In September 1999, the Company entered into a settlement
agreement with BCIA New England Holdings LLC. Under the settlement, the Company agreed to pay $200,000 in cash, relinquish its $300,000 security deposit, issue 500,000 shares of common stock and provide $71,000 of furniture and equipment. All of these
items were charged against the accrued restructuring liability during the third quarter of 1999. The Company also charged the liability for a $734,000 write-off of leasehold improvements and other fixed assets directly tied to its Billerica facility. The
favorable Billerica settlement resulted in a release from the restructuring accrual of $392,000.





The total facility-related release of $436,000 in the third quarter of 1999 broke down as follows:





|Billerica related |  | $(392,000 | )
|----------------- |  | --------- | -
|Lisle related     |  | (44,000   | )
|                  |  |           |  
|Total             |  | $(436,000 | )
|                  |  |           |  




The Lisle related release resulted from the settlement of the Lisle telephone system lease for less than the capitalized lease
liability.





In total, the Company recorded a net favorable impact of $450,000 associated with restructuring to the results of operations
for the three months ended September 30, 1999, of which $436,000 related to facilities and $14,000 related to terminated employees.





Interest Income (Expense), Net





Interest income and expense consists primarily of interest income from investments and cash balances, partially offset by
interest expense on debt. The Company had interest income, net, of $102,000 in the three months ended September 30, 2000 compared to interest income, net, of $25,000 in the three months ended September 30, 1999. This change in interest income (expense),
net, was primarily attributable to increased interest income from interest bearing investments as a result of the proceeds from the Rocket investment.





Provision for Income Taxes





The Companys income tax provision was a credit of $15,000 for the three months ended September 30, 2000 and a charge of
$5,000 for the three months ended September 30, 1999. During the three months ended September 30, 2000, the Company received a refund of $15,000 for foreign taxes withheld from a customer payment in 1999. The provision of $5,000 for the three months ended
September 30, 1999 was for several small city and state tax obligations.





NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1999





Revenue





Total revenue decreased 63.7% to $3,538,000 in the nine months ended September 30, 2000 from $9,740,000 in the nine months
ended September 30, 1999. The decrease in revenue was primarily due to a decrease in outsourcing and other services revenues and, to a lesser extent, in the licensing of the Companys software products and tools.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








The Company anticipates that total revenue for the fourth quarter of 2000 will be substantially below the level achieved in
1999 for reasons that may include, without limitation, decreases in outsourcing revenues, other services revenues, and/or licenses revenues.





Outsourcing Services.Outsourcing services revenue decreased 57.2% to $2,072,000 in the nine
months ended September 30, 2000 from $4,846,000 in the nine months ended September 30, 1999. As a percentage of total revenue, outsourcing services revenue increased to 58.6% in the nine months ended September 30, 2000 from 49.8% for the nine months ended
September 30, 1999. The increase in outsourcing services revenue as a percentage of total revenue reflects the decreased contribution of other services revenue to total revenue during the nine months ended September 30, 2000 when compared to the same
period in the prior year. The decrease in outsourcing services revenue in absolute dollars in the nine months ended September 30, 2000, compared to September 30, 1999, was attributable to recording lower amounts of revenue under existing outsourcing
engagements due to reduced workload or contract terminations. The Company did not sign any new outsourcing contracts during the nine months ended September 30, 2000.





License.License revenue decreased 46.1% to $1,045,000 in the nine months ended September 30,
2000, or 29.5% of total revenue, compared to $1,937,000, or 19.9% of total revenue, in the nine months ended September 30, 1999. The increase in license revenue as a percentage of total revenue reflects the decreased contribution of other services revenue
to total revenue during the nine months ended September 30, 2000 when compared to the same period in the prior year. The decrease in license revenue for 2000 in absolute dollars was primarily attributable to a decrease in year 2000 related license revenue
from end users and value added integrators. The Company will continue to pursue licenses of its software maintenance methodology and SAM Relay tool and future revenue is dependent on the success of such efforts.





Other Services.Other services revenue decreased 85.8% to $421,000 in the nine months ended
September 30, 2000 from $2,957,000 in the nine months ended September 30, 1999. As a percentage of total revenue, other services revenue decreased to 11.9% in the nine months ended September 30, 2000 from 30.4% in the nine months ended September 30, 1999.
The decreases in other services revenue both in absolute dollars and as a percentage of total revenue were primarily attributable to a decrease in direct delivery, consulting and client support services relating to the Companys year 2000 products
and services. Future revenue from other services is dependent on the Companys success in licensing its software maintenance methodology and its SAM Relay tool, which would generate maintenance, consulting and training revenue. Future revenue from
other services is also dependent on the development and sale of other successful service offerings.





Cost of Revenue





Cost of Outsourcing Services Revenue.The cost of outsourcing services revenue decreased 71.4%
to $1,178,000 in the nine months ended September 30, 2000 from $4,125,000 for the nine months ended September 30, 1999. Cost of outsourcing services revenue as a percentage of outsourcing services revenue decreased to 56.9% in the nine months ended
September 30, 2000 from 85.1% in the nine months ended September 30, 1999. Costs in the nine months ended September 30, 1999 were significantly higher than in the nine months ended September 30, 2000 due to expenditures in anticipation of generating new
business that did not materialize.





Cost of License Revenue.Cost of license revenue was $0 in the nine months ended September 30,
2000. Cost of license revenue was $162,000 or 8.4% of license revenue, in the nine months ended September 30, 1999. The decrease in cost of license revenue was primarily related to the termination (in the fourth quarter of 1999) of amortization expense of
intangibles related to the Companys December 1997 acquisition of MDI.





Cost of Other Services Revenue.Cost of other services revenue decreased 87.5% to $230,000 in
the nine months ended September 30, 2000 from $1,842,000 in the nine months ended September 30, 1999. Cost of other
services revenue as a percentage of other services revenue decreased to 54.6% in the nine months ended September 30, 2000 from 62.3% in the nine months ended September 30, 1999. Costs decreased in absolute dollars and as a percentage of other services
revenue in the nine months ended September 30, 2000 due to reduced staffing for the Companys client support, training and consulting organizations related to fewer customers for the Companys year 2000 products and services, including year 2000
renovations and RQE services, and more effective utilization of the remaining staff.





Operating Expenses





Sales and Marketing.Sales and marketing expenses decreased 77.4% to $309,000 in the nine months
ended September 30, 2000 from $1,367,000 in the nine months ended September 30, 1999. As a percentage of total revenue, sales and marketing expenses decreased to 8.7% in the nine months ended September 30, 2000 from 14.0% in the nine months ended
September 30, 1999. The decreases in expenses in absolute dollars and as a percentage of total revenue were primarily attributable to reduced staffing, commissions and promotional activities.





Research and Development.Research and development expenses decreased 16.2% to $903,000 in the
nine months ended September 30, 2000 from $1,078,000 in the nine months ended September 30, 1999. As a percentage of total revenue, research and development expenses increased to 25.5% in the nine months ended September 30, 2000 from 11.1% in the nine
months ended September 30, 1999. The increase in research and development expenses as a percentage of total revenue reflects the decrease in total revenue. The decrease in research and development expenses in absolute dollars was primarily attributable to
reduced staffing. The Company plans to continue limited maintenance of and enhancements to its existing products and may selectively develop new products. The Company also may develop other service offerings.





General and Administrative.General and administrative expenses decreased 57.3% to $1,400,000 in
the nine months ended September 30, 2000 from $3,276,000 in the nine months ended September 30, 1999. As a percentage of total revenue, general and administrative expenses increased to 39.6% in the nine months ended September 30, 2000 from 33.6% in the
nine months ended September 30, 1999. The increase in general and administrative expenses as a percentage of total revenue reflects the decrease in total revenue. The decrease in general and administrative expenses in absolute dollars was primarily due to
the reductions in staffing, the cost of excess space, and legal and accounting fees.





Impairment of Long-lived Assets





The Company periodically assesses whether any events or changes in circumstances have occurred that would indicate that the
carrying amount of a long-lived asset might not be recoverable. When such an event or change in circumstance occurs, the Company evaluates whether the carrying amount of such asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to such asset. If it is determined that the carrying amount is not recoverable, the Company recognizes an impairment loss equal to the excess of the carrying amount of the asset over
the estimated fair value of such asset.





The Company did not record an impairment charge in the nine months ended September 30, 2000.





In June 1999, as a result of the continuing downsizing of the Companys operations and continuing decline in operating
results, the Company reviewed the carrying amount of its property and equipment and committed to a plan to dispose certain of its assets, primarily excess computer equipment and furniture relating to its restructured operations, either by sale or by
abandonment. Based upon managements review, the carrying
amount of assets having a net book value of $1,143,000 was written-down to a total amount of $389,000, representing the lower of carrying amount or fair value (salvage value) and the Company recorded an impairment charge totaling $754,000.





During the third quarter of 1999, the Company transferred the research and development responsibility for its CodeNine tool
from India to the United States. As a result of that decision, the personnel in India were no longer required and were transferred to another unrelated company at cost. In anticipation of completing the sale of all furniture and equipment in India prior
to the expiration of the lease in February, 2000, the Company recorded an impairment charge of $145,000 against assets having a net book value of $182,000 to write down assets to their estimated fair value (salvage value) of $37,000.





Also in the third quarter of 1999, the Company completed its review of its product offering going forward. It was determined
that the Company would not be able to afford to develop future products based upon its patented technology. In addition, the Company expected to receive minimal future revenue from its existing products that include the patented technology. Accordingly,
the remaining patent book value of $62,000 could no longer be supported and was written down to zero.





The combination of the $754,000 impairment charge in June 1999 for writedown of the Companys assets in the United
States, the $145,000 impairment charge in September 1999 for write down of the Companys assets in India, and the $62,000 impairment charge in September 1999, for remaining patent book value resulted in a total impairment charge of $961,000 for the
nine months ended September 30 1999.





Restructuring Charges





The Company had no restructuring charges in the nine months ended September 30, 2000.





On March 29, 1999, the Company announced its intention to restructure and recorded a charge of $291,000, consisting of
severence payments associated with the termination of 40 employees.





In April 1999, the Company decided to further reduce the amount of space it occupied in its Billerica, Massachusetts
headquarters facility. The space consolidation was completed in the second quarter of 1999 and the Company increased the amount of space it was offering for sublease from 50,000 to 75,000 square feet. Accordingly, in June 1999, the Company recorded an
additional restructure charge of $517,000 consisting primarily of the cost of lease expenses and real estate commissions associated with the additional vacated 25,000 square feet net of estimated sublease income.





At the end of the second quarter of 1999, the Company re-evaluated its estimated costs associated with its previous
restructure charges based upon activity and experience to date. This evaluation included a re-estimate of the remaining costs to be incurred in the future under the previous restructurings and resulted in an $813,000 release from the restructuring
accrual. The $813,000 release in the second quarter of 1999 represented the difference between the remaining restructure accrual and the future estimated costs. Of the total release, $75,000 was related to the provision of severance and benefit payments
for terminated employees and $738,000 was related to the closure of facilities and the reduction of occupied space.





The $738,000 facility related release in the second quarter of 1999 broke down as follows:





|Billerica related  |  | $(502,000 | )
|------------------ |  | --------- | -
|Cincinnati related |  | (272,000  | )
|Lisle related      |  | 36,000    |  
|                   |  |           |  
|Total              |  | $(738,000 | )
|                   |  |           |  

PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








The Billerica related release resulted from changes in sublease assumptions. The Cincinnati related release resulted from a
favorable lease settlement. The Lisle related negative amount was due to the fact that a settlement agreement had been negotiated (but not concluded) and it exceeded the remaining accrual.





In August 1999, the Company executed a lease termination agreement for its Lisle, Illinois facility. Under the agreement, the
Company paid $100,000 and relinquished its $16,000 security deposit. These amounts were charged against the accrued restructuring liability during the third quarter of 1999.





During the third quarter of 1999, the Company developed a workable plan to relocate its headquarters from Billerica to its
existing facility in Westborough, Massachusetts. The plan, along with the Companys degraded financial condition, enabled the Company to negotiate a favorable settlement of its Billerica lease. In September 1999, the Company entered into a settlement
agreement with BCIA New England Holdings LLC. Under the settlement, the Company agreed to pay $200,000 in cash, relinquish its $300,000 security deposit, issue 500,000 shares of common stock and provide $71,000 of furniture and equipment. All of these
items were charged against the accrued restructuring liability during the third quarter of 1999. The Company also charged the liability for a $734,000 write-off of leasehold improvements and other fixed assets directly tied to its Billerica facility. The
favorable Billerica settlement resulted in a release from the restructuring accrual of $392,000.





The total facility-related release of $436,000 in the third quarter of 1999 broke down as follows:





|Billerica related |  | $(392,000 | )
|----------------- |  | --------- | -
|Lisle related     |  | (44,000   | )
|                  |  |           |  
|Total             |  | $(436,000 | )
|                  |  |           |  




The Lisle related release resulted from the settlement of the Lisle telephone system lease for less than the capitalized lease
liability.





In total, the Company recorded a net favorable impact of $450,000 in the third quarter 1999, associated with restructuring of
which $436,000 related to facilities and $14,000 related to terminated employees.





The combination of the 1999 first quarter provision of $291,000, the 1999 second quarter provision of $517,000, the 1999
second quarter release of $813,000, and the 1999 third quarter release $450,000, resulted in a net favorable impact of $455,000 to operations for the nine months ended September 30, 1999.





Gain on the Sale of Assets





For the nine months ended September 30, 2000, the Company recorded a gain on the sale of assets of $24,000 that represented
the excess of the sales proceeds over the net book value of the fixed assets of the Companys India subsidiary that were sold during the first quarter of 2000.





Interest Income (Expense), Net





Interest income and expense consists primarily of interest income from investments and cash balances, partially offset by
interest expense on debt. The Company had interest income, net, of $241,000 in the nine months ended September 30, 2000 compared to interest income, net, of $63,000 in the nine months ended September 30, 1999. This change in interest income (expense),
net, was primarily attributable to increased interest income from interest bearing investments as a result of the Rocket investment.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








Cost of Strategic Investment





On March 27, 2000, Rocket invested $4,000,000 in the Company in exchange for 10,000,000 shares ($0.40 per share) of restricted
common stock (approximately 37% of the outstanding shares of common stock after investment). For the nine months ended September 30, 2000, the Company recorded a non-cash charge of $4,000,000 for the cost of this strategic investment equal to the
difference between the purchase price per share of $0.40 and the market price per share of $0.80 on March 27, 2000.





Provision for Income Taxes





The Companys income tax provision was a credit of $15,000 for the nine months ended September 30, 2000 and a charge of
$5,000 for the nine months ended September 30, 1999. During the nine months ended September 30, 2000, the Company received a refund of $15,000 for foreign taxes withheld from a customer payment in 1999. The provision of $5,000 for the nine months ended
September 30, 1999 was for several small city and state tax obligations.





LIQUIDITY AND CAPITAL RESOURCES





The Company has financed its operations and capital expenditures primarily with the proceeds from sales of the Companys
convertible preferred stock and common stock, borrowings, and advance payments for services from clients. The Companys cash balances were $2,754,000 and $2,475,000 at September 30, 2000 and December 31, 1999, respectively. The Companys
short-term and long-term investments were $1,411,000 and $2,000,000 at September 30, 2000. There were no short-term or long-term investments at December 31, 1999. The Companys working capital was $3,879,000 and $1,640,000 at September 30, 2000 and
December 31, 1999, respectively.





The Companys operating activities used cash of $378,000 and $1,195,000 during the nine months ended September 30, 2000
and 1999, respectively. The cash used during the nine months ended September 30, 2000 was primarily caused by a net loss of $4,202,000 (less the non-cash cost of the strategic investment of $4,000,000 by Rocket, depreciation and amortization expense of
$384,000, and the gain from the sale of assets of $24,000). Other sources were a decrease in accounts receivable of $194,000, a decrease in costs and estimated earnings in excess of billings on uncompleted contracts of $198,000, an increase in accounts
payable of $18,000, and a decrease in other assets of $13,000. These amounts were partially offset by a decrease in other accrued liabilities of $611,000, a decrease in deferred revenue of $189,000, a decrease in billings in excess of costs and estimated
earnings on uncompleted contracts of $118,000 and an increase in prepaid expenses and other assets of $41,000.





The Companys investing activities used cash of $3,359,000 and provided cash of $740,000 during the nine months ended
September 30, 2000 and 1999, respectively. During the nine months ended September 30, 2000, the Company purchased short-term investments of $1,411,000, long-term investments of $2,000,000, and property and equipment of $5,000. These amounts were partially
offset by proceeds from the sale of property and equipment of $57,000 from the sale of the remaining assets of the Companys India subsidiary.





The Companys financing activities provided cash of $4,020,000 and $117,000 during the nine months ended September 30,
2000 and 1999, respectively. Financing activities in the nine months ended September 30, 2000 primarily reflect an increase from the proceeds of issuance of new common stock of $4,000,000 and the exercise of stock options of $30,000, partially offset by
payments on capital lease obligations of $10,000.





The Company has an accounts receivable purchase agreement with a lender to permit borrowing against certain acceptable
receivables at a rate of 80% of the face amount of such receivables up to a maximum of $4,000,000. In exchange for such agreement, the Company granted the lender security interest on substantially all of its assets. There were no borrowings outstanding
under the agreement at September 30, 2000.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








On March 27, 2000, Rocket invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40 per share) of restricted
common stock (approximately 37% of the outstanding shares of stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. Based on the Companys current forecasted cash expenditures, its cash on hand
prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance its operations through the year 2001. The Companys future beyond the year 2001 is dependent upon its ability to achieve a
breakeven cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.





On October 16, 2000, the Company announced that it retained The Catalyst Group, LLC to render financial advisory and
investment banking services in connection with exploring strategic alternatives, including the potential sale of the Company.





To date, the Company has not invested in derivative securities or any other financial instruments that involve a high level of
complexity or risk. Excess cash has been, and the Company contemplates that it will continue to be, invested in interest-bearing, investment grade securities.





FOREIGN CURRENCY





Assets and liabilities of the Companys majority-owned foreign subsidiary are translated into U.S. dollars at exchange
rates in effect at the balance sheet date. Income and expense items are translated at average exchange rates for the period. Accumulated net translation adjustments are included in stockholders equity.





INFLATION





To date, inflation has not had a material impact on the Companys results of operations.





FACTORS THAT MAY AFFECT FUTURE RESULTS





Failure to Achieve Cash Flow Breakeven





The Companys ability to achieve a cash flow breakeven position is critical for achieving financial stability. There can
be no assurance that the Company will achieve a cash flow breakeven position in the future.





Financing





There can be no assurance that the Company will be able to obtain additional funds in the future through equity and/or debt
financings or borrow against its accounts receivable financing agreement.





Strategic Alternatives





On October 16, 2000, the Company announced that it retained The Catalyst Group, LLC to render financial advisory and
investment banking services in connection with exploring strategic alternatives, including the potential sale of the Company. There can be no assurance that the Company will be able to implement any strategic alternatives that are presented to the Company
for consideration.





Risk of Current Strategy





In the past, the Company generated significant revenues from marketing and selling products and services that addressed the
year 2000 problem. The demand for such products and services has ended and the Company no longer actively markets and sells year 2000 products and services. The Companys current strategy is to continue to service its existing outsourcing customers
and to renew expiring contracts. At the same time, the
Company is pursuing new business through (i) the licensing of, and associated consulting and training for, its software maintenance methodology (technology transfer services) and SAM Relay tool and (ii) the provision of various service offerings
including, without limitation, contracted research and development and other general software consulting.





The Company plans to continue limited maintenance of and enhancements to its existing products and may selectively develop new
products. The Company also may develop other service offerings. The Company has explored certain extensions of its CodeNine tool beyond the field of application understanding and has concluded that such extensions are not feasible at this time.





The failure to sell existing products or services and/or develop and sell new products and/or services would have a material
adverse effect on the Companys business, financial condition and results of operations. There can be no assurance that the Company will be able to grow or maintain its outsourcing business or sell its products or services. There can be no assurance
that the Companys current strategy will generate revenues sufficient for the Company to achieve a cash flow breakeven position.





Over the Counter Listing





Trading of the common stock is conducted in the over-the-counter market which could make it more difficult for an investor to
dispose of, or obtain accurate quotations as to the market value of, the common stock. In addition, there are additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited
investors. For transactions covered by this rule, the broker-dealer must make a special suitability determination for the purchaser and must have received the purchasers written consent to the transaction prior to sale. In addition, if the trading
price of the common stock is below $5.00 per share, trading in the common stock would also be subject to the requirements of certain rules promulgated under the Securities Exchange Act of 1934, which require additional disclosure by broker-dealers in
connection with any trades involving a stock defined as a penny stock (generally any non-NASDAQ equity security that has a market price of less than $5.00 per share, subject to certain exceptions). Such rules require the delivery, prior to any penny stock
transaction, of a disclosure schedule explaining the penny stock market and the risks associate therewith, and impose various sales practice requirements on broker-dealers who sell penny stocks to persons other than established customers and accredited
investors (generally institutions). For these types of transactions, the broker-dealer must make a special suitability determination for the purchaser and have received the purchasers written consent to the transaction prior to sale. The additional
burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in the common stock, which could severely limit the market liquidity of the common stock and the ability of the Companys shareholders
to sell the common stock in the secondary market.





Potential Fluctuations in Quarterly Performance





The Companys revenue and operating results have varied significantly in the past and are likely to vary significantly
from quarter to quarter in the future. The Companys quarterly operating results may continue to fluctuate due to a number of factors, including the timing, size and nature of the Companys individual outsourcing, technology transfer, insourcing
and licensing transactions; unforeseen difficulties in performing such transactions; the performance of the Companys value added integrators and distributors; the timing of the introduction and the market acceptance of new services, products or
product enhancements by the Company or its competitors; the relative proportions of revenue derived from license fees and professional services; changes in the Companys operating expenses; personnel changes; foreign currency exchange rates and
fluctuations in economic and financial market conditions.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








The timing, size and nature of individual outsourcing, technology transfer, insourcing and licensing transactions are
important factors in the Companys quarterly operating results. Many such transactions involve large dollar amounts and the sales cycle for these transactions is often lengthy and unpredictable. In addition, the sales cycle associated with these
transactions is subject to a number of uncertainties, including clients budgetary constraints, the timing of clients budget cycles and clients internal approval processes. There can be no assurance that the Company will be successful in
closing such large transactions on a timely basis or at all. Most of the Companys outsourcing engagements are performed on a fixed-price basis and, therefore, the Company bears the risk of cost overruns and inflation. A significant percentage of the
Companys revenue derived from these engagements is recognized on the percentage-of-completion method, which requires revenue to be recorded over the term of a client contract. A loss is recorded at the time when current estimates of project costs
exceed unrecognized revenue. The Companys operating results may be adversely affected by inaccurate estimates of contract completion costs.





The Companys expense levels are based, in part, on its expectations as to future revenue and are fixed, to a large
extent, in the short term. As a result, the Company has been and may continue to be unable to adjust spending in a timely manner to compensate for any further unexpected revenue shortfall. Accordingly, any significant shortfall in revenue, in addition to
those already experienced in relation to the Companys expectations, would have an immediate and material adverse effect on the Companys business, financial condition and results of operations.





Due to all of the foregoing factors, the Company believes that period-to-period comparisons of its operating results are not
necessarily meaningful and that such comparisons cannot be relied upon as indicators of future performance. There can be no assurance that future revenue and operating results will not continue to vary substantially. It is also possible that, in a
quarter, the Companys operating results will be below the expectations of public market analysts and investors. In either case, the price of the Companys Common Stock has been and could continue to be materially adversely affected.





Concentration of Clients





The Companys revenue is highly concentrated among a small number of clients. During the year ended December 31, 1999,
revenue from three clients accounted for 40.5% of the years revenue, with one client representing 21.7%. The contracts for two of these three clients (representing 18.8% of the revenue for the year ended December 31, 1999) terminated in November
1999 and March 2000. During the three and nine month periods ended September 30, 2000, $375,000 and $1,045,000 of license revenue were attributable to paid-up license revenue from one and two customers, respectively. The loss of, or a significant
reduction in revenue from, any of the Companys major clients would have a material adverse impact on the Companys business, financial condition and results of operations. In addition, with such a large percentage of the Companys revenue
attributable to a small number of clients, the loss of one or more major clients would have a material adverse impact on the Companys liquidity.





Competition





The market for the Companys products and services is intensely competitive and is characterized by rapid changes in
technology and user needs and the frequent introduction of new products. In addition, the Company faces competition in the software maintenance outsourcing services market and the software maintenance tools market. A number of the Companys
competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than those of the Company. As a result, there can be no assurance that the Companys products and
services will compete effectively with those of their respective competitors.


PERITUS SOFTWARE SERVICES, INC.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Continued)








Competitive Market for Technical Personnel





The Company depends, to a significant extent, on its ability to attract, train, motivate and retain highly skilled software
professionals, particularly project managers, software engineers and other senior technical personnel. The Company believes that there is a shortage of, and significant competition for, software development professionals with the skills and experience
necessary to perform the services offered by the Company. The Companys ability to develop new products and services, maintain and renew existing engagements and obtain new business depends, in large part, on its ability to hire and retain technical
personnel with the IT and other skills that keep pace with continuing changes in software evolution, industry standards and technologies, client preferences and the Companys business strategy. The inability to hire additional qualified personnel
could impair the Companys ability to satisfy its client base and to develop new products and services, requiring an increase in the level of responsibility for both existing and new personnel. There can be no assurance that the Company will be
successful in attracting new employees or retaining current or future employees.





Fixed-Price, Fixed-Time Contracts





Part of the Companys business is to offer its outsourcing and technology transfer services on fixed-price, fixed-time
frame contracts, rather than contracts in which payment to the Company is determined solely on a time-and-materials basis. These contracts are terminable by either party generally upon prior written notice. Although the Company uses its proprietary tools
and methodologies and its past project experience to reduce the risks associated with estimating, planning and performing the fixed-price projects, the Companys standard outsourcing and technology transfer agreements provide for a fixed-fee based on
projected reductions in a clients maintenance costs and increases in a clients maintenance productivity. The Companys failure to estimate accurately the resources, costs and time required for a project or its failure to complete its
contractual obligations within the time frame committed could have a material adverse effect on the Companys business, financial condition and results of operations.





Potential for Contract Liability





The Companys products and services relating to software maintenance involve key aspects of its clients computer
systems. A failure in a clients system could result in a claim for substantial damages against the Company, regardless of the Companys responsibility for such failure. The Company attempts to limit contractually its liability for damages
arising from negligent acts, errors, mistakes or omissions in rendering its products and services. Despite this precaution, there can be no assurance that the limitations of liability set forth in its contracts would be enforceable or would otherwise
protect the Company from liability for damages. Additionally, the Company maintains general liability insurance coverage, including coverage for errors and omissions. However, there can be no assurance that such coverage will continue to be available on
acceptable terms or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims against the Company that exceed
available insurance coverage or changes in the Companys insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on the Companys business,
financial condition and results of operations. Furthermore, litigation, regardless of its outcome, could result in substantial cost to the Company and divert managements attention from the Companys operations. Any contract liability claim or
litigation against the Company could, therefore, have a material adverse effect on the Companys business, financial conditions and results of operations.





Software Errors or Bugs





The Companys software products and tools are highly complex and sophisticated and could from time to time contain design
defects or software errors that could be difficult to detect and correct. Errors, bugs or viruses may result in loss of or delay in market acceptance, a failure in a clients system or loss or corruption of client data. Although the Company has not
experienced material adverse effects resulting from any software defects or
errors, there can be no assurance that, despite testing by the Company and its clients, errors will not be found in new products, which errors could have a material adverse effect upon the Companys business, financial condition and results of
operations.





Limited Protection of Proprietary Rights





The Company relies on a combination of patent, copyright, trademark and trade secret laws and license agreements to establish
and protect its rights in its software products and proprietary technology. In addition, the Company currently requires its employees and consultants to enter into nondisclosure and assignment of invention agreements to limit use of, access to and
distribution of its proprietary information. There can be no assurance that the Companys means of protecting its proprietary rights in the United States or abroad will be adequate. The laws of some foreign countries may not protect the Company
s proprietary rights as fully or in the same manner as do the laws of the United States. Also, despite the steps taken by the Company to protect its proprietary rights, it may be possible for unauthorized third parties to copy aspects of the Company
s products, reverse engineer, develop similar technology independently or obtain and use information that the Company regards as proprietary. Furthermore, there can be no assurance that others will not develop technologies similar or superior to the
Companys technology or design around the proprietary rights owned by the Company.





The Company has entered into license agreements with certain clients that allow these clients access to and use of the source
code of certain of the Companys software for certain purposes. Access to the Companys source code may increase the likelihood of misappropriation or misuse by third parties.





The Company has been granted certain patents. There can be no assurance that such patents would survive a legal challenge to
their validity or provide meaningful or significant protection to the Company. In addition, the Company has abandoned its pending patent applications because, among other things, it has determined that continued prosecution of such applications would be
too costly, the technologies, processes or methodologies are not critical to the Companys business in the foreseeable future or it is unlikely that a patent will issue with regard to a particular application. Certain of the Companys technology
incorporated in some of its products may infringe on patents held by others. Any infringement claim or litigation against the Company could have a material adverse effect on the Companys business, financial condition and results of operations.





The Company maintains trademarks and service marks to identify its various service offerings, products and software. Although
the Company has registered certain trademarks and service marks with the United States Patent and Trademark Office (PTO) and has several trademark and service mark applications pending in the United States and foreign jurisdictions, not all of
the applications have been granted and, even if granted, there can be no assurance that a particular trademark or service mark will survive a legal challenge to its validity or provide meaningful or significant protection to the Company. In addition, the
Company has abandoned the applications of certain trademarks or service marks that it believes are not critical to its business in the future. In some cases, entities other than the Company are using certain trademarks and service marks either in a
jurisdiction where the Company has not filed an application or in which the Company is using a mark in a different manner than a third party. There may be some risk of infringement claims against the Company in the event that a service or product of the
Company is too similar to that of another entity that is using a similar mark.





Dependence on Third-Party Technology





The Companys proprietary software is currently designed, and may in the future be designed, to work on or in conjunction
with certain third-party hardware and/or software products. If any of these current or future third-party vendors were to discontinue making their products available to the Company or to licensees of the Companys software or to increase materially
the cost to the Company or its licensees to acquire, license or purchase the third-party vendors products, or if a material problem were to arise in connection with the ability
of the Company to design its software to properly use or operate with third-party hardware and/or software products, the Company would be required to redesign its software to function with or on alternative third-party products or attempt to develop
internally a replacement for the third-party products. In such an event, interruptions in the availability or functioning of the Companys software and delays in the introduction of new products and services may occur until equivalent technology is
obtained. There can be no assurance that an alternative source of suitable technology would be available or that the Company would be able to develop an alternative product in sufficient time or at a reasonable cost. The failure of the Company to obtain
or develop alternative technologies or products on a timely basis and at a reasonable cost could have a material adverse effect on the Companys business, financial condition and results of operations.





Rapid Technological Change





The market for the Companys products and services is characterized by rapidly changing technology, evolving industry
standards and new product introductions and enhancements that may render existing products obsolete. As a result, the Companys market position could erode further due to unforeseen changes in the features and functionality of competing products. The
process of developing products and services such as those offered by the Company is extremely complex and is expected to become increasingly complex and expensive in the future with the introduction of new platforms and technologies. There can be no
assurance that the Company will develop any new products or services at all or in a timely fashion or that the Companys current or future products or services will satisfy the needs of its target market.





Potential Adverse Effects of Anti-Takeover Provisions; Possible Issuance of Preferred Stock





The Companys Amended and Restated Articles of Organization and Amended and Restated By-laws contain provisions that may
make it more difficult for a third party to acquire, or discourage acquisition bids for, the Company. For instance, the Companys Amended and Restated By-laws provide that special meetings of stockholders may be called only by the President, the
Board of Directors or the holders of at least 80% of the voting securities of the Company. In addition, the Massachusetts General Laws provide that stockholders may take action without a meeting only by the unanimous written consent of all stockholders.
The Companys Board of Directors is also divided into three classes, as nearly equal in size as possible, with staggered three-year terms. The Company is also subject to an anti-takeover provision of the Massachusetts General Laws which prohibits,
subject to certain exceptions, a holder of 5% or more of the outstanding voting stock of the Company from engaging in certain activities with the Company, including a merger, stock or asset sale. The foregoing provisions could limit the price that certain
investors might be willing to pay in the future for shares of the Companys Common Stock. In addition, shares of the Companys Preferred Stock may be issued in the future without further stockholder approval and upon such terms and conditions,
and having such rights, privileges and preferences, as the Board of Directors may determine. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of any holders of Preferred Stock that may be issued in
the future. The issuance of Preferred Stock, while providing desirable flexibility in connection with possible strategic transactions, acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to
acquire, or discouraging a third party from acquiring, a majority of the outstanding voting stock of the Company.





ITEM 3.    Quantitative and Qualitative Disclosures About Market Risk





As of September 30, 2000, the Company was exposed to market risks which primarily included changes in U.S. interest rates. The
Company maintains a substantial portion of its cash and cash equivalents in financial instruments with purchased maturities of one year or less. These financial instruments are subject to interest rate risk and will decline in value if interest rates
increase. Due to the short duration of these financial instruments, an immediate increase in interest rates would not have a material effect of the Companys financial condition or results of operations.





PERITUS SOFTWARE SERVICES, INC.





PART II. OTHER INFORMATION





ITEM 1.    Legal Proceedings





On or about April 28, 1999, the Company filed a lawsuit in the United States District Court for the District of Massachusetts
against Micah Technology Services, Inc. and Affiliated Computer Services, Inc. (collectively, Micah). The lawsuit principally alleges that Micah breached its contract with the Company by failing to pay for services performed by the Company
under such contract. The lawsuit further alleges that since Micah was unjustly enriched by the services performed by the Company, the Company is entitled to recovery based on quantum meruit, and that Micah engaged in unfair and/or deceptive trade
practices or acts in violation of Massachusetts General Laws (M.G.L.) Chapter 93A by allowing the Company to perform services when Micah did not pay for such services. The lawsuit seeks unspecified damages on the breach of contract and quantum
meruit claims and double or triple damages on the Chapter 93A claim. Micah has denied the Companys allegations and has filed a counterclaim against the Company principally alleging fraud, negligent misrepresentations, breach of contract and that the
Company engaged in unfair and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by its misrepresentations and breach of contract. The Company denied the allegations contained in Micahs counterclaim and intends to contest the
counterclaim vigorously. A non-binding mediation hearing was held on March 17, 2000 and no settlement was reached. The parties are in the discovery phase of the litigation and are presently engaged in discussions in order to attempt to settle the lawsuit.





In addition to the matters noted above, the Company is from time to time subject to legal proceedings and claims which arise
in the normal course of its business. In the opinion of management, the amount of ultimate liability with respect to these other actions, currently known, will not have a material adverse effect on the Companys financial position or results of
operations.





ITEM 6.    Exhibits And Reports On Form 8-K





(a)  Exhibits:





Documents listed below, except for documents identified by footnotes, are being filed as exhibits herewith. Documents
identified by footnotes, if any, are not being filed herewith and, pursuant to Rule 12b-32 of the General Rules and Regulations promulgated by the Commission under the Securities Exchange Act of 1934 (the Exchange Act), reference is made to
such documents as previously filed as exhibits with the Commission. The Companys file number under the Exchange Act is 000-22647.





|Exhibit 10.1 |  | Consulting Services Agreement dated as of June 22, 2000 by and between the Company and

Dominic K. Chan                                             
|------------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|
|Exhibit 10.2 |  | Consulting Services Agreement dated as of July 1, 2000 for the IBM/SBC and Other Projects

between the Company and Rocket Software, Inc.            
|
|Exhibit 10.3 |  | Mainframe Equipment Use Agreement dated as of July 1, 2000 by and between the Company

and Rocket Software, Inc.                                    
|
|Exhibit 10.4 |  | Consulting Services Agreement for Professional/Administrative Services dated as of May 1,

2000 by and between the Company and Rocket Software, Inc.
|
|Exhibit 27.1 |  | Financial Data Schedule for the nine months ended September 30, 2000                                                                                
|
|Exhibit 27.2 |  | Amended Financial Data Schedule for the six months ended June 30, 2000                                                                              




(b)  Reports on Form 8-K:





None





SIGNATURES





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





Dated:  November 9, 2000





| | PERITUS
SOFTWARE
SERVICES
, INC
 .
| | ----------------------------------




| | /s/    JOHN
D. GIORDANO
| | -----------------------

| | By:
| | ---

| | John D. Giordano
| | ----------------

| | President, Chief Executive Officer

and Chief Financial Officer

(Principal Financial Officer)
| | ----------------------------------------------------------------------------------------------




| | PERITUS
SOFTWARE
SERVICES
, INC
| | -------------------------------




| | /s/    PATRICK
MANNING
| | ----------------------

| | By:
| | ---

| | Patrick Manning
| | ---------------

| | Corporate Controller

(Chief Accounting Officer)
| | ------------------------------------------------




PERITUS SOFTWARE SERVICES, INC.





FORM 10-Q





FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000





EXHIBIT INDEX





|Exhibit No   |  | Description                                                                                                                                        
|------------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit 10.1 |  | Consulting Services Agreement dated as of June 22, 2000 by and between the Company and

Dominic K. Chan                                            
|Exhibit 10.2 |  | Consulting Services Agreement dated as of July 1, 2000 for the IBM/SBC and Other Projects

between the Company and Rocket Software, Inc.           
|Exhibit 10.3 |  | Mainframe Equipment Use Agreement dated as of July 1, by and between the Company and

Rocket 2000 Software, Inc                                    
|Exhibit 10.4 |  | Consulting Services Agreement for Professional/Administrative Services dated as of May 1,

2000 by and between the Company and Rocket Software, Inc
|Exhibit 27.1 |  | Financial Data Schedule for the nine months ended September 30, 2000                                                                               
|Exhibit 27.2 |  | Amended Financial Data Schedule for the six months ended June 30, 2000