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BLACKBAUD INC - 10-Q - Management's discussion and analysis of financial condition and results of operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements reflect our current view with respect to future events and financial performance and are subject to risks and uncertainties, including those set forth under "Cautionary statement" included in this "Management's discussion and analysis of financial condition and results of operations" and elsewhere in this report, that could cause actual results to differ materially from historical or anticipated results. Executive summary We are the leading global provider of software and related services designed specifically for nonprofit organizations. Our products and services enable nonprofit organizations to increase donations, reduce fundraising costs, improve communications with constituents, manage finances and optimize internal operations. We have focused solely on the nonprofit market since our incorporation in 1982 and have developed our suite of products and services based upon our extensive knowledge of the operating challenges facing nonprofit organizations. As of June 30, 2011, we had approximately 24,000 active customers. Our customers operate in multiple verticals within the nonprofit market, including education, foundations, health and human services, religion, arts and cultural, public and societal benefits, environment and animal welfare and international foreign affairs. We derive revenue from selling perpetual licenses or charging for the use of our software products in a hosted environment and providing a broad offering of services, including consulting, training, installation and implementation, as well as ongoing customer support and maintenance. Consulting, training and implementation services are generally not essential to the functionality of our software products and are sold separately. Furthermore, we derive revenue from providing hosting services, performing donor prospect research engagements, selling lists of potential donors, and providing benchmarking studies and data modeling services. Overall, revenue for the second quarter of 2011 and the first six months of 2011 increased 16% and 15% compared to the same periods in 2010, respectively. When removing the impact of foreign currency translation and revenue from acquired companies, revenue increased by approximately 12% for both the second quarter of 2011 and the first six months of 2011 when compared to the same periods in 2010. These increases resulted from continued growth in our subscription revenue, principally attributable to increased demand for our hosting services, online fundraising and data management offerings and the shift in our business towards hosted solutions. Also contributing to the growth in revenue is an increase in our services revenue, which is primarily due to an increase in volume of consulting and training services provided. We continue to experience declines in revenue associated with our core perpetual license offerings as a result of the continuing decreases in sales of our perpetual license offerings to the mid-market customer base, which is principally the result of customers opting to purchase our solutions under alternative packaging with more flexible subscription-based pricing. We believe this trend will continue in the future. Income from operations for the second quarter of 2011 and the first six months of 2011 increased by $2.6 million and $3.2 million, respectively, when compared to the same periods in 2010. The increase in income from operations is primarily attributable to growth in revenue, partially offset by (1) acquisition-related costs, (2) an increase in stock-based compensation expense and (3) an increase in sales and marketing and general and administrative expenses. The increase in these expenses is principally attributable to merit-based salary increases, an increase in commission expense associated with higher commissionable revenue and an increase in marketing costs associated with the launch of our new corporate branding and newly packaged offerings. We ended the second quarter of 2011 with cash and cash equivalents totaling $33.4 million and no outstanding borrowings on our credit facility. During the first six months of 2011, we generated $37.8 million in cash flow from operations, of which we used $16.5 million to acquire a business, $10.7 million to pay dividends and $7.7 to purchase software and computer equipment. While we have experienced growth in revenue as our market has stabilized, we continue to believe the pace and impact of economic recovery on the nonprofit market remains uncertain. We expect that our existing and prospective customers will remain cautious in their expenditure decisions for the remainder of 2011. Notwithstanding these conditions, we remain focused on execution, investing in our key growth initiatives, 17 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) strengthening our leadership position and carefully managing our costs and expenses to achieve our targeted level of profitability. Results of operations Comparison of the three and six months ended June 30, 2011 and 2010 We completed the acquisition of Public Interest Data, Inc., or PIDI, on February 1, 2011. We have included PIDI's results of operations in our consolidated results of operations from the date of acquisition, which impacts the comparability of our results of operations. We have noted in the discussion below, to the extent meaningful, the impact on the comparability of our consolidated results of operations due to the inclusion of PIDI. During the first six months of 2011, PIDI's total revenue was $3.6 million, cost of revenue was $2.2 million and operating expenses was $0.1 million. Revenue The table below compares revenue from our statements of operations for the three and six months ended June 30, 2011 with the same period in 2010. Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change License fees $ 5.1 $ 7.0 $ (1.9) (27 )% $ 9.7 $ 12.1 $ (2.4) (20 )% Subscriptions 25.9 20.4 5.5 27 % 51.4 39.6 11.8 30 % Services 28.0 20.9 7.1 34 % 52.0 41.0 11.0 27 % Maintenance 32.6 30.9 1.7 6 % 64.4 61.5 2.9 5 % Other 1.8 1.5 0.3 20 % 3.2 2.7 0.5 19 % Total revenue $ 93.4 $ 80.7 $ 12.7 16 % $ 180.7 $ 156.9 $ 23.8 15 % Total revenue increased 16% and 15% in the second quarter of 2011 and in the first six months of 2011 when compared to the same periods in 2010. When removing the impact of revenue from PIDI, revenue increased by 13% for both the second quarter of 2011 and the first six months of 2011 when compared to the same periods in 2010. The increase in revenue is primarily attributable to growth in our subscriptions and services revenue. The increase in subscriptions revenue is primarily due to an increase in demand for our hosting services, online fundraising and data management offerings. The growth in revenue from our subscription offerings is also a result of the ongoing evolution of our product offerings from traditional perpetual license-based arrangements with upfront payments to subscription-based offerings with more flexible pricing and payments. Services revenue grew principally due to an increase in the volume of consulting services associated with implementation engagements of Blackbaud Enterprise CRM. The increase in maintenance revenue is primarily attributable to new maintenance contracts associated with new license agreements and increases in contracts with existing customers when compared to the same periods in 2010. The decrease in license fees is principally attributable to the continued shift in our customers' buying preference away from traditional perpetual license-based arrangements with upfront payments to offerings with subscription-based payment arrangements. Operating results The operating results analyzed below are presented on a non-GAAP basis: the results exclude the impact of stock-based compensation expense, amortization of intangibles arising from business combinations, gain on the sale of assets and acquisition-related expenses incurred in connection with our 2011 acquisition of PIDI because, in managing our operations, we believe that the exclusion of these costs allows us to better understand and manage our operating expenses and cash needs. These excluded costs are analyzed separately following the discussion of operating expenses. 18 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) License fees Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change License fee revenue $ 5.1 $ 7.0 $ (1.9) (27)% $ 9.7 $ 12.1 $ (2.4 ) (20)% Controllable cost of license fees 0.9 0.9 - 0% 1.5 1.4 0.1 7% License fee gross profit $ 4.2 $ 6.1 $ (1.9) (31)% $ 8.2 $ 10.7 $ (2.5 ) (23)% License fee gross margin 82% 87% 85% 88% Revenue from license fees is derived from the sale of our software products under a perpetual license agreement. We continue to experience a shift in our customers' buying preference away from solutions offered under perpetual license arrangements with upfront payments to offerings with subscription-based payment arrangements. Additionally, we continue to experience longer sales cycle times, delays and postponements of purchasing decisions and overall caution exercised by existing and prospective customers as a result of continued challenges posed by the economic environment. During the second quarter of 2011, revenue from license fees to existing customers remained unchanged and sales to new customers decreased by $1.9 million when compared to the same period in 2010. During the first six months of 2011, revenue from license fees to existing customers slightly increased and sales to new customers decreased by $2.4 million when compared to the same period in 2010. Direct controllable cost of license fees is principally comprised of third-party software royalties and variable reseller commissions. Cost of license fees in the second quarter of 2011 compared to the same period in 2010 remained unchanged. The increase in cost of license fees in the first six months of 2011 compared to the same period in 2010 is primarily attributable to higher reseller commissions. Reseller commissions have increased due to the increase in use of resellers during the first six months of 2011 when compared to the same period in 2010. The decrease in license fee gross margin in the second quarter of 2011 and the first six months of 2011 when compared to the same periods in 2010 is the result of an increase in the mix of license revenue for which we paid variable reseller commissions during 2011. Subscriptions Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Subscriptions revenue $ 25.9 $ 20.4 $ 5.5 27% $ 51.4 $ 39.6 $ 11.8 30% Controllable cost of subscriptions 9.4 6.8 2.6 38% 17.7 13.1 4.6 35% Subscriptions gross profit $ 16.5 $ 13.6 $ 2.9 21% $ 33.7 $ 26.5 $ 7.2 27% Subscriptions gross margin 64% 67% 66% 67% Revenue from subscriptions is principally comprised of revenue from providing access to hosted applications and hosting services, access to certain data services and our online subscription training offerings, and variable transaction fees associated with the use of our products to fundraise online. We continue to experience growth in our hosted applications business and are increasingly experiencing a shift in our customers' buying preference away from traditional perpetual licenses arrangements with upfront payment terms towards subscription based-offerings with more flexible pricing and payments. Additionally, revenue from our hosting services continues to increase as demand for these services continues to grow from both our existing and new perpetual license customers. Included in subscriptions revenue for the second quarter of 2011 is $1.6 million of revenue attributable to the inclusion of PIDI. Excluding the revenue from PIDI, the increase in subscriptions revenue of $3.9 million, or 19%, is principally attributable to the increase in demand for hosting services, online fundraising and data management offerings. Included in subscriptions revenue for the first six months of 2011 is $2.7 million of revenue attributable to the inclusion of PIDI and an out-of-period adjustment of $1.7 million, which increased subscriptions revenue in the first quarter 2011, related to our accounting for subscription-based offerings that were earned in prior periods. Excluding the revenue from PIDI and the out-of-period adjustment, the increase in subscriptions revenue of $7.4 million, or 19%, is principally attributable to the increase in demand for hosting services, online fundraising and data management offerings. Controllable cost of subscriptions is primarily comprised of human resource costs, third-party royalty and data expenses, hosting expenses, an allocation of depreciation, facilities and IT support costs and other costs incurred in 19-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) providing support and services to our customers. The increase in cost of subscriptions in the second quarter of 2011 and in the first six months of 2011 compared to the same periods in 2010 is principally attributable to an increase in headcount and investments we are making in our infrastructure to support the growth in our subscription offerings. Human resource costs increased $1.9 million and $3.3 million in the second quarter of 2011 and the first six months of 2011, respectively, compared to the same periods in 2010 as a result of the increase in headcount. Additional headcount due to the inclusion of PIDI represented approximately $0.8 million and $1.4 million of the increase in human resource costs for the second quarter of 2011 and the first six months of 2011, respectively. The remaining increase in headcount is due to additional resources needed to support the continued growth in this area. The remaining increase in cost of subscriptions is due to an increase in data center operating costs. The decrease in subscriptions gross margin in the second quarter of 2011 and the first six months of 2011 compared to the same periods in 2010 is due to an increase in the investments we are making in the infrastructure to support the growth in our subscriptions offerings. Services Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Services revenue $ 28.0 $ 20.9 $ 7.1 34% $ 52.0 $ 41.0 $ 11.0 27% Controllable cost of services 19.4 15.1 4.3 28% 37.5 30.2 7.3 24% Services gross profit $ 8.6 $ 5.8 $ 2.8 48% $ 14.5 $ 10.8 $ 3.7 34% Services gross margin 31% 28% 28% 26% Services revenue consists of consulting, installation, implementation, education and analytic services. Consulting, installation and implementation services involve converting data from a customer's existing system, assistance in file set up and system configuration, and/or process re-engineering. Education services involve customer training activities. Analytic services are comprised of donor prospect research, selling lists of potential donors, benchmarking studies and data modeling services. These services involve the assessment of current and prospective donor information of the customer and are performed using our proprietary analytical tools. The end product enables organizations to more effectively target their fundraising activities. We recognize services revenue attributable to consulting services for implementation of our hosted applications and subscription offerings ratably over the related term of the hosting or subscription arrangement. We also recognize the direct and incremental costs associated with consulting services revenue ratably over the service period. However, we continue to expense indirect costs in the period the cost is incurred. Included in services revenue for the second quarter of 2011 is $0.5 million of revenue attributable to the inclusion of PIDI. Excluding the revenue from PIDI, the increase in services revenue of $6.6 million, or 32%, is attributable to increases in consulting services revenue of $5.2 million, analytic services revenue of $0.8 million and education services revenue of $0.6 million. The increase in consulting services revenue is principally attributable to an increase in the volume of consulting, installation and implementation services associated with our Blackbaud Enterprise CRM product offering. The rates we charge for our education and analytic services offerings have remained relatively constant year over year and, as such, the increase in revenue is principally the result of an increase in the volume of services provided. Included in services revenue for the first six months of 2011 is $0.9 million of revenue attributable to the inclusion of PIDI. Excluding the revenue from PIDI, the increase in services revenue of $10.1 million, or 25%, is attributable to increases in consulting services revenue of $8.7 million, analytic services revenue of $1.0 million and education services revenue of $1.2 million, partially offset by an out-of-period adjustment recorded in the first quarter of 2011 of $0.8 million which reduced consulting services revenue. The increase in consulting services revenue is principally attributable to an increase in the volume of consulting, installation and implementation services associated with our Blackbaud Enterprise CRM product offering, which was partially offset by a reduction in the effective rates we charge as a result of a higher level of discounts offered on our consulting services during 2010. The rates we charge for our education and analytic services offerings have remained relatively constant year over year and, as such, the increase in revenue is principally the result of an increase in the volume of services provided. Controllable cost of services is principally comprised of human resource costs, third-party contractor expenses, classroom rentals, other costs incurred in providing consulting, installation and implementation services and customer training, data expense incurred to perform analytic services and an allocation of depreciation, facilities and IT support costs. The increase in cost of services in the second quarter of 2011 and first six months of 2011 when compared to the same periods in 2010 is primarily attributable to an increase in human resource and third-party 20-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) contractor costs, which was driven by the need for additional resource capacity to meet the increasing demand for consulting services. Additionally, we continue to experience a shift in the mix of consultants to meet the needs of our enterprise customers, which require a higher level of skilled resources that carry a higher cost. The services gross margin increased in the second quarter of 2011 and the first six months of 2011 compared to the same periods in 2010 primarily as a result of an increase in demand for consulting services associated with our Blackbaud Enterprise CRM offering and a shift in the mix of consulting engagements to higher margin projects. Maintenance Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Maintenance revenue $ 32.6 $ 30.9 $ 1.7 6% $ 64.4 $ 61.5 $ 2.9 5% Controllable cost of maintenance 5.6 5.4 0.2 4% 11.4 10.7 0.7 7% Maintenance gross profit $ 27.0 $ 25.5 $ 1.5 6% $ 53.0 $ 50.8 $ 2.2 4% Maintenance gross margin 83% 83% 82% 83% Revenue from maintenance is comprised of annual fees derived from maintenance contracts associated with new software licenses and annual renewals of existing maintenance contracts. These contracts provide customers with updates, enhancements and upgrades to our software products and online, telephone and email support. The increase in maintenance revenue of $1.7 million in the second quarter of 2011 compared to the same period in 2010 is principally comprised of $2.5 million of maintenance with new customers associated with new license agreements and increases in contracts with existing customers and $0.9 million from maintenance contract inflationary rate adjustments, offset by $1.7 million from maintenance contracts that were not renewed. The increase in maintenance revenue of $2.9 million in the first six months of 2011 compared to the same period in 2010 is principally comprised of $4.0 million of maintenance with new customers associated with new license agreements and increases in contracts with existing customers and $1.9 million from maintenance contract inflationary rate adjustments, offset by $3.0 million from maintenance contracts that were not renewed. Controllable cost of maintenance is primarily comprised of human resource costs, third-party contractor expenses, third-party royalty costs, an allocation of depreciation, facilities and IT support costs and other costs incurred in providing support and services to our customers. The increase in cost of maintenance in the second quarter of 2011 and the first six months of 2011 compared to the same periods in 2010 is principally attributable to an increase in human resource costs. Human resource costs increased due to merit-based salary increases, an increase in headcount and a change in the mix of support resources. Headcount increased due to an increase in volume of our new maintenance contracts and increases in our existing maintenance customer contracts. Additionally, we continue to experience a shift in the mix of support resources to the meet the needs of our enterprise customers, which require a higher level of skilled resources that carry a higher cost. The decrease in maintenance gross margin in the first six months of 2011 compared to the same period in 2010 is due to the shift in the mix of support resources to more highly skilled resources. Other revenue Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Other revenue $ 1.8 $ 1.5 $ 0.3 20% $ 3.2 $ 2.7 $ 0.5 19% Controllable cost of other revenue 1.4 1.3 0.1 8% 2.5 2.5 - 0% Other gross profit $ 0.4 $ 0.2 $ 0.2 100% $ 0.7 $ 0.2 $ 0.5 250% Other gross margin 22% 13% 22% 7% Other revenue includes the sale of business forms that are used in conjunction with our software products, reimbursement of travel-related expenses, primarily incurred during the performance of services at customer locations, fees from user conferences and third party software referral fees. Other revenue increased in the second quarter of 2011 and the first six months of 2011 when compared to the same periods in 2010 primarily due to an increase in revenue from third party software referral fees. 21 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) Controllable cost of other revenue includes human resource costs, costs of business forms, costs of user conferences, reimbursable expenses relating to the performance of services at customer locations and an allocation of depreciation, facilities and IT support costs. The increase in other gross margin is due to the increase in revenue from third party software referral fees. The following schedule reconciles non-GAAP gross profit discussed above to gross profit as presented on the statement of operations: Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change License fees $ 4.2 $ 6.1 $ (1.9 ) (31)% $ 8.2 $ 10.7 $ (2.5 ) (23)% Subscriptions 16.5 13.6 2.9 21% 33.7 26.5 7.2 27% Services 8.6 5.8 2.8 48% 14.5 10.8 3.7 34% Maintenance 27.0 25.5 1.5 6% 53.0 50.8 2.2 4% Other 0.4 0.2 0.2 100% 0.7 0.2 0.5 250% Total non-GAAP gross profit $ 56.7 $ 51.2 $ 5.5 11% $ 110.1 $ 99.0 $ 11.1 11% Less corporate costs not allocated: Stock-based compensation expense 0.8 0.7 0.1 14% 1.6 1.4 0.2 14% Amortization of intangible assets acquired in business combinations 1.6 1.5 0.1 7% 3.2 3.0 0.2 7% Gross profit as stated in statements of operations $ 54.3 $ 49.0 $ 5.3 11% $ 105.3 $ 94.6 $ 10.7 11% Gross margin % 58% 61% 58% 60% Operating expenses Sales and marketing Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Sales and marketing expense excluding stock-based compensation $ 18.8 $ 18.7 $ 0.1 1% $ 37.8 $ 34.7 $ 3.1 9% Add: Stock-based compensation expense 0.3 0.3 - 0% 0.6 0.7 (0.1 ) (14)% Sales and marketing expense $ 19.1 $ 19.0 $ 0.1 1% $ 38.4 $ 35.4 $ 3.0 8% % of revenue (excluding stock-based compensation) 20% 23% 21% 22% Sales and marketing expense includes salaries and related human resource costs, travel-related expenses, sales commissions, advertising and marketing materials, public relations and an allocation of depreciation, facilities and IT support costs. Sales and marketing expense in the second quarter of 2011 compared to the same period in 2010 increased by $0.1 million. During second quarter 2010, we recorded an out-of-period adjustment of $0.8 million related to our accounting for deferred sales commissions. Excluding the out-of-period adjustment, sales and marketing expense increased $0.9 million, largely due to an increase in human resource costs as a result of additional headcount. Excluding the out-of-period adjustment discussed above, sales and marketing expense in the first six months of 2011 compared to the same period in 2010 increased by $3.9 million, principally due to an increase of $1.6 million in commission expense and $1.7 million in human resource costs. The increase in commission expense is principally attributable to higher commission rates and an increase in commissionable sales and revenue in 2011. Human resources costs increased due to additional headcount. Additionally, marketing programs related costs increased by $0.6 million. The increase in marketing programs related costs is principally attributable to the launch of our new corporate branding and an increase in marketing costs associated with our newly packaged offerings. The decrease in sales and marketing expense as a percentage of revenue in the second quarter of 2011 and first six months of 2011 when compared to the same periods in 2010 is principally due to the out-of-period adjustment recorded in 2010. 22 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) Research and development Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Research and development expense excluding stock-based compensation $ 11.4 $ 11.0 $ 0.4 4% $ 22.5 $ 21.2 $ 1.3 6% Add: Stock-based compensation 0.6 0.7 (0.1 ) (14)% 1.5 1.4 0.1 7% Research and development expense $ 12.0 $ 11.7 $ 0.3 3% $ 24.0 $ 22.6 $ 1.4 6% % of revenue (excluding stock-based compensation) 12% 14% 12% 14% Research and development expenses include human resource costs, third-party contractor expenses, software development tools and other expenses related to developing new products, upgrading and enhancing existing products and an allocation of depreciation, facilities and IT support costs. During the second quarter of 2011 and the first six months of 2011, the increase in research and development costs is principally attributable to an increase in human resource costs resulting from the ongoing investment we are making in our products. General and administrative Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change General and administrative expense excluding stock-based compensation, acquisition-related costs and gain on sale of assets $ 7.4 $ 5.7 $ 1.7 30% $ 14.3 $ 12.7 $ 1.6 13% Add: Acquisition-related costs - - - - % 1.0 - 1.0 - % Add: Gain on sale of assets - - - - % (0.5 ) - (0.5 ) - % Add: Stock-based compensation 1.8 1.2 0.6 50% 3.6 2.6 1.0 38% General and administrative expense $ 9.2 $ 6.9 $ 2.3 33% $ 18.4 $ 15.3 $ 3.1 20% % of revenue (excluding stock-based compensation) 8% 7% 8% 8% General and administrative expense consists primarily of human resource costs for general corporate functions, including senior management, finance, accounting, legal, human resources, corporate development, third-party professional fees, insurance, an allocation of depreciation, facilities and IT support costs, and other administrative expenses. During the second quarter of 2011 and the first six months of 2011 compared to the same periods in 2010, the increase in general and administrative expense and the increase in general and administrative costs as a percentage of revenue was principally attributable to an increase in human resource costs due to merit-based salary increases, higher health benefit costs and an increase in bonus expense. Stock-based compensation We recognize compensation expense related to stock-based awards granted to employees. We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the requisite service period, which is the vesting period. 23-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) Our consolidated statements of operations for the three and six months ended June 30, 2011 and 2010 include the amounts of stock-based compensation illustrated below: Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Included in cost of revenue: Cost of subscriptions $ 0.2 $ 0.1 $ 0.1 100% $ 0.3 $ 0.2 $ 0.1 50% Cost of services 0.5 0.4 0.1 25% 0.9 0.8 0.1 13% Cost of maintenance 0.1 0.2 (0.1) (50)% 0.4 0.4 - - % Total included in cost of revenue 0.8 0.7 0.1 14% 1.6 1.4 0.2 14% Included in operating expenses: Sales and marketing 0.3 0.3 - 0% 0.6 0.7 (0.1) (14)% Research and development 0.6 0.7 (0.1) (14)% 1.5 1.4 0.1 7% General and administrative 1.8 1.2 0.6 50% 3.6 2.6 1.0 38% Total included in operating expenses 2.7 2.2 0.5 23% 5.7 4.7 1.0 21% Total $ 3.5 $ 2.9 $ 0.6 21% $ 7.3 $ 6.1 $ 1.2 20% Stock-based compensation is comprised of expense from restricted stock, performance-based restricted stock units and stock appreciation rights. The table below summarizes the stock-based compensation by award type for the three and six months ended June 30, 2011 and 2010. Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Stock-based compensation from: Restricted stock $ 2.4 $ 2.1 $ 0.3 14% $ 4.8 $ 4.4 $ 0.4 9% Performance-based restricted stock units 0.1 - 0.1 - % 0.4 - 0.4 - % Stock appreciation rights 1.0 0.8 0.2 25% 2.1 1.7 0.4 24% Total stock-based compensation $ 3.5 $ 2.9 $ 0.6 21% $ 7.3 $ 6.1 $ 1.2 20% Stock-based compensation expense increased in the second quarter of 2011 and the first six months of 2011 compared to the same periods in 2010 due to additional grants in the second half of 2010, partially offset by the vesting of grants issued in prior years. The total amount of compensation costs related to non-vested awards not yet recognized was $27.4 million as of June 30, 2011. This amount will be recognized as expense over a weighted average period of 1.7 years. Amortization We allocated amortization expense to cost of revenue based on the nature of the respective identifiable intangible asset and whether the asset is directly associated with a specific component of revenue. Amortization expense included in our consolidated statements of operations for the three and six months ended June 30, 2011 and 2010 is illustrated below: Three months ended June 30, Six months ended June 30, (in millions) 2011 2010 Change % Change 2011 2010 Change % Change Included in cost of revenue: Cost of license fees $ 0.1 $ 0.1 $ - 0% $ 0.3 $ 0.2 $ 0.1 50% Cost of subscriptions 0.8 0.8 - 0% 1.6 1.5 0.1 7 % Cost of services 0.4 0.3 0.1 33% 0.8 0.7 0.1 14% Cost of maintenance 0.3 0.3 - 0% 0.5 0.6 (0.1) (17)% Cost of other revenue - - - -% - - - - % Total included in cost of revenue 1.6 1.5 0.1 7% 3.2 3.0 0.2 7 % Included in operating expenses 0.2 0.2 - 0% 0.5 0.4 0.1 25% Total $ 1.8 $ 1.7 $ 0.1 6% $ 3.7 $ 3.4 $ 0.3 $ 9% Acquisition-related costs 24 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) During the first six months of 2011, we expensed $1.0 million of acquisition-related costs, in connection with the acquisition of PIDI, which were recorded in general and administrative expense. There were no similar expenses in the first six months of 2010. Gain on sale of assets During the first six months of 2011, we recognized a gain of $0.5 million from the sale of intangible assets, which was recorded as a reduction of general and administrative expense. There was no similar transaction in the first six months of 2010. Income tax provision The estimated annual effective tax rate for 2011 is 36.5%, which excludes period-specific items. Following is our effective tax rate, including the effects of period-specific items, for the three and six months ended June 30: Three months Six months ended June 30, ended June 30, 2011 2010 2011 2010 Effective tax rate 36.1% 37.8% 32.2% 38.0% Period-specific items recorded in the six months ended June 30, 2011 included a decrease of $1.0 million in the valuation allowance for certain state net operating loss carryforwards, which reduced income tax expense. There were no material period-specific items recorded in the three months ended June 30, 2011 or the three and six months ended June 30, 2010. Our deferred tax assets and liabilities are recorded at an amount based upon a U.S. federal income tax rate of 35.0% and appropriate statutory tax rates of various foreign, state and local jurisdictions in which we operate. If our tax rates change in the future, we will adjust our deferred tax assets and liabilities to an amount reflecting those income tax rates. Any change will affect the provision for income taxes during the period in which the determination is made. The amount of unrecognized tax benefit that, if recognized, would favorably affect our effective rate as of June 30, 2011 was $1.5 million. We have taken positions in certain taxing jurisdictions related to state nexus issues for which it is reasonably possible that the total amount of unrecognized tax benefits may decrease within the next twelve months. The possible decrease could result from the finalization of state income tax reviews and the expiration of statutes of limitations. The reasonably possible decrease was not material at June 30, 2011. Liquidity and capital resources At June 30, 2011, cash and cash equivalents totaled $33.4 million, compared to $28.0 million at December 31, 2010. The $5.4 million increase in cash and cash equivalents during the first six months of 2011 is principally the result of cash generated from operations of $37.8 million, of which $16.5 million was used to acquire a business, $10.7 million to pay dividends and $7.7 to purchase software and computer equipment. Our principal source of liquidity is our operating cash flow, which depends on continued customer renewal of our maintenance, support and subscription agreements and market acceptance of our products and services. Based on current estimates of revenue and expenses, we believe that the currently available sources of funds and anticipated cash flows from operations will be adequate for at least the next twelve months to finance our operations, fund anticipated capital expenditures and pay dividends. Dividend payments are not guaranteed and our Board of Directors may decide, in its absolute discretion, at any time and for any reason, not to declare or pay further dividends and/or repurchase our common stock. We have drawn on our credit facility from time to time to help us meet short-term financial needs, such as business acquisitions and purchase of common stock under our repurchase program. In June 2011, we entered into a new five-year $125.0 million credit facility which replaced our previous $90.0 million credit facility that was to mature in July 2012. Under the new credit facility we have three options to increase the aggregate amount available by up to $75.0 million. At June 30, 2011, we had no outstanding borrowings under our credit facility. We believe our cash on hand, cash generated from operations and our credit facility provides us with sufficient flexibility to meet our financial needs. 25 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) Operating cash flow Net cash provided by operating activities of $37.8 million increased by $13.2 million during the first six months of 2011 when compared to the same period in 2010. Throughout both periods, our cash flows from operations were derived principally from: (i) our earnings from on-going operations prior to non-cash expenses such as depreciation, amortization and stock-based compensation and adjustments to our provision for sales returns and allowances; (ii) the tax benefit associated with our deferred tax asset, which reduces our cash outlay for income tax expense; and (iii) changes in our working capital. Working capital changes as they impact the statement of cash flows are composed of changes in accounts receivable, prepaid expenses and other assets, accounts payable, accrued expenses, accrued liabilities and deferred revenue. Cash flow from operations associated with working capital increased $5.1 million in the first six months of 2011 when compared to the same period in 2010. This net increase is principally due to: • an increase of $1.9 million in cash associated with a decrease in accounts receivable, primarily from an increase in the collection of accounts receivable as a result the timing of billings in late 2010 as compared to late 2009, and a slight improvement in collections; and • a refund of income tax payments of $6.0 million; partially offset by • a decrease of $1.1 million in cash associated with a decrease in deferred revenue, primarily resulting from a decrease in consulting services billings for which revenue could not be recognized; and • a decrease of $1.7 million in cash associated with an increase in payments for deferred commissions and other prepaid items as a result of fluctuations in timing of vendor payments. The provision for doubtful accounts and sales returns increased $1.7 million during the six months ended June 30, 2011 when compared to the same period in 2010. The increase is principally due to an increase in credits associated with maintenance, subscription and consulting services that is commensurate with the growth in sales. Additionally, during the first six months of 2010, we decreased our allowance for doubtful accounts and sales returns by $0.5 million as a result of favorable returns and collections experience, which contributed to the year-over-year increase. Investing cash flow Net cash used in the first six months of 2011 for investing activities was $23.5 million compared to $9.3 million in the same period in 2010. The increase is principally due to the purchase of PIDI in the first quarter of 2011. As of June 30, 2011, we spent $7.7 million on software and computer equipment associated with the infrastructure that supports our subscription-based offerings. We expect to continue making similar investments in our infrastructure and expect our full year 2011 capital expenditures to be in the range of $15.0 million to $20.0 million. Financing cash flow Net cash used in financing activities for the first six months of 2011 was $9.3 million compared to $24.5 million in the same period in 2010. The decrease in cash used in financing activities is primarily due to a decrease in the purchase of treasury stock under our repurchase program. We did not repurchase any treasury shares during the six months ended June 30, 2011, and as of June 30, 2011, $50.0 million remained available under our share repurchase program. Commitments and contingencies As of June 30, 2011, we had future minimum lease commitments of $62.1 million. There were no material changes outside the ordinary course of business in our contractual obligations since December 31, 2010. We utilize third-party relationships in conjunction with our products. The contractual arrangements vary in length from one to three years. In certain cases, these arrangements require a minimum annual purchase commitment. The total remaining minimum purchase commitments under these arrangements at June 30, 2011 were $4.4 million through 2013. We incurred expense under these arrangements of $1.2 million and $0.9 million for the three months ended June 30, 2011 and 2010, respectively, and $2.3 million and $1.7 million for the six months ended June 30, 2011 and 2010, respectively. In February 2011, our Board of Directors approved our annual dividend rate of $0.48 per share for 2011. Dividends at the annual rate would aggregate to $21.1 million assuming 44.0 million shares of common stock are outstanding. Our ability to continue to declare and pay dividends quarterly this year and beyond might be restricted by, among other things, the terms of our credit facility, general economic conditions and our ability to generate operating cash flow. 26 -------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 2. Management's discussion and analysis of financial condition and results of operations (continued) Off-balance sheet arrangements We do not have any off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons. Foreign currency exchange rates Approximately 14% of our total net revenue for the six months ended June 30, 2011 was derived from operations outside the United States. We do not have significant operations in countries in which the economy is considered to be highly inflationary. Our consolidated financial statements are denominated in U.S. dollars and, accordingly, changes in the exchange rate between foreign currencies and the U.S. dollar will affect the translation of our subsidiaries' financial results into U.S. dollars for purposes of reporting our consolidated financial results. The accumulated currency translation adjustment, recorded as a separate component of stockholders' equity, was $0.5 million at June 30, 2011 and at December 31, 2010. The vast majority of our contracts are entered into by our U.S., Canadian or U.K. entities. The contracts entered into by the U.S. entity are almost always denominated in U.S. dollars, contracts entered into by our Canadian subsidiary are generally denominated in Canadian dollars, and contracts entered into by our U.K., Australian and Netherlands subsidiaries are generally denominated in pounds sterling, Australian dollars and Euros, respectively. Historically, as the U.S. dollar weakened, foreign currency translation resulted in an increase in our revenues and expenses denominated in non-U.S. currencies. During second quarter 2011, foreign translation resulted in an increase in our revenues and expenses denominated in non-U.S. currencies. Though we do not believe our exposure to currency exchange rates have had a material impact on our consolidated results of operations or financial position, we intend to continue to monitor such exposure and take action as appropriate. Cautionary statement We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks. Statements contained in this Form 10-Q, which are not historical facts, are or might constitute forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be attained. Forward-looking statements involve known and unknown risks that could cause actual results to differ materially from expected results. Factors that could cause actual results to differ materially from our expectations expressed in the report include: general economic risk; lengthy sales and implementation cycles, particularly in larger organizations; uncertainty regarding increased business and renewals from existing customers; continued success in sales growth; management of integration of recently acquired companies and other risks associated with acquisitions; the ability to attract and retain key personnel, including a new CFO; risk associated with successful implementation of multiple integrated software products; risks related to our dividend policy and stock repurchase program, including potential limitations on our ability to grow and the possibility that we might discontinue payment of dividends; risks relating to restrictions imposed by the credit facility; risks associated with management of growth; technological changes that make our products and services less competitive; and the other risk factors set forth from time to time in our SEC filings. |