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LYRIS, INC. - 10-K - 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 in Item 8 of this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those forward-looking statements. Our fiscal year ends on June 30, and references throughout this Annual Report to a given year are to our fiscal year ended on that date. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed above in the section entitled "Item 1A. Risk Factors." Overview We are a leading provider of digital marketing software solutions that help organizations engage with their customers across multiple interactive channels. Our solutions empower marketers to design, automate and optimize data-driven campaigns that generate superior engagement, increased business value through greater customer conversions and measurable return on marketing investment. Our Lyris HQ and Lyris ListManager platforms improve marketing efficiency by providing campaign management and automated message delivery, using robust segmentation and analytics driven by real-time social, mobile and web interactions. Lyris HQ is offered as an in-the-cloud solution for enterprises while Lyris ListManager is offered as an on-premises solution primarily for the SMB market. During the three months ended June 30, 2012, over 5,000 organizations worldwide actively used our solutions. Our solutions help companies increase customer conversions and grow revenues. Real-time customer data defines and automates targeted message flows that facilitate superior customer experiences. Our private cloud technology stack is architected for "big data" to consolidate and analyze large amounts of vital behavioral and transactional information from online activities in order to increase the relevance of every customer message. With more than ten years' experience and billions of digital messages processed by our solutions, we are continuously expanding ways companies deliver value to their customers. The majority of our revenue is recurring, comprised of subscription and support and maintenance. We derive revenue from subscriptions to our SaaS solutions (Lyris HQ), software (Lyris ListManager), support, maintenance and related professional services. As part of an annual subscription, a customer is provided 24 × 7 access to our SaaS solution, including digital message delivery, reporting and analytics, training and support. Subscription revenue is recurring, which permits sending up to a specified number of email messages. Software revenue is derived from perpetual licensing rights of our software that we sell to our customers. Support and maintenance revenue is primarily comprised of customer service and support for our products. Professional services revenue is primarily comprised of training, custom product implementation and integration, which includes web analytics and reporting, web design, email deliverability and search engine marketing. Financial Summary Highlights of our recent financial performance include: º • º Recurring revenue, consisting of subscription and support and maintenance revenue, represented 85% of total revenues in fiscal 2012. º • º Sales of our Lyris HQ product grew from $9.3 million in fiscal 2009 to $20.3 million in fiscal 2012 a 21% CAGR: º • º In July, 2011, we intensified our new product development activities associated with our Lyris ONE, which was launched in September, 2012. We decreased our operating expenses, excluding 37 -------------------------------------------------------------------------------- Table of Contents non-cash impairment charges, by $1.2 million, or 4.56%, from $26.3 million in fiscal 2011, to $25.1 million in fiscal 2012. º • º We returned to profitability for the three month periods ended March 31, 2012 and June 30, 2012 due to a tighter focus on our core business and expense management recording net income of $0.6 million for the three month period ended March 31, 2012 and $0.4 million for the three month period ended June 30, 2012. Results of Operations for Fiscal 2011 and Fiscal 2012 The following table summarizes our consolidated statements of operations data as a percentage of total revenues for the periods presented: Years Ended June 30, 2011 2012 Revenue: Subscription revenue 76 % 75 % Support and maintenance revenue 9 % 10 % Professional services revenue 10 % 11 % Software revenue 5 % 4 % Total revenues 100 % 100 % Cost of revenues 52 % 37 % Gross profit 48 % 63 % Operating expenses: Sales and marketing 36 % 23 % General and administrative 21 % 23 % Research and development 5 % 15 % Amortization and impairments 5 % 28 % Total operating expenses 67 % 89 % Loss from operations (19 )% (26 )% Interest and other income (expense), net 1 % (1 )% Loss before income tax provision and non-controlling interest (18 )% (27 )% Income tax provision (benefit) 0 % 0 % Net loss (18 )% (27 )% Less: Net loss attributable to non-controlling interest 0 % (0 )% Net loss attributable to Lyris, Inc. (18 )% (27 )% 38 -------------------------------------------------------------------------------- Table of Contents Revenue Lyris recognizes revenue from subscriptions, support and maintenance, professional services, and licensing of our software products to our customers. Revenues for fiscal 2011 and fiscal 2012 were: Years Ended June 30, Change 2011 2012 Dollars Percent (In thousands, except percentages) Recurring revenue: Subscription revenue Lyris HQ $ 18,535 $ 20,295 $ 1,760 9.5 % Legacy products 11,899 8,910 (2,989 ) (25.1 )% Total subscription revenue 30,434 29,205 (1,229 ) (4.0 )% Support and maintenance revenue 3,649 3,778 129 3.5 % Total recurring revenue 34,083 32,983 (1,100 ) (3.2 )% Professional services revenue 4,150 4,059 (91 ) (2.2 )% Software revenue 1,892 1,737 (155 ) (8.2 )% Total revenues $ 40,125 $ 38,779 $ (1,346 ) (3.4 )% Subscription Revenue In fiscal 2011, subscription revenue was $30.4 million, or 76% of our total revenues, compared to $29.2 million, or 75% of our total revenues for fiscal 2012, a decrease of $1.2 million or 4%. Subscription revenue decreased because we continued to experience pricing pressures from our customers on our subscription renewals, due in part to the difficult economic environment. Subscription revenue related to Lyris HQ for fiscal 2012, increased $1.7 million versus the prior year, primarily coming from larger actual and committed volumes from existing customers, as well as sales to new customers partially offset by customer turnover. Subscription revenue related to legacy products for fiscal 2012, declined compared to the prior year primarily due to ending contracts with low-priced subscriptions and the end-of-life of some of our low-value legacy products. Support and Maintenance Revenue In fiscal 2011, support and maintenance revenue was $3.6 million, or 9% of our total revenues, compared to $3.8 million, or 10% of our total revenues for fiscal 2012, an increase of $129 thousand. Support and maintenance revenue increased slightly as we focused our efforts to renew existing customers. Professional Services Revenue In fiscal 2011, professional services revenue was $4.2 million, or 10% of our total revenues, compared to $4.1 million, or 11% of our total revenues for fiscal 2012, a decrease of $91 thousand or 2%. Fiscal 2011 included $0.6 million in one-time revenue recognized from a specific customer. As such, without this one-time recognition, the increase of professional services revenue was due to our acquisition of certain service contracts in Australia. Software Revenue In fiscal 2011, software revenue was $1.9 million, or 5% of our total revenues, compared to $1.7 million, or 4% of our total revenues for fiscal 2012, a decrease of $155 thousand or 8%. The software 39 -------------------------------------------------------------------------------- Table of Contents revenue decrease was attributable to our continued focus on sales of our SaaS solutions and services throughout fiscal 2012. Cost of Revenues Cost of revenues consists principally of the amortization of intangible assets related to internally developed software to support our cloud-based marketing products, amortization of our intangibles and software acquired from our strategic acquisitions, payroll-related expenses related to our engineers assigned to product and revenue-support projects, data center and depreciation costs associated with our supporting hardware, various support costs such as website development, processing fees, and allocated overhead. In July, 2011, due to the hiring of a new Chief Technology Officer, we fundamentally changed the role of our engineering and quality assurance departments to work on next generation products. We also retooled the customer support department to provide support for cost of revenues. For fiscal 2011 and 2012, cost of revenues was as follows: Years ended June 30, Change 2011 2012 Dollars Percent (unaudited) (in thousands, except percentages) Cost of revenues $ 20,705 $ 14,170 $ (6,535 ) (31.6 )% Cost of revenues for fiscal 2011 and fiscal 2012 was $20.7 million and $14.2 million, respectively, a decrease of $6.5 million. As a percentage of total revenues, cost of revenues decreased to 37% for fiscal 2012 from 52% for fiscal 2011. Engineering employee salaries and related expense allocated to the statements of operations decreased as personnel were increasingly deployed to new product development efforts, which costs were then reflected in the balance sheet as capitalized software development. During fiscal 2012, cost of revenue employee salaries and related expense decreased $7.6 million, or 57%, as a result of our re-assignment of engineering resources from product support to product development activities in July 2011, while capitalized software increased $2.2 million, or 235%. We also realized significant increases in our data center expense for the support and hosting of our subscription services, which increased $0.7 million, or 20%, during fiscal 2012. This increase was due in large part to the addition of our Milpitas facility, without yet having shut down Sunnyvale and Fremont as we execute our migration strategy. Amortization of developed technology and depreciation of computer equipment did not change significantly during the period, but through our cost control efforts we have been able to achieve a 4% reduction in the various support costs such as website development, processing fees, and allocated overhead, achieving a $0.1 million decrease in fiscal 2012. During fiscal 2012, publisher payments increased $0.5 million, or 647%, as a result of the Cogent acquisition in June, 2011. Gross Profit and Gross Margin Years Ended June 30, Change 2011 2012 Dollars Percent (unaudited) (in thousands, except percentages) Gross profit $ 19,420 $ 24,609 $ 5,189 26.7 % Gross margin 48 % 63 % Gross profit for fiscal 2011 and fiscal 2012 was $19.4 million and $24.6 million, respectively, an increase of $5.2 million. The increase in gross profits for fiscal 2012 compared to fiscal 2011 was due to our re-assignment of engineering resources from product support to new product development activities. As a percentage of total revenues, gross profits increased to 63% for fiscal 2012 from 48% for fiscal 2011. 40 -------------------------------------------------------------------------------- Table of Contents Operating Expenses Operating expenses for fiscal 2011 and 2012 were: Percent of Years Ended June 30, Change Revenue 2011 2012 Dollars Percent 2011 2012 (unaudited) (in thousands, except percentages) Sales and marketing $ 14,584 $ 8,999 $ (5,585 ) (38.3 )% 36 % 23 % General and administrative 8,233 8,916 683 8.3 % 21 % 23 % Research and development 2,032 5,893 3,861 190.0 % 5 % 15 % Operating expenses before amortization and impairment 24,849 23,808 (1,041 ) (4.2 )% 62 % 61 % Amortization of customer relationships and trade names 1,449 1,336 (113 ) (7.8 )% 4 % 4 % Impairment of goodwill - 9,000 9,000 100 % - % 23 % Impairment of capitalized software 408 385 (23 ) (5.6 )% 1 % 1 % Total operating expenses $ 26,706 $ 34,529 $ 7,823 29.3 % 67 % 89 % Sales and Marketing Sales and marketing includes expenses primarily related to employee salaries and related costs, costs associated with advertising and other promotional programs, and allocated facilities costs. Sales and marketing expense for fiscal 2011 and fiscal 2012 was $14.6 million and $9.0 million, respectively, a decrease of $5.6 million, or 38%. This decrease in sales and marketing expense from fiscal 2011 to fiscal 2012 was largely attributable to a $2.9 million, or 36%, decrease in employee salaries and related costs due to a reduction in our sales and marketing workforce, and a $2.3 million reduction in spending for advertising and other promotional programs. As a percentage of total revenues, sales and marketing expense decreased to 23% for fiscal 2012, from 36% for fiscal 2011. General and Administrative General and administrative expense consists primarily of salaries and related costs for administrative personnel, professional services such as consultants, legal fees and accounting, audit and tax fees, and related allocation of overhead including stock-based compensation and other corporate development costs. General and administrative expense for fiscal 2011 and fiscal 2012 was $8.2 million and $8.9 million, respectively, an increase of $0.7 million, or 8.3%. The increase in general and administrative expense for fiscal 2012 compared to fiscal 2011 was attributable to increases in outside services of $0.5 million due to an increase in consulting services for several projects to improve our operational systems and processes, plus $0.5 million due to financing costs related to a withdrawn Form S-1. These were offset by a decrease of $0.2 million in severance costs. As a percentage of total revenues, general and administrative expense increased to 23% for fiscal 2012 from 21% for fiscal 2011. Research and Development Research and development expense consists of salaries and related costs for engineering personnel, stock-based compensation and other headcount-related expenses associated with development of our next generation product line and increasing the functionality of current lines. We capitalize product development expenses incurred during the application development stage until the product is available for general release, provided we can ascertain that there is future economic value. We expense 41 -------------------------------------------------------------------------------- Table of Contents engineering costs in cost of revenues if the expense is related to supporting on-going platforms and is more related to product support activities. Management's judgement is used to determine the allocation between these three categories, and we refer to these three categories in aggregate as "product investment". In July, 2011, due to the hiring of a new Chief Technology Officer, we fundamentally changed the role of our engineering and quality assurance departments to work on next generation products and retooled the customer support department to provide support for cost of revenues. We terminated employees whose skill sets were not compatible with the development demands of the new product roadmaps and hired new developers and software engineers. Whereas a majority of our software engineers were previously focused on product support, our team is now focused on product development and enhancement. Prior to July of 2011 a majority of our engineers supported current products. Research and development expense for fiscal 2011 and 2012 was $2.0 million and $5.9 million, respectively, an increase of $3.9 million, or 190%. The increase in research and development expense was primarily due to a $3.5 million increase in engineering compensation-related expense for resources working on new product development, followed by $0.3 million of allocated facilities expense, and $0.1 million of outside services. This shift in engineering resources also resulted in a larger amount of compensation-related expense being capitalized software development. Over the past year, we achieved certain product development milestones and made the related product functionality available to our customers resulting in a further reduction of research and development costs. As a percentage of total revenues, research and development expense increased to 15% for fiscal 2012 from 5% for fiscal 2011. Product investment for fiscal 2011 and fiscal 2012 was $9.1 million and $10.0 million, respectively, an increase of $0.9 million, or 10%. Product investment for fiscal 2011 included cost of revenues of $6.5 million, research and development expense of $2.0 million, and the increase in capitalized software of $0.6 million. Product investment for fiscal 2012 included no cost of revenues, research and development expense of $5.9 million, and the increase in capitalized software of $4.1 million. Amortization of Customer Relationships and Trade Names Amortization of customer relationships and trade names expense consists of intangibles that we obtained through the acquisition of other businesses. Amortization of customer relationships and trade names expense for fiscal 2011 and fiscal 2012 was $1.4 million and $1.3 million, respectively, a decrease of $0.1 million, or 8%. As a percentage of total revenues, amortization of customer relationships and trade names expense decreased to 3% for fiscal 2012 from 4% for fiscal 2011. The decrease in amortization of customer relationships and trade names expense for fiscal 2012 compared to fiscal 2011 was primarily due to one customer relationship reaching full amortization in October 2010. We acquired customer relationships from an acquisition in fiscal 2011 and will amortize this over a six year period. Impairment of Capitalized Software Impairment of capitalized software consists of internal-use software, which was intended to provide a major feature upgrade to Lyris HQ. Internal-use software had been in the application development stage since the fourth quarter of fiscal 2011. Throughout the life of the project, $0.4 million in costs have been accounted for as capitalized software. In the second quarter of fiscal 2012, we focused our research and development efforts on the new Lyris ONE initiative, resulting in the recording of an impairment charge of $0.4 million for fiscal 2012 related to the termination of other development projects. 42 -------------------------------------------------------------------------------- Table of Contents Impairment of Goodwill The following table outlines our goodwill, by acquisition: Years Ended June 30, 2011 2012 (in thousands) Lyris Technologies $ 16,505 $ 9,707 Email Labs 2,202 - Cogent 84 84 Total $ 18,791 $ 9,791 In fiscal 2012, we determined that the goodwill associated with the acquisitions of Lyris Technologies on May 12, 2005 and Email Labs on October 12, 2005 exceeded their fair value. We have recorded $9.0 million in impairment of goodwill in fiscal 2012. We performed our annual impairment testing of goodwill at June 30, 2011 and determined that the estimated fair value of our reporting unit was in excess of its carrying value; therefore no impairment charge was recorded in fiscal 2011. See Note 5 "Goodwill" of the Notes to Consolidated Financial Statements. Interest Expense Years Ended June 30, Change 2011 2012 Dollars Percent (in thousands, except percentages) Interest expense $ (94 ) $ (396 ) $ (302 ) 321.3 % Interest expense relates to our revolving line of credit with the Bank and our short and long-term capital lease obligations in connection with acquiring computer equipment for our data center operations which is included in property and equipment. Interest expense for fiscal 2011 and fiscal 2012 was $0.1 million and $0.4 million, respectively, an increase of $0.3 million or 321%. The increase in interest expense was primarily attributable to a higher average balance of $4.1 million on our revolving line of credit for fiscal 2012 compared to an average balance of $1.7 million for fiscal 2011. Income Tax Provision For fiscal 2011 and fiscal 2012, our effective tax rates were 2.3% and (1.6%), respectively. For additional information about income taxes, see Note 10 "Income Taxes" of the Notes to Consolidated Financial Statements. Liquidity, Capital Resources and Financial Condition Since our inception, we have financed our operations primarily from the issuance of our stock, cash flows from operations, and borrowings under credit facilities. As of June 30, 2012, our primary sources of liquidity to fund our operations was from the collection of accounts receivable balances generated from net sales, proceeds from our revolving line of credit, and proceeds from stock issuances. For additional operational funds requirements, we have an available revolving line of credit with the Bank which matures on April 30, 2013, see Note 8 "Revolving Lines of Credit" of the Notes to Condensed Consolidated Financial Statements for detail information. 43 -------------------------------------------------------------------------------- Table of Contents As of June 30, 2012, our availability under this credit facility was approximately $0.2 million. As of June 30, 2012, our cash and cash equivalents totaled $1.6 million compared to $0.2 million as of June 30, 2011. As of June 30, 2012, our accounts receivable, less allowances, totaled $4.9 million compared to $6.3 million as of June 30, 2011. Years Ended June 30, Change 2011 2012 Dollars Percent (unaudited) (in thousands, except percentages) Accounts receivable $ 7,264 $ 5,620 $ (1,644 ) (23 )% Allowance for doubtful accounts (936 ) (686 ) 250 27 % Total-Accounts receivable $ 6,328 $ 4,934 $ (1,394 ) (22 )% During the year ended June 30, 2012, accounts receivable decreased $1.6 million, or 23%, to $5.6 million from $7.3 million at June 30, 2011. Our allowance for doubtful accounts decreased $0.3 million, or 27%, to $0.7 million at June 30, 2012 from $0.9 million at June 30, 2011. Changes in accounts receivable during fiscal 2012 were predominantly due to a decrease related to write-offs of $1.4 million offset by additional cash collections of $0.3 million. Product investment for fiscal 2011 and fiscal 2012 was $9.1 million and $10 million, respectively, an increase of $0.9 million, or 10%. Product investment for fiscal 2011 included cost of revenues of $6.5 million, research and development expense of $2.0 million, and the increase in capitalized software of $0.6 million. Product investment for fiscal 2012 included research and development expense of $5.9 million, and the increase in capitalized software of $4.1 million. Significant costs incurred in fiscal 2011 were one-time charges associated with a corporate reorganization. We do not expect to incur these costs in the near future. Throughout fiscal 2011, we had to draw upon our revolving line of credit to fund our operations. At June 30, 2012, our outstanding borrowings totaled $5 million compared to $3.3 million of outstanding borrowings at June 30, 2011. On August 31, 2011 we entered into an amendment to our revolving credit facility which improves our liquidity position. Previously, our $5.0 million commitment from the Bank was based on eligible receivables, which limited our borrowings to between $3.5 million to $4.3 million during the fiscal year. Our credit facility was amended on August 31, 2011 to provide that only $2.5 million would be limited by eligible receivables; while a second $2.5 million credit line would not be limited by eligible receivables, which increased our available borrowings. On April 18, 2012, our credit facility was further amended to increase the credit line limited by eligible receivables to $3.5 million. These increases in availability under our revolving credit facility coupled with our cash flow from operations, will provide us sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending for fiscal 2012. Revolving Lines of Credit We have a revolving line of credit ("credit agreement") with the Bank, secured by substantially all of our assets. William T. Comfort, III, our Chairman of the Board, agreed to guarantee our repayment of indebtedness through a series of cross-collateralized agreements. (See Note 8 "Revolving Lines of Credit" of the Notes to the Consolidated Financial Statements). We currently maintain a revolving line of credit of $3,500,000 ("Revolving Line"). The amount available under the Revolving Line is limited by a borrowing base, which is 80% of the amount of the aggregate of our accounts receivable, less certain exclusions. The revolving line bears interest at a variable rate equal to the lender's most recently announced prime rate plus 2.5%. 44 -------------------------------------------------------------------------------- Table of Contents Lyris currently maintains a second revolving line of credit of $2,500,000 ("Non-Formula Line," and together with the Revolving Line, the "Revolving Lines"). The Non-Formula Line bears interest at a variable rate equal to the Bank's most recently announced prime rate plus 0.5%. We have negotiated a one-year renewal of the agreement with the Bank through April 30, 2013. The credit agreement requires us to comply with certain financial covenants, including with respect to recurring revenue, capital expenditures, and adjusted EBITDA on a three-month trailing basis. Under these covenants, we are required to maintain certain specified levels of recurring revenue and adjusted EBITDA (each as defined in the loan and security agreement) each quarter and we are required to limit our annual unfinanced capital expenditures to certain specified levels. As of June 30, 2012, Lyris was in compliance with all of its covenants for all applicable measurement periods in fiscal 2012. Our outstanding borrowings totaled $5.0 million with $0.2 million in available credit remaining as of June 30, 2012. The credit agreement also contains various customary negative covenants which restrict our ability to, among other things, dispose of assets, change our business, management, ownership or business locations, encumber our assets, incur additional debt, merge with or acquire other companies, engage in transactions with affiliates and pay dividends. In addition, the credit agreement contains various customary affirmative covenants, including covenants that require us to maintain bank accounts with the Bank, comply with various regulations and laws, provide the Bank with access to certain of our books and records and protect our intellectual property rights. The credit agreement also contains usual and customary events of default (subject to certain grace periods) upon the occurrence of certain events, such as nonpayment of amounts due under the agreement, violation of the covenants referred to above, violation of other contractual provisions, and a material adverse change in our business or our insolvency. In addition, the rejection by the Bank, in its reasonable discretion, of certain periodic financial and operating performance projections to be made by our Board pursuant to the loan and security agreement would constitute an event of default. If an event of default occurs, the Bank will be able to accelerate the maturity of any obligations owing under the loan and security agreement, terminate the commitments to make additional advances thereunder, demand cash collateral for issued letters of credit, terminate foreign exchange forward contracts, and exercise other rights and remedies. At June 30, 2012, our existing cash and cash equivalents, cash flow from operations, and the availability from our revolving credit facility, provides, projected working capital requirements, and capital spending for at least the next 12 months at our current growth and spending rate. We anticipate that we will continue to improve our cash flow from operations through both expense reductions and stabilization of our customer base and will continue building our cash reserves. See Notes 8 and 18 "Revolving Lines of Credit" and "Subsequent Events," respectively, of the Notes to Consolidated Financial Statements. Our ability to service any indebtedness we incur under our revolving credit facility will depend on our ability to generate cash in the future. We may not have significant cash available to meet any large unanticipated liquidity requirements, other than from available borrowings, if any, under our revolving credit facility. As a result, we may not retain a sufficient amount of cash to finance growth opportunities, including acquisitions, or unanticipated capital expenditures or to fund our operations. If we do not have sufficient cash for these purposes, our financial condition and our business could suffer. We expect to maintain long-term growth in our hosted revenue offerings, particularly with Lyris HQ, and increase efficiency within our operating expenses to generate available cash to satisfy our capital needs and debt obligations. To the extent that existing cash and cash equivalents and cash from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Additionally, we may enter into agreements or letters of 45 -------------------------------------------------------------------------------- Table of Contents intent with respect to potential investments in, or acquisitions of, complementary businesses, applications or technologies in the future, which could also require us to seek additional equity or debt financing. Cash flows In summary, our cash flows were as follows for fiscal 2011 and fiscal 2012: Years Ended June 30, 2011 2012 (in thousands) Net cash provided by (used in) operating activities $ (529 ) $ 3,175 Net cash used in investing activities (2,520 ) (4,865 ) Net cash provided by financing activities 2,867 3,085 Effect of exchange rate changes on cash (66 ) (37 ) Increase (decrease) in cash and cash equivalents $ (248 ) $ 1,358 Cash flows for fiscal 2011 compared to fiscal 2012 Operating activities Net cash flows used in operating activities were $0.5 million for fiscal 2011, as compared to net cash flows provided by operating activities of $3.2 million for fiscal 2012. Cash flows from operating activities are comprised of net losses, adjustments to reconcile the net loss to net cash provided by or used in operating activities, and the change in balance sheet accounts. Adjustments had a $14.2 million positive effect on cash flows from operating activities in fiscal 2012, including non-cash charges of $9.4 million for impairment of goodwill and capitalized development costs, $3.4 million of depreciation and amortization, $0.7 million of stock-based compensation, and $0.7 million provision for bad debt. Changes in assets and liabilities had a $0.6 million negative effect on cash flows provided by operating activities in fiscal 2012, due largely to a $0.8 million decrease in deferred revenue, and a $0.5 million decrease in accounts payable and accrued expense offset by a $0.7 million decrease in accounts receivable. In fiscal 2011 contributions from working capital were $1.4 million, compared to uses of $(0.6) million in fiscal 2012. Investing activities Net cash flows used in investing activities were $2.5 million for fiscal 2011 as compared to net cash flows used in investing activities of $4.9 million for fiscal 2012, primarily reflecting capitalized software expenditures. The net cash flow used in investing activities for fiscal 2012 consisted of a $0.7 million used in purchasing property and equipment and $4.1 million in capitalized software expenditures. Financing activities Net cash flows provided by financing activities was $2.9 million for fiscal 2011 as compared to net cash flows provided by financing activities of $3.0 million for fiscal 2012. Financing cash flows for 2012 consisted primarily net proceeds over payments from our revolving line of credit with the Bank, of $1.7 million, and $1.9 million in proceeds from the sale of stock in the second quarter of fiscal 2012, offset by $0.5 million in payments under our capital lease obligations in connection with acquiring computer equipment for our data center operations. 46 -------------------------------------------------------------------------------- Table of Contents Off-balance sheet arrangements As of June 30, 2012, we had $0.1 million in irrevocable letters of credit ("LOC") issued by the Bank, consisting of a $0.1 million LOC in favor of the Hartford Insurance Company ("Hartford") and a small LOC in favor of Legacy Partners I SJ North Second, LLC ("Legacy"). The Hartford LOC is held by Hartford as collateral for deductible payments that may become due under a worker's compensation insurance policy. Under the terms of the Hartford LOC, any amount drawn down by Hartford on this LOC would be added to our existing debt as part of our line of credit with the Bank. The Hartford LOC was originally entered into on September 5, 2007 with an expiration date of September 1, 2008 and will automatically renew annually unless we are notified by the Bank 30 days prior to the annual expiration date that it has chosen not to extend the Hartford LOC for the next year. The current expiration of the letter of credit is September 1, 2012. As of June 30, 2012, there have been no draw downs on this LOC by Hartford. The Legacy LOC is held by Legacy in connection with our lease dated January 31, 2008 for our offices in San Jose, California. We do not have any interest in entities referred to as variable interest entities, which include special purpose entities and other structured finance activities. Long-term contractual obligations Our commitments consist of obligations under operating leases for corporate office space and co-location facilities for data center capacity for research and test data centers. We entered into capital leases in connection with acquiring computer equipment for our data center operations which is included in property and equipment. We used a 5.25% interest rate to calculate the present value of the future principal payments and interest expense related to our capital leases. Additionally, in the ordinary course of business, we enter into contractual purchase obligations and other agreements that are legally binding and specify certain minimum payment terms. The following table summarizes by period the remaining payments due for contractual obligations estimated as of June 30, 2012: Payments due by period Less Than 3 - 5 More than Total 1 year 1 - 3 Years Years 5 Years (in thousands) Facilities(1) $ 4,381 $ 1,171 $ 2,266 $ 734 $ 210 Co-location hosting facilities(2) 169 151 18 - - Other(3) 96 46 34 16 - Total operating leases 4,646 1,368 2,318 750 210 Capital leases(4) 1,390 699 573 118 - Total $ 6,036 $ 2,067 $ 2,891 $ 868 $ 210 -------------------------------------------------------------------------------- º (1) º Represents our significant leased office facilities. º (2) º Represents our co-location facilities for data center capacity for research and test data centers. º (3) º Represents our software contracts used in our production environment. º (4) º Represents our capital leases in connection with acquiring computer equipment for our data center operations which is included in property and equipment in our Consolidated Balance Sheets. Capital lease payments include interest. 47 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Use of Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP"). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Our accounting estimates and assumptions bear the risk of change due to the uncertainty attached to the estimates and assumptions, or some estimates and assumptions may be difficult to measure or value. Accordingly, actual results could differ significantly from the estimates made by our management. On an ongoing basis, we evaluate these estimates, judgments and assumptions, including those related to revenue recognition, stock-based compensation, goodwill and acquired intangible assets, capitalization of software, allowances for bad debt and income taxes. We base these estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities and recorded revenue and expenses that are not readily apparent from other sources. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application, while in other cases, management's judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. Our management has reviewed these critical accounting policies, our use of estimates and the related disclosures with our Audit Committee. In October 2009, the Financial Accounting Standards Board ("FASB") issued an Accounting Standards Update 2009-13, Multiple-Deliverable Revenue Arrangements ("ASU No. 2009-13"), which addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit and modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. The ASU significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. We adopted ASU No. 2009-13 in the first quarter of fiscal 2011 and are described in detail below. Revenue recognition We recognize revenue from providing hosting and professional services and licensing our software products to our customers. We recognize revenue when all of the following conditions are satisfied: there is persuasive evidence of an arrangement; the service has been provided to the customer (for software licenses, revenue is recognized when the customer is given electronic access to the licensed software); the amount of fees to be paid by the customer is fixed or determinable; and the collection of fees is probable. Subscription and other services revenue We generate services revenue from several sources, including hosted software services bundled with technical support (maintenance) services, and professional services. We recognize subscription revenue in two ways: (1) based on the subscription plan defined in the agreement with specified monthly volume, and (2) based on actual usages at rates specified in the agreement. Additionally, we invoice excess usage and recognize it as revenue when incurred by our customers. 48 -------------------------------------------------------------------------------- Table of Contents In October 2009, the Financial Accounting Standards Board ("FASB") issued an Accounting Standards Update 2009-13, Multiple-Deliverable Revenue Arrangements ("ASU No. 2009-13") which amended the accounting standards for revenue recognition for multiple deliverable revenue arrangements to: º • º Provide updated guidance on how the deliverables of an arrangement should be separated, and how the consideration should be allocated; º • º Eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method; and º • º Require an entity to allocate revenue to an arrangement using the estimated selling prices ("ESP") of deliverables if it does not have vendor-specific objective evidence ("VSOE") of fair value or third-party evidence ("TPE") of selling price. Valuation terms are defined as set forth below: º • º VSOE-the price at which the element is sold in a separate stand-alone transaction º • º TPE-evidence from Lyris or other companies of the value of a largely interchangeable element in a transaction º • º ESP-Our best estimate of the selling price of an element in a transaction Lyris adopted ASU No. 2009-13 in fiscal 2011 on a prospective basis for multiple-element arrangements that include subscription services bundled with technical support and professional services. The implementation resulted in an immaterial difference in revenue recognized and additional disclosures that are included below. We follow accounting guidance for revenue recognition of multiple-element arrangements to determine whether such arrangements contain more than one unit of accounting. Multiple-element arrangements require the delivery or performance of multiple products, services and/or rights to use assets. Although our professional services that are a part of multiple element arrangement have standalone value to the customer, such services could not be accounted as separate units of accounting under the previous guidance, as VSOE did not exist for the undelivered element. The VSOE for subscription services could not be established based on the historical pricing trends to date, which indicate that the price of the majority of standalone sales does not yet fall within a narrow range around the median price. Since our subscription services have standalone value as such services are often sold separately, but do not have VSOE, we use ESP to determine fair value for our subscription services when sold in a multiple-element arrangement and recognize revenue based on ASU No. 2009-13. For fiscal 2012, TPE was concluded to be an impractical alternative due to differences in features and functionality of other companies' offerings and lack of access to the actual selling price of competitor standalone sales. If new subscription service products are acquired or developed that require significant professional services in order to deliver the subscription service and the subscription service and professional services cannot support standalone value, then such subscription services and professional services will be evaluated as one unit of accounting. We determined ESP of fair value for subscription services based on the following: º • º We have defined processes and controls to ensure our pricing integrity. Such controls include oversight by a cross-functional team and members of executive management. Significant factors considered when establishing pricing include market conditions, underlying costs, promotions, and pricing history of similar services. Based on this information and actual pricing trends, management establishes or modifies the pricing. 49 -------------------------------------------------------------------------------- Table of Contents º • º We identified the population of transactions to serve as the basis for establishing ESP, including subscription services and professional services pricing history in transactions with multiple-element arrangements and those sold on a standalone basis. º • º We analyzed the population of items sold by stratifying the population by product type and level, and considered several data points, such as (1) average price charged, (2) weighted average price to incorporate the frequency of each item sold at any given price, and (3) the median price charged. These three price points were then compared with the existing price list that is used as a point of reference to negotiate contracts and does not represent fair value. Additionally, we gathered and analyzed sales' team feedback gained from interaction with customers and similar activities. This feedback included consideration of current market trends for pricing charged by companies offering similar services, competitive advantage of the products we offer and recent economic pressures that have resulted in lower spending on marketing activities. ESP for each item in the population was established based on the factors noted above and was reviewed by management. For transactions entered into or materially modified after July 1, 2010, we allocate consideration in multiple-element arrangements based on the relative selling prices. Revenue is then recognized as appropriate for each separate element based on its fair value. For fiscal 2012, the impact on our revenue under the new accounting guidance as compared to the previous methodology resulted in an immaterial difference in revenue recognized as compared to that which would have previously been deferred and recognized ratably. The immaterial impact is primarily a result of the limited population of transactions subject to newly adopted guidance, as it includes only those arrangements entered into or materially modified since its adoption in fiscal 2011. The accounting treatment for arrangements entered into prior to July 1, 2010 continues to follow legacy accounting rules and the revenue recognition method applied to certain types of arrangements has not changed upon adopting new guidance, and does not affect the revenue recognized. The adoption of new guidance did not result in a material impact to the financial statements for fiscal 2012. However, new guidance may result in a material impact in the future, due to the change in other factors affecting the revenue recognition method, as the impact on the timing and pattern of revenue will vary depending on the nature and volume of new or materially modified contracts in any given period. We expect that the new accounting guidance will facilitate our efforts to optimize the sales and marketing of our offerings due to better alignment between the economics of an arrangement and the accounting for that arrangement. Such optimization may lead us to modify our pricing practices, which could result in changes in the relative selling prices of our elements, including both VSOE and ESP, and therefore change the allocation of the sales price between multiple elements within an arrangement. However, this will not change the total revenues recognized with respect to the arrangement. We defer technical support consisting of maintenance revenue, including revenue that is part of a multiple element arrangement, and recognizes it ratably over the term of the agreement, which is generally one year. For professional services sold separately from subscription services, we recognize professional service revenues as delivered. Expenses associated with delivering all professional services are recognized as incurred when the services are performed. Associated out-of-pocket travel costs and expenses related to the delivery of professional services are typically reimbursed by the customer and are accounted for as both revenue and expense in the period the cost is incurred. For multiple element arrangements entered into prior to July 1, 2010 that include both subscription and professional services and did not meet the reparability criteria under the previous guidance, we have accounted for them as a single unit of accounting. Consistent with the revenue recognition method applied prior to the adoption of ASU No. 2009-13, revenue for these arrangements 50 -------------------------------------------------------------------------------- Table of Contents continues to be recognized ratably over the term of the related subscription arrangement. If the multi-element arrangement is materially modified, the transaction is evaluated in accordance with the new accounting guidance which will most likely result in any deferred services revenue being recognized at the time of the material modification. Software revenue Lyris enters into certain revenue arrangements for which it is obligated to deliver multiple elements, consisting of products and/or services. For these arrangements, which generally include software products, technical or maintenance support and professional services, we allocate and defer revenue for the undelivered elements based on their VSOE. We allocate total earned revenue under the agreement among the various elements based on their relative fair value. VSOE exists for all elements of multiple element arrangements. In the event that VSOE cannot be established for one of the elements of multiple element arrangement, we will use TPE or ESP to determine how much revenue to allocate to the multiple element arrangements. We determine VSOE based on actual prices charged for standalone sales of maintenance. To accomplish this, we track sales for the maintenance product when sold on a standalone basis for a one year term and compare them to sales of the associated licensed software product. We perform a quarterly analysis of the actual sales for standalone maintenance and licensed software to establish the percentage of sales relationships for each level of maintenance and licensed software. The result of this analysis has historically been a tight range of percentage of sales relationships centered on a mid-point. Renewal rates, expressed as a consistent percentage of the license fee at each level, represent VSOE of fair value for the maintenance element of the arrangements. We recognize revenue from our professional services as rendered. VSOE for professional services is based on the use of a consistent rate per hour when similar services are sold separately on a time-and-material basis. Valuation allowances and reserves We record accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the accounts receivable balances and charged to the provision for doubtful accounts. We use the aged receivable and specific-identification methods of estimating our allowance for doubtful accounts. During the monthly accounts receivable analysis, we apply the aged receivable method by categorizing each customer's balance by the number of days or months the underlying invoices have remained outstanding. Based on historical collection experience, changes in our customer payment history and a review of the current status of a customer's trade accounts receivable, historical bad debts percentages are applied to each of these aggregate amounts, with larger percentages being applied to the older accounts. The computed total dollar amount is compared to the balance in the valuation account and an adjustment is made for the difference. On a quarterly basis, we use the specific-identification method by categorizing each customer's balance based on all outstanding receivables greater than 90 days in the following uncollectible categories: receivables sent to collection agency; receivables under legal determination; and receivables in higher collection risk. Consequently, our quarterly allowance for doubtful accounts adjustment is determined by comparing the difference of the total of the uncollectible amounts as identified from the uncollectible categories with the pre-adjusted allowance provision. 51 -------------------------------------------------------------------------------- Table of Contents Loss contingencies and commitments We record an estimated loss contingency when information is available that indicates that it is probable that a material loss has been incurred or an asset has been impaired and the amount of the loss can be reasonably estimated. We disclose if the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, or if an exposure to loss exists in excess of the amount accrued. Loss contingencies considered remote are generally not disclosed unless they arise from guarantees, in which case the guarantees would be disclosed. Determining the likelihood of incurring a liability and estimating the amount of the liability involves an exercise of judgment. If the litigation results in an outcome that has greater adverse consequences to us than management currently expects, then we may have to record additional charges in the future. As of June 30, 2012, there were no probable material losses incurred that could be reasonably estimated. Our commitments consist of obligations under operating leases for corporate office space, co-location facilities for data center capacity for research and test data centers, software contracts used in our production environment and capital leases. Goodwill, long-lived assets and other intangible assets We classify our intangible assets into three categories: intangible assets with definite lives subject to amortization; intangible assets with indefinite lives not subject to amortization; and goodwill. Periodically, we evaluate our fixed assets and intangible assets with definite lives for impairment. If the carrying amount of an asset or asset group (in use or under development) is evaluated and found not to be recoverable (carrying amount exceeds the gross, undiscounted cash flows from use and disposition), then an impairment loss must be recognized. The impairment loss is measured as the excess of the carrying amount over the asset's or asset group's fair value. In addition, the potential impairment of finite life intangibles is assessed whenever events or a change in circumstances indicate the carrying value may not be recoverable. We conduct a test for the impairment of goodwill on at least an annual basis. We have one reporting unit, Lyris, Inc. We adopted June 30th as the date of the annual impairment test, but will conduct the test at an earlier date if indicators of possible impairment arise that would cause a triggering event. Due to the triggering event of the decline of our stock price from $0.34 as of the date of our annual impairment test at June 30, 2010, to lesser amounts at each quarter end in fiscal 2011, we tested the impairment of our goodwill during each quarter ended for fiscal 2011. The impairment test first compares the fair value of our reporting unit to its carrying amount, including goodwill, to assess whether impairment is present. The fair values calculated in our impairment test are determined using the weight of two methods: Public Company Market Multiple Method and the Income Approach. At June 30, 2011 we determined that the estimated fair value of our reporting unit was in excess of its carrying value. The carrying value of our reporting unit was approximately $28.1 million at June 30, 2011. The fair value of our reporting unit under the Public Company Market Multiple Method was approximately $39.7 million at June 30, 2011 based on a comparison of us to other publicly traded companies within the same industry and market; and similar product lines, growth, margins and risk. Our comparison is based on published data regarding the public companies' stock price and earnings, sales and/or revenues. This method resulted in an excess of fair value under the Public Company Market Multiple Method over the carrying value of approximately $11.6 million or 41%. The fair value of our reporting unit under the Income Approach, specifically utilizing the Discounted Cash Flow Method, was approximately $35.2 million at June 30, 2011. This resulted in an excess of fair value under the Income Approach over the carrying value of approximately $7.1 million or 25%. The Discounted Cash Flow Method under the Income Approach utilized several assumptions 52 -------------------------------------------------------------------------------- Table of Contents and estimates. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions. We base these estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities and recorded revenue and expenses that are not readily apparent from other sources. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. These assumptions and estimates include, but are not limited to, anticipated operating income growth rates, our long-term anticipated operating income growth rate, and the discount rate, including a specific reporting unit risk premium. The assumptions used are based upon what we believe a hypothetical marketplace participant would use in estimating fair value. Our accounting estimates and assumptions bear the risk of change due to the degree of uncertainty attached to the estimates and assumptions, or some estimates and assumptions may be difficult to measure or value. Accordingly, actual results could differ significantly from the estimates made by our management. For example, if our revenue projections, expected growth rate and economic upturn do not materialize, this will negatively affect our key assumptions. Based on our impairment test conducted at December 31, 2011, we concluded that there was an impairment of goodwill for the six months ended December 31, 2011. Based on our impairment test conducted at June 30, 2012, we concluded that there was no further impairment of goodwill or intangible assets for fiscal 2012. See Note 5 "Goodwill" of the Notes to Consolidated Financial Statements. Capitalized Software Costs Software licensing We expense internal costs incurred in researching and developing computer software products designed for sale or licensing until technological feasibility has been established for the product. Once technological feasibility is established, applicable development software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We determined that technological feasibility is established when we have completed all necessary planning and designing and after we have resolved all high-risk development issues through coding and testing. Moreover, these activities are necessary to establish that the product can meet our design specifications including functions, features and technical performance requirements. We discontinue capitalization when the product is available for general release to customers. SaaS software costs We capitalize the direct costs associated with the software we develop for use in providing software-as-a-service to our customers during its application development stage, primarily consisting of employee-related costs. The types of activities performed during the application development stage create probable future economic benefits. Once the software is available for use in providing services to customers, we amortize the capitalized amount over three years with the amortization charged to cost of revenues. We expense activities performed during the preliminary project stage which are analogous to research and development activities. In addition, we expense the types of activities performed during the post-implementation / operation stage. These activities are likely to include release ready and release launch activities. Total capitalized hosting software costs were approximately $1.5 million and $4.5 million during fiscal 2011 and fiscal 2012, respectively. 53 -------------------------------------------------------------------------------- Table of Contents Stock-Based Compensation We amortize stock-based compensation expense based on the fair value of stock-based awards on a straight-line basis over the requisite vesting period as defined in the applicable plan documents which is typically four years. We determine the fair value of each option grant using the Black-Scholes model. The Black-Scholes model utilizes the expected volatility, the term which the option is expected to be outstanding and the risk free interest rate to calculate the fair value of an option. On November 18, 2011, the Board authorized an offer to employees, including executives, to exchange each employee stock option with an exercise price equal to or greater than $4.95 for a stock option with an exercise price of $1.58. This offer commenced on March 26, 2012 and expired April 23, 2012. 55 employees participated in the exchange offer for a total of 269,183 shares. We used the Black-Scholes method to determine the stock based compensation effect of the tender offer in the fourth quarter of fiscal 2012. Accounting for income taxes We recognize deferred tax assets and liabilities for the future tax consequences of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We measure deferred tax assets, including tax loss and credit carry forwards and liabilities using enacted tax rates expected to be applicable to taxable income in the years in which we expect those temporary differences to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and deferred tax liabilities. The components of the deferred tax assets and liabilities are individually classified as current and non-current based on their characteristics. We establish a valuation allowance if we believe that it is more likely than not that some or all of our deferred tax assets will not be realized. We do not recognize a tax benefit unless we determine that it is more likely than not that the benefit will be sustained upon external examination, such as an audit by a taxing authority. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. See Note 10 "Income Taxes" of the Notes to Consolidated Financial Statements. Recent Accounting Pronouncements See Note 2 "Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements for a discussion of recent accounting standards and pronouncements. |