Summary of INFOSPACE INC - Yahoo! Finance

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis in conjunction with "Selected Consolidated Financial Data" and our consolidated financial statements and notes thereto included elsewhere in this report. The following Management's Discussion and Analysis of Financial Condition and Results of Operations has been revised to give effect to the restatement discussed in "Note 1: The Company and Basis of Presentation" of the Notes to Consolidated Financial Statements contained in Item 8 of Part II of this Report.

Overview

InfoSpace, Inc. ("InfoSpace", "Our" or "We") is a developer of search tools and technologies that assist consumers with finding content and information on the Internet. We use our metasearch technology to power our own branded Web sites and provide online search services to distribution partners.

We offer search services that enable Internet users to locate information, merchants, individuals, and products online. We offer search services through our Web sites, such as Dogpile.com, WebCrawler.com, MetaCrawler.com, and WebFetch.com, as well as through the Web properties of distribution partners. Partner versions of our Web offerings are generally private-labeled and delivered with each distribution partner's unique requirements.

We were founded in 1996 and are incorporated in the state of Delaware. Our principal corporate office is located in Bellevue, Washington. We also have an office in Bangalore, India. Our common stock is listed on the NASDAQ Global Select Market under the symbol "INSP."

From 2004 to 2007, InfoSpace was comprised of three businesses: online search, online directory, and mobile. The mobile business was comprised of a mobile content product offering and a mobile services offering. In 2006, as a result of being informed by one of our carrier partners that it intended to develop direct relationships for mobile ringtone content with the major record labels beginning in 2007, we restructured our operations accordingly, substantially reduced our mobile content offerings in 2007 and sold significant portions of our remaining mobile content assets. In addition, we undertook further strategic restructuring initiatives in 2007 which resulted in the sales of our online directory business and mobile services business in the fourth quarter of 2007. In December 2007, as a result of the sales of those businesses, we committed to a plan to make operational changes to our business, which included a reduction in our workforce and, as part of the workforce reduction, consolidation of our facilities. Following the sale of our mobile and directory businesses, our revenues are derived exclusively from providing online search services.

We generate revenues from our Web search services when an end user of our services clicks on a paid search link displayed on our owned Web site or displayed on a distribution partner's Web property. We receive content for our search services from certain content providers, whom we refer to as our customers. Revenue from Google and Yahoo! jointly account for over 95% of our total revenue for the year ended December 31, 2008, and we expect this concentration to continue in the foreseeable future. If either of these customers reduces or eliminates the content it provides to us or our distribution partners, or if either of these customers was unwilling to pay us amounts that it owes us, our financial results may materially suffer. Our principal agreements with these customers expire in 2011.

In addition to revenues from search services, we earn service revenue from certain distribution partners, such as a fixed monthly fee in exchange for portal infrastructure services.

Our ability to grow our online search services revenue on our owned Web sites relies on growth in the volume of paid clicks, the fees advertisers pay our customers for these paid clicks, and the percentage of these fees our customers share with us.

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Similar to the revenues earned on our owned Web sites, revenues from distribution partners are dependent upon growth in the volume of paid clicks, the fees advertisers pay our customers for these paid clicks, and the percentage of these fees our customers share with us. We have experienced steady growth in revenues from our search services offered through the Web properties of distribution partners, which has been primarily attributable to growth in paid click volumes from new distribution partners' Web properties in the United States. In recent periods, our customers' process of measuring the quality of paid clicks and adjusting the fees paid to us has adversely affected revenues from certain of our distribution partners. In an effort to drive quality traffic to our customers, we continue to invest in product development to expand the online search services we offer to our distribution partners.

Engineering, operations and product management personnel remain paramount to our ability to deliver high quality online search services, as well as enhance our current technology and grow our product offerings. Therefore, we expect to continue to invest in our workforce and increase our research and development operations in India. Additionally, we may utilize our cash and short-term and long-term available-for-sale investments to acquire businesses and other assets that will enhance our current technologies and extend our product offerings.

In 2008, we closed our European facilities and incurred $757,000 in charges primarily related to employee separation.

Overview of 2008 Operating Results

The following is an overview of our operating results for the year ended December 31, 2008. A more detailed discussion of our operating results, comparing our operating results for the years ended December 31, 2008, 2007, and 2006, is included under the heading "Historical Results of Operations" in this Management's Discussion and Analysis of Financial Condition and Results of Operations.

The operating results of the directory and mobile businesses have been presented as discontinued operations in our consolidated financial statements for all periods presented. The process used to separately present continuing and discontinued operations relied on certain estimates and assumptions, and the historical results of operations presented in our consolidated financial statements do not necessarily reflect the results that would have existed had we provided our online search services as a standalone business throughout the periods presented. Due to the rapidly evolving nature of our business, overall market conditions and the process used to separately present continuing and discontinued operations, we believe that comparisons of our 2008 operating results to prior years are not necessarily meaningful, and you should not rely upon them as indications of future performance. The loss from our discontinued operations, net of income taxes, was $1.5 million in 2008, compared to $25.2 million in 2007.

Revenues for 2008 increased to $156.7 million from $140.5 million in 2007. This increase was due to an increase in revenue from search results delivered through our distribution partners. This increase was partially offset by a decrease in revenue from our owned and operated properties. Revenue from owned and operated properties was down due to a decrease in the average fees per paid click that our customers share with us although paid click volume on our owned properties increased in 2008. The decrease in average fees per paid click was the result of a decrease in advertiser fees paid per click to our customers and a shift in the mix of revenue reflecting a higher proportion derived from our direct marketing initiatives on our owned properties. Average fees per paid click for revenues derived through our direct marketing initiatives historically have been lower. During 2008, 65% of our search revenues came from our search distribution partners, compared to 58% in 2007.

Content and distribution costs for 2008 increased to $76.0 million from $61.8 million in 2007, primarily due to an increase in revenue from search results delivered through certain of our distribution partners, and increases in our revenue sharing rates with our distribution partners.

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Other operating expenses for 2008, excluding Restructuring and Other, net, were $77.1 million, a decrease of $82.5 million from $159.6 million in 2007. Other operating expenses include expenses related to Systems and network operations, Product development, Sales and marketing, General and administrative, and Depreciation. The decrease from 2007 was primarily attributable to expenses recorded in 2007 for cash payments and equity awards to employees and directors related to the $507.3 million in cash distributions to shareholders declared in 2007, and stock-based compensation related to accelerating the vesting of equity awards for certain employees in connection with the sale of our mobile and directory businesses, and a decrease in 2008 in other operating expenses as a result of our restructuring described in the "Overview" section above.

Total restructuring charges for 2008 were $17,000, compared to $9.6 million in 2007. Other, net of $1.9 million and $3.2 million for 2008 and 2007, respectively, was related to the gains on the sales of non-core assets. Loss on investments, net for 2008 was $28.5 million, compared to $2.1 million in 2007. The increase from 2007 was primarily due to other-than-temporary impairments of our auction rate securities investments and our investment in a privately-owned company.

Other income decreased to $7.1 million in 2008 compared to other income of $18.2 million in 2007 primarily due to reduced interest income resulting from lower cash and marketable investments balances as well as from declining interest rates. We recognized income tax expense from continuing operations in 2008 of $598,000 primarily relating to current federal, state and foreign income taxes, compared to income tax expense from continuing operations in 2007 of $13.4 million, primarily from the establishment of a valuation allowance against deferred tax assets.

Loss from continuing operations in 2008 was $16.5 million, compared to loss from continuing operations of $84.5 million in 2007, and was attributable to the items noted above.

Critical Accounting Policies and Estimates

"Management's Discussion and Analysis of Financial Condition and Results of Operations," as well as disclosures included elsewhere in this Annual Report on Form 10-K, is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and disclosures of contingencies. In some cases, we could have reasonably used different accounting policies and estimates.

The Securities and Exchange Commission ("SEC") has defined a company's most critical accounting policies as the ones that are the most important to the portrayal of the company's financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. On an ongoing basis, we evaluate the estimates used, including those related to revenue recognition, the fair value of investments, impairment of goodwill, the estimated allowance for sales returns and doubtful accounts, stock-based compensation, discontinued operations, accrued contingencies and the valuation allowance for our deferred tax assets. We base our estimates on historical experience, current conditions and on various other assumptions that we believe to be reasonable under the circumstances and, based on information available to us at that time, we make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identify and assess our accounting treatment with respect to commitments and contingencies. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our consolidated financial statements. We also have other accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results. For additional information see "Note 2: Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements (Item 8 of Part II of this Report).

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Revenue Recognition

Our revenues are derived from products and services delivered to our search customers. In general, we recognize revenues in the period in which the services are performed. Search revenue is recorded on a gross basis in accordance with Emerging Issues Task Force Issue 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. We are the primary obligor in the revenue-generating relationships with our search engine customers, we separately negotiate each revenue or unit pricing contract independent of any revenue sharing arrangements and assume the credit risk for amounts invoiced to such customers. We, through our meta-search technology, determine the paid click, content and information directed to our owned and operated Web sites and our distribution partners' Web properties. We earn revenue from our search engine and directory listing customers by providing paid search clicks generated from our distribution partners' Web properties based on separately negotiated and agreed-upon terms with each distribution partner.

We recognize amounts due to our distribution partners in the period they are earned and classify such costs as Content and distribution expense in the Consolidated Statements of Operations and Comprehensive Income (Loss). See "Note 2: Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements (Item 8 of Part II of this Report) for a description of products and services and the related revenue recognition policy.

Fair Value Measurements

On January 1, 2008, we adopted Statement of Financial Accounting Standards ("SFAS") No. 157, Fair Value Measurements, issued by the Financial Accounting Standards Board ("FASB"). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands required disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Our $155.5 million of available-for-sale securities include $141.6 million of investments which are classified as short-term as of December 31, 2008, in the Level 1 input category, as defined by SFAS No. 157, because active markets and quoted prices exist for those assets. The remainder of our available-for-sale securities is comprised of $13.6 million of auction rate securities ("ARS") which are classified as long-term, in the Level 3 category, as defined by SFAS No. 157, because there are significant unobservable inputs associated with those investments. We paid $33.4 million for our ARS that we held at December 31, 2008, which are floating rate securities with either long-term maturities or no maturity date, which are marketed by financial institutions with auction reset dates primarily at 28-day intervals to provide short-term liquidity, and which pay interest rates at 2% above the London Interbank Offered Rate ("LIBOR"). Beginning in August 2007, auctions for the ARS that we held at December 31, 2008 began to fail due to insufficient bids from buyers, which resulted in higher interest rates being earned on those securities. Although we continue to receive regular interest payments on those ARS, we do not expect to be able to receive the principal amounts until one or more of the following events occur: future auctions of those ARS are successful, we sell those securities in a secondary market which is currently not active, or the issuers redeem those ARS.

We own two types of ARS. The first type of ARS is collateralized by investment-grade corporate debt and prime-rated mortgage-backed debt, has a long-term maturity date, and is insured in the event of default by monoline insurance companies. We paid $21.4 million for our holdings at December 31, 2008 in the this type of ARS, and determined the fair values by using discounted cash flow models for both the ARS trust payments and the monoline insurer payments, weighted by the probabilities of trust default and the fair value of the collateral. Those models relied upon certain unobservable inputs, including our estimate of the holding periods, ranging from 6 to 28 years for the ARS trusts and from 16 to 42 years for the monoline insurers, the annual discount rates applied to future cash flows, which we primarily based on the historical credit default swap rates for comparable ARS trust entities and monoline insurance companies, ranging from 4% to 36% in excess of LIBOR for the ARS trusts and from 16% to 49% for the monoline insurers, and our estimate of the probabilities of ARS trust default, ranging from 0% to 50%.

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The second type of ARS has no maturity date and, in the event of default or liquidation of the collateral by the ARS issuer, we or the ARS trust are entitled to receive non-convertible preferred shares in the ARS issuer; ARS of that type are also known as auction rate preferred securities ("ARPS"). We originally paid $12.0 million for the ARPS that we held at December 31, 2008. In 2008, an issuer of one of our ARPS liquidated the ARPS trust collateral and replaced it with non-cumulative perpetual preferred shares in the ARPS issuer. We paid $5.0 million for that ARPS, and the fair value at December 31, 2008 was zero ($0). We determined the fair value of that ARPS at December 31, 2008 by using a discounted cash flow model for the preferred dividend payments, weighted by the estimated probability of dividend payments being declared and paid. The model relied upon certain unobservable inputs, including our estimate of the holding period, which was 40 years, the annual discount rates applied to future cash flows, which we primarily based on the historical credit default swap rates for the ARPS issuers, ranging from 49% to 82% in excess of LIBOR, and our estimate of the probability of dividends being declared and paid, which was 0%. No dividend has been declared or paid on that ARPS and we do not expect a dividend to be declared or paid in the future. In 2008, an issuer of certain of our ARPS terminated the ARPS trusts and issued us non-cumulative perpetual preferred shares in the ARPS issuer. We paid $7.0 million for those ARPS, and the fair value of the preferred shares at December 31, 2008 was $365,000. We determined the fair values of those preferred shares at December 31, 2008 by using discounted cash flow models for the preferred dividend payments, weighted by the estimated probabilities of dividend payments being declared and paid. The models relied upon certain unobservable inputs including our estimate of the holding periods, which was 40 years, the annual discount rates applied to future cash flows, which we primarily based on the historical credit default swap rates for the ARPS issuer, ranging from 22% to 47% in excess of LIBOR, and our estimate of the probabilities of dividends being declared and paid, ranging from 0% to 50%. Dividends have been declared and paid on those preferred shares subsequent to December 31, 2008. For the remaining ARPS, for which we paid $7.0 million, there was a single issuer, and we determined their fair values to be an aggregate $1.8 million at December 31, 2008 by using discounted cash flow models for the ARPS trust payments, weighted by our estimated probability of trust default. The models relied upon certain unobservable inputs, including our estimate of the holding periods, which was 40 years, the annual discount rate applied to future cash flows, which was primarily based on the historical credit default swap rates for the ARPS issuer, ranging from 11% to 24% in excess of LIBOR, and our estimate of the probabilities of trust default, which was 0%.

In the year ended December 31, 2008, we recorded an other-than-temporary impairment of our available-for-sale investments in Loss on investments, net in our Consolidated Statements of Operations and Comprehensive Income (Loss) of $24.3 million, which included $776,000 of impairments previously classified as temporary. We recorded ARS investment impairments in Loss on investments, net of $2.2 million and zero ($0) in the years ended December 31, 2007 and 2006, respectively.

We review the impairments of our available-for-sale investments in accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and related guidance issued by the FASB and the SEC. We classify the impairment of any individual ARS as either temporary or other-than-temporary. The differentiating factors between temporary and other-than-temporary impairments are primarily the length of the time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer and our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

As of December 31, 2007, we held warrants to purchase shares in a privately-held company that had a carrying value of $188,000. In the year ended December 31, 2008, we recorded a charge of $188,000 related to those warrants in Loss on investments, net in our Consolidated Statements of Operations and Comprehensive Income (Loss), reducing the carrying value of those warrants to zero ($0). The warrants are classified in Other long-term assets, in the Level 3 category, because there are significant unobservable inputs associated with them. We consider the warrants to be derivatives, and follow SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, which requires that all derivatives be carried at fair value. We account for all derivatives by recognizing the changes in their fair values as gains or losses on investments in our Consolidated Statements of Operations and Comprehensive Income (Loss).

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We use fair value measurements on a recurring basis in the assessment of our equity investment in a privately-held company classified as Other long-term assets, in the Level 3 category, because there are significant unobservable inputs associated with them. In the year ended December 31, 2008, we recorded an other-than-temporary impairment charge of $2.0 million in Loss on investments, net in our Consolidated Statements of Operations and Comprehensive Income
(Loss), reducing the carrying value of our investment in that privately-held company to zero ($0). We assessed our investment in that privately-held company for impairment in accordance with FASB Staff Position FAS 115-1/124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and the SEC's Staff Accounting Bulletin Topic 5M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities. We did not record any impairment charges for the investment in a privately-held company in the years ended December 31, 2007 and 2006.

In the years ended December 31, 2008, 2007 and 2006, we did not measure the fair value of any of our assets or liabilities other than cash and cash equivalents, available-for-sale investments, warrants and investment in a privately-held company. We consider the carrying values of accounts receivable, notes and other receivables, prepaid expenses and other current assets, accounts payable, accrued expenses and other current liabilities and assets and liabilities of discontinued operations to approximate fair values primarily due to their short-term nature.

For additional information see "Note 4: Fair Value Measurements" of the Notes to Consolidated Financial Statements (Item 8 of Part II of this Report.)

Accounting for Goodwill and Certain Other Intangible Assets

SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill and intangible assets with indefinite lives be tested for impairment on an annual basis and between annual tests in certain circumstances and requires an allocation of goodwill to the portions of a reporting unit when a portion of that reporting unit is disposed. In addition, certain circumstances may require testing for impairment in conjunction with restructuring in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. On a quarterly basis, we assess whether business conditions, including material changes in the fair value of our outstanding common stock, indicate that our goodwill may not be recoverable.

When a portion of a reporting unit is disposed, goodwill is allocated to the disposed and retained portions based on the relative fair values of the respective businesses. Allocating goodwill to portions of a reporting unit requires judgment, including the identification of reporting unit portions, assigning assets and liabilities to the portions, assigning goodwill to the portions, and determining the fair value of each portion. The goodwill associated with the disposed portion is included in the portion's carrying amount in determining the gain or loss on disposal. In 2007, we sold our directory business, which was combined with our search business in our online reporting unit. Based upon our analysis, we allocated $60.5 million of goodwill to our directory business, which was used in determining the gain on its sale to Idearc Inc.

Upon the sale of the mobile business in 2007, we determined that we no longer operate separate reporting units. We performed our annual impairment analysis of the goodwill on our balance sheet as of November 30, 2008, and we determined that there was no impairment. Our analysis compared the book value of our shareholders' equity to the fair value of our outstanding common stock, based on quoted market prices, which exceeded the book value of our shareholders' equity on the annual measurement date. At December 31, 2008, we had $43.9 million of goodwill on our balance sheet. Subsequent to December 31, 2008, there has been a decline in our market capitalization to an amount below our recorded stockholders' equity as of December 31, 2008. This may be a triggering event requiring us to perform a test for impairment of our goodwill during the quarter ending March 31, 2009 and may result in an impairment charge for some or all of our recorded goodwill balance.

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Other intangible assets were tested for impairment by comparing their carrying amounts to their fair values. We measured the fair value of such assets by estimating the future undiscounted cash flows attributable to them, and recognized an impairment if their carrying amounts exceeded the estimated fair values. Such evaluations rely on various assumptions, including the timing of future events and market conditions. At December 31, 2008, we no longer held material other intangible assets.

Allowances for Sales and Doubtful Accounts

Our management must make estimates of potential future sales allowances related . . .