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DRIV > SEC Filings for DRIV > Form 10-Q on 7-Nov-2012All Recent SEC Filings

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Form 10-Q for DIGITAL RIVER INC /DE


7-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The discussion in this Quarterly Report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Additional factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled "Risk Factors," included in Item 1A of Part II of this Quarterly Report. When used in this document, the words "believes," "expects," "anticipates," "intends," "plans," and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. We have no obligation to update the matters set forth herein, whether as a result of new information, future events or otherwise.

Business Overview

We provide end-to-end global cloud-commerce, payments and marketing solutions to a wide variety of companies in software, consumer electronics, computer games, video games and other markets. We offer our clients a broad range of services that enable them to quickly and cost effectively establish an online sales channel capability and to subsequently manage and grow online sales on a global basis while mitigating risks. Our services include design, development and hosting of online stores and shopping carts, store merchandising and optimization, order management, denied parties screening, export controls and management, tax compliance and management, fraud management, digital product delivery via download, physical product fulfillment, subscription management, online marketing including e-mail marketing, management of affiliate programs, paid search programs, payment processing services, website optimization, web analytics and reporting, and CD production and delivery.

Our products and services allow our clients to focus on promoting and marketing their products and brands worldwide while leveraging our investments in technology and infrastructure to facilitate the purchase of products through their online websites. When shoppers visit one of our clients' branded websites they are transferred to an online commerce store and/or shopping cart operated by us on our commerce platforms. Once on our system, shoppers can browse for products and make purchases online. We typically are the seller of record for transactions through our client branded stores. After a purchase is made, we either deliver the product digitally via download over the Internet or transmit instructions to a third party for physical fulfillment of the order. We also typically process the buyer's payment as the merchant of record, including collection and remittance of applicable taxes and compliance with various regulatory matters. We have invested substantial resources to develop our cloud-commerce and marketing platforms, including direct-to-buyer software, and we provide access and use of our platforms to our clients as a service as opposed to selling the software to be operated on their own in-house computer hardware. Our cloud-commerce store solutions range from simple remote control models to more comprehensive online store models.

In addition to the services we provide that facilitate the completion of an online transaction, we also offer services designed to increase traffic to our clients' websites and the associated online stores and to improve the sales productivity of those stores. Our services include paid search advertising, search engine optimization, affiliate marketing, store optimization, multi-variant testing, web analytic services and e-mail optimization. All of our services are designed to help our clients acquire customers more effectively, sell to those customers more often and more efficiently, and increase the lifetime value of each customer.

Additionally, through our Digital River World Payments subsidiary, we offer a full range of payment processing services to clients. These services include multiple payment methods, fraud management, tax management, cloud-based billing and other payment optimization services.

Current Period Results and Outlook

For the quarter ended September 30, 2012, we recorded a net loss of $0.7 million or $0.02 per share compared to net income of $5.5 million or $0.15 per diluted share for the same period in the prior year. Revenues in the current quarter decreased 3.9% versus the third quarter of 2011 to $91.7 million. Total costs and expenses in the current quarter increased 0.4% versus the third quarter of 2011 to $91.0 million. As of September 30, 2012 and December 31, 2011, we had $675.0 million and $720.5 million in cash, cash equivalents and short-term investments, respectively.

For the fourth quarter, we expect fairly strong customer traffic on key selling days - similar to what we have seen in previous years; however, we expect to see some consumer pricing pressure leading to lower average order values on Black Friday and Cyber Monday. While we had a good third quarter and anticipate a solid fourth quarter, we expect challenges in 2013. Like many companies, we continue to have concerns about the overall softness of the economy, especially in Europe, as well as the decline in PC sales. We have undergone some client attrition this year and expect it will continue into next year. Additionally, we have seen a decline in our supporting businesses revenue this year and expect a similar decline in 2013. Taking all these challenges into consideration, we believe it will be difficult to achieve revenue growth next year, including any revenue from the proposed acquisition of LML Payment Systems (see Item 1, Note 9 in this Quarterly Report on Form 10-Q).

Currently, we are taking actions to solidify our existing revenue base and respond to trends we are seeing in the market. These actions include continued investment in our technology platforms, the transition of our architecture and platforms towards a more modular, plug-and-play commerce ecosystem and reducing operating expenses.

Other

On May 8, 2012, we entered into with Microsoft Corporation ("Microsoft"), in the ordinary course of business, the Third Omnibus Amendment to the Microsoft Operations Digital Distribution Agreement (the "Third Omnibus Amendment"). The Third Omnibus Amendment extends the term of Microsoft Operations Digital Distribution Agreement to a date no earlier than March 1, 2014. Additionally, the Third Omnibus Amendment contemplates the expansion of the business relationship whereby we will build, host and manage the Microsoft Store, an e-commerce store that supports the sale and fulfillment of Microsoft and third party software as well as consumer electronics products, to customers throughout the world. The Third Omnibus Amendment contemplates us providing e-commerce services in connection with Microsoft Store on a global basis in addition to maintaining and expanding our role as a reseller of Microsoft products via Digital River's existing online stores in addition to new stores offering physical media.


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We view our operations and manage our business as one reportable segment, providing outsourced commerce solutions globally to a variety of companies, primarily in the software and consumer electronics product markets.

We were incorporated in Delaware in February 1994. Our headquarters are located at 10380 Bren Road West, Minnetonka, Minnesota and our telephone number is 952-253-1234.

General information about us can be found at www.digitalriver.com under the "Company/Investor Relations" link or follow the Company on Twitter at twitter.com/digitalriverinc. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments or exhibits to those reports, are available free of charge through our website as soon as reasonably practicable after we file such reports with the Securities and Exchange Commission.

Results of Operations



The following table sets forth certain items from our Consolidated Statements of
Operations as a percentage of total revenue for the periods indicated:



                                     Three Months Ended         Nine Months Ended
                                        September 30,             September 30,
                                     2012          2011         2012         2011
Revenue                                100.0 %       100.0 %      100.0 %      100.0 %
Costs and expenses (exclusive
of depreciation and
amortization expense shown
separately below):
Direct cost of services                  3.2           3.8          3.4          4.1
Network and infrastructure              14.6          12.6         13.7         13.0
Sales and marketing                     41.4          42.5         42.4         41.1
Product research and
development                             17.1          17.6         16.5         17.6
General and administrative              15.6          10.2         13.6         11.0
Depreciation and amortization            5.3           6.0          5.4          5.8
Amortization of
acquisition-related intangibles          1.9           2.3          1.8          2.3
Total costs and expenses                99.1          95.0         96.8         94.9
Income (loss) from operations            0.9           5.0          3.2          5.1
Interest income                          0.8           1.7          1.0          1.7
Interest expense                        (2.5 )        (2.4 )       (2.4 )       (2.4 )
Other income (expense), net             (0.7 )        (0.5 )          -            -
Income (loss) before income
taxes                                   (1.5 )         3.8          1.8          4.4
Income tax expense (benefit)            (0.7 )        (1.9 )        0.3         (0.1 )
Net income (loss)                       (0.8 )%        5.8 %        1.5 %        4.5 %

REVENUE. Our revenue was $91.7 million for the three months ended September 30, 2012, compared to $95.4 million for the same period in the prior year, a decrease of $3.7 million or 3.9%. For the nine months ended September 30, 2012, revenue totaled $284.9 million, a decrease of $1.2 million, or 0.4%, from revenue of $286.1 million for the same period in the prior year.

Our commerce revenues are driven primarily by global commerce and payment services provided to a wide variety of companies in the software, consumer electronics, computer games and other markets. Commerce revenues include revenues generated from Microsoft. All other non-commerce revenue or support business revenue is driven primarily by our e-mail and affiliate marketing businesses.

For the three months ended September 30, 2012, the $3.7 million decrease in revenue was driven primarily by a decrease in our support business revenue of $2.9 million and foreign exchange unfavorability of $2.3 million, offset by an increase in commerce revenue of $1.5 million compared to the same period in the prior year. For the nine months ended September 30, 2012, the $1.2 million decrease in revenue was driven primarily by a decrease in support business of $9.1 million and foreign exchange unfavorability of $5.4 million, partially offset by an increase in commerce revenue of $13.3 million compared to the same period in the prior year.


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International sales were approximately 45.8% and 46.4% of total sales in the three and nine month periods ended September 30, 2012, compared to 46.2% for both the same periods in the prior year.

DIRECT COST OF SERVICES. Direct cost of services primarily includes costs related to product fulfillment, backup CD production, delivery solutions and certain client-specific costs. Direct cost of service expenses were $3.0 million for the three months ended September 30, 2012, compared to $3.7 million for the same period in the prior year. Direct cost of service expenses were $9.7 million for the nine months ended September 30, 2012, compared to $11.7 million for the same period in the prior year. The decreases for both periods were primarily attributable to lower CD production and delivery costs.

As a percentage of revenue, direct cost of services was 3.2% and 3.4% for the three and nine months ended September 30, 2012, compared to 3.8% and 4.1% for the same periods in the prior year.

NETWORK AND INFRASTRUCTURE. Our network and infrastructure expenses primarily include costs to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expenses were $13.4 million and $12.0 million for the three months ended September 30, 2012 and 2011, respectively. Network and infrastructure expenses were $39.1 million and $37.1 million for the nine months ended September 30, 2012 and 2011, respectively. The increases for both periods were mainly due to higher data communication and IT related costs.

As a percentage of revenue, network and infrastructure expenses were 14.6% and 13.7% for the three and nine months ended September 30, 2012, compared to 12.6% and 13.0% for the same periods in the prior year.

SALES AND MARKETING. Our sales and marketing expenses include credit card transaction and other payment processing fees, personnel and related costs, advertising, promotional and product marketing expenses, credit card chargebacks and bad debt expense. Sales and marketing expenses were $38.0 million and $40.5 million for the three months ended September 30, 2012 and 2011, respectively. Sales and marketing expenses were $120.8 million and $117.7 million for the nine months ended September 30, 2012 and 2011, respectively. The decrease for the current period is driven primarily by a decrease in workforce related costs. The year to date increases year-over-year were primarily driven by increased payment processing costs and credit card chargebacks associated with our commerce revenue.

As a percentage of revenue, sales and marketing expenses were 41.4% and 42.4% in the three and nine months ended September 30, 2012, compared to 42.5% and 41.1% for the same periods in the prior year.

PRODUCT RESEARCH AND DEVELOPMENT. Our product research and development expenses include costs associated with design, development and enhancement of our technology platforms and related systems. Research and development costs are expensed as incurred, except certain internal-use software development costs eligible for capitalization and costs directly associated with preparing a client website launch eligible to be deferred and amortized over the life of the sites associated revenue streams. Product research and development expenses were $15.7 million and $16.8 million for the three months ended September 30, 2012 and 2011, respectively. Product research and development expenses were $47.1 million and $50.5 million for the nine months ended September 30, 2012 and 2011, respectively. The decreases in both periods were primarily due to a reduction in workforce related costs.

As a percentage of revenue, product research and development expenses were 17.1% and 16.5% in the three and nine months ended September 30, 2012, compared to 17.6% for both of the same periods in the prior year.

GENERAL AND ADMINISTRATIVE. Our general and administrative expenses primarily include executive, finance, human resources and other administrative workforce and other related expenses, fees for professional services, bank fees, litigation costs, insurance costs and non-income related taxes. General and administrative expenses were $14.3 million and $9.7 million for the three months ended September 30, 2012 and 2011, respectively. General and administrative expenses were $38.8 million and $31.4 million for the nine months ended September 30, 2012 and 2011, respectively. The increases in the current period were driven by legal fees and settlement of DDR Holdings, LLC litigation, acquisition costs associated with LML Payment Systems, Inc. and consulting costs incurred. The year to date increases year-over-year are driven by the current period costs above and higher workforce related costs.

As a percentage of revenue, general and administrative expenses were 15.6% and 13.6% for the three and nine months ended September 30, 2012, compared to 10.2% and 11.0% for the same periods in the prior year.

DEPRECIATION AND AMORTIZATION. Our depreciation and amortization expenses include the depreciation of computer equipment, office furniture, the amortization of purchased and internally developed software and leasehold improvements. Computer equipment, software and furniture are depreciated under the straight-line method using three to


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seven year lives and leasehold improvements are amortized over the shorter of the life of the asset or the remaining length of the lease. Depreciation and amortization expense was $5.0 million and $5.7 million for the three months ended September 30, 2012 and 2011, respectively. Depreciation and amortization expense was $15.3 million and $16.7 million for the nine months ended September 30, 2012 and 2011, respectively.

As a percentage of revenue, depreciation and amortization was 5.3% and 5.4% for the three and nine months ended September 30, 2012, compared to 6.0% and 5.8% for the same periods in the prior year.

AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES. Amortization of acquisition-related intangibles consists of the amortization of intangible assets such as customer relationships, technology and trade names acquired in business combinations. Amortization of acquisition-related intangible assets was $1.7 million and $2.2 million for the three months ended September 30, 2012 and 2011, respectively. Amortization of acquisition-related intangible assets was $5.3 million and $6.5 million for the nine months ended September 30, 2012 and 2011, respectively. The decrease for the nine months ended September 30, 2012, was driven primarily by intangible assets becoming fully amortized and the impairment recorded in the fourth quarter of 2011, as reported in the 2011 Form 10-K.

As a percentage of revenue, amortization of acquisition-related intangibles was 1.9% and 1.8% for the three and nine months ended September 30, 2012, compared to 2.3% for both of the same periods in the prior year.

INTEREST INCOME. Our interest income represents the total of interest income on our cash, cash equivalents, short-term investments and certain long-term investments. Interest income was $0.8 million and $1.6 million for the three months ended September 30, 2012 and 2011, respectively. Interest income was $2.9 million and $4.8 million for the nine months ended September 30, 2012 and 2011, respectively.

INTEREST EXPENSE. Our interest expense includes the total of cash and non-cash interest expense attributable to our outstanding convertible debt. For the three months ended September 30, 2012 and 2011, interest expense was $2.3 million, which included $0.5 million of debt financing cost amortization for both periods. For the nine months ended September 30, 2012 and 2011, interest expense was $6.8 million, which included $1.5 million of debt financing cost amortization for both periods.

OTHER INCOME (EXPENSE), NET. Our other income (expense), net includes foreign currency transaction gains and losses, asset disposal gains and losses, other-than-temporary impairment of investments and dividend income. Other income (expense), net was expense of $0.6 million and $0.5 million for the three months ended September 30, 2012 and 2011, respectively. Other income (expense), net was income of $0.1 million and $0.03 million for the nine months ended September 30, 2012 and 2011, respectively. For the three months ended September 30, 2012 the increase is primarily driven by a year-over-year favorable $1.1 million foreign exchange expense offset by an increase in a $0.6 million note receivable reserve and $0.6 million reduction in gain on sale of investments. For the nine months ended September 30, 2012, the increase is driven by an increase in dividend income.

INCOME TAXES. For the three months ended September 30, 2012 and 2011, our tax benefit was $0.7 million and $1.9 million, respectively. For the three months ended September 30, 2012, our tax expense consisted of approximately $0.5 million of U.S. tax benefit and $0.2 million of foreign tax benefit. The tax benefit was largely driven by provision-to-return items, recorded as discrete events in the current quarter. For the three months ended September 30, 2011, our tax benefit consisted of approximately $2.6 million of U.S. tax benefit and $0.7 million of foreign tax expense. The tax benefit was due to a reduction in the estimated annual effective tax rate from 19.0% in the second quarter to 17.0% in the third quarter, as well as the release of unrecognized tax benefits from completed tax examinations and expiration of statutes of limitation. For the three months ended September 30, 2012 and 2011, the tax rate was 48.7% and (53.9%), respectively. The high tax rate for the current quarter was due to discrete items in the quarter and the negative tax rate for the comparative quarter in the prior year was also due to discrete items in that quarter.

For the nine months ended September 30, 2012 and 2011, our tax expense was $0.9 million and our tax benefit was $0.2 million, respectively. For the nine months ended September 30, 2012, our tax expense consisted of approximately $0.8 million of U.S. tax expense and $0.1 million of foreign tax expense. For the nine months ended September 30, 2011, our tax benefit consisted of approximately $2.6 million of U.S. tax benefit and $2.4 million of foreign tax expense. For the nine months ended September 30, 2012 and 2011, the tax rate was 17.7% and (1.7%), respectively.

Off Balance Sheet Arrangements

None.


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