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DRIV > SEC Filings for DRIV > Form 10-Q on 8-Nov-2013All Recent SEC Filings

Show all filings for DIGITAL RIVER INC /DE | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for DIGITAL RIVER INC /DE


8-Nov-2013

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, web analytics and reporting, and website optimization.

Our commerce 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


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models to more comprehensive online store models.

Through Digital River World Payments (DRWP) and LML, 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.

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.

Current Period Results and Outlook

For the quarter ended September 30, 2013, we recorded a net loss of $12.5 million or ($0.40) per share, comprised of net loss from continuing operations of $7.6 million or ($0.24) per share and net loss from discontinued operations of $4.9 million or ($0.16) per share. For the comparative quarter ended September 30, 2012, we recorded a net loss of $0.7 million or ($0.02) per share, comprised of net loss from continuing operations of $0.7 million and breakeven discontinued operations. Revenues from continuing operations of $87.3 million in the quarter ended September 30, 2013, are consistent with revenues from continuing operations of $87.1 million in the same period in the prior year as payments revenue growth of $8.7 million offset a decrease in commerce revenue of $8.5 million compared to prior year. $5.8 million of the growth in payments revenue was related to LML, which was acquired in the first quarter of 2013. Client attrition was the primary driver of the decrease in commerce revenue compared to prior year. However, the level of client attrition and its impact on revenue continues to be consistent with our expectations and previous communications.

Total costs and expenses in continuing operations as of September 30, 2013, of $93.8 million increased 8.6% compared to the same period in the prior year. As of September 30, 2013 and December 31, 2012, we had $580.8 million and $705.6 million in cash, cash equivalents and short-term investments, respectively.

Our management's discussion and analysis includes the quarterly results of LML's earnings starting as of the acquisition date of January 10, 2013.

We continue to move forward with the strategic transformation process. We are making substantial investments, up to $22 million in 2013, with continuing investments into 2014, to deliver a more flexible commerce ecosystem, pursue high-impact growth markets, as well as create financial capacity that will drive growth and improved operating margins over time.

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 allowed for the expansion of the business relationship pursuant to which we have and continue to 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. In addition, pursuant to the Third Omnibus Amendment, we continue to act as a reseller of Microsoft products.

We view our operations and manage our business as one reportable segment, providing outsourced commerce and payments solutions globally to a variety of companies.

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.


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Results of Operations

LML Acquisition

On January 10, 2013, we acquired all of the capital stock of LML Payment Systems, Inc., a publically held payment service provider with operations in Victoria, British Columbia in an all cash transaction valued at $3.45 per share, or an aggregate purchase price of approximately $102.8 million. The inclusion of LML's financial results since the acquisition date represent an increase to our operations in the nine months ended September 30, 2013 when compared to the same period in the prior year.

Reclassifications

The results of the operations of CustomCD and DRES have been classified within Discontinued Operations within our Consolidated Statements of Operations for the three and nine month periods ending September 30, 2013. The operations of these entities in the corresponding periods of 2012 have been reclassified into Discontinued Operations for comparative purposes to conform to the current year presentation. In addition, all of the assets and liabilities of DRES, which was sold on October 1, 2013, meet the criteria for assets held for sale as of September 30, 2013, and are separately reported as current assets, at fair value, and current liabilities of discontinued operations within the Consolidated Balance Sheet at September 30, 2013. The assets and liabilities of CustomCD have been removed from our Consolidated Balance Sheet as of September 30, 2013, as the entity was sold on September 30, 2013. The assets and liabilities of both CustomCD and DRES in the December 31, 2012 Consolidated Balance Sheet have been reclassified and separately presented as current assets and current liabilities of discontinued operations for comparative purposes with the current year presentation.

Certain items in the prior year's Consolidated Statements of Operations have been reclassified for comparative purposes to conform to the current year presentation. Historically, we have reported payment processing fees, chargebacks, and directly related personnel expenses within the "Sales and marketing" and "General and administrative" line items. We have reclassified these expenses to the "Direct cost of services" line as these costs are associated directly with services rendered. For the three and nine months ended September 30, 2012, excluding amounts related to CustomCD and DRES which have been reclassified to discontinued operations, we have reclassified $12.8 million and $39.3 million, respectively, previously reported as "Sales and marketing" and $0.4 million and $1.4 million, respectively, previously reported as "General and administrative" to "Direct cost of services". The reclassifications did not have an effect on reported consolidated net income (loss).

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


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                                      Three Months Ended          Nine Months Ended
                                         September 30,              September 30,
                                      2013          2012         2013          2012
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                  18.5          17.8         19.1          17.5
Network and infrastructure               16.8          15.1         15.3          14.1
Sales and marketing                      28.7          26.1         27.9          27.4
Product research and development         20.8          17.4         18.4          16.7
General and administrative               13.8          15.8         15.3          13.6
Goodwill impairment                         -             -          7.4             -
Depreciation and amortization             6.5           5.7          5.4           5.6
Amortization of
acquisition-related intangibles           2.4           1.3          2.2           1.3
Total costs and expenses                107.5          99.2        111.0          96.2
Income (loss) from operations            (7.5 )         0.8        (11.0 )         3.8
Interest income                           0.6           0.9          0.6           1.1
Interest expense                         (2.2 )        (2.6 )       (2.0 )        (2.5 )
Other income (expense), net              (0.3 )        (0.7 )        5.8             -
Income (loss) from continuing
operations before income taxes           (9.4 )        (1.6 )       (6.6 )         2.4
Income tax expense (benefit)             (0.7 )        (0.8 )       (0.2 )         0.5
Income (loss) from continuing
operations                               (8.7 )        (0.8 )       (6.4 )         1.9
Income (loss) from discontinued
operations, net of tax                   (5.6 )           -         (2.2 )        (0.4 )
Net income (loss)                       (14.3 )%       (0.8 )%      (8.6 )%        1.5 %

The following narrative discussion addresses the results of continuing operations for each financial statement caption. The results of discontinued operations are separately addressed at the conclusion of this discussion.

Revenue. Our revenue of $87.3 million for the three months ended September 30, 2013 was consistent with $87.1 million for the same period in the prior year. For the nine months ended September 30, 2013, revenue totaled $288.4 million, an increase of $16.0 million, or 6%, from revenue of $272.4 million for the same period in the prior year.

Our 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. Continuing commerce revenues include revenues generated from Microsoft, as well as, our remaining supporting businesses. Revenues from our former supporting businesses, DRES and CustomCD, are included within discontinued operations. Payments revenues include revenues from DRWP and our first quarter 2013 acquisition, LML.

For the three months ended September 30, 2013, payments revenue increased $8.7 million, primarily due to $5.8 million of revenue from LML. DRWP revenue of $9.0 million was also up 47% compared to $6.1 million in the third quarter of 2012, driven by continued client expansion. This increase in payments revenue was offset by a decrease of $8.5 million in the continuing operations of our commerce business due mainly to the continued impact of client attrition from prior periods. For the nine months ended September 30, 2013, the $16.0 million increase in revenue was due to a $28.1 million increase in payments revenue, offset by $12.1 million decrease in commerce revenue. LML revenue for the period starting as of the acquisition date of January 10, 2013, and ending on September 30, 2013, was $18.0 million.

International sales were approximately 46.8% and 47.7% of total sales in the three and nine month periods ended September 30, 2013, compared to 45.8% and 46.4% for the same periods in the prior year.

Direct Cost of Services. Direct cost of services includes payment processing fees, chargeback expense, fraud detection and prevention, costs related to product fulfillment, delivery solutions and certain client-specific costs. Direct cost of service were $16.2 million for the three months ended September 30, 2013, compared to $15.5 million for the same period in the prior year. Direct cost of service expenses were $55.3 million for the nine months ended September 30, 2013, compared to $47.8 million for the same period in the prior year. The increase in direct cost of services is primarily related to higher revenue in the first nine months of 2013 compared to the same period in the prior year.


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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 $14.6 million and $13.2 million for the three months ended September 30, 2013 and 2012, respectively. Network and infrastructure expenses were $44.0 million and $38.3 million for the nine months ended September 30, 2013 and 2012, respectively. The increase was mainly due to higher data communication and IT related costs related to enhancing our flexibility and stability within our commerce environments.

Sales and Marketing. Our sales and marketing expenses include personnel and related costs, advertising, promotional and product marketing expenses, and bad debt expense. Sales and marketing expenses were $25.0 million and $22.8 million for the three months ended September 30, 2013 and 2012, respectively. Sales and marketing expenses were $80.4 million and $74.6 million for the nine months ended September 30, 2013 and 2012, respectively. The increase in costs in the third quarter was due mainly to increased workforce related expenses and LML sales and marketing initiatives. Year-to-date increases were driven by additional first quarter 2013 expenses primarily related to corporate website redesign and branding initiatives as well as the additional of LML expenses.

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 that are eligible for capitalization and costs directly associated with preparing a client website launch that are eligible to be deferred and amortized over the life of the site's associated revenue streams. These costs drive enhanced technologies and strengthen our leadership position in the markets we serve. These investments advance our global system scalability, e-marketing capabilities, data management and client reporting. Product research and development expenses were $18.1 million and $15.2 million for the three months ended September 30, 2013 and 2012, respectively. Product research and development expenses were $53.0 million and $45.6 million for the nine months ended September 30, 2013 and 2012, respectively. The increase was primarily due to increased emphasis in our investment in platform stability, LML related research and development, and the recognition of expenses that were previously deferred until completion of a client site.

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, integration costs and non-income related taxes. General and administrative expenses were $12.0 million and $13.7 million for the three months ended September 30, 2013 and 2012, respectively. General and administrative expenses were $44.0 million and $37.0 million for the nine months ended September 30, 2013 and 2012, respectively. The decrease in third quarter expenses was related mainly to lower stock compensation and consulting expense, as well as, LML acquisition fees that were incurred in the third quarter of 2012. The year-to-date increase is due to severance, legal fees, and acquisition and integration costs associated with LML in the first quarter of 2013 and strategic consulting expenses associated with business process transformation plans in the second quarter of 2013.

Goodwill Impairment. In December 2012, due to the deterioration in our stock price in the second half of 2012, adjustments in our forecasted revenue growth and change in our chief operating decision maker, management completed an interim impairment test and determined that the book value of the Company was in excess of fair value and a goodwill impairment was required. In the fourth quarter 2012, we recorded a non-cash pretax goodwill impairment charge of $175.2 million, or $161.1 million after tax, relating to our single reporting unit. The impairment charge was an estimate pending final valuation of a privately held equity security in calculating the goodwill impairment charge of $175.2 million. During the first quarter of 2013, we determined the fair market value of the privately held equity security which we had estimated at year end and completed our goodwill impairment analysis, recording an additional non-cash pretax goodwill impairment charge of $21.2 million, relating to our single reporting unit.

Depreciation and Amortization. Our depreciation and amortization expenses include the depreciation of computer equipment, office furniture and leasehold improvements and the amortization of purchased and internally developed software. Computer equipment, furniture and software are depreciated/amortized under the straight-line method using three to seven year lives and leasehold improvements are depreciated over the shorter of the life of the asset or the remaining length of the lease. Depreciation and amortization expense was $5.7 million and $4.9 million for the three months ended September 30, 2013 and 2012, respectively. Depreciation and amortization expense was $15.7 million and $15.2 million for the nine months ended September 30, 2013 and 2012, respectively.

Amortization of Acquisition-Related Intangibles. Amortization of acquisition-related intangibles consists of the amortization of intangible assets such as customer and partner relationships, technology and trade names acquired in business combinations. Amortization of acquisition-related intangible assets was $2.1 million and $1.1 million for the three months ended September 30, 2013 and 2012, respectively. Amortization of acquisition-related intangible assets was $6.4 million and


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$3.5 million for the nine months ended September 30, 2013 and 2012, respectively. The increase was driven by the addition of intangibles associated with the purchase of LML.

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 $0.6 million and $0.8 million for the three months ended September 30, 2013 and 2012, respectively. Interest income was $1.9 million and $2.9 million for the nine months ended September 30, 2013 and 2012, respectively. The decrease in interest income was due to less cash and cash equivalents and short-term investments due to the acquisition of LML and stock and debt repurchases completed during 2013 and the fourth quarter of 2012.

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, 2013 and 2012, interest expense was $1.9 million and $2.3 million, respectively, which included $0.4 million and $0.5 million of debt financing cost amortization, respectively. For the nine months ended September 30, 2013 and 2012, interest expense was $5.9 million and $6.8 million, respectively, which included $1.3 million and $1.5 million of debt financing cost amortization, respectively. The decrease in interest expense, including debt financing cost amortization, was due to the repurchase of our 2010 senior convertible notes during the first half of 2013 and the fourth quarter of 2012, which bear an annual interest rate of 2.0%.

Other Income (Expense), Net. Our other income (expense), net includes foreign currency transaction gains and losses, gains and losses on investments or asset disposals (excluding disposal of businesses), other-than-temporary impairment of investments and dividend income. Other income (expense), net was ($0.3) million and ($0.6) million for the three months ended September 30, 2013 and 2012, respectively. For the three months ended September 30, 2013, the net decrease in expense was due to a $0.6 million note receivable reserve recorded in the third quarter of 2012, offset by $0.3 million of unfavorable foreign currency re-measurement losses during the quarter the third quarter of 2013. Other income (expense), net was $16.7 million and $0.1 million for the nine months ended September 30, 2013 and 2012, respectively. For the nine months ended September 30, 2013 the increase is primarily driven by the sale of a cost method equity investment to a third party which resulted in a gain of $17.6 million, offset by unfavorable foreign currency re-measurement losses.

Income Tax Expense (Benefit). For the three months ended September 30, 2013 and 2012, our tax benefit related to continuing operations was $0.6 million and $0.7 million, respectively. For the three month period ended September 30, 2013, our income tax expense related to discontinued operations was $2.6 million, with immaterial expense related to discontinued operations in the comparative prior quarter ended September 30, 2012. For the three months ended September 30, 2013, our total tax expense consisted of approximately $2.3 million of U.S. tax expense and $0.2 million of foreign tax benefit. For the three months ended September 30, 2012, our total tax benefit consisted of approximately $0.5 million of U.S. tax benefit and $0.2 million of foreign tax benefit. For the three months ended September 30, 2013 and 2012, the tax rate was (19.4%) and 48.7%, respectively. The difference in tax rates is due to different discrete items occurring in the quarters, as well as, the valuation allowance established in the fourth quarter of 2012.

For the nine months ended September 30, 2013, our tax benefit related to continuing operations was $0.4 million compared to $1.4 million of tax expense related to continuing operations for the nine months ended September 30, 2012. For the nine months ended September 30, 2013, our tax expense related to discontinued operations was $2.5 million compared to $0.5 million tax benefit related to discontinued operations for the nine months ended September 30, 2012. For the nine months ended September 30, 2013, our total tax expense consisted of approximately $3.7 million of U.S. tax expense and $1.6 million of foreign tax benefit. For the nine months ended September 30, 2012, our total 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, 2013 and 2012, the tax rate was (9.3%) and 17.7%, respectively. The difference in tax rates is due to different discrete items occurring between the periods, as well as, the valuation allowance established in the fourth quarter of 2012.

Discontinued Operations. For the three months ended September 30, 2013 revenues included within discontinued operations totaled $3.1 million, a decrease of $1.5 million, or 34%, from revenues of $4.6 million for the same period in the prior year. $1.0 million of the decrease relates to DRES and $0.5 million relates to CustomCD. Loss from discontinued operations before tax and loss on disposals for the three months ended September 30, 2013, totaled $0.1 million compared to break-even for the three months ended September 30, 2012. The pre-tax loss on disposal recorded in the three months ended September 30, 2013 was $2.1 million, $2.0 million related to DRES and $0.1 million related to CustomCD. Total net losses from discontinued operations were $4.9 million for the three months ended September 30, 2013, compared to break-even for the three months ended September 30, 2012.

For the nine months ended September 30, 2013, revenues included within . . .

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