Kendall square research

Harvard Business School 9-194-068 Rev. November 10, 1998

Professor William J. Bruns, Jr., prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation..

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Kendall Square Research Corporation (A)

Kendall Square Research Corporation (KSR) was founded in 1986 by Henry Burkhardt III and Steve Frank, another computer designer. KSR was the third computer company co-founded by Burkhardt—the first two having been Data General Corporation and Encore Computer Corporation. At KSR, Burkhardt chose a radical design for a supercomputer that would make the machines attractive for both government and university laboratories and for commercial users. The company delivered its first machine to the Oak Ridge National Laboratory in the fall of 1991, and Kendall Square Research reported that it reached break-even volume before the end of 1992.

From its beginning KSR funded its development and the design of its products through private placements of its equity and debt securities and an initial public stock offering in April 1992. A subsequent stock offering in April 1993 brought the total financing of the start-up to about $150 million—more than $80 million of which had come in two offerings of stock to the public. Shares in the first of the public offerings had more than doubled in price in less than 18 months. By October 1993, the market capitalization of the shares was about five times estimated 1993 sales and 45 times estimated 1993 earnings.1

From the time of its first sale, some critics questioned the criteria used by KSR to determine when revenue would be recognized. The company recognized revenue on product sales upon written customer acceptance of the product. Acceptance often occurred before the configuration of a particular system was finalized or any payment had been received from a customer. Kendall Square Research fully disclosed its policy on revenue recognition in its financial reports to shareholders. (See Exhibit 1 for excerpts from the 1992 Kendall Square Research Corporation Annual Report to Shareholders.)

Kendall Square Research and Supercomputing

Kendall Square Research2 recognized at its founding that a key to its success would be its ability to deliver more computing power at lower cost per computation than its competitors. Its

1John R. Dorfman and William M. Bulkeley, "Heard on the Street: Supercomputer Maker Kendall Square's Effort to Crack Business Markets Has Some Skeptics," The Wall Street Journal, October 11, 1993, p. C2. 2This section is based on information take from the 1992 Annual Report of Kendall Square Research Corporation.

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194-068 Kendall Square Research Corporation (A)

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approach was based on linking many low-cost minicomputers and dividing the computer task among them, rather than building larger mainframe computers or trying to improve programming and software to wring more performance from the computer architectures that were available. The concept of massively parallel processing had first surfaced in the 1980s, and several competitors felt that it had tremendous potential.

A large-scale parallel computer was potentially faster and less expensive than traditional mainframes or available supercomputers. In addition to lower cost per computation or transaction, large-scale parallel computers were theoretically scaleable; bigger and more powerful machines could be assembled merely by adding processors and the memory and input and output devices to support them. However, as processors were added, programming became more difficult and cumbersome.

Kendall Square’s founders believed that a highly successful parallel computer could succeed only if it could take advantage of the library of applications and languages that were already standard in the mainframe and supercomputer worlds. Their goal was to develop a standards-based multi-user system that could run multiple applications simultaneously, so that a sufficiently powerful system could serve an entire technical or business enterprise. Their ideal system would even be able to run scientific and business applications at the same time.

The technology that was needed to develop such a computer did not exist in 1986 when KSR was founded. For six years Kendall Square scientists and engineers invested in chip development technology that they hoped would turn their insight into a working computer. By 1992 they were sure they had succeeded. They had developed a large scale parallel computer which combined the power of massively parallel, distributed memory machines with the familiar shared-memory programming environment of conventional mainframes. The KSR1 family of computers was designed for high performance computing requirements typical of scientific environments, for decision support and complex database query applications, and for on-line transaction-intensive environments such as automatic teller machines or airline reservation systems.

The KSR1 family of systems scaled from 16 to 1088 processors. A $975,000 model with 16 processors could handle 1,200 transactions per second, a measure of commercial computer speed. Scalability allowed users to add computer resources in incremental and cost-effective steps without changes in software and without performance degradation. Therefore, a customer could add to an installation at a later date without the need to replace all software or to reprogram operating systems. While the scaling up of processors in massive parallel processing computer systems was not fully reliable, reports from users of KSR machines seemed to support the company’s contention that they scale up more effectively than those of some other competitors.

In 1993 supercomputers with massively parallel processing were more commonly found in scientific applications than in commercial applications. One reason for this was the tendency for supercomputers to crash as users pushed their limits. In scientific applications, users were often willing to sacrifice reliability for performance, but most commercial applications required computers to work reliably for months at a time. The business market for supercomputers had been estimated to be about $31 billion—far larger than the scientific and research market, which had been estimated to be about $4 billion.3 In 1992, Kendall Square signed contracts with Neodata, a direct-mail company working with Electronic Data Systems (EDS), and AMR, the parent company of American Airlines, to work together to develop systems using KSR computers.

3Dorfman and Bulkeley, loc. cit.

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Kendall Square Research Corporation (A) 194-068

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Revenue Recognition at Kendall Square Research Corp.

Critics of the revenue recognition practices used by KSR claimed that the company was far too liberal in what it called a sale of a machine or system. They cited cases in which laboratories had ordered or received equipment which was subsequently accepted but for which there was no prospective funding, or for which research grants had been requested but not yet granted. In such cases there was no assurance that the research grant would be received and, even if it was, there could be significant delays before the customer would pay KSR.

Other analysts thought that the liberal accounting practices used by KSR were not uncommon in the computer industry, but such practices were less visible in the financial statements of more mature companies such as IBM or Digital Equipment Corporation. These analysts pointed out that terms requiring payment in six or nine months after a customer had received a grant from a government agency—often very slow payers—were not unusual. Such terms might be appropriate for the typical university or research laboratory that were the base of early KSR users.

Terms of Kendall’s supercomputer deliveries were often extremely attractive to researchers. For example, Edward Lazowska, chairman of the department of computer science at the University of Washington, said that it has two KSR1 computers with a total of 60 processors. He said, “We paid $1 million for half of it, and the rest was a loan of equipment against future grants.” Kendall . . . treated the entire shipment as a sale.

William Goddard, a physicist at the California Institute of Technology, said he paid for 32 processors in September 1992 using a National Science Foundation grant. He liked it so much that last spring he wanted to double the size of the system and applied for more grant money. Kendall shipped him the computer immediately, but he and Kendall are still waiting for the grant award. “I’m committed to buying it,” he said. “I am applying for two very large grants.”4

Other contracts included one for $1.5 million that could be canceled if the second of two phases was not completed. Still others involved distributors that had the right to cancel the contract if a customer could not be found.

A second sales practice added to the concerns of critics of KSR’s accounting policies. Some users purchased machines with fewer processors than were eventually thought to be needed. In these cases the processors purchased were booked as revenue and accounts receivable, but KSR had delivered additional processors to the customer for installation and use by the customer. The additional processors remained on KSR’s balance sheet as inventory pending the customer’s decision to keep the processors, apply for grants to buy them, or to otherwise make arrangements to pay for the loaned processors.

As a result of these practices, revenues recognized had exceeded cash collected from customers by significant amounts. Some critics thought this indicated that revenue was being recognized too early. Other observers thought this was normal for a new, growing company in the process of ramping up sales.

Of additional concern was the practice of KSR giving research grants to some users of its systems. Such grants had been reported to range between $5,000 and $50,000 or more. Henry

4William M. Bulkeley, "Kendall Square . . . " The Wall Street Journal, December 2, 1993, p. A3.

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194-068 Kendall Square Research Corporation (A)

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Burkhardt was reported to have agreed that grants “. . . sometimes do run into substantial amounts, but are legitimate expenses to foster software development, not disguised sales incentives. . . .”5

Kendall Square Research in 1993

In August 1993, The Wall Street Journal reported:

WALTHAM, Mass Kendall Square Research Inc. is “quite comfortable” with analysts’ estimates that it will earn 45 cents to 50 cents a share for the year, President Henry Burkhardt said.

Mr. Burkhardt also said he is comfortable with estimates that revenue for the year will top $60 million, up from $20.7 million. And he said he is comfortable with third- quarter earnings estimates of 9 cents to 13 cents a share. For the year-earlier quarter, Kendall Square reported a net loss of 29 cents a share on revenue of $5.3 million.6

Questions

1. Evaluate the revenue recognition policies used by Kendall Square Research.

Do they conform to generally accepted accounting principles with respect to

a. the timing of revenue recognition?

b. the amount of revenue recognized?

c. the matching of costs and expenses to revenue?

2. The rapid growth in sales expected by Kendall Square Research managers will strain the company’s ability to finance its expansion. How, if at all, should this fact affect the ways in which management chooses accounting principles and a reporting strategy?

5Ibid. 6"Kendall Square Agrees with Profit Estimates for Quarter and Year," The Wall Street Journal, August 13, 1993, p. B5A.

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Kendall Square Research Corporation (A) 194-068

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Exhibit 1 Excerpts from 1992 Annual Report of Kendall Square Research Corporation

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

Introduction

The Company was incorporated in February 1986 and sold its first computer system in September 1991. As of December 26, 1992, the Company had sold 22 systems, of which 11 were sold to customers in the United States and 11 to customers in Europe. Several of these customers have enlarged the size of their system configuration since initial installation. The Company’s revenue for the fiscal year ended December 26, 1992, was $20.7 million. The Company has not been profitable on an annual basis since its inception and no assurance can be given that the Company will be able to operate on a profitable basis. As of December 26, 1992, the Company’s accumulated deficit was approximately $69.7 million.

The Company’s future operating results will depend on many factors, including the demand for the Company’s products for both technical and commercial applications, the level of competition faced by the Company and the ability of the Company to develop and market new products and control costs. The Company’s sales and marketing strategy contemplates sales of its computer systems for both technical and commercial applications. To date, however, all of the computer systems have been sold for technical applications.

Results of Operations

Years Ended December 28, 1991, and December 26, 1992

The Company does not believe that the year-to-year comparison of various items of expense as a percentage of revenue is meaningful due to the significant growth in the Company’s revenue from 1991 to 1992.

Revenue

Revenue increased from $904,000 to $20,729,000. The Company shipped its first computer system in September 1991 and recorded its first revenue in the third quarter of 1991. The Company recorded revenue growth in each of the four quarters in 1992 as it increased the number of systems shipped. There can be no assurance that the Company will continue to achieve quarterly revenue growth in future periods. See “Quarterly Results.” Sales to customers in Europe accounted for approximately 44% of revenue in 1992.

Cost of Revenue

Cost of revenue increased from $332,000 to $9,189,000, or from 37% to 44% of revenue. These expenses include actual material, labor, and indirect costs associated with the manufacture of systems for which revenue has been recognized. The Company does not believe that the year-to-year comparison is meaningful due to the low level of revenues in fiscal 1991 as well as the allocation of certain start-up manufacturing costs in 1991 to other operating costs.

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194-068 Kendall Square Research Corporation (A)

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Research and Development

Research and development expenses decreased by 11% from $15,786,000 to $14,113,000. Additionally, in 1992 the Company capitalized $3,506,000 of costs attributable to software license fees and software development. No such costs were capitalized in 1991. The Company increased research and development staffing levels from 79 to 115 persons from 1991 to 1992. In order to establish a competitive position and to develop new and enhanced products, the Company intends to continue to devote substantial resources to research and development. The Company expects that research and development expenses will fluctuate from quarter to quarter but will generally increase over time.

Selling, General and Administrative

Selling, general and administrative expenses increased by 63% from $6,441,000 to $10,475,000. These expenses were comprised primarily of selling and marketing expenses, reflecting significant increases in sales, marketing, and support staffing levels from 49 to 66 persons from 1991 to 1992. These expenses are expected to continue to increase as the Company expands its selling and marketing efforts.

Other Operating Costs and Expenses

Other operating costs in 1991 of $850,000 resulted from costs incurred in the establishment of the Company’s manufacturing facilities and procedures and other initial manufacturing costs, including depreciation of test equipment. The manufacturing facilities and procedures became operational during the fourth quarter of 1991. There were no such costs incurred in 1992.

Other Income (Expense), Net

The Company recorded other income of $326,000 in 1992, compared to other expense of $2,000 in 1991. Interest income increased by 104% from $380,000 to $775,000 which was partially offset by an 18% increase in interest expense from $382,000 to $449,000. The Company’s average cash and investments balances were higher in 1992 than in 1991 as a result of the receipt of proceeds from convertible debt financings and the Company’s initial public offering. All of the convertible debt was converted into shares of common stock upon the closing of the Company’s initial public offering on April 3, 1992.

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

Years Ended December 29, 1990, and December 28, 1991

Revenue

Revenue for the year ended December 28, 1991, of $904,000 resulted from the Company’s first shipment and customer acceptance of one KSR1-20 system. There were no shipments in the year ended December 29, 1990.

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Kendall Square Research Corporation (A) 194-068

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Cost of Revenue

Cost of revenue of $332,000 includes actual material, labor, and indirect costs associated with the manufacture of systems for which revenue was recognized.

Research and Development

Research and development expenses increased by 49% from $10,575,000 to $15,786,000. This increase resulted primarily from materials and other costs incurred in the design and development of product prototypes, as well as an increase in research and development staffing levels from 77 to 79 persons from 1990 to 1991.

Selling, General and Administrative

Selling, general and administrative expenses increased by 108% from $3,099,000 to $6,441,000. These expenses were comprised primarily of selling and marketing expenses, reflecting an increase in sales, marketing and support staffing level from 24 to 49 persons from 1990 to 1991. These expenses were incurred as part of the Company’s strategy to market its computer systems concurrently with its development efforts.

Other Operating Costs and Expenses

Other operating costs increased by 134% from $363,000 to $850,000. This increase resulted from costs incurred in the establishment of the Company’s manufacturing facilities and procedures and other initial manufacturing costs, including depreciation of test equipment.

Other Income (Expense), Net

The Company recorded other expense of $2,000 in 1991 compared to other income of $687,000 in 1990. The Company had more proceeds from private equity and convertible subordinated debt financings in 1990 available for investment than in 1991 and earned higher average interest rates thereon. Additionally, interest expense was higher in 1991 as a result of higher capital lease obligations and the issuance in 1991 of $12,820,000 in convertible subordinated notes.