ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to historical information, this quarterly report contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as in the “Risk Factors” in Item 1A to Part 1 to the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2013 (the “Form 10-K”) and in the “Risk Factors” in Item 1A to Part II of this quarterly report on Form 10-Q. They include the following: the level of demand for Selectica’s products and services; the intensity of competition; Selectica’s ability to effectively manage product transitions and to continue to expand and improve internal infrastructure; the impact of current economic conditions on our customers and our business; and our reliance on a relatively small number of customers for a substantial portion of our revenue. For a more detailed discussion of the risks relating to our business, readers should refer to Item 1A to Part 1 in the Form 10-K entitled “Risk Factors” and Item 1A to Part II of this quarterly report on Form 10-Q Readers are cautioned not to place undue reliance on the forward-looking statements, including statements regarding our expectations, beliefs, intentions or strategies regarding the future, which speak only as of the date of this quarterly report. We assume no obligation to update these forward-looking statements.

Overview

We provide cloud-based software solutions that help growing companies close deals faster, more profitably, and with lower risk.

Selectica Contract Lifecycle Management (CLM) combines a single, company-wide contract repository with a flexible workflow engine capable of supporting each organization’s unique contract management processes. Our cloud-based solution streamlines contract processes, from request, authoring, negotiation, and approval through ongoing obligations management, analysis, reporting, and renewals.  It helps companies take control of their contract management processes by converting from paper-based to electronic repositories and by unlocking multiple layers of critical business data, making it available for the evaluation of risk, the exposure of lost revenue, the evaluation of supplier performance, and other purposes.  The solution helps improve the customer buying experience for sales organizations, improve the control of risk and decrease time spent drafting, monitoring and managing contracts, and gain access to previously hidden discounts through the exposure and elimination of unfavorable agreements for procurement and sourcing organizations.

Selectica Guided Selling (GS) streamlines the management and dissemination of complex product information enabling companies to streamline the opportunity-to-order process for manufacturers, service providers, and financial services companies. Our Guided Selling solution can be seamlessly integrated with leading CRM systems, as well as ERP systems like Oracle and SAP, to ensure that the latest product, customer, and pricing data is always being used.  This helps to simplify and automate the configuration, pricing, and quoting of complex products and services.  By empowering customers, product management, marketing, sales leadership, sales operations, salespeople, and channel partners to generate error-free sales proposals for their unique requirements, we believe our cloud-based solution helps companies to close sales faster, accelerate revenue generation and enhance customer relationships.

Quarterly Financial Overview

For the three months ended June 30, 2013, our total revenues increased by 5%, or $0.2 million, to $4.4 million compared with total revenues of $4.2 million for the three months ended June 30, 2012. Recurring revenues, comprised of subscription license sales, maintenance revenues from previously sold perpetual licenses, and hosting revenues, totaled $3.2 million, or 72% of total revenues, representing an increase of $0.5 million, or 20%, over the three months ended June 30, 2012. Non-recurring revenues, comprised of perpetual license sales and revenues from professional services for system implementations, enhancements, and training, totaled $1.2 million, or 28% of total revenues, representing a decrease of $0.3 million, or 22%, over the three months ended June 30, 2012. The increase in recurring revenues year over year resulted primarily from new subscription license customers reflecting the shift in business focus and strategy to emphasize our cloud-based solutions. The decrease in non-recurring revenues year over year was primarily due to a decrease in perpetual license revenues related to a shift in sales of subscription license.

During the quarter ended June 30, 2013, our net loss totaled approximately $2.4 million, representing an increased loss of $1.7 million, or 243%, over our net loss of $0.7 million for the three months ended June 30, 2012.  The increase in net loss relates primarily to a $1.4 million increase in operating expenses. General and administrative expenses increased $0.7 million, primarily due to increased bad debt and stock compensation. Sales and marketing expenses increased $0.5 million due to increased headcount. See “ Results of Operations ” below for further discussion on the components of net loss.

Shift in Business Model

In response to market demand, beginning in 2012, we have shifted our primary business focus from the sale of perpetual licenses to subscription license arrangements for our cloud-based solutions which we host. Our business and revenue model is now focused on recurring revenues. This shift could adversely affect our short-term financial results and cash flows since the financial terms of the subscription arrangements typically require smaller periodic payments over the term of the arrangement versus the larger, initial payments we have historically received under the perpetual license arrangements. However, we believe that the subscription licensing arrangements will help to increase our ability to attract new customers and improve the predictability of our revenues and cash flows by reducing our dependency on the larger, perpetual licensing arrangements. Despite the shift in our business model to focus more on subscription licensing arrangements, which has had the corresponding effect of increasing our recurring revenue, our customers have varied preferences for how they want to deploy our solutions. As such, we will continue to offer and support the traditional software license model that some of our customers still prefer. 

Critical Accounting Policies and Estimates

Other than the significant policies added below, there have been no material changes to any of our significant accounting policies and estimates as disclosed in the Company’s Annual Report on Form 10-K for the year ended March 31, 2013.

Redeemable Convertible Preferred Stock and Warrants

On May 31, 2013, we sold and issued 577,105 shares of our common stock (the “Common Shares”), and 231,518 shares of our newly created redeemable Series C Convertible Preferred Stock (the “Series C Stock”), to certain institutional funds and other accredited investors (“Outside Investors”) at a purchase price of $7.00 per share. The Series C Stock is convertible to common stock upon shareholder approval. We anticipate that our stockholders will approve such conversion in the annual meeting on September 10, 2013. If conversion is not approved, the Series C Stock is redeemable at the option of the holder beginning one year after issuance. In addition we issued to the Outside Investors Series A Warrants to purchase Common Stock (the “Series A Warrants”), initially exercisable for 404,309 shares of common stock. The exercise price of the warrants is $8.75 per share. The warrants have a five-year term, are not exercisable for the first six months following the date of issuance. The number of warrants and the exercise price for each warrant are subject to adjustment in the event we issue securities, other than certain excepted issuances, at a price below the then current exercise price, subject to certain limitations.

In connection with the Financing, we issued to Lake Street Capital Markets, LLC, who served as the placement agent in the Financing, warrants to purchase an aggregate of 24,258 shares of Common Stock, which represents 3% of the total number of Common Shares and shares of Series C Stock sold in the Financing.

Because of the potential adjustment to the warrant exercise price that could result in the event we issue securities at a price below the then current exercise price, the warrants do not meet the criteria set forth in ASC 815-40, “Derivatives and Hedging – Contracts in Entity’s own Stock” to be considered indexed to the Company’s own stock. Accordingly, we have recorded the fair value of these warrants as a liability. We estimated the fair value of these warrants at the issuance date using the Black-Scholes model and revalue the warrants at the end of each quarter. The Black-Scholes model requires the input of highly subjective assumptions, including the warrant’s risk free rate and stock price volatility. The change in the fair value of the warrants is recognized in the statements of operations within non-operating income (expense).

Because the Series C Stock is redeemable at the option of the holder (assuming the shareholders do not approve conversion on September 10, 2013 as discussed above), we have recorded it in temporary equity.

The Series C Stock was assessed under ASC 470, “Debt,” and we determined that the conversion to common qualifies as a BCF since it is a nondetachable conversion feature that was in the money at the commitment date. The BCF compares the carrying value of the preferred stock after the value of any derivatives has been allocated from the proceeds (in this case, the warrant liability) to the transaction date value of number of shares that the holder can convert into. The calculation resulted in a BCF of $0.8 million. The BCF was recorded in additional paid-in capital. 

Factors Affecting Operating Results

A small number of customers continue to account for a significant portion of our total revenues. We expect that our revenues will continue to depend upon a limited number of customers. If we were to lose a large customer, it would have a significant impact upon future revenues. Customers who accounted for at least 10% of total revenues were as follows:

 We do not have significant foreign activities. Sales to foreign customers accounted for only 13% of total revenue, and only 1% of revenues were denominated in foreign currency in the quarter ended June 30, 2013 as well as in fiscal 2013. We anticipate that any exposure to foreign currency fluctuations will not be significant in the foreseeable future.

Recurring revenues .  Recurring revenues consist of subscription license sales, maintenance revenues from previously sold perpetual licenses, and hosting revenues. Our recurring revenues during the three months ended June 30, 2013 increased by $0.5 million, or 9%, year over year. Subscription revenues grew by $0.6 million, accounting for the growth in recurring revenues. This reflects the shift in business focus and strategy to emphasize our cloud-based solutions. Recurring revenues continue to account for over 70% of our total revenues and we expect this trend to continue going forward.

Non-recurring revenues . Non-recurring revenues are comprised of revenues from professional services for system implementations, enhancements, and training and, historically, perpetual license sales. Non-recurring revenues during the three months ended June 30, 2013 decreased by $0.3 million compared to the three months ended June 30, 2012. This decrease was due to a decrease in perpetual license sales with a shift to cloud based solutions. For the quarter ended June 30, 2013, all non-recurring revenues related to professional services. For the quarter ended June 30, 2012, non-recurring revenues included $0.4 million of perpetual license sales and $1.1 million related to professional services.

We expect non-recurring revenues to continue to fluctuate in future periods as a percentage of total revenues and in absolute dollars. This will depend on the number and size of new software implementations and follow-on services to our existing customers. We expect recurring revenues to increase in absolute dollars and as a percentage of total revenues as we continue to emphasize our cloud-based solutions. This will depend in part on the number of maintenance renewals, and the number and size of new subscription license contracts. In addition, maintenance renewals are extremely dependent upon economic conditions, customer satisfaction and the level of need to make changes or upgrade versions of our software by our customers. Fluctuations in revenue are also due to timing of revenue recognition, achievement of milestones, customer acceptance, changes in scope or renegotiated terms, and additional services.

Cost of recurring revenues. Cost of recurring revenues consist of costs associated with supporting our data centers, the cost of bug fixes, maintenance and support, and salaries and related expenses of our support organization. During the three months ended June 30, 2013, cost of recurring revenues increased $0.3 million, compared to the three months ended June 30, 2012 primarily due to an increase in license and support costs in our data centers, as well as higher compensation expenses in our support organization.

We expect cost of recurring revenues to remain relatively flat as a percentage of recurring revenues in throughout the remainder of fiscal 2014.

Cost of non-recurring revenues. Non-recurring cost of revenues is comprised mainly of salaries and related expenses of our services organization, fees paid to resellers, costs of purchased third party licenses sold to customers as part of a bundled arrangement, and certain allocated corporate expenses. During the three months ended June 30, 2013, these costs were within $8,000 dollars compared to the three months ended June 30, 2012, in-line with the consistency of professional services revenues between the two quarters.

We expect cost of non-recurring revenues to remain relatively flat as a percentage of recurring revenues in throughout the remainder of fiscal 2014.

Gross profit was $2.5 million, or 56%, during the three months ended June 30, 2013, compared with $2.6 million, or 63%, during the three months ended June 30, 2012. This decrease in our gross margin was primarily due to non-recurring revenues, which experienced a $0.4 million decrease in perpetual license revenue which had a gross profit of approximately 98% in the prior year. Additionally, gross margins on recurring revenues decreased as we continued to invest in our data center over the past twelve months.

We expect that our overall gross margins will continue to fluctuate primarily due to the timing of service revenue recognized and will continue to be adversely affected by lower margins associated with service revenues. The impact on our gross margin will depend on the mix of services we provide, whether the services are performed by our professional services employees or third party consultants, and the overall utilization rates of our professional services organization. 

Research and development expenses consist primarily of salaries and related costs of our engineering, quality assurance, technical publication efforts and certain allocated expenses.  Research and development expenses increased $0.2 million, during the three months ending June 30, 2013 compared to the same period in 2012. These increases are primarily due to higher employee compensation expenses.

We expect research and development expenditures to remain relatively flat during the remainder of fiscal 2014 due to increased headcount.

Sales and marketing expenses consist primarily of salaries and related costs for our sales and marketing organization, sales commissions, expenses for travel and entertainment, trade shows, public relations, collateral sales materials, advertising and certain allocated expenses. For the three months ended June 30, 2013, sales and marketing expenses increased $0.5 million, or 11%, compared to the same periods in 2012. The increase is primarily due to higher employee compensation expenses.

We expect to make small incremental investments in sales and marketing expenses during the remainder of fiscal 2014.

General and administrative expenses consist mainly of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, bad debt expense and certain allocated expenses.  During the three months ended June 30, 2013, general and administrative expenses increased by $0.7 million, compared to the same period in 2012.  

We expect general and administrative expenses to remain relatively flat during the remainder of fiscal 2014, with the exception of reductions in stock-based compensation as discussed in Note 12 Subsequent Events .

Increase in Fair Value of Warrant Liability

The increase in the fair value of the warrant liability relates to the increased value of the warrants using the Black Scholes model from the time of issuance on May 31, 2013 to June 30, 2013. The increase is primarily as a result of an increase in the trading price of the Company’s common stock during that time.

Interest and Other Income (Expense), Net

Interest and other income (expense), net consists primarily of interest earned on cash balances and short-term investments, foreign currency fluctuations, and other miscellaneous expenditures. During the three months ended June 30, 2013 and 2012, interest and other income (expense), net was immaterial for all periods presented.

Provision for Income Taxes

During the three months ended June 30, 2013 and 2012, we did not record an income tax provision. 

Our primary sources of liquidity consisted of approximately $13.9 million in cash and cash equivalents as of June 30, 2013, $5.6 million of which was received from our short-term credit facility.  This compares to approximately $12.1 million in cash, cash equivalents and short-term investments as of March 31, 2013, $6.0 million of which was also received from our short-term credit facility.

Net cash used in operating activities was $2.9 million for the three months ended June 30, 2013, resulting primarily from our year-to-date net loss of $2.4 million, a $1.1 million decrease in deferred revenue, and a $0.5 million decrease in accounts receivable, net.

Net cash used in operating activities was $2.4 million for the three months ended June 30, 2012, resulting primarily from our year-to-date net loss of $0.7 million, a $1.1 million increase in accounts receivable, net and a $1.2 million decrease in accrued payroll and related liabilities. These decreases were partially offset by a $0.5 million increase in accounts payable.

Net cash used in investing activities was not significant for the three months ended June 30, 2013, resulting primarily from capital asset purchases.

Net cash provided by investing activities was $0.1 million for the three months ended June 30, 2012, resulting primarily from maturities of short-term investments partially offset by capital asset purchases.  

Net cash provided by financing activities was $4.8 million for the three months ended June 30, 2013, resulting primarily from $5.3 million in sale of our common stock, net of issuance.

Net cash used in financing activities was not significant for the three months ended June 30, 2012.

We expect to incur significant operating costs for the foreseeable future. We expect to fund our operating costs, as well as our future capital expenditures and liquidity needs, from a combination of available cash balances, internally generated funds, and our short-term credit facility.  We have no outside debt other than our short-term credit facility, and do not have any plans to enter into any additional borrowing arrangements. As a result, our net cash flows will depend heavily on the level of future sales, changes in deferred revenues, and our ability to manage costs.

We expect that our cash on hand and future cash flows provided by operating activities will be sufficient to fund our working capital and general corporate needs and the non-discretionary capital expenditures for the foreseeable future. In the first quarter of fiscal 2014, we closed the initial tranche of a private placement sale of common and preferred shares of stock with net proceeds to the Company of approximately $5.2 million.

Contractual Obligations

We had no significant commitments for capital expenditures as of June 30, 2013.

Our contractual obligations and commercial commitments at June 30, 2013, are summarized as follows:

Our contractual obligations and commercial commitments at March 31, 2013 were approximately $6.4 million.