Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
This document contains various forward-looking statements and information that are based on management's beliefs, assumptions made by management and information currently available to management. Such statements are subject to various risks and uncertainties, which could cause actual results to vary materially from those contained in such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected or projected. Certain of these, as well as other risks and uncertainties are described in more detail herein and in Astea International Inc.'s ("Astea or the Company") Annual Report on Form 10-K for the fiscal year ended December 31, 2017.
Astea is a global provider of service management software that addresses the unique needs of companies who manage capital equipment, mission critical assets and human capital. Clients include Fortune 500 to mid-size companies which Astea services through company facilities in the United States, United Kingdom, Australia, Japan, the Netherlands and Israel. Since its inception in 1979, Astea has licensed applications to companies in a wide range of sectors including information technology, telecommunications, instruments and controls, business systems, and medical devices.
Astea Alliance, the Company's service management suite of solutions, supports the complete service lifecycle, from lead generation and project quotation to service and billing through asset retirement. It integrates and optimizes critical business processes for Campaigns, Call Center, Depot Repair, Field Service, Logistics, Projects and Sales, and Order Processing applications. Astea extends its application suite with mobile workforce management, dynamic scheduling optimization, third party vendor and customer self-service portals, and business intelligence. In order to ensure customer satisfaction, Astea also offers infrastructure tools and services. Astea Alliance provides service organizations with technology-enabled business solutions that improve profitability, stabilize cash-flows, and reduce operational costs through automating and integrating key service, sales and marketing processes.
The FieldCentrix Enterprise is a service management solution that runs on a wide range of mobile devices (handheld computers, laptops and PCs, and Pocket PC devices), and integrates seamlessly with popular customer relationship management ("CRM") and ERP applications. Add-on features include a web-based customer self-service portal, workforce optimization capabilities, and equipment-centric functionality. FieldCentrix has licensed applications to companies in a wide range of sectors including HVAC, building and real estate services, manufacturing and process instruments and controls, and medical equipment.
The Company's sales and marketing efforts are primarily focused on new software licensing (on premise and cloud solutions) and support services for its latest generation of Astea Alliance and FieldCentrix products.
Critical Accounting Policies and Estimates
The Company's significant accounting policies are described in its "Summary of Accounting Policies," Note 2, in the Company's 2017 Annual Report on Form 10-K. The preparation of financial statements in conformity with accounting principles generally accepted within the United States requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying financial statements and related notes. In preparing these financial statements, management has made its best estimates and judgments of certain amounts included in the financial statements, giving due consideration to materiality. The Company does not believe there is a great likelihood that materially different amounts would be reported related to the accounting policies described below; however, application of these accounting policies involves the exercise of judgments and the use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates.
Revenue Recognition
Astea's revenue is principally recognized from three sources: (i) licensing arrangements, (ii) subscription services and (iii) services and maintenance.
The Company markets its products primarily through its direct sales force and resellers. License agreements do not provide for a right of return, and historically, product returns have not been significant.
In May 2014, the Financial Accounting Standards Board (FASB) issued
Revenue from Contracts with Customers
which modifies how all entities recognize revenue, and consolidates revenue recognition guidance into one,
Revenue from Contracts with Customers
("new guidance"). The Company adopted the new guidance on January 1, 2018 and applied the modified retrospective method of adoption with a cumulative catch-up adjustment to the opening balance of accumulated deficit at January 1, 2018. Under this method, the Company applied the revised guidance in the year of adoption and applied the old guidance,
Revenue Recognition
("old guidance"), in the prior years. As a result, the Company applied the new guidance only to contracts that were not yet completed as of January 1, 2018. The Company recognized a cumulative catch-up adjustment to the opening balance of accumulated deficit at the effective date for contracts that still required performance by the Company at the date of adoption. The new guidance outlines a comprehensive five-step revenue recognition model based on the principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The five steps are:
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Identify the contract with a customer
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Identify the performance obligations in the contract
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Determine the transaction price
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Allocate the transaction price to performance obligations in the contract
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Recognize revenue when or as the Company satisfies a performance obligation
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The Company satisfies performance obligations as discussed in further detail below. Revenue is recognized at the time the related performance obligation is satisfied by transferring a promised service to a customer.
The Company recognizes revenue from license sales when the above criteria are met. The Company generally uses written contracts as a means to establish the terms and conditions by which our products, services and maintenance support are sold to our customers. The Company satisfies the performance obligation when the license key has been delivered electronically to the customer. If these criteria are not met, then revenue is deferred until such criteria are met or until the period(s) over which the last performance obligation is delivered.
The Company recognizes revenues from maintenance ratably over the term of the underlying maintenance contract term. The term of the maintenance contract is usually one year. Renewals of maintenance contracts create new performance obligations that are satisfied over the contract term.
Revenues from professional services mostly consist of time and material services. The performance obligations are satisfied, and revenues are recognized, when the services are provided or when the service term has expired.
In subscription based arrangements, even though customers use the software element, they generally do not have a contractual right to take possession of the software at any time during the hosting period without significant penalty to either run the software on its own hardware or contract with an unrelated third party to host the software. Accordingly, these software as a service (SaaS) arrangements, including the software license fees within the arrangements, are accounted for as subscription services provided all other revenue recognition criteria have been met. The subscription revenue is recognized on a straight-line basis over the performance obligation. The Company recognize subscription revenue once a customer goes-live ratably over the remaining contract period or customer life whichever is longer. The contract period is typically 1 to 3 years. The average expected life of a customer is 2 years. The average customer takes about 8 to 10 months to go live. The Company expects the average life of a customer to increase as more customers begin to renew their subscription contracts. When implementation, consulting and training services are bundled with the subscription based arrangement, these services are recognized over the life of the initial contract (performance obligation), once the project goes live.
In contracts with multiple performance obligations, the Company accounts for individual performance obligations separately, if they are distinct. The Company allocates the transaction price to each performance obligation based on its relative standalone selling price out of total consideration of the contract. For maintenance and support, the Company determines the standalone selling price based on the price at which the Company separately sells a renewal contract. The Company determines the standalone selling price for sales of licenses using the residual approach. For professional services, the Company determines the standalone selling prices based on the price at which the Company separately sells those services.
The new guidance prefers that revenue in a contract with multiple performance obligations use the adjusted market approach which includes standalone selling price (SSP) or third part evidence (TPE) or expected cost plus margin approach as the methodology for allocating revenues to software. The Company uses the Residual Method for allocating the revenues from a contract to the license component of the sale. Due to competition, highly variable pricing, customer demographics, varying size of our customers, and other such factors, the Company's selling prices are considered uncertain for each perpetual license sale. Therefore, SSP is not an appropriate methodology as it relates to our license revenue. In terms of TPE as a basis to price our software, our product is unique and expansive in terms of the system's inherent functionality. There are no directly comparable products in the marketplace today, which we could use as the basis to set our standard license pricing based on a comparison with other vendors. In addition, most of the companies with whom we compete, are privately owned, which prevents us from obtaining reliable TPE. Accordingly, the new guidance permits the Company to use the Residual Method for allocating selling price if the first two preferable choices cannot be used. The residual between the total transaction price and the observable standalone selling prices of those performance obligations with observable standalone selling prices is considered to be the estimated standalone selling price of the goods or services underlying the performance obligation.
Astea commonly sells its software products bundled with other products (maintenance) and professional services. As noted above, the new standard requires an entity to allocate the transaction price to the distinct performance obligations in a contract on a relative SSP basis. Under the new guidance, "…an entity shall determine the standalone selling price at contract inception of the distinct good or service underlying each performance obligation in the contract and allocate the transaction price in proportion to those standalone selling prices." SSP is defined as the price at which an entity would sell a promised good or service separately to a customer. Astea has a history of selling maintenance renewals and professional services on a standalone basis. Therefore, the Company will utilize SSP for its performance obligations as it relates to service and maintenance revenue. In addition, due to the Company having different maintenance and service rates in other parts of the world in which it operates, the Company has developed a reasonable range for its SSP for maintenance and services rather than a single point.
The incremental costs of obtaining a customer contract (i.e., those costs related to obtaining the customer contract that would not have been incurred if the customer contract was not obtained), such as a sales commission, should be capitalized if the Company expects to recover those costs (based on net future cash flows from the contract and expected contract renewals). The Company may expense the incremental costs of obtaining a contract if the amortization period would otherwise be one year or less. Since sales commissions are costs that are incremental and the amortization of sales commissions would be one year or less, the Company will continue to expense these items as incurred. Costs of obtaining a customer contract that are not incremental (i.e., costs related to obtaining the customer contract that would have been incurred regardless of whether the customer contract had been obtained), such as travel costs incurred to present the customer proposal, should only be capitalized if those costs are explicitly chargeable to the customer regardless of whether the entity enters into a contract with the customer. Otherwise, such costs are expensed as incurred. The Company will continue to expense these costs as they are incurred.
The primary change in how we report revenues and expenses under the new guidance will be in the way we report expenses related to our subscription business. In the past, we deferred all hosting revenue until the customer went live. This practice will continue. The purpose of this practice is to only recognize subscription revenue over the period in which the customer receives the benefit of using the system (performance obligation is satisfied). The major change resulting from the adoption of the new guidance will relate to costs incurred in getting a hosted customer live. Through the end of 2017, the Company charged all implementation costs to expense in the period incurred. Starting January 1, 2018, we will defer all implementation related costs on the balance sheet (primarily labor costs and hosting costs) until the customer goes live. Once live, we will recognize the deferred implementation costs related to that customer ratably over the remaining expected life of the customer contract or two years, whichever is longer.. At this point, based on the Company's relatively short time-span as a provider of a hosted solution, our analysis shows that the average lifespan of an Astea hosted customer is 2 years. Therefore, we will amortize the deferred cost over 2 years or the remaining life of the contract, whichever is longer. This is consistent with the revenue recognition methodology used for the subscription service revenue for that customer.
The Company satisfies performance obligations as discussed in further detail below. Revenue is recognized at the time the related performance obligation is satisfied by transferring a promised service to a customer.
We believe that our accounting estimates used in applying our revenue recognition are critical because:
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the determination that it is probable that the customer will pay for the products and services purchased is inherently judgmental and includes credit risk;
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determining the performance obligations and transaction price to certain elements in multiple-element arrangements is complex; and
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the determination of whether a service is essential to the functionality of the software is complex and could potentially create a new performance obligation.
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Changes in the aforementioned items could have a material effect on the type and timing of revenue recognized. In addition, Company's payment terms and conditions vary by contract and size of customer, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined that its contracts generally do not include a significant financing component. The primary purpose of invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, and not to facilitate financing arrangements.
The Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided by the allowance for doubtful accounts is believed by management to be probable in the Company's accounts receivable. The Company has not adjusted revenues for customers related to credit risk.
At September 30, 2018 there were two customers that accounted for 10% or more of accounts receivable, net and at December 31, 2017, no individual customer accounted for 10% or more of accounts receivable, net. For the nine months ended September 30, 2018, one customer accounted for 10% of total revenue. For the nine months ended September 30, 2017, no individual customer accounted for 10% or more of total revenue. For the three months ended September 30, 2018 and 2017 no individual customer accounted for 10% or more of total revenue.
We present taxes assessed by a governmental authority including sales, use, value added and excise taxes on a net basis and therefore the presentation of these taxes is excluded from our revenues and is included in accrued expenses in the accompanying consolidated balance sheets until such amounts are remitted to the taxing authority.
Capitalized Software Research and Development Costs
The Company capitalizes software development costs incurred during the period subsequent to the establishment of technological feasibility through the product's availability for general release. Costs incurred prior to the establishment of technological feasibility are charged to product development expense as they are incurred. Product development expense includes payroll, employee benefits, other headcount-related costs associated with product development and any related costs to third parties under sub-contracting or net of any collaborative arrangements.
Capitalized software development costs are amortized on a product-by-product basis over the greater of the ratio of current revenues to total anticipated revenues or on a straight-line basis over the estimated useful lives of the products beginning with the initial release to customers. The Company's estimated life for its capitalized software products is two years based on current sales trends and the rate of product release. The Company continually evaluates whether events or circumstances have occurred that indicate that the remaining useful life of the capitalized software development costs should be revised or that the remaining balance of such assets may not be recoverable. The Company evaluates the recoverability of capitalized software based on the net realizable value of each product, which includes the estimated future gross revenues from that product reduced by the estimated future costs of completing and disposing of that product, including the costs of performing maintenance and customer support required to satisfy the Company's responsibility set forth at the time of sale. As of September 30, 2018, management believes that no revisions to the remaining useful lives or write-downs of capitalized software development costs are required.
Currency Translation
The international subsidiaries and foreign branch operations translate their assets and liabilities from international operations by using the exchange rate in effect at the balance sheet date. The results of operations are translated at average exchange rates during the period. The effects of exchange rate fluctuations in translating assets and liabilities of international operations into U.S. dollars are accumulated and reflected as a currency translation adjustment as a component of other comprehensive loss in the accompanying consolidated statements of changes in stockholders' deficit. Foreign exchange transaction gains and losses are included in general and administrative expenses in the consolidated statements of operations. General and administrative expenses include a foreign exchange transaction gain of $15,000 for the nine months ended September 30, 2018 and a $25,000 loss for the nine months ended September 30, 2017.
Results of Operations
Financial results for the three and nine months ended September 30, 2018, as compared to the three and nine months ended September 30, 2017 reflect the effects of adopting Revenue from Contracts with Customers, which provided a new basis of accounting for our revenue arrangements beginning upon adoption on January 1, 2018.
The adoption of Revenue from Contracts with Customers limits the comparability of certain expenses, including cost of subscriptions, services and maintenance, presented in the results of operations for the three and nine months ended September 30, 2018, when compared to the three and nine months ended September 30, 2017. For additional information regarding the adoption of this accounting standard, refer to Note 1 in the notes to consolidated financial statements under the heading "Recently Adopted Accounting Standards."
Comparison of Three Months Ended September 30, 2018 and 2017
Revenues
Total revenues increased by $643,000 or 10%, to $7,125,000 for the three months ended September 30, 2018 from $6,482,000 for the three months ended September 30, 2017. Software license fee revenues decreased $168,000, or 18%, from the same quarter in 2017. Subscription revenues increased $820,000 or 139% to $1,412,000 from $592,000 for the same period last year. Services and maintenance revenues for the three months ended September 30, 2018 decreased $9,000 or less than 1% from the same quarter in 2017.
Software license fee revenue decreased 18% to $765,000 in the third quarter of 2018 from $933,000 in the third quarter of 2017. Astea Alliance license revenues decreased $346,000 or 37%, to $587,000 in the third quarter of 2018 from $933,000 in the third quarter of 2017. The decrease was primarily due to lower perpetual license sales in Japan, partially offset by higher sales in EMEA. FieldCentrix license sales were $178,000 in the third quarter of 2018 compared to no license sales in the third quarter of 2017. The increase was due to the sale of additional licenses to existing customers.
Subscription revenue increased 139% to $1,412,000 in the third quarter of 2018 from $592,000 in the third quarter of 2017. The primary reason for the increase resulted from a hosted customer in Japan who went live in the third quarter of 2018 for which hosting revenue of $424,000 had been deferred since 2016. The extended implementation period was due to certain functionality requirements of the customer that lengthened the implementation time required for this customer to go-live. Future subscription revenue will not continue at this same level for this customer because we will only recognize revenue on a monthly basis. The previously deferred annual hosting revenues were recognized as the 2-year service period for those hosting services had lapsed. This implementation was more complex than most, as typically most customers go live in 6 to 10 months. The Company sells Software as a Service (SaaS) for which hosting revenue is not recognized until the customers go-live and the performance obligation is completed.
Services and maintenance revenues decreased by less than 1% to $4,948,000 in the third quarter of 2018 compared to $4,957,000 in the third quarter of 2017. Astea Alliance service and maintenance revenues decreased by $23,000 or 1% compared to the third quarter of 2018. Service and maintenance revenues generated by FieldCentrix increased by $13,000 or 2% to $551,000 in the third quarter of 2018 compared to $538,000 during the same period in 2017. T
he increase is primarily due to increased maintenance revenue resulting from the sale of licenses to existing customers over the year.
Costs of Revenues
Cost of software license fees increased 43% to $750,000 in the third quarter of 2018 from $526,000 in the third quarter of 2017. Included in the cost of software license fees is capitalized software amortization and the third party software embedded in the Company's software licenses sold to customers. Amortization of capitalized software development costs was $739,000 for the quarter ended September 30, 2018 compared to $525,000 for the same quarter in 2017. The increase resulted from the release of Astea Alliance Version 14.5 in September 2017 and Astea Alliance Enterprise Version 15 in September 2018. The gross margin percentage on software license sales was 2% in the third quarter of 2018 compared to 44% in the third quarter of 2017. The decline in the third quarter 2018 license margin resulted primarily from the decrease in software license fees revenue and the increase in cost of software license fees.
Cost of subscriptions increased 91% to $369,000 in the third quarter of 2018 from $193,000 in the third quarter of 2017. The Company defers the cost of subscriptions for hosting customers who are in the implementation process during each quarter until they go live, then the related deferred hosting costs are recognized ratably with the subscription revenue
. Because the 2 year service period had lapsed on the customer who went live during the quarter, all deferred costs that had previously been deferred for that customer, were recognized in the quarter ended September 30, 2018, causing the large cost increase compared to the same period last year when the customer went live. Third quarter 2018 hosting costs would have been $175,000 lower under the previous revenue recognition rules, because the costs would have previously been expensed. However, under the new revenue guidance, the Company deferred certain hosting costs which are amortized over the hosting period once the customer goes live. Under the old guidance, as presented for the third quarter of 2017, the Company expensed these costs as incurred.
These increases were partially offset by increased
costs from a growing base of hosted customers from sales in the first three quarters of 2018
. The gross margin percentage on hosting was 74% in the third quarter of 2018 compared to 67% in the third quarter of 2017. The growth in the gross margin is mainly due to the increase in subscription revenue from customers going live and the deferral of hosting costs until the customer goes live in 2018.
Cost of services and maintenance decreased 2% to $3,696,000 in the third quarter of 2018 from $3,760,000 in the third quarter of 2017. The decrease was due to a slightly reduced headcount in 2018 compared to 2017 as well as weaker currency rates in Europe compared to the U.S. dollar, which reduced the costs when converted to U.S. dollars. Partially offsetting the cost decreases were the recognition of $474,000 of previously deferred implementation costs offset by the deferral of $295,000 in costs related to SaaS implementation projects during the quarter. The gross margin percentage was 25% in the third quarter of 2018 compared to 24% in the third quarter of 2017.
Gross Profit
Total gross profit increased 15% to $2,310,000 in the third quarter of 2018 from $2,003,000 in the third quarter of 2017 primarily due to an increase in subscription revenues due to a Japanese customer that went live in the third quarter of 2018, partially offset by the increase in cost of software license fees. As a percentage of revenue, gross profit in the third quarter of 2018 was 32% compared to 31% in the third quarter of 2017.
Operating Expenses
Product Development
Product development expenses increased 120% to $330,000 in the third quarter of 2018 from $150,000 in the third quarter of 2017.
Fluctuations in product development expense from period to period result from the amount of product development expense that is capitalized. Development costs of $645,000 were capitalized in the third quarter of 2018 compared to $741,000 during the same period in 2017. Gross product development expense was $975,000 in the third quarter of 2018 which is 10% higher than $891,000 during the same quarter in 2017.
The increase was due to increases in salary and benefits and an unfavorable exchange rate on the Israeli shekel relative to the U.S. dollar, as the majority of development work is performed in Israel.
Product development expense as a percentage of revenues was 5% in the third quarter of 2018 and 2% in the third quarter of 2017.
Sales and Marketing
Sales and marketing expense increased 19% to $1,013,000 in the third quarter of 2018 from $853,000 in the third quarter of 2017. The increase in sales and marketing expense resulted from increased travel costs and higher commissions due to an increase in license revenue and subscriptions sales and an increase in third party marketing costs. These increases were partially offset by a decrease in salary expense due to decreased headcount and decreased commissions resulting from reduced sales compared to the same quarter of 2017. The increase in third party marketing costs is due to the Company
expanding its marketing presence through additional efforts to increase awareness of our products in order to improve lead generation and sales opportunities.
Increased awareness occurs through additional webinars in all regions focused on the vertical industries in which the Company operates, attendance at more trade shows, and new strategies to improve lead generation for the Company's sales force.
As a percentage of revenues, sales and marketing expense was 14% in the third quarter of 2018 compared to 13% in the same period of 2017.
General and Administrative
General and administrative expenses consist of salaries, benefits and related costs for the Company's finance, administrative and executive management personnel, legal costs, accounting costs, bad debt expense and various costs associated with the Company's status as a public company.
General and administrative expenses increased 32% to $972,000 during the third quarter of 2018 from $737,000 in the third quarter of 2017 due to increases in
legal fees, bad debt expense, investor relation cost, travel expenses, salary and benefit, and recruiting costs
which we did not incur during the same period in 2017. As a percentage of revenue, general and administrative expenses were 14% in the third quarter of 2018 compared to 11% in the third quarter of 2017.
Net Interest Expense
Net interest expense was $64,000 in the third quarter of 2018 compared to $70,000 in the third quarter of 2017. The decrease in interest expense is mainly due payoff of the term loan and SVB line of credit and lower deferred financing cost, partially offset by interest paid on accrued preferred dividends compared to the same period in 2017. Per the preferred stock agreements, any unpaid accrued preferred dividends will incur an interest charge at 10% per annum.
Income Tax Expense
The Company reported a provision for income tax of $1,000 for the third quarter of 2018 compared to $7,000 during the third quarter of 2017. The tax expense results from a tax provision in Israel. The parent company purchases all work performed by the Israeli development team under a cost plus agreement. This means the parent company pays all expenses incurred in Israel plus a mark-up rate established by the Israeli Tax Authority. The mark-up rate results in the Israeli operation generating a profit as a stand-alone entity, which results in a tax expense every quarter. Because the rate was reduced in the third quarter, the cumulative tax expense for the year was reduced which is reflected in the tax accrual for the quarter ended September 30, 2018.
International Operations
The Company's international operations generated revenues of $3,530,000 in the third quarter of 2018, an increase of 16% over the same quarter in 2017. Revenues from international operations comprised 50% of the Company's total revenue for the third quarter in 2018, compared to 47% of total revenues for the same quarter in 2017. The increase in international revenues compared to the same period in 2017 is primarily due to increases in subscription revenue generated by Japan due to a customer going live in the third quarter of 2018.
Comparison of Nine Months Ended September 30, 2018 and 2017
Revenues
Total revenues increased by $2,014,000 or 11%, to $20,453,000 for the nine months ended September 30, 2018 from $18,439,000 for the nine months ended September 30, 2017. Software license fee revenues increased $498,000, or 32%, from the same period in 2017. Subscription revenues increased $1,241,000 or 67% to $3,104,000 from the same period last year. Services and maintenance revenue for the nine months ended September 30, 2018 increased $275,000 or 2% from the same period in 2017.
Software license fee revenues increased 32% to $2,076,000 in the first nine months of 2018 from $1,578,000 in the first nine months of 2017. Astea Alliance license revenues increased $467,000 or 34%, to $1,832,000 in the first nine months of 2018 from $1,365,000 in the first nine months of 2017. The increase was primarily due to higher perpetual license sales in the U.S. and Europe. FieldCentrix license sales were $244,000 in the first nine months of 2018 compared to $213,000 in the first nine months of 2017. The increase was due to additional license sold to existing customers that are expanding their users during the first nine months of 2018.
Subscription revenue increased 67% to $3,104,000 in the first nine months of 2018 from $1,863,000 in the first nine months of 2017. The increase resulted from increases in users which generated more revenue as we charge hosted customers a fee for each user and a number of hosted customers who went live in 2018 compared to the same period in 2017. One Japanese customer went live in the third quarter of 2018 and generated hosting revenue of $424,000 which had been deferred since 2016. The extended implementation period was due to certain functional requirements of the customer that lengthened the time required for this customer to go-live. Future subscription revenue from this customer will not continue at this same level, because the previously deferred annual hosting revenues were recognized as the 2 year service period for those hosting services had lapsed. This implementation was more complex than most, as typically most customers go live in 6 to 10 months. Even though the Company signed several new Software as a Service (SaaS) customers in the first nine months of 2018, the associated hosting revenue has been deferred until the new customers go-live.
Services and maintenance revenues increased by 2% to $15,273,000 in the first nine months of 2018 compared to $14,998,000 in the first nine months of 2017. Astea Alliance service and maintenance revenues increased by $152,000 or 1% compared to the first nine months of 2017. The increase was mainly attributable to an increase in services and maintenance revenues in the U.S. and Japan. Japan service and maintenance revenue increased 50% or $1,175,000 compared to the first nine months of 2017 which resulted from a significant hosted customer that went live in the third quarter of 2018 for which the hosting implementation services were previously deferred. The service revenue was recognized when the customer went live as the contracted service period of 2 years had lapsed.
Service and maintenance revenues generated by FieldCentrix increased by $122,000 or 8% to $1,722,000 in the first nine months of 2018 compared to $1,600,000 during the same period in 2017. T
he increase is due to an increase in upgrade projects for several existing customers and increase in maintenance revenue from existing customers who purchased additional licenses.
Costs of Revenues
Cost of software license fees increased by 9% to $1,976,000 in the first nine months of 2018 from $1,816,000 in the first nine months of 2017. Included in the cost of software license fees are the costs of capitalized software amortization and the cost of all third party software embedded in the Company's software licenses sold to customers. Amortization of capitalized software development costs was $1,940,000 for the first nine months in 2018 compared to $1,796,000 for the same period in 2017. The increase is from Astea Alliance Version 14.5 being released in September 2017 which generated 9 months of amortization in 2018 and Astea Alliance Enterprise Version 15 being released in the third quarter of 2018 with the start of its amortization in September. The Company expects amortization costs to increase over the next two years due to the significant investment needed for the release of Version 15 in September of 2018. The gross margin percentage on software license sales was 5% in the first nine months of 2018 compared to (15%) in the first nine months of 2017. The improvement in the license margin resulted primarily from the increase in software license fees revenue in the first nine months of 2018.
Cost of subscriptions increased 27% to $794,000 in the first nine months of 2018 from $626,000 in the first nine months of 2017. The Company defers the costs of subscriptions for hosting customers who are in the implementation process during each quarter until they go live. Then the costs are recognized ratably along with the deferred subscription revenue
. Because a hosted customer went live in the third quarter of 2018, the implementation costs that had previously been deferred, were recognized because the 2 year service period had lapsed. Under the new revenue guidance, the Company deferred certain hosting costs, which are now amortized over the hosting period once the customer goes live. Under the old guidance, as presented for the third quarter of 2017, the Company expensed these costs as incurred.
The cost increases resulted from additional costs
from a growing base of hosted customers from sales in the first nine months of 2018
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The gross margin percentage on hosting was 74% in the first nine months of 2018 compared to 66% in the first nine months of 2017. Had the Company not deferred any hosting costs in 2018, the gross profit percentage would have been 56%.
Cost of services and maintenance decreased 2% to $10,705,000 in the first nine months of 2018 from $10,913,000 in the first nine months of 2017. Part of the decrease was due to the net impact of the new revenue recognition rules in which the Company deferred $823,000 in costs offset by the recognition of $774,000 in costs. Additional factors causing the increase in cost of service and maintenance is mainly attributed to a decrease in contracted service work in Japan and decreased travel expense in all regions. The gross margin percentage was 30% in the first nine months of 2018 compared to 27% in the first nine months of 2017. Had the Company expensed all service and maintenance costs incurred in 2018, the gross margin as a percentage of total revenue would have been 25%.
Gross Profit
Gross profit increased 37% to $6,978,000 in the first nine months of 2018 from $5,084,000 in the first nine months of 2017 primarily due to an 11% increase of total revenue only and a 1% in costs of revenues.
As a percentage of revenue, gross profit in the first nine months of 2018 was 34% compared to 28% in the first nine months of 2017. In addition, due to the adoption of revenue from contract with customers
the Company deferred $708,000 of costs that under the previous guidance would have been expensed as incurred. Had the Company expensed these costs in 2018, the gross profit as a percentage of revenue would have been 34%.
Operating Expenses
Product Development
Product development expenses decreased 26% to $697,000 in the first nine months of 2018 from $947,000 in the first nine months of 2017.
Fluctuations in product development expense from period to period result from the amount of product development expense that is capitalized. Development costs of $2,430,000 were capitalized in the first nine months of 2018 compared to $1,987,000 during the same period in 2017 due to additional resources working on Astea Alliance Enterprise Version 15. There has been extra time and resources allocated to Astea Alliance Enterprise Version 15 due to all the additional functionality and upgrades made to this version. Gross product development expense was $3,127,000 in the first nine months of 2018 compared to $2,934,000 during the same period in 2017.
The increase was primarily due to salary increases and an unfavorable exchange rate on the Israeli shekel relative to the U.S. dollar, as the majority of development work is performed in Israel.
Product development expense as a percentage of revenues was 3% in the first nine months of 2018 and 5% in the first nine months of 2017.
Sales and Marketing
Sales and marketing expense increased 16% to $2,991,000 in the first nine months of 2018 from $2,587,000 in the first nine months of 2017. The increase in sales and marketing expense resulted from higher commissions and travel costs due to an increase in license revenue and subscriptions sales and an increase in third party marketing costs. These increases were partially offset by decrease in sales headcount. The increase in third party marketing costs is due to the Company
expanding its marketing presence through additional efforts to increase awareness of our products in order to improve lead generation and sales opportunities.
Increased awareness occurs through additional webinars in all regions focused on the vertical industries in which the Company operates, attendance at more trade shows, and new strategies to improve lead generation for the Company's sales force.
As a percentage of revenues, sales and marketing expense was 15% in the first nine months of 2018 and 14% in the first nine months of 2017.
General and Administrative
General and administrative expenses consist of salaries, benefits and related costs for the Company's finance, administrative and executive management personnel, legal costs, accounting costs, and various costs associated with the Company's status as a public company.
General and administrative expenses increased 36% to $2,868,000 during the first nine months of 2018 from $2,105,000 in the first nine months of 2017 mainly due to the timing of accounting fees being invoiced to Astea, increased
legal fees, investor relations cost, bad debt expense, travel expenses, salary and benefit, and recruiting costs
which we did not incur during the same period in 2017. As a percentage of revenue, general and administrative expenses were 14% in the first nine months of 2018 compared to 11% in the first nine months of 2017.
Net Interest Expense
Net interest expense was $163,000 in the first nine months of 2018 compared to $144,000 in the first nine months of 2017. The increase in interest expense is mainly due to interest paid on accrued, but unpaid preferred dividends compared to the same period in 2017. Per the preferred stock agreements, unpaid accrued preferred dividends incur an interest charge calculated at 10% per annum. In addition, the interest rate charged by Bridge Bank to the Company increased.
Income Tax Expense
The Company reported a provision for income tax of $19,000 for first nine months of 2018 compared to $21,000 income expense for the same quarter in 2017. The tax provision results from operations in Israel.
International Operations
The Company's international operations generated revenues of $9,204,000 in the first nine months of 2018, an increase of 12% over the same quarter in 2017. Revenues from international operations comprised 45% of the Company's total revenue for the first nine months in 2018 and 2017. The increase in international revenues compared to the same period in 2017 is primarily due to increases in all Japan revenues partially offset by a decline in Europe and APAC service and maintenance revenues.
Liquidity and Capital Resources
Operating Activities
The Company generated $1,722,000 of cash from operating activities in the first nine months of 2018 compared to $2,051,000 for the first nine months of 2017. The decrease in operating cash flows of $329,000 resulted from an increased use of $408,000 to reduce accounts payable and accrued expenses, reduced cash generated from deferred revenues of $1,157,000, the use of $936,000 for deferred hosting costs and an increase in cash used to prepay expenses of $18,000. Partially offsetting the increased uses of cash was an increase in cash generated by net income of $960,000, an increase in cash generated by the collection of accounts receivable of $481,000, $786,000 of non-cash changes due to amortization of deferred hosting costs and an increase in cash provided by other long-term assets of $4,000.
Investing Activities
The Company used $2,472,000 for investing activities in the first nine months of 2018 compared to $1,991,000 for the first nine months of 2017. The increase in cash used for investing activities is primarily attributable to an increase of $443,000 in capitalized software development costs and an increase of $38,000 for purchases of property and equipment.
Financing Activities
The Company generated $146,000 of cash from financing activities in the first nine months of 2018, which is a decrease of $476,000 compared to the same period in 2017. The Company paid $105,000 in preferred stock dividends in the first nine months of 2018 compared to $125,000 in the first nine months of 2017. In the first nine months of 2017, the Company borrowed $400,000 on the term loan with WAB. In the first nine months of 2018, the Company paid $225,000 to eliminate its term loan with WAB. The term loan expired in April 2018.
In addition, the Company borrowed $8,367,000 and repaid $7,975,000 on its line of credit from WAB in the first nine months of 2018. During the same period in 2017, the Company borrowed $6,734,000 and repaid $8,661,000 on its line of credit from SVB. The line of credit with SVB was cancelled and fully repaid in August of 2017.
The Company repaid $350,000 on its line of credit with the CEO/Director during the first nine months ended September 30, 2017. The Company also generated cash of $84,000 from the exercise of stock options in the first nine months of 2018.
The effect of exchange rates on cash related to the U.S. dollar exchange rates for most other currencies in which the Company operates, primarily the Australian dollar, Japanese yen, the Euro, the British pound sterling and Israel shekel, provided an inflow of $19,000 in the first nine months of 2018 compared to an outflow of $8,000 in the first nine months of 2017.
The Company has a history of net losses and an accumulated deficit of $34,468,000 as of September 30, 2018. In the first nine months of 2018, the Company generated net income of $240,000 compared to a net loss of $720,000 generated in the first nine months of 2017. Further, at September 30, 2018, the Company had a working capital ratio of .65:1, with cash and cash equivalents of $1,342,000 compared to December 31, 2017 when the Company had cash and cash equivalents of $1,924,000. The decrease in cash and cash equivalents for the first nine months of 2018 was primarily driven by a decrease of cash provided by operations in 2018 compared to 2017, repayment of the Company's term loan for $225,000 and an increase in capitalized software development cost of $443,000 for the first nine months of 2018.
As of September 30, 2018, the Company owed $2,697,000 against the line of credit from
Western Alliance Bank ("WAB")
. As of September 30, 2018, there was $153,000 available under the line of credit. The Company has projected revenues that management believes will provide sufficient funds along with the additional borrowings available under its line of credit to sustain its continuing operations through at least November 14, 2019. The Second Loan Agreement increased the availability under the line of credit from $2,400,000 to $2,850,000 (see footnote #9).
The Company was in compliance with the WAB financial and liquidity covenant as of September 30, 2018 and expects to be able to continue to comply with the required covenants under the modified agreement with WAB for at least the next year. As a result, the amounts due to WAB under the line of credit and term loan as of September 30, 2018 were classified in the accompanying consolidated balance sheet in accordance with the repayment terms stipulated in the agreement with WAB.
Our primary cash requirements are to fund operations
which mainly include personnel-related costs, marketing costs, third party costs related to hosting and software, general and administrative costs associated with being a public company, travel costs, and quarterly preferred stock dividends. The Company expects to continue to incur operating expenses for research and development and investment in software development costs to achieve its projected revenue growth. We continually evaluate our operating cash flows which can vary subject to the actual timing of expected new sales compared to our expectations of those sales and are sensitive to many factors, including changes in working capital and our results of operations.
However, projections of future cash needs and cash flows are subject to risks and uncertainty.
Management's current operating plan is to maintain and/or reduce operating expenses in order to be aligned with expected revenues. The primary area of focus will continue to be headcount and costs from outside consultants. The Company remains focused on maximizing revenue from its revenue generating resources and will continue to repurpose, if necessary, certain personnel to become billable so the Company can continue to improve its liquidity. The Company has a substantial professional services backlog that resulted from new customers added in the first nine months of 2018 as well as upgrade projects from our existing customers as they move to the latest version of Astea Alliance. In 2018, the Company continues to consider ways to reduce operating expenses in certain areas of the Company in order to maintain our liquidity. However, management has implemented new marketing initiatives which has increased our spending in this area in 2018 that we believe will directly contribute to improving new business that is essential to our growth.
Operations will generate enough cash to meet obligations at least
through November 14, 2019.
As noted above, if the Company's actual results fall short of expectations, the Company will make cost adjustments to improve the Company's operating cash flows.
In addition, we plan to maintain the same level of investment in software development and we do not expect to increase capital expenditures.
Our operations are subject to certain risks and uncertainties including, among others, current and potential competitors with greater resources, dependence on our significant and existing customer base, closing license and subscription sales in a timely manner, lack of a history of consistently generating net income and uncertainty of future profitability, and possible fluctuations in financial results.
Off-Balance Sheet Arrangement Transactions
The Company is not involved in off-balance sheet arrangements that have or are reasonably likely to have a material current or future impact on our financial condition, changes in financial condition, revenues or expenses result in operations, liquidity, capital expenditures or capital resources.