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AKAMAI TECHNOLOGIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This quarterly report on Form 10-Q, particularly Management's Discussion and Analysis of Financial Condition and Results of Operations set forth below, and notes to our unaudited consolidated financial statements included herein contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management as of the date hereof based on information currently available to our management. Use of words such as "believes," "expects," "anticipates," "intends," "plans," "estimates," "should," "forecasts," "if," "continues," "goal," "likely" or similar expressions indicates a forward-looking statement. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions. Actual results may differ materially from the forward-looking statements we make. See "Risk Factors" elsewhere in this quarterly report on Form 10-Q for a discussion of certain risks associated with our business. We disclaim any obligation to update forward-looking statements as a result of new information, future events or otherwise. We provide services for accelerating and improving the delivery of content and applications over the Internet. We primarily derive income from the sale of services to customers executing contracts with terms of one year or longer, which we refer to as recurring revenue contracts or long-term contracts. These contracts generally commit the customer to a minimum monthly level of usage with additional charges that apply to actual usage above the monthly minimum. In recent years, however, we have also entered into customer contracts that have minimum usage commitments that are based on quarterly, twelve-month or longer periods. Our goal of having a consistent and predictable base level of income is important to our financial success. Accordingly, to be successful, we must maintain our base of recurring revenue contracts by eliminating or reducing lost monthly, quarterly or annual recurring revenue due to customer cancellations or terminations and limiting the impact of price reductions reflected in contract renewals and build on that base by adding new customers and increasing the number of services, features and functionalities that our existing customers purchase. At the same time, we must ensure that our expenses do not increase faster than, or at the same rate as, our revenues. Accomplishing these goals requires that we compete effectively in the marketplace on the basis of quality, price and the attractiveness of our services and technology. Overview of Financial Results The following sets forth, as a percentage of revenues, consolidated statements of operations data, for the periods indicated: For the Three Months For the Six Months Ended June 30, Ended June 30, 2011 2010 2011 2010 Revenues 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenues 32.4 29.3 32.3 28.7 Research and development expense 4.0 5.5 4.3 5.5 Sales and marketing expense 19.1 22.5 19.2 21.6 General and administrative expense 16.6 17.8 16.3 17.2 Amortization of other intangible assets 1.5 1.7 1.5 1.7 Total cost and operating expenses 73.6 76.8 73.6 74.7 Income from operations 26.4 23.2 26.4 25.3 Interest income 1.1 1.3 1.1 1.3 Interest expense - (0.3 ) - (0.2 ) Other (expense) income, net - - (0.2 ) - Gain on investments, net - 0.1 - 0.1 Loss on early extinguishment of debt - (0.1 ) - (0.1 ) Income before provision for income taxes 27.5 24.2 27.3 26.4 Provision for income taxes 10.2 8.7 9.5 10.1 Net income 17.3 % 15.5 % 17.8 % 16.3 % We were profitable for the fiscal year 2010 and for the six months ended June 30, 2011; however, we cannot guarantee continued profitability or profitability for any period in the future at the levels we have recently experienced. We have observed the following trends and events that are likely to have an impact on our financial condition and results of operations in the foreseeable future: • During each of the first two quarters of 2011, we were able to offset lost committed recurring revenue due to customer cancellations, terminations or price reductions by adding new customers and increasing the number of services, features 17-------------------------------------------------------------------------------- Table of Contents and functionalities that our existing customers purchase. A continuation of this trend, in conjunction with increased revenues from non-recurring revenue contracts, could lead to increased revenues; however, any such increased revenues could be offset if lower traffic reduces the revenues we earn on a non-committed basis or as a result of further declines in the prices we charge. If we do not offset lost committed revenue in this manner, our revenues will decrease. • During each of the first two quarters of 2011, unit prices offered to some new and existing customers declined, primarily as a result of competition from new and established competitors. These price reductions primarily impacted customers for which we deliver high volumes of traffic over our network, such as digital media customers. If we continue to experience decreases in unit prices for new and existing customers and we are unable to offset such reductions with increased traffic over our network or increased sales of value-added services to customers, our revenues and profit margins could decrease. • Historically, we have experienced seasonal variations in our quarterly revenues attributable to e-commerce services used by our retail customers, with higher revenues in the fourth quarter of the year and lower revenues during the summer months. If this trend continues, our ability to generate quarterly revenue growth on a sequential basis could be impacted.• In the first two quarters of 2011, we experienced a moderation in the rate of traffic growth in our volume-driven solutions as compared to the second half of 2010. If this trend continues, our ability to generate revenue growth could be impacted. • During the first two quarters of 2011, we reduced our network bandwidth costs per unit by entering into new supplier contracts with lower pricing and amending existing contracts to take advantage of price reductions offered by our existing suppliers. Additionally, we continued to invest in internal-use software development to improve the performance and efficiency of our network. Due to the increased traffic delivered over our network, our total bandwidth costs increased during the first two quarters of 2011 as compared to the same periods in 2010. We believe that our overall bandwidth costs will continue to increase as a result of expected higher traffic levels, partially offset by anticipated continued reductions in bandwidth costs per unit. If we do not experience lower per unit bandwidth pricing or we are unsuccessful at effectively routing traffic over our network through lower cost providers, total network bandwidth costs could increase more than expected during the remainder of 2011. • In recent quarters, we have seen co-location costs increase and become a higher percentage of total cost of revenues due to the expansion of our network. Continuation of this trend may negatively impact our profitability. • During each of the first two quarters of 2011, revenues derived from customers outside the United States accounted for 30% of our total revenues. For the remainder 2011, we anticipate revenues from such customers as a percentage of our total revenues to be consistent with each of the first two quarters. • Depreciation and amortization expense related to our network equipment and internal-use software development costs increased during each of the first two quarters of 2011 as compared to the same quarters in 2010. Due to expected future purchases of network equipment during 2011, we believe that depreciation expense, as well as co-location costs, related to our network equipment will continue to increase in 2011. We expect to continue to enhance and add functionality to our service offerings and capitalize stock-based compensation expense attributable to employees working on such projects, which would increase the amount of capitalized internal-use software costs. As a result, we believe that the amortization of internal-use software development costs, which we include in cost of revenues, will be higher in 2011 as compared to 2010. All of these increased costs could negatively affect our profitability. • For the three and six months ended June 30, 2011, our stock-based compensation expense was $11.6 million and $27.3 million, respectively, as compared to $20.3 million and $39.4 million, respectively, for the three and six months ended June 30, 2010. The decrease in stock-based compensation expense for the three and six months ended June 30, 2011 as compared to the same periods in 2010 was primarily due to management's assessment, as of June 30, 2011, that certain outstanding restricted stock units, or RSUs, with performance-based vesting conditions will not vest because the associated performance targets are unlikely to be met. We expect that stock-based compensation expense for 2011 will decrease as compared to 2010, related to this change in management's assessment of the expected vesting of the RSUs granted in prior periods. As of June 30, 2011, our total pre-tax unrecognized compensation costs for stock-based awards were $108.0 million, which we expect to recognize as expense over a weighted average period of 1.3 years through 2015. • As of June 30, 2011, we held $136.4 million in par value of auction rate securities, which we refer to as ARS. Based upon our cash, cash equivalents and marketable securities balance of $1.3 billion at June 30, 2011 and expected operating cash flows, we do not anticipate that the lack of liquidity associated with our ARS will adversely affect our ability to conduct business during the remainder of 2011. We believe we have the ability to hold these ARS until a recovery of the auction process, a buyer is found outside the auction process, the securities are called or refinanced by the issuer, or until maturity. • During the six months ended June 30, 2011, our effective income tax rate was 34.7%. We expect our annual effective income tax rate in 2011 to remain relatively consistent in the remaining quarters of 2011; this expectation does not take into consideration the effect of discrete items such as those relating to stock-based compensation. In 2010, due to our continued utilization of available net operating losses, or NOLs, and tax credit carryforwards, our tax payments were significantly lower than our recorded income tax provision. We expect to utilize substantially all of our tax credit 18-------------------------------------------------------------------------------- Table of Contents carryforwards in 2011. Once we have done so, the amount of cash tax payments we make will increase over those made in previous years. Based on our analysis of, among other things, the aforementioned trends and events, as of the date of this quarterly report on Form 10-Q, we expect to continue to generate net income on a quarterly and annual basis during 2011; however, our future results are likely to be affected by the factors discussed in the paragraphs above as well as those identified in the section captioned "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, including our ability to: • increase our revenue by adding customers through long-term contracts and limiting customer cancellations and terminations; • offset unit price declines for our services with higher volumes of traffic delivered on our network as well as increased sales of our value-added solutions; • prevent disruptions to our services and network due to accidents or intentional attacks; and • maintain our network bandwidth and co-location costs and other operating expenses consistent with our revenues. As a result, there is no assurance that we will achieve our expected financial objectives, including generating positive net income, in any future period. Our management's discussion and analysis of our financial condition and results of operations are based upon our unaudited consolidated financial statements included elsewhere in this quarterly report on Form 10-Q, which we have prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim periods and with Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended, or the Exchange Act. The preparation of these unaudited consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related items, including, but not limited to, revenue recognition, accounts receivable and related reserves, valuation and impairment of investments and marketable securities, goodwill and other intangible assets, capitalized internal-use software costs, impairment and useful lives of long-lived assets, tax reserves, loss contingencies and stock-based compensation costs. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time they are made. Actual results may differ from our estimates. See the section entitled "Application of Critical Accounting Policies and Estimates" in our annual report on Form 10-K for the year ended December 31, 2010 for further discussion of our critical accounting policies and estimates. Recent Accounting Pronouncements In December 2010, the Financial Accounting Standards Board ("FASB") issued an accounting standard update for business combinations specifically related to the disclosure of supplementary pro forma information for business combinations. This guidance specifies that pro forma disclosures should be reported as if the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period, and the pro forma disclosures must include a description of material, nonrecurring pro forma adjustments. This standard was effective for business combinations with an acquisition date of January 1, 2011 or later. The adoption of the guidance did not have an impact on our financial position or results of operations. In May 2011, the FASB issued amended guidance and disclosure requirements for fair value measurements. This guidance provides a consistent definition of fair value and ensures that the fair value measurement and disclosure requirements are similar between U.S. GAAP and international financial reporting standards. The guidance changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements. This standard will be effective for interim and annual periods beginning after December 15, 2011 and will be applied prospectively. The adoption of the guidance is not expected to have a material impact on our consolidated financial statements. In June 2011, the FASB issued amended disclosure requirements for the presentation of comprehensive income. The amended guidance eliminates the option to present components of other comprehensive income ("OCI") as part of the statement of changes in equity. Under the amended guidance, all changes in OCI are to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive financial statements. The changes will be effective January 1, 2012 and early adoption is permitted. There will be no impact on our consolidated financial results as the amendments relate only to changes in financial statement presentation. Results of Operations Revenues. Total revenues increased 13%, or $31.7 million to $277.0 million for the three months ended June 30, 2011 as compared to $245.3 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, revenues increased 14%, or $67.6 million, to $552.9 million as compared to $485.3 million for the six months ended June 30, 2010. The following 19-------------------------------------------------------------------------------- Table of Contents table quantifies the contribution to growth in revenues during the periods presented from the different industry verticals in which we sell our services (in millions): For the For the Three Months Ended Six Months Ended June 30, 2011 June 30, 2011 as compared to 2010 as compared to 2010Media & Entertainment $ 11.2 $ 26.3 Commerce 10.1 21.9 Enterprise 8.2 16.8 High Tech 0.6 (1.0 ) Public Sector 1.6 3.6 Total net increase $ 31.7 $ 67.6 A significant portion of the increase in revenues for the three and six months ended June 30, 2011 as compared to the same periods in 2010 was driven by traffic growth from customers in our media and entertainment vertical. The revenues from this traffic growth were partially offset by reduced prices charged to our customers. The increase in revenues from our commerce and enterprise customers was principally due to increased purchases of value-added services. Revenues from our high tech vertical remained relatively flat as increased demand for value-added solutions offset the decline in software download revenues. The increase in revenues from public sector customers was primarily attributable to entering into new contracts with government agencies. For each of the three and six month periods ended June 30, 2011 and 2010, approximately 30% and 28%, respectively, of our revenues were derived from our operations located outside of the United States, including 18% derived from Europe during each of the three and six month periods ended June 30, 2011 and June 30, 2010. No single country outside of the United States accounted for 10% or more of revenues during these periods. For each of the three and six month periods ended June 30, 2011 and 2010, resellers accounted for 19% of revenues. For each of the three and six month periods ended June 30, 2011 and 2010, no customer accounted for 10% or more of revenues. Cost of Revenues. Cost of revenues was comprised of the following (in millions) for the periods presented: For the Three Months For the Six Months Ended June 30, Ended June 30, 2011 2010 2011 2010 Bandwidth and service-related fees $ 19.7 $ 18.6 $ 41.7 $ 37.1 Co-location fees 32.6 22.7 62.6 43.0 Payroll and related costs of network operations personnel 3.6 3.3 7.4 6.4 Stock-based compensation, including amortization of prior capitalized amounts 2.5 2.5 5.1 5.1 Depreciation and impairment of network equipment 23.5 18.3 46.4 34.9 Amortization of internal-use software 7.7 6.4 15.5 12.8 Total cost of revenues $ 89.6 $ 71.8 $ 178.7 $ 139.3 Cost of revenues increased 25%, or $17.8 million, to $89.6 million for the three months ended June 30, 2011 as compared to $71.8 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, cost of revenues increased 28%, or $39.4 million, to $178.7 million as compared to $139.3 million for the six months ended June 30, 2010. This increase was primarily due to: • increases in co-location costs as we deployed more servers worldwide; • an increase in depreciation expense of network equipment and amortization of internal-use software as we continued to invest in our infrastructure; and • an increase in amounts paid to network providers for bandwidth due to higher traffic levels, partially offset by reduced bandwidth costs per unit. Cost of revenues during the three and six months ended June 30, 2011 also included credits received of approximately $1.6 million and $2.9 million, respectively, from settlements and renegotiated contracts entered into in connection with billing disputes related to bandwidth contracts. During the three and six months ended June 30, 2010, cost of revenues included similar credits of 20-------------------------------------------------------------------------------- Table of Contents approximately $1.1 million and $2.1 million, respectively. Credits of this nature may occur in the future; however, the timing and amount of future credits, if any, are unpredictable. We have long-term purchase commitments for bandwidth usage and co-location services with various network and Internet service providers. For the remainder of 2011 and for the years ending December 31, 2012, 2013 and 2014, we estimate that the minimum commitments related to bandwidth usage and co-location services under agreements currently in effect are approximately $52.9 million, $27.6 million, $2.1 million and $0.2 million, respectively. We believe that cost of revenues will increase during the remaining quarters of 2011 as compared to each of the first two quarters of 2011. We expect to deploy more servers and to deliver more traffic on our network, which would result in higher expenses associated with the increased traffic and co-location fees; however, such costs are likely to be partially offset by lower bandwidth costs per unit. Additionally, for the remainder of 2011, we anticipate increases in depreciation expense related to our network equipment and amortization of internal-use software development costs, along with increased payroll and related costs, as we continue to make investments in our network with the expectation that our customer base will continue to expand. Research and Development. Research and development expenses consist primarily of payroll and related costs and stock-based compensation expense for research and development personnel who design, develop, test and enhance our services and our network. Research and development costs are expensed as incurred, except certain internal-use software development costs eligible for capitalization. During the three and six months ended June 30, 2011, we capitalized software development costs of $9.4 million and $19.3 million, respectively, net of impairments. During the three and six months ended June 30, 2010, we capitalized software development costs of $7.2 million and $13.7 million, respectively, net of impairments. These development costs consisted of external consulting expenses and payroll and payroll-related costs for personnel involved in the development of internal-use software used to deliver our services and operate our network. Additionally, during the three and six months ended June 30, 2011, we capitalized $1.6 million and $3.4 million of stock-based compensation, respectively, as compared to $2.1 million and $3.5 million during the three and six months ended June 30, 2010, respectively. These capitalized internal-use software costs are amortized to cost of revenues over their estimated useful lives of two years. Research and development expenses decreased 19%, or $2.6 million, to $11.0 million for the three months ended June 30, 2011 as compared to $13.6 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, research and development expenses decreased 12%, or $3.2 million, to $23.6 million as compared to $26.8 million for the six months ended June 30, 2010. The decrease during the three and six months ended June 30, 2011 as compared to the same periods in 2010 was due to higher capitalized salaries and a decrease in stock-based compensation, partially offset by an increase in payroll and related costs as a result of headcount growth. The following table quantifies the changes in the various components of our research and development expenses for the periods presented (in millions): For the For the Three Months Ended Six Months Ended June 30, 2011 June 30, 2011 as compared to 2010 as compared to 2010 Payroll and related costs $ 1.5 $ 5.4 Stock-based compensation (1.4 ) (2.6 ) Capitalized salaries and other expenses (2.7 ) (6.0 ) Total net decrease $ (2.6 ) $ (3.2 ) We believe that research and development expenses, in absolute dollar terms, will increase in the remaining quarters of 2011 as compared to the first six months of 2011 because we expect to continue to hire additional development personnel in order to make improvements in our core technology, develop new services and make refinements to our existing service offerings. Sales and Marketing. Sales and marketing expenses consist primarily of payroll and related costs, stock-based compensation expense and commissions for personnel engaged in marketing, sales and support functions, as well as advertising and promotional expenses. Sales and marketing expenses decreased 4%, or $2.4 million, to $52.8 million for the three months ended June 30, 2011 as compared to $55.2 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, sales and marketing expenses increased 1%, or $1.3 million, to $106.2 million as compared to $104.9 million for the six months ended June 30, 2010. The decrease in sales and marketing expenses during the three months ended June 30, 2011 as compared to the same period in 2010 was primarily due to a decrease in stock-based compensation, partially offset by an increase in payroll and related costs. The increase in sales and marketing expenses during the six months ended June 30, 2011 as compared to the same period in 2010 was primarily due to an increase in payroll and related costs due to an increase in headcount, partially offset by a decrease in stock- 21-------------------------------------------------------------------------------- Table of Contents based compensation, as well as a decrease in marketing and related costs and other expenses, such as facility related costs. The following table quantifies the changes in the various components of our sales and marketing expenses for the periods presented (in millions): For the For the Three Months Ended Six Months Ended June 30, 2011 June 30, 2011 as compared to 2010 as compared to 2010 Payroll and related costs $ 2.1 $ 8.8 Stock-based compensation (3.5 ) (5.6 ) Marketing and related costs (0.5 ) (0.9 ) Other expenses (0.5 ) (1.0 ) Total net (decrease) increase $ (2.4 ) $ 1.3 We believe that sales and marketing expenses will increase, in absolute dollar terms, during the remaining quarters of 2011 as compared to the first two quarters of 2011 due to an expected increase in commissions on higher forecasted sales of our services and an increase in payroll and related costs due to continued headcount growth in our sales and marketing organization. General and Administrative. General and administrative expenses consist primarily of the following components: • payroll, stock-based compensation expense and other related costs, including expenses for executive, finance, business applications, network management, human resources and other administrative personnel; • depreciation and amortization of property and equipment we use internally; • fees for professional services; • rent and other facility-related expenditures for leased properties; • provision for doubtful accounts; • insurance costs; and • non-income related taxes. General and administrative expenses increased 5%, or $2.3 million, to $46.0 million for the three months ended June 30, 2011 as compared to $43.7 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, general and administrative expenses increased 8%, or $6.6 million, to $89.9 million as compared to $83.3 million for the six months ended June 30, 2010. The increase in general and administrative expenses for the three and six months ended June 30, 2011 as compared to the same periods in 2010 was primarily due to an increase in payroll and related costs as a result of headcount growth, facilities and related costs and legal fees. These increases were partially offset by reductions in stock-based compensation and consulting and advisory services expense. The following table quantifies the changes in various components of our general and administrative expenses for the periods presented (in millions): For the For the Three Months Ended Six Months Ended June 30, 2011 June 30, 2011 as compared to 2010 as compared to 2010 Payroll and related costs $ 0.6 $ 3.9 Stock-based compensation (3.7 ) (3.5 ) Depreciation and amortization (0.1 ) 0.1 Facilities-related costs 1.5 3.1 Provision for doubtful accounts 0.7 0.7 Legal fees 2.7 1.8 Non-income taxes 0.2 (0.7 ) Consulting and advisory services (0.2 ) (0.8 ) Other expenses 0.6 2.0 Total net increase $ 2.3 $ 6.6 During the remaining quarters of 2011, we expect general and administrative expenses to increase, in absolute dollar terms, 22-------------------------------------------------------------------------------- Table of Contents as compared to each of the first two quarters of 2011 due to anticipated higher payroll and related costs attributable to increased hiring as well as facilities and related costs. Amortization of Other Intangible Assets. Amortization of other intangible assets consists of amortization of intangible assets acquired in business combinations and amortization of acquired license rights. Amortization of other intangible assets increased 3%, or $0.1 million, to $4.3 million for the three months ended June 30, 2011 as compared to $4.2 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, amortization of other intangible assets increased 4%, or $0.3 million, to $8.6 million as compared to $8.3 million for the six months ended June 30, 2010. The increase in amortization of other intangible assets for the three and six months ended June 30, 2011 as compared to the same periods in 2010 was primarily due to the amortization of assets related to our acquisition of substantially all of the assets and liabilities of Velocitude during the second quarter of 2010. Based on our intangible assets at June 30, 2011, we expect amortization of other intangible assets to be approximately $8.3 million for the remainder of 2011, and $15.9 million, $13.1 million, $7.6 million and $5.1 million for fiscal years 2012, 2013, 2014 and 2015, respectively. Interest Income. Interest income includes interest earned on invested cash balances and marketable securities. Interest income decreased 7%, or $0.2 million, to $3.0 million for the three months ended June 30, 2011 as compared to $3.3 million for the three months ended June 30, 2010. For the six months ended June 30, 2011, interest income decreased 8%, or $0.5 million, to $6.0 million as compared to $6.5 million for the six months ended June 30, 2010. The decreases were due to lower interest rates earned on our investments during the comparable periods. Interest Expense. Interest expense includes interest paid on our debt obligations as well as amortization of deferred financing costs. Interest expense was $0.6 million and $1.3 million for the three and six months ended June 30, 2010, respectively. As of June 30, 2010, we had $63.6 million in principal amount of outstanding senior convertible notes. During the six months ended June 30, 2011, we had no outstanding indebtedness requiring the payment of interest. Other (Expense) Income, net. Other (expense) income, net primarily represents net foreign exchange gains and losses incurred, gains from legal settlements, and other non-operating (expense) income items. Other expense, net for the three months ended June 30, 2011 increased to $0.1 million as compared to $0.1 million of other income for the three months ended June 30, 2010. For the six months ended June 30, 2011, other expense, net was $1.1 million as compared to $47,000 of other income, net for the six months ended June 30, 2010. The increases in other expense, net for the three and six months ended June 30, 2011 as compared to the same periods in 2010 was primarily due to exchange rate fluctuations. Other expense, net may fluctuate in the future based upon movements in foreign exchange rates, the outcome of legal proceedings or other events. Loss on Early Extinguishment of Debt. During the three months ended June 30, 2010, we recorded a loss on early extinguishment of debt of $0.3 million as a result of the conversion of $136.2 million in principal amount of our 1% convertible notes into shares of our common stock. Provision for Income Taxes. For the six months ended June 30, 2011 and 2010, our effective income tax rate, including discrete items, was 34.7% and 38.3%, respectively. For the each of the three and six months ended June 30, 2011, the effective income tax rate was lower than the federal statutory tax rate mainly due to the composition of income in foreign jurisdictions. For each of the three and six month periods ended June 30, 2010, the effective income tax rate was higher than the federal statutory tax rate mainly due to the effects of accounting for stock-based compensation in accordance with the authoritative guidance for share-based payments, and state income tax expense. The effective income tax rate is based upon the estimated income for the year, the estimated composition of the income in different jurisdictions and discrete adjustments, if any, in the applicable quarterly periods, including settlements of tax audits or assessments, the resolution or identification of tax position uncertainties, and acquisitions of other companies. Provision for income taxes increased 33%, or $7.0 million, to $28.3 million for the three months ended June 30, 2011 as compared to $21.3 million for the three months ended June 30, 2010. Provision for income taxes increased 7%, or $3.3 million, to $52.4 million for the six months ended June 30, 2011 as compared to $49.1 million for the six months ended June 30, 2010. The increase in the three and six months ended June 30, 2011 as compared to the same periods in 2010 was mainly due to the increase in operating income partially offset by the lower effective income tax rate in 2011 as compared to 2010. While we expect our effective income tax rate for the remaining quarters of 2011 to remain relatively consistent with the year to date rate in the second quarter of 2011, this expectation does not take into consideration the effect of any potential discrete items to be recorded in the future. The effective tax rate could be materially different depending on the nature and timing of dispositions of incentive stock options and other employee equity awards. Further, our effective tax rate may fluctuate within a fiscal year and from quarter to quarter, due to items arising from discrete events, including settlements of tax audits and assessments, the resolution or identification of tax position uncertainties and acquisitions of other companies. In 2010, due to our continued utilization of available NOLs and tax credit carryforwards, our tax payments were significantly lower than our recorded income tax provision. We expect to utilize substantially all of our tax credit carryforwards in 2011. Once we have done so, the amount of cash tax payments we make will increase over those made in previous years. 23-------------------------------------------------------------------------------- Table of Contents In determining our net deferred tax assets and valuation allowances, annualized effective tax rates, and cash paid for income taxes, management is required to make judgments and estimates about domestic and foreign profitability, the timing and extent of the utilization of NOL carryforwards, applicable tax rates, transfer pricing methodologies and tax planning strategies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from our projections. We have recorded certain tax reserves to address potential exposures involving our income tax and sales and use tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different taxing jurisdictions. Our estimate of the value of these tax reserves reflects assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the ultimate tax liability or benefit from these matters may be materially greater or less than the amount that we have estimated. Non-GAAP Measures In addition to the traditional financial measurements that are reflected in our financial statements that have been prepared in accordance with GAAP, we also compile and monitor certain non-GAAP financial measures related to the performance of our business. We typically discuss the non-GAAP financial measures described below on our quarterly public earnings release calls. A "non-GAAP financial measure" is a numerical measure of a company's historical or future financial performance that excludes amounts that are included in the most directly comparable measure calculated and presented in the GAAP statement of operations. We believe that making available the non-GAAP financial measures described below helps investors to gain a meaningful understanding of our past performance and future prospects, especially when comparing such results to previous periods, forecasts or competitors' financial statements. Our management uses these non-GAAP measures, in addition to GAAP financial measures, as the basis for measuring our core operating performance and comparing such performance to that of prior periods and to the performance of our competitors. These measures are also used by management in its financial and operational decision-making. We consider normalized net income and normalized net income per diluted common share to be important indicators of our overall performance as they eliminate the effects of events that are either not part of our core operations or are non-cash. We define normalized net income as net income determined in accordance with GAAP excluding the following pre-tax items: amortization of other acquired intangible assets, stock-based compensation expense, stock-based compensation reflected as a component of amortization of capitalized internal-use software, restructuring charges and benefits, acquisition-related costs and benefits, certain gains and losses on investments and loss on early extinguishment of debt. These non-GAAP financial measures should be used in addition to and in conjunction with results presented in accordance with GAAP. The following table reconciles GAAP net income to normalized net income and normalized net income per diluted share for the periods presented: Unaudited For the Three Months For the Six Months Ended June 30, Ended June 30, 2011 2010 2011 2010 (in thousands, except per share data) Net income $ 47,921 $ 38,123 $ 98,538 $ 79,001 Amortization of other intangible assets 4,292 4,152 8,569 8,260 Stock-based compensation 11,612 20,276 27,324 39,384 Amortization of capitalized stock-based compensation 1,938 1,830 4,003 3,705 Loss on early extinguishment of debt - 294 - 294 Acquisition-related costs (benefits) - 345 (440 ) 345 Total normalized net income $ 65,763 $ 65,020 $ 137,994 $ 130,989 Normalized net income per diluted share $ 0.35 $ 0.34 $ 0.72 $ 0.69 Shares used in per share calculations 190,179 190,479 190,781 189,746 We consider Adjusted EBITDA to be another important indicator of our operational strength and the performance of our business and a good measure of our historical operating trend. Adjusted EBITDA eliminates items that are either not part of our core operations or do not require a cash outlay. We define Adjusted EBITDA as net income determined in accordance with GAAP excluding interest, income taxes, depreciation and amortization of tangible and intangible assets, stock-based compensation 24-------------------------------------------------------------------------------- Table of Contents expense, stock-based compensation reflected as a component of amortization of capitalized internal-use software, restructuring charges and benefits, acquisition-related costs and benefits, certain gains and losses on investments, foreign exchange gains and losses, loss on early extinguishment of debt, and gains or losses on legal settlements. The following table reconciles GAAP net income to Adjusted EBITDA for the periods presented: Unaudited For the Three Months For the Six Months Ended June 30, Ended June 30, 2011 2010 2011 2010 (in thousands) Net income $ 47,921 $ 38,123 $ 98,538 $ 79,001 Amortization of other intangible assets 4,292 4,152 8,569 8,260 Stock-based compensation 11,612 20,276 27,324 39,384 Amortization of capitalized stock-based compensation 1,938 1,830 4,003 3,705 Loss on early extinguishment of debt - 294 - 294 Acquisition-related costs (benefits) - 345 (440 ) 345 Interest income, net (3,096 ) (2,771 ) (6,056 ) (5,433 ) Provision for income taxes 28,300 21,315 52,356 49,074 Depreciation and amortization 35,103 28,692 69,895 55,669 Other loss (income), net 107 (122 ) 1,142 (47 ) Adjusted EBITDA $ 126,177 $ 112,134 $ 255,331 $ 230,252 Liquidity and Capital Resources To date, we have financed our operations primarily through public and private sales of debt and equity securities, proceeds from exercises of stock awards and cash generated by operations. As of June 30, 2011, our cash, cash equivalents and marketable securities, which consisted of corporate debt securities, U.S. Treasury and government agency securities, commercial paper, corporate debt securities, and student loan-backed ARS, totaled $1.3 billion. We place our cash investments in instruments that meet high credit quality standards, as specified in our investment policy. Our investment policy also limits the amount of our credit exposure to any one issue or issuer and seeks to manage these assets to achieve our goals of preserving principal, maintaining adequate liquidity at all times, and maximizing returns subject to our investment policy. As of June 30, 2011 and December 31, 2010, we held approximately $136.4 million and $150.8 million in par value of ARS. The ARS are primarily AAA-rated bonds, most of which are guaranteed by the U.S. government as part of the Federal Family Education Loan Program through the U.S. Department of Education. None of the ARS in our portfolio is mortgage-based or collateralized debt obligations. In mid-February 2008, all of our ARS experienced failed auctions, which failures continued throughout the period ended June 30, 2011. As a result, we have been unable to liquidate most of our holdings of ARS. Based on our ability to access our cash and other short-term investments, our expected operating cash flows, and our other sources of cash, we do not anticipate the current lack of liquidity on these investments to have a material impact on our financial condition or results of operations in 2011 or the foreseeable future. Net cash provided by operating activities was $200.4 million for the six months ended June 30, 2011, compared to $174.1 million for the six months ended June 30, 2010. The increase in cash provided by operating activities for the six months ended June 30, 2011 as compared to the same period in 2010 was primarily due to a reduction in cash used in working capital and an increase in net income, partially offset by a reduction in the provision for deferred income taxes. We expect that cash provided by operating activities will increase as a result of an expected increase in cash collections related to anticipated higher revenues, partially offset by an anticipated increase in operating expenses that require cash outlays such as salaries and higher commissions. Net cash used in investing activities was $156.2 million for the six months ended June 30, 2011, compared to $223.7 million for the six months ended June 30, 2010. Cash used in investing activities for the six months ended June 30, 2011 reflects net purchases of short- and long-term marketable securities of $67.0 million, and purchases of property and equipment of $89.0 million, including $20.5 million related to the capitalization of internal-use software development costs. Cash used in investing activities for the six months ended June 30, 2010 reflects net purchases of short- and long-term marketable securities of $110.0 million, 25-------------------------------------------------------------------------------- Table of Contents purchases of property and equipment of $101.3 million, including $14.8 million related to the capitalization of internal-use software development costs, cash paid for the acquisition of substantially all of the assets of Velocitude of $12.0 million, and an increase in other investments of $0.5 million. For fiscal year 2011, we expect total capital expenditures, a component of cash used in investing activities, to be approximately 16% of total revenues for the year, which reflects our plan to continue expansion of our network capacity to meet expected future traffic growth. We expect to fund such capital expenditures through cash generated from operations. Net cash used in financing activities was $73.1 million for the six months ended June 30, 2011, as compared to $8.7 million in net cash used in financing activities for the six months ended June 30, 2010. Cash used in financing activities during the six months ended June 30, 2011 consisted of $92.6 million related to a common stock repurchase program we initiated in April 2009 and extended in April 2010 as well as a new program implemented in April 2011, as described more fully below, as well as $3.5 million used for taxes paid related to net share settlements of equity awards. This was offset by cash provided by financing activities for the six months ended June 30, 2011 of $10.9 million related to excess tax benefits resulting from the exercise of stock options and vesting of RSUs and proceeds of $12.1 million from issuances of common stock upon exercises of stock options under our stock option plans and employee stock purchase plan. Cash used in financing activities during the six months ended June 30, 2010 consisted of $42.6 million related to our common stock repurchase program. This was offset by cash provided by financing activities during the six months ended June 30, 2010 of $12.9 million related to excess tax benefits resulting from the exercise of stock options and vesting of RSUs and proceeds of $21.0 million from issuances of common stock upon exercises of stock options under our stock option plans and employee stock purchase plan. Changes in cash, cash equivalents and marketable securities are dependent upon changes in, among other things, working capital items such as deferred revenues, accounts payable, accounts receivable and various accrued expenses, as well as changes in our capital and financial structure due to debt repurchases and issuances, stock option exercises, purchases and sales of equity investments and similar events. The following table presents the net inflows and outflows of cash, cash equivalents and marketable securities for the periods presented (in millions): For the Six Months Ended June 30, 2011 2010 Cash, cash equivalents and marketable securities balance as of December 31, 2010 and 2009, respectively $ 1,243.4 $ 1,061.5 Changes in cash, cash equivalents and marketable securities: Receipts from customers 570.1 486.7 Payments to vendors (302.3 ) (287.1 ) Payments for employee payroll (160.7 ) (126.3 ) Debt interest and premium payments - (1.0 ) Stock option exercises and employee stock purchase plan issuances 12.1 21.0 Cash used in business acquisition (0.6 ) (12.0 ) Employee taxes paid related to net share settlement of equity awards (3.5 ) - Common stock repurchases (92.6 ) (42.6 ) Realized and unrealized gains on marketable investments and other investment-related assets, net 2.8 4.2 Interest income 6.0 6.5 Other 10.8 1.4 Net increase 42.1 50.8 Cash, cash equivalents and marketable securities balance as of June 30, 2011 and 2010, respectively $ 1,285.5 $ 1,112.3 On April 29, 2009, we announced that our Board of Directors had authorized a one-year stock repurchase program permitting purchases of up to $100.0 million of our common stock from time to time on the open market or in privately-negotiated transactions. In April 2010, the Board of Directors authorized a $150.0 million, one-year extension of such stock repurchase program. In April 2011, the Board of Directors authorized a second, one-year $150.0 million stock repurchase program that began in May 2011. On August 8, 2011, the Company's Board of Directors authorized an additional $250.0 million of stock repurchases over the twelve 26-------------------------------------------------------------------------------- Table of Contents month period that commenced in May 2011. The total authorized funding for stock repurchases in that twelve month period is now $400.0 million. Unused amounts from the prior year's authorization were not carried over to the new program. During the six months ended June 30, 2011, we repurchased 2.6 million shares of common stock for an aggregate of $93.3 million at an average price of $36.39 per share. During the six months ended June 30, 2010, we repurchased 1.4 million shares of common stock for an aggregate of $42.3 million at an average price of $30.87 per share. The timing and amount of any future share repurchases will be determined by our management based on its evaluation of market conditions and other factors. Repurchases may also be made under a Rule 10b5-1 plan, which would permit us to repurchase shares when we might otherwise be precluded from doing so under insider trading laws. Subject to applicable securities laws requirements, we may choose to suspend or discontinue the repurchase program at any time. Any purchases made under the program will be reflected as an increase in cash used in financing activities. See Item 2 of Part II of this quarterly report on Form 10-Q for more detailed information about our repurchases. We believe, based on our present business plan, that our current cash, cash equivalents and marketable securities and forecasted cash flows from operations will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next 24 months. If the assumptions underlying our business plan regarding future revenue and expenses change, if we are unable to liquidate our marketable securities, or if unexpected opportunities or needs arise, we may seek to raise additional cash by selling equity or debt securities. We may not, however, be able to sell equity or debt securities on terms we consider reasonable, or at all. If additional funds are raised through the issuance of equity or debt securities, these securities could have rights, preferences and privileges senior to those accruing to holders of common stock, and the terms of any such debt could impose restrictions on our operations. The sale of additional equity or convertible debt securities could result in additional dilution to our existing stockholders. See "Risk Factors" in Item 1A of Part II of this quarterly report on Form 10-Q for a discussion of additional factors that could affect our liquidity. Contractual Obligations, Contingent Liabilities and Commercial Commitments The following table presents our contractual obligations and commercial commitments, as of June 30, 2011, for the next five years and thereafter (in millions): |