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SYNC > SEC Filings for SYNC > Form 10-K on 26-Mar-2013All Recent SEC Filings

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Form 10-K for SYNACOR, INC.


26-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our results of operations and financial condition should be read in conjunction with the information set forth in "Selected Financial Data" and our financial statements and the notes thereto included in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon our current expectations, estimates and projections that involve risks and uncertainties. Actual results could differ materially from those anticipated in these forward-looking statements due to, among other considerations, the matters discussed under "Risk Factors" and "Special Note Regarding Forward-Looking Statements."
Overview
We are a leading provider of startpages, TV Everywhere solutions, Identity Management (IDM) and various cloud-based services across multiple devices for cable, satellite, telecom and consumer electronics companies. We are also a leading provider of authentication and aggregation solutions for delivery of online content. Our technology allows our customers to package a wide array of online content and cloud-based services with their high-speed Internet, communications, television and other offerings. Our customers offer our services under their own brands on Internet-enabled devices such as PCs, tablets, smartphones and connected TVs.
We generate revenue from search and display advertising and by charging subscriber-based fees for services and products delivered through our startpages. Our results are driven primarily by our customer mix, the product and service mix preferences of those customers and the pricing of those products and services. We generate the majority of our revenue from search and display advertising on our startpages, which comprise consumer-facing components of our technology. Adding new customers with large consumer bases and expansion of our relationships with existing customers have resulted in an increasing shift in our revenue mix towards search and display advertising revenue. In addition, as new customers adopt our solutions, and as their respective consumers' use of our startpages ramps up as described below, our growth is increasingly driven by search and display advertising revenue. These increases are largely driven by our model of sharing a portion of this search and advertising revenue with our customers. As we expand our value added services offerings, we expect to generate increased subscriber-based revenue from our customers.
Growth in search and display advertising revenue is driven largely by increasing consumer use of our startpages. As more consumers use our startpages and as consumers spend more time on these startpages, we have a greater number of opportunities to deliver advertisements. During the year ended December 31, 2012, search and display advertising revenue was $101.6 million, a growth of 41% over $72.1 million for the year ended December 31, 2011. Over the same period, our unique visitors increased by 40%, our search queries increased by 29% and our advertising impressions increased by 52%. We expect future growth in consumer engagement as our customers deliver more services through our cross-device, touchscreen-enabled startpages.
Our subscriber-based revenue consists of fees charged for the use of our proprietary technology and for the use of, or access to, services, such as e-mail, security, TV Everywhere, online games, music and other value added services and paid content. During the year ended December 31, 2012, subscriber-based revenue was $20.4 million, an increase of 8% from $19.0 million during the year ended December 31, 2011. We believe there are opportunities to generate new sources of subscriber-based revenue, such as the introduction of new value added services, including those delivered on cross-device, touchscreen-enabled devices. We believe that the variety of value added services and the introduction of new value added services will also drive increased search and display advertising revenue.
As new customers introduce our startpages to their consumers, usage of our solutions and our revenue from our startpages tends to increase over time. There are a variety of reasons for this ramp-up period. For example, a new customer may migrate its consumers from its existing technology to our technology over a period of time. Moreover, a new customer may initially launch a selection of our services and products, rather than our entire suite of offerings, and subsequently broaden their service and product offerings over time. When a customer launches a new service or product, marketing and promotional activities may be required to generate awareness and interest among consumers. Search and display advertising revenue typically grows significantly during the first one to three years after a customer launch, although there can be notable variances from customer to customer. Thereafter, changes in revenue tend to mirror changes in the consumer base of the applicable customer.
For the year ended December 31, 2012, we derived revenue from over 45 customers, with revenue attributable to four customers, CenturyLink (including revenue attributable to Qwest), Charter, Verizon and Toshiba, together accounting for approximately 73% of our revenue for the year ended December 31, 2012, or $88.4 million. One of these customers accounted


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for 20% or more of revenue in such period, and revenue attributable to each of the other three customers accounted for more than 10% in such period. Revenue attributable to our customers includes the subscriber-based revenue earned directly from them, as well as the search and display advertising revenue generated through our relationships with our search and display advertising partners (such as Google for search advertising and advertising networks, advertising agencies and advertisers for display advertising). This revenue is attributable to our customers because it is produced from the traffic on our startpages. These partners provide us with advertisements that we then deliver with search results and other content on our startpages. Since our search advertising partner, Google, and our advertising network partners generate their revenue by selling those advertisements, we create a revenue stream for these partners. In the year ended December 31, 2012, search advertising through our relationship with Google generated approximately 56% of our revenue, or $68.5 million (all of which was attributable to our customers).
We have experienced and expect in the future to experience growth in our business as we acquire new customers, as our existing customers acquire new consumers, as we roll out new products and services and as we expand our presence into international markets. We expect to continue to make capital expenditures in 2013 related to both the customer supporting activities and our internal information technology infrastructure. We expect in 2013 that our research and development headcount and associated expenses will be relatively consistent with the run rate of the fourth quarter of 2012, as we continue to develop our technology, deliver new products and services, and make those and existing products and services available across different devices. Although we experienced net losses in 2010 (as well as in prior years), we believe that the revenue opportunities afforded us by the growth in search and display advertising across our customers have enhanced our ability to achieve profitability in the future. Our costs of revenue, as a percentage of revenue, are expected to remain relatively consistent as most of these costs are associated with the sharing of revenue with our customers. We expect our operating expenses, as a percentage of revenue, in 2013 to be consistent with 2012.
The initiatives described below under "Key Initiatives" are expected to contribute to our ability to maintain and grow profitability via increases in advertising revenue, increases in customers and our consumer reach, and increases in availability of products across more devices. We expect the period in which we experience a return on future investments in each of these initiatives to differ. For example, more direct advertising at higher CPMs would be expected to have an immediate and direct impact on profitability while expansion into international markets may require an investment that involves a longer term return. We expect that some of the net proceeds of our initial public offering will be utilized with a goal of enhancing our technology and our systems capabilities to more efficiently support our customers, develop new products and features and report upon, analyze and manage the financial performance of the business in order to improve our ability to achieve consistent profitability in the future. As of the date of this Annual Report on Form 10-K, we have not yet determined the specific uses of the net proceeds of our initial public offering.
Trends Affecting Our Business
Our customers, who are predominantly high-speed Internet service providers that also offer television services, are facing increasing competition from companies that deliver video content over the Internet, more commonly referred to as "over-the-top," or OTT. These new competitors include a number of large and growing companies, such as Google, Netflix, Inc., or Netflix, Hulu, LLC, or Hulu, and Amazon.com Inc., or Amazon. With the increased availability of high-speed Internet access and over-the-top programming, consumers' video content consumption preferences may shift away from current viewing habits. As a result, many of our customers and potential customers are compelled to find new ways to deliver services and content to their consumers via the Internet. We expect this pressure to become even greater as more video content becomes available online. We expect to continue to benefit from this trend as customers adopt our solutions to package and deliver video programming and other related authentication services on our startpages.
Another trend affecting our customers and our business is the proliferation of Internet-connected devices, especially mobile devices. Smartphones, tablets and connected TVs have made it more convenient for consumers to access services and content online, including television programming. To remain competitive, our customers and potential customers must have the capability to deliver their services and products to consumers on these new devices. Our technology enables them to extend their presence beyond traditional personal computers, and we expect that some portion of our revenue growth will come from traffic on these devices.
Our business is also affected by growth in advertising on the Internet, of which proliferation of high-speed Internet access and Internet-connected devices will be the principal drivers. We believe such search advertising will continue to attract advertising spending to the Internet and will benefit our results of operations. Also, we expect our results of operations will benefit from the growth in the number of mobile Internet users as our customers adopt our cross-device, touchscreen-enabled startpages.


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The launch of the Microsoft Windows 8 operating system in October 2012 has had an impact on our business. As it relates to our business with consumer electronics customers that have the Windows 8 operating system pre-installed on their laptop or desktop computers, our startpages are now placed on a second tab when the Internet browser is launched. This has caused us to reduce our revenue expectations from our consumer electronics customers. Key Initiatives
We are focused on several key initiatives to drive our business:
add new, and expand our existing offerings with current, cable, telecom, satellite and consumer electronics customers to increase our consumer reach;

          continue to expand our offerings of, and invest in, cloud-based
           services such as e-mail and TV Everywhere and increase the number of
           customers using our TV Everywhere technology;


          enhance our direct advertising sales effort to increase the CPMs
           derived from advertising;


          extend the availability of our existing and new products and services
           to additional devices including tablets and smartphones;

expand our presence into international markets; and

invest in and acquire new technologies and products.

Key Business Metrics
In addition to the line items in our financial statements, we regularly review a
number of business metrics related to Internet traffic and search and display
advertising to evaluate our business, determine the allocation of resources and
make decisions regarding business strategies. We believe disclosing these
metrics is useful for investors and analysts to understand the underlying trends
in our business. The following table summarizes our key business metrics, which
are unaudited, for the years ended December 31, 2010, 2011 and 2012:
                                          Year Ended December 31,
                                 2010              2011              2012
Key Business Metrics:
Unique Visitors (1)              8,235,583        14,619,254        20,440,169
Search Queries (2)             453,687,989       748,576,869       968,233,560

Advertising Impressions (3) 18,832,969,669 27,749,105,979 42,170,186,571

Notes:
(1) Reflects the number of unique visitors to our startpages computed on an average monthly basis during the applicable period.

(2) Reflects the total number of search queries during the applicable period.

(3) Reflects the total number of advertising impressions during the applicable period.

Unique Visitors
We define unique visitors as consumers who have visited one of our startpages at least once during a particular time period. We rely on comScore to provide this data. comScore estimates this data based on the U.S. portion of the Internet activity of its worldwide panel of consumers and its proprietary data collection method.
Search Queries
We define search queries as the number of instances in which a consumer entered a query into a search bar on our startpages during a particular time period. We rely on reports from our search partner, Google, to measure the number of such instances.


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Advertising Impressions
We define advertising impressions as graphical, textual or video paid advertisements displayed to consumers on our startpages during a particular time period. We rely on reports from technology and advertising partners, including DoubleClick (a division of Google), to measure the number of advertising impressions delivered on our platform.
Components of our Results of Operations
Revenue
We derive our revenue from two categories: revenue generated from search and display advertising activities and subscriber-based revenue, each of which is described below. We record our search and display advertising revenue on a gross basis, which includes the net amount received from Google under our agreement with them. The following table shows the revenue in each category, both in amount and as a percentage of revenue, for 2010, 2011 and 2012.

                                      Year Ended December 31,
                                  2010         2011         2012
                                          (in thousands)
Revenue:
Search and display advertising $ 45,859     $ 72,084     $ 101,559
Subscriber-based                 20,373       18,976        20,422
Total revenue                  $ 66,232     $ 91,060     $ 121,981
Percentage of revenue:
Search and display advertising       69 %         79 %          83 %
Subscriber-based                     31           21            17
Total revenue                       100 %        100 %         100 %

Search and Display Advertising Revenue
We use Internet search and display advertising to generate revenue from the traffic on our startpages.

          In the case of search advertising, we have a revenue-sharing
           relationship with Google, pursuant to which we include a
           Google-branded search tool on our startpages. When a consumer makes a
           search query using this tool, we deliver the query to Google and they
           return search results to consumers that include advertiser-sponsored
           links. If the consumer clicks on a sponsored link, Google receives
           payment from the sponsor of that link and shares a portion of that
           payment with us, which we in turn share with the applicable customer.
           The net payment we receive from Google is recognized as revenue.


          We generate display advertising revenue when consumers view or click
           on a text, graphic or video advertisement that was delivered on a
           Synacor-operated startpage. We fill our advertising inventory with
           advertisements sourced by our direct salesforce, independent
           advertising sales representatives and advertising network partners.
           Revenue may be calculated differently depending on our agreements with
           our advertisers or the agreements between our advertising network
           partners and their advertisers. It may be calculated on a cost per
           impression basis, which means the advertiser pays based on the number
           of times its advertisements appear, or a cost per action basis, which
           means that an advertiser pays when a consumer performs an action after
           engaging one of its advertisements. Historically only a small
           percentage of our display advertising revenue has been calculated on a
           cost per action basis.

Subscriber-Based Revenue
We define subscriber-based revenue as subscription fees and other fees that we receive from our customers for the use of our proprietary technology and the use of, or access to, e-mail, security, TV Everywhere, games and other services, including value added services and paid content. Monthly subscriber levels typically form the basis for calculating and generating subscriber-based revenue. They are generally determined by multiplying a per-subscriber per-month fee by the number of subscribers using the particular services being offered or consumed. In other cases, the fee is fixed. We recognize revenue from our customers as the service is delivered.


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Costs and Expenses
Cost of Revenue
Cost of revenue consists of revenue sharing, content acquisition costs and co-location facility costs. Revenue sharing consists of amounts accrued and paid to our customers for the traffic on our startpage resulting in the generation of search and display advertising revenue. The revenue-sharing agreements with our customers are primarily variable payments based on a percentage of the search and display advertising revenue. Content acquisition agreements may be based on a fixed payment schedule, on the number of subscribers per month, or a combination of both. Fixed-payment agreements are expensed over the term defined in the agreement. Agreements based on the number of subscribers are expensed on a monthly basis. Co-location facility costs consist of rent and operating costs for our data center facilities.
Research and Development
Research and development expenses consist primarily of compensation-related expenses incurred for the development of, enhancements to, and maintenance and operation of our technology and related infrastructure. Sales and Marketing
Sales and marketing expenses consist primarily of compensation-related expenses to our direct sales and marketing personnel, as well as costs related to advertising, industry conferences, promotional materials, and other sales and marketing programs. Advertising cost is expensed as incurred. General and Administrative
General and administrative expenses consist primarily of compensation related expenses for executive management, finance, accounting, human resources and other administrative functions.
Depreciation
Depreciation includes depreciation of our computer hardware and software, furniture and fixtures, leasehold improvements, and other property, and depreciation on capital leased assets.
Other Income (Expense)
Other income (expense) consists primarily of interest income earned and foreign exchange gains and losses.
Interest Expense
Interest expense primarily consists of expenses associated with our long-term debt, capital leases, and amortization of debt issuance costs. Provision for Income Taxes
Income tax expense consists of federal and state income taxes in the United States and taxes in certain foreign jurisdictions. Critical Accounting Policies
The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts and classifications of assets and liabilities, revenue and expenses, and the related disclosures of contingent liabilities in the financial statements and accompanying notes. The SEC has defined a company's critical accounting policies as the ones that are 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. Based on this definition, we have identified the following critical accounting policies and estimates addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. See Note 1, The Company and Summary of Significant Accounting Policies, of Notes to the Financial Statements. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information available at the time. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.


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Revenue Recognition
We recognize revenue when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the selling price is fixed or determinable; and collectability is reasonably assured.
The terms of our arrangements with our customers, Google and our advertising network partners are specified in written agreements. These written agreements constitute the persuasive evidence of the arrangements with our customers that are a pre-condition to the recognition of revenue. The evidence used to document that delivery or performance has occurred generally consists of communication of either numbers of subscribers or the revenue generated in a reporting period from customers, advertising partners, vendors and our own internally-generated reports. Occasionally, a customer will notify us of subsequent adjustments to previously reported subscriber data. These adjustments, once accepted by us, will result in adjustments to revenue and cost of revenue. The historical occurrences of such adjustments, and the amounts involved, have not been significant.
Although prices used in our revenue recognition formulas are generally fixed pursuant to the written arrangements with our customers, Google and our advertising network partners, the number of subscribers or the amount of search and display advertising revenue that are subject to our pricing arrangements are not known until the reporting period has ended. Although this data is, in most cases, available prior to the completion of our periodic financial statements, this data may need to be estimated. When made, these estimates are based upon our historical experience with the relevant party. Adjustments to these estimates have historically not been significant. The receipt of this volume data also serves to verify that we have appropriately satisfied our obligation to our customers for that reporting period. Adjustments are recorded in the period in which the data is received.
Pursuant to the terms of our customer contracts, we recognize revenue in each period for our services once the contract has been signed, its terms reviewed and understood, the service, content or both have been made available to the customer and reliable active subscriber information is made available to us. We undertake an evaluation of the creditworthiness of both new and, on a periodic basis, existing customers. Based on these reviews we determine whether collection of our prospective revenue is probable. Revenue Sharing
We pay our customers a portion of the revenue generated from search and display advertising. The portion paid to our customers depends on, among other things, the consumer base of the customer and their expected ability to drive consumer traffic to our startpages. This revenue consists of the consideration we receive from Google and our display advertising partners in connection with traffic supplied by the applicable customer.
Gross Versus Net Presentation of Revenue for Revenue Sharing We evaluate our relationship between our search and display advertising partners and our customers in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, 605-45, Principal Agent Considerations. We have determined that the revenue derived from traffic supplied by our customers is reported on a gross basis because we are the primary obligor (we are responsible to our customers for fulfilling search and display advertising services and value added and other services), are involved in the service specifications, perform part of the service, have discretion in supplier selection, have latitude in establishing price and bear credit risk. Stock-Based Compensation
We account for stock-based compensation in accordance with the authoritative guidance on stock compensation. Under the fair value recognition provisions of this guidance, stock-based compensation is measured at the grant date based on the fair value of the award and is recognized as expense, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. As a result, we are required to estimate the amount of stock-based compensation we expect to be forfeited based on our historical experience. If actual forfeitures differ significantly from our estimates, stock-based compensation expense and our results of operations could be materially impacted.

Determining the fair value of stock-based awards at the grant date requires judgment. We use the Black-Scholes option-pricing model to determine the fair value of stock options. The determination of the grant date fair value of options using an option-pricing model is affected by our estimated common stock fair value as well as assumptions regarding a number of other complex and subjective variables. These variables include the fair value of our common stock, our expected stock price volatility over the expected term of the options, stock option exercise and cancellation behaviors, risk-free interest rates, and expected dividends, which are estimated as follows:


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Fair Value of Our Common Stock. Because our stock was not publicly traded prior to our initial public offering, the fair value of our common stock underlying our stock options was determined by our board of directors based on valuations prepared by an independent valuation specialist. The board of directors intended . . .

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