---




UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





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FORM 10-Q





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




For the quarterly period ended March 31, 2002





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 NO. 000-26937





QUEST SOFTWARE, INC.


(Exact name of registrant as specified in its charter)





California (State or other jurisdiction of incorporation or organization)

33-0231678 (I.R.S. Employer Identification No.)8001 Irvine Center Drive Irvine, California (Address of principal executive offices)

92618 (Zip code)





Registrants telephone number, including area code: (949) 754-8000





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  ̈





The number of shares outstanding of the Registrants Common Stock, no par value, as of May 10, 2002 was 90,269,212.





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QUEST SOFTWARE, INC.





FORM 10-Q





TABLE OF CONTENTS





Page NumberPART I.

FINANCIAL INFORMATIONItem 1.

Financial StatementsConsolidated Balance Sheets as of December 31, 2001 and March 31, 2002 (unaudited)

3Consolidated Statements of Operations for the Three Months Ended March 31, 2001 and 2002 (unaudited)

4Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2001 and 2002 (unaudited)

5Consolidated Statements of Comprehensive Operations for the Three Months Ended March 31, 2001 and 2002 (unaudited)

6Notes to Consolidated Financial Statements (unaudited)

7Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

12Item 3.

Quantitative and Qualitative Disclosures about Market Risk

22PART II.

OTHER INFORMATIONItem 6.

Exhibits and Reports on Form 8-K

24SIGNATURES

25




2




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PART IFINANCIAL INFORMATION





Item 1: Financial Statements





QUEST SOFTWARE, INC.


CONSOLIDATED BALANCE SHEETS


(In thousands)





ASSETSDecember 31, 2001


March 31, 2002(Unaudited)Current assets:Cash and cash equivalents

$
30,279


$
30,995Short-term marketable securities available for sale


23,039



21,083Accounts receivable, net


35,783



27,135Prepaid expenses and other current assets


8,230



8,164Deferred income taxes


12,085



11,005Total current assets


109,416



98,382Property and equipment, net


57,496



54,614Long-term marketable securities


153,838



167,326Goodwill and purchased intangible assets, net


202,706



208,357Deferred income taxes


10,902



10,902Other assets


5,767



5,823Total assets

$
540,125


$
545,404LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable

$
5,495


$
4,978Accrued compensation


12,764



12,116Other accrued expenses


21,720



17,548Income taxes payable


3,243



2,849Deferred revenue


50,395



55,158Total current liabilities


93,617



92,649Long-term liabilities and other


5,140



5,827Shareholders equity:Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding






Common stock, no par value, 150,000 shares authorized; 89,226 and 90,211 issued and outstanding at December 31, 2001 and March 31,
2002, respectively


537,081



542,040Accumulated deficit


(78,973
)


(77,251
)Accumulated other comprehensive income (loss)


522



(324
)Notes receivable from sale of common stock


(17,262
)


(17,537
)Total shareholders equity


441,368



446,928Total liabilities and shareholders equity

$
540,125


$
545,404





See accompanying notes to the consolidated financial statements.




3




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QUEST SOFTWARE, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS


(In thousands, except per share data)


(Unaudited)





Three Months Ended March 31,2001


2002Revenues:Licenses

$
48,429


$
37,490Services


15,008



21,903Total revenues


63,437



59,393Cost of revenues:Licenses


889



724Services


4,403



4,311Amortization of purchased intangible assets


2,035



1,402Total cost of revenues


7,327



6,437Gross profit


56,110



52,956Operating expenses:Sales and marketing


30,860



29,694Research and development


13,930



14,835General and administrative


6,353



5,851Other compensation costs and intangible amortization


15,982



1,310Total operating expenses


67,125



51,690Income (loss) from operations


(11,015
)


1,266Other income, net


1,777



1,617Income (loss) before income taxes


(9,238
)


2,833Income tax provision


5,543



1,162Net income (loss)

$
(14,781
)

$
1,721Net income (loss) per share:Basic and Diluted

$
(0.17
)

$
0.02Weighted average shares:Basic


87,016



89,748Diluted


87,016



93,808





See accompanying notes to the consolidated financial statements.




4




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QUEST SOFTWARE, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)


(Unaudited)





Three Months Ended March 31,2001


2002Cash flows from operating activities:Net income (loss)

$
(14,781
)

$
1,721Adjustments to reconcile net loss to net cash provided by operating activities:Depreciation and amortization


18,453



5,302Compensation expense associated with stock option grants


2,029



924Accrued interest receivable from shareholders


(301
)


(275
)Deferred income taxes






1,097Provision for bad debts


285



146Changes in operating assets and liabilities, net of effects of acquisitions:Accounts receivable


1,170



8,432Prepaid expenses and other current assets


329



52Other assets


(496
)


(67
)Accounts payable


(322
)


(510
)Accrued compensation


948



(618
)Income taxes payable


5,474



745Other accrued expenses


(3,848
)


(4,057
)Other liabilities


(226
)


(59
)Deferred revenue


8,717



4,796Net cash provided by operating activities


17,431



17,629Cash flows from investing activities:Purchases of property and equipment


(12,534
)


(3,051
)Cash paid for acquisition, net of cash acquired (Note 3)






(4,063
)Purchases of marketable securities


(18,939
)


(21,823
)Sales and maturities of marketable securities


20,277



9,455Net cash used by investing activities


(11,196
)


(19,482
)Cash flows from financing activities:Repayment of notes payable






(191
)Repayment of capital lease obligations


(146
)


(27
)Proceeds from exercise of stock options


905



615Proceeds from employee stock purchase plan


2,992



2,522Net cash provided by financing activities


3,751



2,919Effect of exchange rate changes on cash and cash equivalents


28



(350
)Net increase in cash and cash equivalents


10,014



716Cash and cash equivalents, beginning of period


25,155



30,279Cash and cash equivalents, end of period

$
35,169


$
30,995Supplemental disclosures of consolidated cash flow information:Cash paid for:Interest

$
36


$
13Income taxes, net of refunds

$
66


$
2Supplemental schedule of noncash investing and financing activities:Unrealized (loss) gain on available-for-sale securities

$
258


$
(846
)Tax benefit related to stock option exercises

$
5,523


$
1,128





See accompanying notes to the consolidated financial statements.




5




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QUEST SOFTWARE, INC.


CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS


(In thousands)


(Unaudited)





Three Months Ended March 31,2001


2002Net income (loss)

$
(14,781
)

$
1,721Accumulated other comprehensive income (loss):Unrealized (loss) gain on available-for-sale securities


258



(846
)Comprehensive income (loss)

$
(14,523
)

$
875





See accompanying notes to the consolidated financial statements.




6




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QUEST SOFTWARE, INC.





NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS





|1. |  | Basis of Presentation
|-- |  | ---------------------




The
accompanying unaudited interim consolidated financial statements of Quest Software, Inc., a California corporation (the Company or Quest), as of March 31, 2002 and for the three months ended March 31, 2001 and 2002 reflect
all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial statements.





Certain reclassifications have been
made to the prior-years balances to conform to the current years presentation, which includes the adoption of Emerging Issues Task Force (EITF) D-103, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. The result of this adoption was an increase in total services revenue with a corresponding increase in cost of services revenue of $325,000 for the three months ended March 31, 2001. The impact for
the current year is higher services revenue and cost of services revenue of $168,000. These amounts were previously offset against cost of services revenue.





These financial statements should be read in conjunction with the audited financial statements included in the Companys Annual Report on Form 10-K for the year ended December 31, 2001.





Operating results for the three months ended March 31, 2002 are not necessarily indicative of the results that may be expected for the quarter or full
year ending December 31, 2002 or any other future period.





2. New Accounting Pronouncements





Effective the beginning of the first quarter of 2002, the company completed the adoption of Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. As required by SFAS
No. 142, the company discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential
impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. In conjunction with the implementation of SFAS No. 142, the Company is evaluating the full impact of adopting the new standard. In addition, impairment reviews may result in charges against earnings to write down the value
of goodwill.





A reconciliation of previously reported net income (loss) and earnings (loss) per share to the amounts adjusted
for the exclusion of goodwill and workforce-in-place amortization, net of the related income tax effect, is as follows (in thousands, except per share amounts):




7




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Three Months Ended March 31,2001


2002Reported net income (loss)

$
(14,781
)

$
1,721Goodwill and workforce amortization (net of tax)


13,526



Adjusted net income (loss)

$
(1,255
)

$
1,721Reported basic and diluted income (loss) per share

$
(0.17
)

$
0.02Goodwill and workforce amortization (net of tax)


0.16



Adjusted basic and diluted income (loss) per share

$
(0.01
)

$
0.02Weighted average shares:Basic


87,016



89,748Diluted


87,016



93,808





The net carrying value of goodwill and amortized intangible assets as of March
31, 2002 is comprised of the following:





Goodwill

$
196,081Amortized intangible assets


12,276$
208,357





Amortized intangible assets as of March 31, 2002 are comprised of the following:





Gross Carrying Amount

Accumulated Amortization


NetAcquired technology

23,117

(14,443
)

8,674Customer list

2,501

(1,167
)

1,334Non-compete agreement

2,200

(183
)

2,017Other

2,263

(2,012
)

25130,081

(17,805
)

12,276





Amortization expense for amortized intangible assets was $1.9 million for the
three months ended March 31, 2002. Estimated annual amortization expense by fiscal year is as follows: 2002$7.4 million; 2003$5.7 million; 2004$1.1 million; 2005$.02 million. All intangible assets currently recorded will be
fully amortized by the end of 2005.





In August 2001, the FASB issued Statement of Financial Accounting Standard No. 143
(SFAS 143), Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No.
143 is required to be adopted for fiscal years beginning after June 15, 2002. The Company has not yet determined what effect this statement will have on its financial statements.





Also in August 2001, the FASB issued Statement of Financial Accounting Standard No. 144 (SFAS 144), Accounting for the Impairment or Disposal of Long-Lived Assets, which
supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board (APB) 30, Reporting the
Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will
require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In addition, more dispositions may
qualify for discontinued operations treatment. The provisions of this statement are required to be applied for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company adopted SFAS 144 effective
January 1, 2002. The adoption of SFAS 144 did not have a significant impact on the financial position, results of operations, or cash flows of the Company.







8




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3. Acquisitions





On February 1,
2002, the Company acquired the outstanding shares of BB4 Technologies, Inc. for a purchase price of $6.6 million. The purchase price for BB4 Technologies, Inc. consisted of $4.2 million cash, direct acquisition costs of $179,000, and future payments
of $2.2 million related to non-compete agreements with former employees. The acquisition was accounted for as a purchase with the purchase price allocated as follows (in thousands):





Current assets

$
123Goodwill and other intangibles


7,589Deferred taxes


(1,097
)Liabilities assumed


(60
)Total purchase price

$
6,555





Operations of the companies acquired throughout fiscal 2001 and 2002 are included
in the consolidated financial statements from the dates of acquisition. The first quarter of 2002 includes actual results of this acquisition. The acquisition, if it had been made in the beginning of 2001, would not have a significant impact on
revenues, net loss, and net loss per share  basic and diluted.





4. Other Compensation Costs





The Company records compensation expense for options to purchase the Companys common stock granted with an exercise price below fair market value.
The expense equals the difference between the fair market value of the Companys common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting period of the stock options, currently four
to five years. The following table shows the allocation to Cost of Services Revenues, Sales and Marketing, Research and Development and General and Administrative expenses of such costs based on the related headcount (in thousands):





As Reported

Allocation

Pro FormaThree Months Ended March 31, 2001Cost of services revenues

$
4,403

$
126

$
4,529Sales and marketing


30,860


725


31,585Research and development


13,930


1,025


14,955General and administrative


6,353


153


6,506Three Months Ended March 31, 2002Cost of services revenues

$
4,311

$
64

$
4,375Sales and marketing


29,695


336


30,031Research and development


14,835


432


15,267General and administrative


5,851


92


5,943





5. Net Loss Per Share





The Company computes net loss per share in accordance with SFAS No. 128, Earnings per Share. Basic earnings per share is computed by dividing net loss by the weighted average number of
common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted average number of common shares outstanding for
a period if the effect of such inclusion would be dilutive.





The table below sets forth the reconciliation of the denominator of
the earnings per share calculations (in thousands):





Three Months Ended March 31,2001


2002Shares used in computing basic net income (loss) per share

87,016


89,748Dilutive effect of stock options


(1)

4,060Shares used in computing diluted net income (loss) per share

87,016


93,808





|(1) |  | Effect would have been anti-dilutive, accordingly, the amount is excluded from shares used in computing diluted net loss per share. The dilutive effect of stock options would
have been 3,985 for the three months ended March 31, 2001.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------






9




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6. Shareholders Equity





In
January 2002, 124,095 shares of common stock were purchased under the Companys Employee Stock Purchase Plan at a price of $20.26 per share.





7.
Stock Option Plans





The following table summarizes information about stock options outstanding as of March 31, 2002 (in
thousands, except for per share data):





NUMBER OF SHARES


WEIGHTED AVERAGE EXERCISE PRICE

NUMBER OF OPTIONS EXERCISABLE AS OF MARCH 31, 2002Balance at December 31, 2001

15,568


$
13.56Granted

246



16.46Exercised

(860
)


.73Canceled

(286
)


23.18Balance at March 31, 2002

14,668


$
14.24

3,119





8. Operating Segment Data





Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Companys chief operating
decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The operating segments of the Company are managed separately because each segment represents a strategic business unit that offers
different products or services.





The Companys reportable operating segments include Licenses and Services. The Licenses
segment develops and markets the Companys software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to the Companys products.





The Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore,
segment information reported includes only revenues, cost of revenues and gross profit, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis.





Reportable segment data for the three months ended March 31, 2001 and 2002 were as follows (in thousands):





LICENSES

SERVICES

TOTALThree months ended March 31, 2001Revenues

$
48,429

$
15,008

$
63,437Cost of Revenues


2,924


4,403


7,327Gross profit

$
45,505

$
10,605

$
56,110Three months ended March 31, 2002Revenues

$
37,490

$
21,903

$
59,393Cost of Revenues


2,126


4,311


6,437Gross profit

$
35,364

$
17,592

$
52,956







10




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Revenues are attributed to geographic areas based on the location of the entity to which the products or services were sold. Revenues,
gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which the Company operates are as follows (in thousands):





NORTH AMERICA(1)


EUROPE


OTHER INTERNATIONAL


TOTALThree months ended March 31, 2001Revenues

$
52,437


$
9,272


$
1,728


$
63,437Gross profit


50,839



5,099



172



56,110Loss from operations


(1,765
)


(2,366
)


(6,884
)


(11,015
)Long-lived assets


292,703



1,611



1,309



295,623Three months ended March 31, 2002Revenues

$
46,509


$
11,320


$
1,564


$
59,393Gross profit


44,621



7,431



904



52,956Income (loss) from operations


2,386



(1,362
)


242



1,266Long-lived assets


260,016



1,528



1,427



262,971


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|(1) |  | Principally represents operations in the United States.
|--- |  | -------------------------------------------------------




9. Investments





The Company has classified all debt securities with original maturities of greater than three
months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders equity net of applicable income taxes. Realized gains and losses and
declines in value judged to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. The
Company has classified available-for-sale securities as current or long-term based primarily on the maturity date of the related securities.





The Company also has certain other minority equity investments in non-publicly traded companies. These investments are included in other assets on the Companys consolidated balance sheet at March 31, 2002 and
are carried at the lower of cost or fair value, subject to adjustment for other than temporary impairment. These investments are privately held information technology companies, many of which are in the start-up or development stage. The Company
monitors these investments for impairment and does not believe that any impairment exists for the three months ended March 31, 2002.




11




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Item
 2:Managements Discussion and Analysis of Financial Condition and Results of Operations





The following discussion of our financial condition and results of operations also should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this
Report. Certain statements in this report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words believe, expect,
anticipate, will, contemplate, would and similar expressions that contemplate future events may identify forward-looking statements.





Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other
forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this report, including those described under Risk Factors, and in other filings with the SEC, that
describe certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect managements opinions only as of the
date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.





Overview





We provide application management software solutions that enhance our
customers return on IT investment dollars by maximizing the availability, performance and manageability of business critical applications and their underlying databases and other associated components and by improving the cost effectiveness of
a customers information technology investments, including personnel, software and hardware.





Our revenues comprise software
license fees and services fees. Our software licensing model is based on perpetual license fees, and our licenses are either server-based or, for our SQL development and report management tools, user-based. Services revenues consist primarily of
annual maintenance contracts for technical support and product enhancements. Services revenues also include consulting services and training revenues. Our policies for recognizing license and services revenues are described in Footnote 1
Description of Business and Summary of Significant Accounting Policies of the Companys Annual Report on Form 10-K for the year ended December 31, 2001.





Results of Operations





The following table sets forth certain consolidated statements of operations data as a
percentage of total revenues, except as indicated:





Three Months Ended March 31,2001


2002Revenues:Licenses

76.3
%

63.1
%Services

23.7


36.9Total revenues

100.0


100.0Cost of revenues:Licenses

1.4


1.2Services

6.9


7.3Amortization of purchased intangible assets

3.2


2.4Total cost of revenues

11.5


10.9Gross profit

88.4


89.1Operating expenses:Sales and marketing

48.6


50.0Research and development

22.0


25.0General and administrative

10.0


9.9Other compensation costs and intangible amortization

25.2


2.2Total operating expenses

105.8


87.1(Loss) income from operations

(17.4
)

2.0Other income, net

2.8


2.7




12




---




(Loss) income before income taxes

(14.6
)

4.7Income tax provision

8.7


2.0Net (loss) income

(23.3
)%

2.7
%As a percentage of related revenues:Cost of licenses

1.8
%

1.9
%Cost of services

29.3
%

19.7
%





Three Months Ended March 31, 2001 and 2002





Revenues





Total revenues for the three months ended March 31, 2002 were $59.4 million, a decrease of 6.4% from the comparable period of 2001. Revenues outside of North America for the three months ended March 31, 2002 were $12.9 million, an increase
of 17.1% from the comparable period of 2001.





License RevenuesLicense revenues for the three months ended March 31,
2002 were $37.5 million, a decrease of 22.6% from the comparable period of 2001. License revenues represented 63.1% of total revenues for the three months ended March 31, 2002, compared to 76.3% for the same period of 2001. License revenues outside
of North America accounted for 18.3% and 24.9% of total license revenues for the three months ended March 31, 2001 and 2002, respectively.The decrease in total license revenues from the prior year is primarily the result of reduced IT
spending levels and associated difficulties of closing larger sales transactions.





Service RevenuesService revenues
for the three months ended March 31, 2002 were $21.9 million, an increase of 45.9% from the comparable period of 2001. Service revenues represented 23.7% and 36.9% of total revenues for the three months ended March 31, 2001 and 2002, respectively.
Service revenues outside of North America accounted for 14.1% and 16.2% of total service revenues for the three months ended March 31, 2001 and 2002, respectively. Maintenance and support revenues represent the bulk of service revenues. Maintenance
and support revenues represent the ratable recognition of fees to enroll licensed products in our software maintenance, enhancement and support program. The growth in service revenues reflects the increase in first-year maintenance and support fees
associated with the growth in product license sales in prior quarters. The growth in service revenues also derived from higher support renewal fees as the installed base of customers grew and we significantly improved our support renewal billing
processes.





Cost of Revenues





Cost of LicensesCost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, and amortization of purchased software rights. Cost of licenses were $0.7 million for the
three months ended March 31, 2002, versus $0.9 million in the comparable period of 2001, representing a decrease of 18.6%. Cost of licenses as a percentage of license revenues was 1.8% and 1.9% for the three months ended March 31, 2001 and 2002,
respectively.





Cost of ServicesCost of services primarily consists of personnel related costs and facilities and
systems costs used in providing support, consulting, and training services. Cost of services for the three months ended March 31, 2002 were $4.3 million versus $4.4 million for the comparable period of 2001, representing a decrease of 2.1%. Cost of
services as a percentage of services revenues were 29.3% and 19.7% for the three months ended March 31, 2001 and 2002, respectively. The improvement in gross margin is primarily due to a much lower rate of increase in support headcount compared to
the increase in support service revenues and from the shift in service revenues mix towards a greater contribution from higher margin support services.




13




---




Amortization of Purchased Intangible AssetsAmortization of purchased intangible
assets includes amortization of the fair value of acquired technology associated with acquisitions made during 2000, 2001, and 2002. Amortization of purchased intangible assets was $1.4 million during the three months ended March 31, 2002 versus
$2.0 million in the same period of 2001, representing a decrease of 31.1%. The decrease is due to the completion of amortization of purchased intangible assets related to acquisitions made in 2000.





Operating Expenses





Sales and
MarketingSales and marketing expenses consist primarily of salaries, sales commissions, benefits, recruiting costs, trade shows, travel and entertainment and other marketing communications costs such as advertising and promotion. Sales and
marketing expenses were $29.7 million for the three months ended March 31, 2002 versus $30.9 million for the comparable period of 2001, representing a decrease of 3.8%. Sales and marketing expenses as a percentage of total revenues were 48.6% and
50.0% for the three months ended March 31, 2001 and 2002, respectively. Reduced sales commissions resulting from lower license revenues in the 2002 period, as well as reduced spending on trade shows and related costs, were the primary reasons for
the decrease in sales and marketing expenses.





Research and DevelopmentResearch and development expenses consist
primarily of salaries and benefits for software developers, software product managers, quality assurance and technical documentation personnel, and of payments made to outside software development contractors. Research and development expenses were
$14.8 million for the three months ended March 31, 2002 versus $13.9 million in the same period of 2001, representing an increase of 6.5%. These expenses as a percentage of total revenues were 22.0% and 25.0% for the three months ended March 31,
2001 and 2002, respectively. The increase is due primarily to increases in the number of personnel conducting research and development, including software developers and technical documentation and quality assurance personnel associated with new
product initiatives and the integration of software products associated with companies acquired during 1999 and 2000 combined with lower revenues in the first quarter of 2002. We believe significant expenditures in research and development are
required to remain competitive, and expect that research and development expenses will continue to represent 20-25% of total revenues for the foreseeable future.





In the development of new products and enhancements of existing products, the technological feasibility of the software is not established until substantially all product development is
complete. All costs related to internal research and development have been expensed as incurred.





General and
AdministrativeGeneral and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, administrative and information services personnel. General and administrative expenses were $5.9
million for the three months ended March 31, 2002 versus $6.4 million in the same period of 2001, representing a decrease of 7.9%. These expenses as a percentage of total revenues were 10.0% and 9.9% for the three months ended March 31, 2001 and
2002, respectively. The decrease in absolute dollars reflects the Companys continuing efforts to contain costs to include reductions in travel related expenses, recruiting costs, office supplies, and bad debt expense.





Other Compensation Costs and Intangible AmortizationOther compensation costs and intangible amortization include compensation expense
associated with the issuance (primarily in 1999) of stock options with exercise prices below fair market value and the amortization of other intangible assets and goodwill in fiscal 2001 associated with acquisitions. These costs totaled $1.3 million
for the three months ended March 31, 2002 compared to $16.0 million in the same period of 2001, representing a decrease of 91.8%. These expenses as a percentage of total revenues were 25.2% and 2.2% for the three months ended March 31, 2001 and
2002, respectively. These costs decreased primarily as a result of the




14




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requirements under the adoption of SFAS No. 142. We are no longer required to record amortization against goodwill and other intangible assets with indefinite
useful lives. In the first quarter of 2001, the Company recorded amortization charges of $13.5 million related to goodwill and other unidentifiable intangible assets.





Other Income (Expense), NetOther income (expense), net consists primarily of interest income and expense. Other income (expense), net was $1.6 million for the three months ended March 31, 2002 compared to
$1.8 million for the same period of 2001, representing a decrease of 9.0%. The decrease is due primarily to lower interest rates. The average interest rates of our investments are summarized under Item 3: Quantitative and Qualitative
Disclosures About Market Risks  Interest Rate Risk below.





Income TaxesProvision for income taxes was $1.2 million for the three
months ended March 31, 2002 compared with $5.5 million for the comparable period of 2001, representing effective rates for these periods of 40% and (60.0%), respectively. Excluding non-deductible amortization of intangible assets and other
compensation costs, our effective income tax rate was 40% for both the three months ended March 31, 2001 and 2002.





Liquidity and Capital Resources





We have funded our business, to date, primarily from cash generated by our operations, net proceeds of $64.9 million from
our initial public offering in August 1999, and net proceeds of $253.5 million from our secondary offering in March 2000. Our sources of liquidity as of March 31, 2002 consisted principally of cash and cash equivalents of $31.0 million and $188.4
million in short- and long-term high grade corporate and government marketable securities.





Net cash provided by operating
activities was $17.4 million and $17.6 million for the three months ended March 31, 2001 and 2002, respectively. Cash provided by operating activities in the three months ending March 31, 2002 was driven primarily by cash collections related to a
drop in days sales outstanding during the quarter. Income taxes payable, which includes tax benefits related to stock options, provided $5.5 million in the three months ended March 31, 2001 and $.8 million in the same period of 2002. This change in
income taxes payable is primarily a result of a decrease in the income tax benefit received from stock options during the three months ended March 31, 2002 compared to 2001.





Investing activities used $11.2 million and $19.5 million during the three months ended March 31, 2001 and 2002, respectively. The increase in cash used in investing activities in the
period ending March 31, 2002 was primarily related to net purchases of marketable securities of $12.4 million and acquisition costs of $4.1 million partially offset by decreased capital expenditures. Capital expenditures primarily consisted of
equipment and related purchases to support our worldwide expansion and related infrastructure needs.





Financing activities
provided $3.8 million and $2.9 million for the three months ended March 31, 2001 and 2002, respectively. The decrease is primarily due to higher net proceeds from securities issued pursuant to our equity incentive programs in the comparable period
of 2001.





In December 2000, our Board of Directors authorized a stock repurchase program under which Quest may purchase up to
two million shares of its common stock. Under the repurchase program, we may purchases shares from time to time at varying prices in open market or private transactions.





In October 2001, our Board of Directors increased the total number of shares authorized for repurchase under the stock repurchase program from two million shares to five million. No
shares were repurchased during the period ended March 31, 2002.





As of March 31, 2002, our only significant contractual
obligations or commercial commitments consisted of our facility lease commitments and operating leases for office facilities and certain items of equipment. These commitments will require cash payments of $11.5 million in 2002, $9.8 million in 2003,
$7.6 million in 2004, $6.2 million in 2005 and $3.6 million thereafter. We do not have any off-balance sheet arrangements that could significantly reduce our liquidity. We would be required to use existing cash, cash equivalents and investment
balances to support our working capital balances if we are not able to generate or sustain positive cash




15




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flow from operations. Our ability to generate cash from operations is subject to substantial risks described below under the caption Risk Factors.





Based on our current operating plan, we believe that our existing cash, cash equivalents and investment balances and cash flows
from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. However, if events occur or circumstances change such that we fail to meet our operating plan as expected, we
may require additional funds to support our working capital requirements or for other purposes and may seek to raise additional funds through public or private equity or debt financing or from other sources. If additional financing is needed, we can
not assure you that such financing will be available to us on commercially reasonable terms or at all.





Recently Issued Accounting Pronouncements





Effective the beginning of the first quarter of 2002, the company completed the adoption of Statement of Financial
Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the
purchase method of accounting. As required by SFAS No. 142, the company discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. All remaining and future acquired goodwill will be subject to impairment tests
annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. In conjunction with the implementation of SFAS No. 142, the Company is evaluating the full impact of adopting the new standards. In addition, impairment reviews may result
in charges against earnings to write down the value of goodwill.





In August 2001, the FASB issued Statement of Financial
Accounting Standard No. 143 (SFAS 143), Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset
retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. The Company has not yet determined what effect this statement will have on its financial statements.





Also in August 2001, the FASB issued Statement of Financial Accounting Standard No. 144 (SFAS 144), Accounting for the Impairment or
Disposal of Long-Lived Assets, which supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board
(APB) 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal
of a segment of a business and will require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In
addition, more dispositions may qualify for discontinued operations treatment. The provisions of this statement are required to be applied for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company
adopted SFAS 144 effective January 1, 2002. The adoption of SFAS 144 did not have a significant impact on the financial position, results of operations, or cash flows of the Company.




16




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RISK FACTORS





An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks
described below are the risks that we currently believe are material risks of business and the industry in which we compete.





Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose
all or part of your investment.





Risks Related to Our Business





Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline





Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the
following:





| |  |  | the size and timing of customer orders. See  The size and timing of our customer orders may vary significantly from quarter to quarter which could cause
fluctuations in our revenues.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | the unpredictability of the timing and level of sales through our indirect sales channel;
| | - |  | -----------------------------------------------------------------------------------------




| |  |  | the timing of revenue recognition for sales of software products and services;
| | - |  | ------------------------------------------------------------------------------




| |  |  | the extent to which our customers renew their maintenance contracts with us;
| | - |  | ----------------------------------------------------------------------------




| |  |  | exposure to general economic conditions and reductions in corporate IT spending;
| | - |  | --------------------------------------------------------------------------------




| |  |  | changes in our level of operating expenses and our ability to control costs;
| | - |  | ----------------------------------------------------------------------------




| |  |  | our ability to attain market acceptance of new products and services and enhancements to our existing products;
| | - |  | ---------------------------------------------------------------------------------------------------------------




| |  |  | changes in our pricing policies or the pricing policies of our competitors;
| | - |  | ---------------------------------------------------------------------------




| |  |  | the relative growth rates of competing operating system, database and application platforms;
| | - |  | --------------------------------------------------------------------------------------------




| |  |  | costs related to acquisitions of technologies or businesses, including amortization costs for intangible assets with indefinite lives; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | the timing of releases of new versions of third-party software products that our products support.
| | - |  | --------------------------------------------------------------------------------------------------




Fluctuations in our results of operations are likely to affect the market price of our common stock that may not be related to our long-term performance.





The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results





Our license revenues in any quarter are substantially dependent on orders booked and shipped in that quarter. Our revenues
in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software
products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount of our sales in the last month, weeks or days of each
quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our
quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In




17




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addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet
expectations until the end of that quarter. Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or
quickly changed.





General economic conditions and reductions in corporate IT spending may continue to affect revenue growth rates and impact our
business





Our business and operating results are subject to the effects of changes in general economic conditions. Recent
unfavorable economic conditions have resulted in reduced corporate IT spending in the industries that we serve and a softening of demand for computer software, not only in the database and application market segments we support but also in the
product segment in which we compete. If these economic conditions do not improve, or we experience continued deterioration in general economic conditions or reduced corporate IT spending, our business and operating results could be adversely
impacted.





Many of our products are dependent on Oracles technologies; if Oracles technologies lose market share or become incompatible
with our products, the demand for our products could suffer





We believe that our success has depended in part, and will
continue to depend in part for the foreseeable future, upon our relationship with Oracle and our status as a complementary software provider for Oracles database and application products. Many versions of our products, including SharePlex and
SQLab Vision, are specifically designed to be used with Oracle databases. Although a number of our products work with other environments, our competitive advantage consists in substantial part on the integration between our products and
Oracles products, and our extensive knowledge of Oracles technology. Currently, a significant portion of our total revenues is derived from products that specifically support Oracle-based products. If Oracle for any reason decides to
promote technologies and standards that are not compatible with our technology, or if Oracle loses market share for its database products, our business, operating results and financial condition would be materially adversely affected.





Many of our products are vulnerable to direct competition from Oracle





We currently compete with Oracle in the market for database management solutions. We expect that Oracles commitment to and presence in the database management product market will increase in the future and
therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. We believe that Oracle will
also continue to enhance its database management technology. Furthermore, Oracle could attempt to increase its presence in this market by acquiring or forming strategic alliances with our competitors, and Oracle may be in better position to
withstand and respond to the current factors impacting this industry. Oracle has a longer operating history, a larger installed base of customers and substantially greater financial, distribution, marketing and technical resources than we do. In
addition, Oracle has well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with Oracle in the future, which could materially adversely affect our business, operating
results and financial condition.





Our success depends on our ability to develop new and enhanced products that achieve widespread market acceptance





Our future success depends on our ability to address the rapidly changing needs of our customers by developing and
introducing new products, product updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business,
we are committing substantial resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize
or occurs more slowly than we expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely
affected.





Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention





We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies. If we make any
additional acquisitions, we will be required to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards,
controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that




18




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are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert managements attention from day-to-day
operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to incur debt or issue equity securities to pay for any future acquisitions. The issuance of equity securities for any
acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions,
we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not
receive the intended benefits of acquisition.





Our past and future growth may strain our management, administrative, operational and financial
infrastructure





We have recently experienced a period of rapid growth in our operations that has placed and will continue to
place a strain on our management, administrative, operational and financial infrastructure. During this period, we have experienced an increase in the number of our employees, increasing demands on our operating and financial systems and personnel,
and an expansion in the geographic coverage of our operations. Our ability to manage our operations and growth requires us to continue to improve our operational, financial and management controls, and reporting systems and procedures. We may need
to expand our facilities or relocate some or all of our employees or operations from time to time to support growth. These relocations could result in temporary disruptions of our operations or a diversion of managements attention and
resources. In addition, we will be required to hire additional management, financial and sales and marketing personnel to manage our expanding operations. If we are unable to manage this growth effectively, our business, operating results and
financial condition may be materially adversely affected.





We may not generate increased business from our current customers, which could slow our
revenue growth in the future





Most of our customers initially make a purchase of our products for a single department or
location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely
affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to
renew their maintenance agreements, our service revenues would be materially adversely affected.





Our international operations and our planned
expansion of our international operations expose us to certain risks





We intend to expand our international sales activities
as part of our business strategy. As a result, we face increasing risks from doing business on an international basis, including, among others:





| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------




| |  |  | longer payment cycles;
| | - |  | ----------------------




| |  |  | seasonal reductions in business activity in Europe;
| | - |  | ---------------------------------------------------




| |  |  | increased financial accounting and reporting burdens and complexities;
| | - |  | ----------------------------------------------------------------------




| |  |  | potentially adverse tax consequences;
| | - |  | -------------------------------------




| |  |  | potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------




| |  |  | delays in localizing our products;
| | - |  | ----------------------------------




| |  |  | compliance with a wide variety of complex foreign laws and treaties; and
| | - |  | ------------------------------------------------------------------------




| |  |  | licenses, tariffs and other trade barriers.
| | - |  | -------------------------------------------



19




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In addition, because our international subsidiaries generally conduct business in the currency
of the country in which they operate, our exposure to exchange rate fluctuations, which are outside of our control, will increase as our international operations expand. We have not yet entered into any hedging transactions to mitigate exposure to
foreign currency fluctuations.





Operating in international markets also requires significant management attention and financial
resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue
or profitability. In addition, we have sold our products internationally for only a few years and we have limited experience in developing localized versions of our products and marketing and distributing them internationally.





Failure to develop strategic relationships could harm our business by denying us selling opportunities and other benefits





Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We also may not be able to enter into
successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. From time to time, we have collaborated with other companies, including Hewlett-Packard and
Oracle and certain of the national accounting firms that provide system integration services, in areas such as product development, marketing, distribution and implementation. We could lose sales opportunities if we fail to work effectively with
these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current partners are either actual or potential
competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these relationships are informal or, if written, are
terminable with little or no notice.





Our proprietary rights may be inadequately protected, and there is risk of infringement claims or independent
development of competing technology that could harm our competitive position





Our success and ability to compete are
dependent on our ability to develop and maintain the proprietary aspects of our technology. We rely on a combination of trademark, trade secret, copyright law and contractual restrictions to protect the proprietary aspects of our technology.





Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to
obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of
others. Any such resulting litigation could result in substantial costs and diversion of resources.





Our means of protecting our
proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software
industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.





Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights
of others. Third parties may claim infringement by us of their intellectual property rights. In the event of a successful claim of product infringement against us and our failure or inability to either license the infringed or similar technology or
develop alternative technology on a timely basis, we may incur substantial licensing fees, be liable for infringement damage, or be unable to market our products.





Our business will suffer if our software contains errors





The software products we offer
are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical
challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third- party software applications and databases. If new or existing customers
have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or if
we fail to meet our customers expectations. As a result of the foregoing, we could experience:




20




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| |  |  | loss of or delay in revenues and loss of market share;
| | - |  | ------------------------------------------------------




| |  |  | loss of customers;
| | - |  | ------------------




| |  |  | damage to our reputation;
| | - |  | -------------------------




| |  |  | failure to achieve market acceptance;
| | - |  | -------------------------------------




| |  |  | diversion of development resources;
| | - |  | -----------------------------------




| |  |  | increased service and warranty costs;
| | - |  | -------------------------------------




| |  |  | legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------




| |  |  | increased insurance costs.
| | - |  | --------------------------




In
addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.





We
incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping
of, our products





Certain of our software products contain components developed and maintained by third-party software
vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software
becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could
harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently
provided to us.





Natural disasters or power outages could disrupt our business





A substantial portion of our operations are located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods and similar events,
as well as from power outages. We have recently experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business
and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do
not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers
or sell and deliver our products.




21




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Risks Related to Our Industry





The demand for our products will depend on our ability to adapt to rapid technological change





Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and satisfy increasingly sophisticated
customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products. The
introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a result of the complexities inherent in todays computing environments and the
performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases
or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We may not be successful in:





| |  |  | developing and marketing, on a timely and cost-effective basis, new products or new product enhancements that respond to technological change, evolving industry standards or
customer requirements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | avoiding difficulties that could delay or prevent the successful development, introduction or marketing of these products; or
| | - |  | -----------------------------------------------------------------------------------------------------------------------------




| |  |  | achieving market acceptance for our new products and product enhancements.
| | - |  | --------------------------------------------------------------------------




We may not be able to attract and retain personnel





Our
future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel, many of whom have recently joined our company. In addition, the success of our business is
substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support
and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our business may not be able to grow if we cannot attract qualified
personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered.





Item 3:Quantitative and Qualitative Disclosures About Market Risks





We transact
business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to
incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.





Our exposure
to foreign exchange risk is directly proportional to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. dollar, as well as our net foreign investment in non-U.S. dollar assets. These exposures have the
potential to produce either gains or losses. Our cumulative currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no
assurance that this pattern will continue to be true in future periods.





The foreign currencies to which we currently have the
most significant exposure are the Canadian dollar, the British pound, the Euro and the Australian dollar.





To date, we have not
used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost benefit of hedging foreign exchange exposures with derivatives
and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.




22




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Interest Rate Risk





Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place
our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one asset class or issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of
investment-grade bonds with average lives of less than five years. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale.
Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders equity. At March 31, 2002, the net loss on available-for-sale securities of $.8 million
comprised 28 positions of which 15 carry unrealized gains and 13 carry unrealized losses.





The following table provides
information about our investment portfolio at March 31, 2002 (dollars in thousands):





BALANCE

AVERAGE RATECash and cash equivalents

$
30,995

1.39Short-term marketable securities, available for sale


21,083

6.01Long-term marketable securities, available for sale


167,326

4.80Total portfolio

$
219,404

4.43





We consider the carrying value of our investment securities to approximate their
fair value due to the relatively short period of time between origination of the investments and their expected realization. We also maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to
maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.




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PART IIOTHER INFORMATION





Item 6:Exhibits and Reports on Form 8-K





| | (a) |  | EXHIBITS
| | --- |  | --------




None





| | (b) |  | REPORTS ON FORM 8-K
| | --- |  | -------------------




No reports on
Form 8-K were filed during the three months ended March 31, 2002.




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SIGNATURES





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





QUEST SOFTWARE, INC.May 15, 2002



/s/    M. BRINKLEY MORSEM. Brinkley Morse Vice President, Finance and Operations/s/    KEVIN E. BROOKSKevin E. Brooks Principal
Accounting Officer




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