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XO GROUP INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this report. Overview XO Group Inc. is the premier media and technology company devoted to weddings, pregnancy, and everything in between, providing young women with the trusted information, products, and advice they need to guide them through the most transformative events of their lives. Our family of premium brands began with the number one wedding brand, The Knot, and has grown to include WeddingChannel.com, The Nest, The Bump, and Ijie.com. XO Group Inc. is recognized by the industry for innovation in all media - from the web to social media and mobile, magazines and books, and video - and our groundbreaking social platforms have ignited passionate communities across the world. XO Group has leveraged its customer loyalty into successful businesses in online sponsorship and advertising, registry services, e-commerce, and publishing. In order to sustain growth within the customer groups we serve, we focus on our key growth strategy, which is to expand our position as a leading lifestage media company providing comprehensive information, services and products to couples from engagement through pregnancy on multiple platforms that remain relevant to the changing media landscape. To that end, we are focused on the following objectives: · Develop products and services to meet the needs of our audience members during critical lifestages. We continuously build tools and create services for our newly engaged, newlywed, and pregnant audiences in order to meet their needs for information and services across multiple media streams. We have built seven mobile apps in the last two years, including popular apps such as The Knot Wedding Planner, The Wedding Dress Look Book, and Pregnancy Buzz by The Bump. Tools such as our newly designed global wedding planner present our lifestage content in innovative ways. We are one of the first companies to stream live video on our Facebook page (as we did during bridal fashion week in 2011), and we continue to look for ways to increase our connection with our audience in innovative ways. · Leverage our strong brand and engaged audience for scalable advertising revenue growth. We have made significant investments in our infrastructure, especially that which supports our local advertising business. For example, we have launched a self-service platform that allows local vendors to automatically select their advertising programs. We have improved our ability to price display inventory dynamically, and we have launched a wedding vendor review site that enables brides to read reviews written by other recent brides. We have launched partnerships to increase the reach for our local vendors, including a microsite built for KleinfeldBridal.com in November 2011. We partner with our national advertisers to design highly targeted, integrated campaigns, which reach our engaged audience. Recent campaigns have featured events organized by The Knot, The Knot Live TV, sponsorships of our iPad apps, and other lifestage buys across our brands and platforms. · Improve transaction growth with innovative solutions for our membership base. Our relationship with our audience also includes services that we provide directly, including the recently upgraded e-commerce shops for wedding and baby gift items, the WeddingChannel registry platform, and other books, products, and services that we may sell from time to time. We are focused on connecting directly with our audience, presenting hard-to-find items, tools specific to the lifestages we serve as well as transactional opportunities. · Increase awareness of our brands and products. We believe that we have generally excelled at marketing to our consumers with compelling brands, engaging content and products and a highly successful consumer public relations program. We continue to garner attention for our brands via editorial appearances on national television, presence on newsstands, content syndication partnerships, and award-winning technology products. Our editors appear frequently on national and local television and radio programs, and attend industry trade shows around the country. In 2010, we increased the publication frequency of The Knot Weddings national magazine from semi-annually to quarterly. We also increased the publication frequency of The Bump local market guides from annually to semi-annually. Our content syndication and content distribution partnerships include MSN, Sling Media, Sugar Inc., McClatchy Tribune, YouTube, Yahoo! and The Huffington Post, among others, and we continue to release new products such as The Knot Weddings magazine for the iPad, which won a 2011 Appy Award. 18 · Expand our brands internationally. We are focused on identifying opportunities in large international markets where we can use our brand recognition and editorial authority on the key lifestages of engagement, newlywed and first-time pregnancy to drive further growth. In 2009, we established a software development center in Guangzhou, China for the purpose of increasing technology development productivity without materially growing technology costs. The software development center also is serving as a development resource for expanding our business in China. With a large number of weddings and an affinity for Western styles, we believe there is a substantial opportunity to serve Chinese couples with information and services about Western-style weddings, through the offices we opened in Beijing and Shanghai. In November 2010, we launched Ai Jie (Ijie.com). The website provides Western inspiration and local resources for weddings, newlyweds and pregnancy in China. There was immaterial revenue generated by our operations in China during 2011 and the nine months ended September 30, 2012. During 2011, we launched partnerships with two of the largest portals in China, SINA and cn.msn.com, for which we provide wedding and lifestyle content on cobranded "Wedding" channels. In addition, we have established an exclusive licensing arrangement for a major Australian media company to represent our brands in Australia. Our quarterly revenue and operating results have fluctuated significantly in the past and are expected to continue to fluctuate significantly in the future as a result of a variety of factors, many of which are outside of our control. These factors include the level of online usage and traffic on our websites, seasonal demand for e-commerce, including sales of registry products and wedding-related merchandise, seasonal frequency of weddings, the addition or loss of advertisers, the advertising budgeting cycles of specific advertisers, the regional and national magazines' publishing cycles, the amount and timing of capital expenditures and other costs relating to the expansion of our operations, including those related to acquisitions, the introduction of new sites and services by us or our competitors, changes in our pricing policies or the pricing policies of our competitors, and general economic conditions, such as the current recession, as well as economic conditions specific to the Internet, online and offline media and e-commerce. The Internet advertising and online markets in which our brands operate are rapidly evolving and intensely competitive, and we expect competition to intensify in the future. There are many wedding-related and baby-related sites on the Internet, which are developed and maintained by online content providers. New media platforms such as blogs, microblogs, social networks, and publisher networks are proliferating rapidly, including popular new sites like WeddingWire, Project Wedding, Wedding Bee, BabyCenter (published by Johnson & Johnson), Kaboose (published by Disney), and Café Mom. Retail stores, manufacturers, wedding magazines and regional wedding directories also have online sites that compete with us for online advertising and merchandise revenue. We expect competition to increase because of the business opportunities presented by the growth of the Internet and e-commerce. Competition may also intensify as a result of industry consolidation and a lack of substantial barriers to entry in our market. In the wedding market, we also face competition for our services from bridal magazines. Brides magazine (published by Condé Nast), Bridal Guide(published by RFP LLC), and Martha Stewart Weddings (published by Martha Stewart Living Omnimedia) are dominant bridal publications in terms of revenue and circulation. Leading publications for parents include Parenting (published by Bonnier), Parents (published by Meredith), and American Baby (published by Meredith). We believe that the principal competitive factors in the wedding market are brand recognition, convenience, ease of use, information, quality of service and products, member affinity and loyalty, reliability and selection. As to these factors, we believe that we compete favorably. Our dedicated editorial, sales and product staffs concentrate their efforts on producing the most comprehensive wedding resources available. Generally, many of our current and potential competitors have longer operating histories, significantly greater financial, technical and marketing resources and high name recognition. Therefore, these competitors have a significant ability to attract advertisers and users. In addition, many independent or start-up competitors may be able to respond more quickly than we can to new or emerging technologies and changes in Internet user requirements, and other competitors may be able to devote greater resources than we do to the development, promotion and sale of services. There can be no assurance that our current or potential competitors will not develop products and services comparable or superior to those developed by us or adapt more quickly than we do to new technologies, evolving industry trends or changing Internet user preferences. Any such developments or advantages of our competitors may have an impact on our future operations and may cause our past financial results not to be necessarily indicative of future operating results. Increased competition could result in price reductions, reduced margins or loss of market share, any of which would materially and adversely affect our business, results of operations and financial condition. 19 Third Quarter 2012 During the third quarter of 2012, both our net revenue and our net income increased compared to the same period in 2011. The highlights of the third quarter of 2012 were: · Total net revenue increased 2.2% over the corresponding 2011 period to $31.7 million. This increase was driven by higher national and local online advertising revenue and increased publishing and other revenue. These increases were partially offset by lower registry and e-commerce revenue. · National online advertising revenue increased 9.8% over the corresponding 2011 period to $6.5 million, driven by higher advertiser spending. · Local online advertising revenue increased 12.5% over the corresponding 2011 period to $12.5 million, driven by increased vendor count and increased average vendor spending. · Publishing and other revenue increased 18% over the corresponding 2011 period to $5.0 million. The increase was primarily due to increased advertising revenue from both our national and regional publications. · Registry services revenue decreased by 5.2% over the corresponding 2011 period to $2.1 million, primarily due to decreased commissions from our registry partners. · Merchandise revenue decreased 25.4% over the corresponding 2011 period to $5.7 million, primarily due to lower traffic and conversion rates at our e-commerce sites. · We had operating income of $3.3 million compared to $1.9 million for the three months ended September 30, 2012 and 2011, respectively. The year-over-year increase in our operating income was driven by increased revenue and gross profit, and was partially offset by increased operating expenses. Operating expenses increased primarily due to intangible asset impairments and increased compensation. We had net income for the three months ended September 30, 2012 of $2.1 million, or $0.08 per basic and diluted share compared to $1.3 million, or $0.05 per basic and $0.04 per diluted share for the three months ended September 30, 2011. · At September 30, 2012, our total cash and cash equivalents decreased to $72.7 million from $77.4 million at December 31, 2011. The primary cause of the decrease was our stock-repurchase activity. During the nine months ended September 30, 2012, we repurchased 2.1 million shares at an aggregate cost of $18.9 million. This was partially offset by cash from operations. · On October 29, 2012, we (in particular, our headquarters located in downtown Manhattan) were impacted by Hurricane Sandy. The storm caused widespread flooding and electricity outages throughout New York City and its surrounding areas. As a result, our headquarters remained closed for four days. Our websites, however, remained fully operational during this time period, as the hardware that operates these websites is located in a secure facility in Austin, Texas. We may file business interruption or other damage claims with our insurance agency to recover any potential lost revenues, additional costs or damages associated with the storm. At this time, we cannot estimate the range of losses or the amount or timing of any insurance proceeds that could potentially be received. This event did not have an impact on our condensed consolidated financial statements for the three and nine months ended September 30, 2012. 20 Results of Operations Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011 The following table summarizes results of operations for the three months ended September 30, 2012 compared to the three months ended September 30, 2011: Three Months Ended September 30, 2012 2011 % of Net % of Net Amount Revenue Amount Revenue (in thousands, except for per share data) Net revenue $ 31,734 100.0 % $ 31,049 100.0 % Cost of revenue 5,317 16.8 6,371 20.5 Gross profit 26,417 83.2 24,678 79.5 Operating expenses 23,150 73.0 22,801 73.4 Income from operations 3,267 10.2 1,877 6.1 Loss in equity interest (19 ) (0.0 ) (29 ) (0.1 )Interest and other income, net 82 0.3 423 1.4 Income before income taxes 3,330 10.5 2,271 7.4 Provision for income taxes 1,271 4.0 1,010 3.4 Net income 2,059 6.5 1,261 4.0 Plus: net loss attributable to non-controlling interest - - 22 0.1 Net income attributable to XO Group Inc. $ 2,059 6.5 % $ 1,283 4.1 % Net income per share attributable to XO Group Inc. common shareholders: Basic $ 0.08 $ 0.05 Diluted $ 0.08 $ 0.04 21 Net Revenue Net revenue of $31.7 million for the three months ended September 30, 2012 was 2.2% higher than the comparable period in the prior year. The following table sets forth revenue by category for the three months ended September 30, 2012 compared to the three months ended September 30, 2011, the percentage increase or decrease between those periods, and the percentage of total net revenue that each category represented for those periods: Three Months Ended September 30, Percentage Percentage of Net Revenue Increase/ Total Net Revenue 2012 2011 (Decrease) 2012 2011 (in thousands) National online sponsorship and advertising $ 6,479 $ 5,899 9.8 % 20.4 % 19.0 % Local online sponsorship and advertising 12,494 11,104 12.5 39.4 35.8 Total online sponsorship and advertising 18,973 17,003 11.6 59.8 54.8 Registry services 2,054 2,166 (5.2 ) 6.5 7.0 Merchandise 5,703 7,647 (25.4 ) 18.0 24.6 Publishing and other 5,004 4,233 18.2 15.7 13.6 Total net revenue $ 31,734 $ 31,049 2.2 % 100.0 % 100.0 % Online sponsorship and advertising - The increase of 11.6% was driven by increased revenue from both national and local advertising programs. National online sponsorship and advertising revenue increased 9.8%, driven by new advertisers and campaigns. Local online sponsorship and advertising revenue increased 12.5%, driven by an increased number of local vendors advertising with us on our network of websites. As of September 30, 2012, we had over 22,000 local vendors displaying over 29,600 profiles compared to over 20,500 vendors displaying over 26,900 profiles as of September 30, 2011. Registry services - The decrease of 5.2% was driven by decreased registry sales from registry partners and lower overall commission rates. Merchandise- The decrease of 25.4% was driven by lower traffic and conversion rates at our e-commerce sites. Publishing and other - The increase of 18.2% was driven by increased print advertising pages sold in The Knot national and regional magazines that published during the quarter. 22 Gross Profit/Gross Margin Gross margin increased 3.7% to 83.2%, compared to 79.5% in the comparable period in 2011. The following table presents the components of gross profit and gross margin for the three months ended September 30, 2012 compared to the three months ended September 30, 2011: Three Months Ended September 30, 2012 2011 Increase/(Decrease) Gross Gross Gross Gross Gross Gross Profit Margin % Profit Margin % Profit Margin % (in thousands) Online sponsorship and advertising (national & local) $ 18,533 97.7 % $ 16,477 96.9 % $ 2,056 0.8 % Registry services 2,054 100.0 2,166 100.0 (112 ) - Merchandise 2,418 42.4 3,100 40.5 (682 ) 1.9 Publishing and other 3,412 68.2 2,935 69.3 477 (1.1 ) Total gross profit $ 26,417 83.2 % $ 24,678 79.5 % $ 1,739 3.7 % The increase in gross margin was driven by the increase in online sponsorship and advertising and merchandise gross margin. The increase in online sponsorship and advertising gross margin was due to increased advertiser spending. Merchandise has a lower gross margin compared to our other lines of business. Therefore, the e-commerce business had lower revenue of $1.9 million and lower gross profit of $682,000 compared to the comparable period in the prior year, which positively impacted the overall gross margin of the Company. These increases in gross margin were partially offset by the decrease in publishing and other gross margin due to increased direct costs associated with other revenue. Additionally, overall gross margin was negatively impacted by reduced registry revenue, which has a 100% gross margin. Operating Expenses Operating expenses increased 1.5% to $23.2 million compared to $22.8 million in 2011. This was primarily due to increased stock-based compensation expense. As a percentage of net revenue, operating expenses were 73.0% and 73.4% during 2012 and 2011, respectively. The following table presents the components of operating expenses and the percentage of revenue that each component represented for the three months ended September 30, 2012 compared to the three months ended September 30, 2011: Three Months Ended September 30, Percentage Percentage of Operating Expenses Increase/ Total Net Revenue 2012 2011 (Decrease) 2012 2011 (in thousands) Product and content development $ 6,768 $ 5,827 16.2 % 21.3 % 18.8 % Sales and marketing 9,096 9,468 (3.9 ) 28.7 30.5 General and administrative 5,461 5,898 (7.4 ) 17.3 19.0 Long-lived asset impairment charges 958 716 33.8 3.0 2.3 Depreciation and amortization 867 892 (2.8 ) 2.7 2.8 Total operating expenses $ 23,150 $ 22,801 1.5 % 73.0 % 73.4 % Product and Content Development - The increase of 16.2% was due to increased stock-based compensation expense, increased headcount in our U.S. offices and software development center in Guangzhou, China, and increased computer hardware and software expenses. 23 Sales and Marketing - The decrease of 3.9% was due to lower sales bonus expense partially offset by increased stock-based compensation expense and increased costs associated with Ijie.com, including higher consulting costs, promotion costs, and headcount related costs. General and Administrative - The decrease of 7.4% was primarily due to a potential employment tax liability related to temporary and contracted employees in 2011. We also had higher rent and office expenses in 2011 due to the commencement of the lease of our new corporate headquarters while leasing and occupying our old facilities. These expenses did not re-occur in 2012. These decreases were partially offset by higher stock-based compensation. Long-lived asset impairment charges - Impairment charges were $958,000 and $716,000 for the three months ended September 30, 2012 and 2011, respectively. During the three months ended September 30, 2012, we concluded there were impairment indicators with respect to the WeddingChannel tradename. The impairment indicators included recent trending of lower overall e-commerce sales, as well as lower advertising and registry sales attributable to this tradename. Based primarily on future cash flow projections for the lines of business most closely related to this tradename, we concluded that an impairment charge of $736,000 was necessary in the third quarter of 2012. In addition, during the three months ended September 30, 2012 and 2011, we concluded that there were impairment indicators with respect to the tradename of an e-commerce we acquired in May 2009. Changes in the search engine optimization environment resulted in significantly lower website traffic. This reduction in traffic resulted in reduced revenue year over year as well as lower projected revenue in the future. These factors resulted in impairment charges of $222,000 and $318,000 against the e-commerce company's tradename during the three months ended September 30, 2012 and 2011, respectively. During the three months ended September 30, 2011, we concluded there were impairment indicators with respect to the WedSnap tradename and technology intangible assets. Facebook introduced changes to its application programming interface for third party applications that made it impractical to continue maintaining the WeddingBuzz message boards, which were the primary component of WeddingBuzz (the WedSnap Facebook application). As a result, we decided to close the WeddingBuzz service and redirect Facebook users to message boards and other services on TheKnot.com and WeddingChannel.com. This resulted in the write-off of the tradename and technology intangible assets associated with WedSnap. The amount of the impairment charge was $398,000. Depreciation and Amortization - The decrease of 2.8% was primarily driven by a lower intangible asset base in 2012 compared to 2011. Loss in Equity Interest Loss in equity interest for the three months ended September 30, 2012 and 2011 was $19,000 and $29,000, respectively. On April 20, 2012, we purchased a 5% equity investment in an entity and during the three months ended September 30, 2012, we recognized a $19,000 equity loss on their operating results. Our equity loss of $29,000 for the three months ended September 30, 2011 represented our 50% share of the operating loss associated with another entity in which we held an equity interest. On August 17, 2011, we entered into a capital contribution agreement concerning this entity. Under the terms of the capital contribution agreement, we contributed $1.0 million to fund operating expenses for the entity. Prior to August 17, 2011, we and another investor each held a 50% equity interest in the entity. Previously, we accounted for our equity interest using the equity method of accounting. Under the equity method of accounting, we recorded our investment in the entity as a component of other assets on the balance sheet and our share of the operating results in the loss in equity interest line of the statement of operations. Under the capital contribution agreement, we held 75% of the equity interest in the entity and the other investor held the remaining 25%. As a result of the change in our equity interest in the entity, we controlled the entity and consolidated 100% of financial results of the entity in our financial statements effective during the second quarter of 2012. We recorded the other investor's share of equity as non-controlling interest in subsidiary on the balance sheet and recorded its share of the operating results as net loss attributable to non-controlling interest on the statement of operations. On April 20, 2012, we contributed an additional $500,000 of capital to the entity. At the same time, we purchased the other investor's equity interest in the entity in exchange for an option to repurchase a portion of our equity interest representing a maximum of 12% of the entity's equity if exercised on or before October 13, 2013 or a maximum of 6% if exercised between October 14, 2013 and April 13, 2015. We now own 100% of the equity interest in the entity. Interest and Other Income Interest and other income, net was income of $82,000 for the three months ended September 30, 2012, compared to income of $423,000 for the three months ended September 30, 2011. The variance was primarily due to a decrease in foreign currency exchange gains of $212,000 and a decrease in other income of $129,000, compared to the prior period. 24 Provision for Income Taxes The effective tax rate for the three months ended September 30, 2012 was approximately 38.2%, compared to 44.6% for the three months ended September 30, 2011. Net Loss Attributable to Non-Controlling Interest Net loss attributable to non-controlling interest was $0 and $22,000 for the three months ended September 30, 2012 and 2011, respectively. Net loss attributable to non-controlling interest represented the 25% equity interest in one of our consolidated subsidiaries held by another investor prior to April 20, 2012, as described in the Loss in Equity Interest section above. 25 Results of Operations Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011 The following table summarizes results of operations for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011: Nine Months Ended September 30, 2012 2011 % of Net % of Net Amount Revenue Amount Revenue (in thousands, except for per share data) Net revenue $ 96,950 100.0 % $ 93,312 100.0 % Cost of revenue 16,946 17.5 19,391 20.8 Gross profit 80,004 82.5 73,921 79.2 Operating expenses 70,936 73.2 68,139 73.0 Income from operations 9,068 9.3 5,782 6.2 Loss in equity interest (29 ) (0.0 ) (269 ) (0.3 )Interest and other income, net 73 0.1 516 0.5 Income before income taxes 9,112 9.4 6,029 6.4 Provision for income taxes 3,584 3.7 2,557 2.7 Net income 5,528 5.7 3,472 3.7 Plus: net loss attributable to non-controlling interest 65 0.1 22 - Net income attributable to XO Group Inc. $ 5,593 5.8 % $ 3,494 3.7 % Net income per share attributable to XO Group Inc. common shareholders: Basic $ 0.23 $ 0.12 Diluted $ 0.22 $ 0.11 26 Net Revenue Net revenue of $97.0 million for the nine months ended September 30, 2012 was 3.9% higher than the comparable period in the prior year. The following table sets forth revenue by category for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, the percentage increase or decrease between those periods, and the percentage of total net revenue that each category represented for those periods: Nine Months Ended September 30, Percentage Percentage of Net Revenue Increase/ Total Net Revenue 2012 2011 (Decrease) 2012 2011 (in thousands) National online sponsorship and advertising $ 19,544 $ 19,574 (0.2 )% 20.2 % 21.0 % Local online sponsorship and advertising 37,030 31,851 16.3 38.2 34.1 Total online sponsorship and advertising 56,574 51,425 10.0 58.4 55.1 Registry services 5,056 5,395 (6.3 ) 5.2 5.8 Merchandise 18,228 21,450 (15.0 ) 18.8 23.0 Publishing and other 17,092 15,042 13.6 17.6 16.1 Total net revenue $ 96,950 $ 93,312 3.9 % 100.0 % 100.0 % Online sponsorship and advertising - The increase of 10.0% was driven by increased revenue from local advertising programs, which was partially offset by lower national online sponsorship and advertising revenue. Local online sponsorship and advertising revenue increased 16.3%, driven by an increased number of local vendors advertising with us on our network of websites. As of September 30, 2012, we had over 22,000 local vendors displaying over 29,600 profiles, compared to over 20,500 vendors displaying nearly 26,900 profiles as of September 30, 2011. National online sponsorship and advertising revenue decreased 0.2% due to decreased spending from our national advertisers. Registry services - The decrease of 6.3% was driven by decreased registry sales from registry partners and lower overall commission rates. Merchandise- The decrease of 15.0% was driven by lower traffic and conversion rates at our e-commerce sites. Publishing and other - The increase of 13.6% was driven by increased print advertising pages sold in The Knot national and regional magazines as well as The Bump magazines that published during the first nine months of the year. 27 Gross Profit/Gross Margin Gross margin increased 3.3% to 82.5%, compared to 79.2% in the comparable period in 2011. The following table presents the components of gross profit and gross margin for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011: Nine Months Ended September 30, 2012 2011 Increase/(Decrease) Gross Gross Gross Gross Gross Gross Profit Margin % Profit Margin % Profit Margin % (in thousands) Online sponsorship and advertising (national & local) $ 55,242 97.6 % $ 49,774 96.8 % $ 5,468 0.8 % Registry 5,056 100.0 5,395 100.0 (339 ) - Merchandise 7,973 43.7 8,633 40.3 (660 ) 3.4 Publishing and other 11,733 68.6 10,119 67.3 1,614 1.3 Total gross profit $ 80,004 82.5 % $ 73,921 79.2 % $ 6,083 3.3 % The increase in gross margin was driven by the increase in online sponsorship and advertising, publishing and other, and merchandise gross margin. The increase in online sponsorship and advertising was due to increased revenue from local advertising programs. The increase in publishing and other gross margin was driven by increased advertising pages sold in both the national and regional The Knot and The Bump magazines. Merchandise has a lower gross margin compared to our other lines of business. Therefore, the e-commerce business had lower revenue of $3.2 million and lower gross profit of $660,000 compared to the comparable period in the prior year, which positively impacted the overall gross margin of the Company. Additionally, overall gross margin was negatively impacted by reduced registry revenue, which has a 100% gross margin. Operating Expenses Operating expenses increased 4.1% to $70.9 million compared to $68.1 million in the comparable period in 2011. This was due in part to increased stock-based compensation expense, increased sales commissions, and salary expense. There were also increased costs associated with Ijie.com due to increased headcount and promotion expenses. As a percentage of net revenue, operating expenses were 73.2% and 73.0% during the nine months ended September 30, 2012 and 2011, respectively. The following table presents the components of operating expenses and the percentage of revenue that each component represented for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011: Nine Months Ended September 30, Percentage Percentage of Operating Expenses Increase/ Total Net Revenue 2012 2011 (Decrease) 2012 2011 (in thousands) Product and content development $ 20,234 $ 18,662 8.4 % 20.9 % 20.0 % Sales and marketing 30,507 29,631 3.0 31.5 31.8 General and administrative 16,497 15,713 5.0 17.0 16.8Long-lived asset impairment charges 958 716 33.8 1.0 0.8 Depreciation and amortization 2,740 3,417 (19.8 ) 2.8 3.6 Total operating expenses $ 70,936 $ 68,139 4.1 % 73.2 % 73.0 % 28 Product and Content Development - The increase of 8.4% was due to increased stock-based compensation expense, increased headcount and rent expense in our software development center in Guangzhou, China, and increased computer hardware and software expenses. Sales and Marketing - The increase of 3.0% was due to increased stock-based compensation expense and increased costs associated with Ijie.com due to increased headcount to support our growth initiatives, consulting costs and promotion costs. General and Administrative - The increase of 5.0% was primarily due to increased stock-based compensation expense, higher rent and occupancy costs and increased bad debt expense. Rent and occupancy office costs increased when we entered into a new lease effective August 2012 for our new corporate headquarters in New York. Our bad debt expense increased due to an additional specific reserve for potential non-payment of an invoice by a customer who recently filed for Chapter 11 bankruptcy protection. Long-lived asset impairment charges - Impairment charges were $958,000 and $716,000 for the nine months ended September 30, 2012 and 2011, respectively. During the nine months ended September 30, 2012, we concluded there were impairment indicators with respect to the WeddingChannel tradename. The impairment indicators included recent trending of lower overall e-commerce sales, as well as lower advertising and registry sales attributable to this tradename. Based primarily on future cash flow projections for the lines of business most closely related to this tradename, we concluded that an impairment charge of $736,000 was necessary in the third quarter of 2012. In addition, during the nine months ended September 30, 2012 and 2011, we concluded that there were impairment indicators with respect to the tradename of an e-commerce company we acquired in May 2009. Changes in the search engine optimization environment resulted in significantly lower website traffic. This reduction in traffic resulted in reduced revenue year over year as well as lower projected revenue in the future. These factors resulted in impairment charges of $222,000 and $318,000 against the e-commerce company's tradename during the nine months ended September 30, 2012 and 2011, respectively. During the nine months ended September 30, 2011, we concluded there were impairment indicators with respect to the WedSnap tradename and technology intangible assets. Facebook introduced changes to its application programming interface for third party applications that made it impractical to continue maintaining the WeddingBuzz message boards, which were the primary component of WeddingBuzz (the WedSnap Facebook application). As a result, we decided to close the WeddingBuzz service and redirect Facebook users to message boards and other services on TheKnot.com and WeddingChannel.com. This resulted in the write-off of the tradename and technology intangible assets associated with WedSnap. The amount of the impairment charge was $398,000. Depreciation and Amortization - The decrease of 19.8% was driven by a lower intangible asset base in 2012 compared to 2011. Loss in Equity Interest Loss in equity interest for the nine months ended September 30, 2012 and 2011 was $29,000 and $269,000, respectively. On April 20, 2012, we purchased a 5% equity investment in an entity and during the nine months ended September 30, 2012, we recognized a $10,000 equity loss on their operating results. Our equity loss of $269,000 for the nine months ended September 30, 2011 represented our 50% share of the operating loss associated with another entity in which we held an equity interest. On August 17, 2011, we entered into a capital contribution agreement concerning this entity. Under the terms of the capital contribution agreement, we contributed $1.0 million to fund operating expenses for the entity. Prior to August 17, 2011, we and another investor each held a 50% equity interest in the entity. Previously, we accounted for our equity interest using the equity method of accounting. Under the equity method of accounting, we recorded our investment in the entity as a component of other assets on the balance sheet and our share of the operating results in the loss in equity interest line of the statement of operations. Under the capital contribution agreement, we held 75% of the equity interest in the entity and the other investor held the remaining 25%. As a result of the change in our equity interest in the entity, we controlled the entity and consolidated 100% of financial results of the entity in our financial statements. We recorded the other investor's share of equity as non-controlling interest in subsidiary on the balance sheet and recorded its share of the operating results as net loss attributable to non-controlling interest on the statement of operations. On April 20, 2012, we contributed an additional $500,000 of capital to the entity. At the same time, we purchased the other investor's equity interest in the entity in exchange for an option to repurchase a portion of our equity interest representing a maximum of 12% of the entity's equity if exercised on or before October 13, 2013 or a maximum of 6% if exercised between October 14, 2013 and April 13, 2015. We now own 100% of the equity interest in the entity. Interest and Other Income, net Interest and other income, net was income of $73,000 for the nine months ended September 30, 2012 as compared to income of $516,000 for nine months ended September 30, 2011. The variance was primarily due to a decrease in foreign currency exchange gains of $310,000 and a decrease in other income of $133,000, compared to the prior period. 29 Provision for Income Taxes The effective tax rate for the nine months ended September 30, 2012, was 39.3% as compared to 42.4% for the nine months ended September 30, 2011. Net Loss Attributable to Non-Controlling Interest Net loss attributable to non-controlling interest was $65,000 and $22,000 for the nine months ended September 30, 2012 and 2011, respectively. Net loss attributable to non-controlling interest represented the 25% equity interest in one of our consolidated subsidiaries held by another investor prior to April 20, 2012, as described in the Loss in Equity Interest section above. 30 Liquidity and Capital Resources Cash Flow Cash and cash equivalents consist of cash and highly liquid investments with maturities of 90 days or less at the date of acquisition. At September 30, 2012, we had $72.7 million in cash and cash equivalents, compared to $84.0 million at September 30, 2011. The following table sets forth our cash flows from operating activities, investing activities and financing activities for the periods indicated: For the Nine Months Ended September 30, 2012 2011 (in thousands) Net cash provided by operating activities $ 18,417 $ 12,212 Net cash used in investing activities (2,536 ) (6,383 ) Net cash used in financing activities (20,550 ) (61,429 ) Decrease in cash and cash equivalents $ (4,669 ) $ (55,600 ) Operating Activities Net cash provided by operating activities was $18.4 million for the nine months ended September 30, 2012. This was driven by our net income of $5.5 million adjusted for non-cash items. Non-cash items included depreciation, amortization, stock-based compensation, reserve for returns and other non-cash items of $13.7 million. Also driving the increase in cash was a decrease in inventory of $1.4 million due to efforts to reduce high inventory levels from last year by decreasing stock replenishments, as well as an increase in deferred revenue of $1.2 million due to advanced billings of our 2012 Winter national The Knot magazine and 2013 Spring and Summer local The Knot magazines. Deferred production and marketing costs and other assets decreased due to our normal amortization of prepaid expenses and publication of our national and local magazines. We experienced an increase in other liabilities of $885,000 associated with the contractual obligations of our New York and Austin leased locations. Partially offsetting these increases were decreases to cash associated with a decrease in accounts payable and accrued expenses of $3.1 million, higher accounts receivable of $824,000, and an increase in other current assets of $558,000. Net cash provided by operating activities was $12.2 million for the nine months ended September 30, 2011. This was driven by our net income of $3.5 million adjusted for non-cash items. Non-cash items included depreciation, amortization, stock-based compensation, reserve for returns and other non-cash items of $12.4 million. These increases were offset by a $3.6 million decrease in working capital. We experienced an increase in trade accounts receivable of $7.0 million driven by our national and local advertising businesses. We experienced increased inventory of $1.1 million in anticipation of higher seasonal sales of merchandise from our e-commerce business in the second and third quarters. We also experienced decreased accounts payable and accrued expenses of $1.6 million driven by payments on magazine production-related invoices. These uses of cash were offset by increased deferred revenue of $2.4 million due to advanced billings and increased other liabilities of $2.2 million driven by rent and other costs incurred in connection with our new lease on office space in New York. Investing Activities Net cash used in investing activities was $2.5 million for the nine months ended September 30, 2012. Capital expenditures of $2.0 million included purchases of fixed assets and capitalized software hours. The $2.6 million in short-term U.S. Treasury Bills purchased on May 13, 2011, matured on May 12, 2012. We purchased another $2.6 million in U.S. Treasury Bills to collateralize the irrevocable letter of credit we entered into with Union Bank of Switzerland. For further information, refer to Note 6 of the Condensed Consolidated Financial Statements included herein. We also made an equity investment in the amount of $500,000 and purchased URLs in the amount of $27,000. Net cash used in investing activities was $6.4 million for the nine months ended September 30, 2011. Capitalized expenditures of $3.4 million consisted of purchases of fixed assets, including $1.6 million on construction for our new corporate headquarters in New York. We also purchased $2.6 million in short-term U.S. Treasury Bills to collateralize the irrevocable letter of credit we entered into with Union Bank of Switzerland, as required under the terms of an agreement entered into on May 13, 2011 with 195 Broadway LLC in respect of our lease of office space in New York. For further information, refer to Note 6 of the Condensed Consolidated Financial Statements included herein. 31 Financing Activities Net cash used in financing activities was $20.6 million for the nine months ended September 30, 2012. On December 19, 2011, the Board of Directors authorized a stock repurchase program of $20.0 million of our common stock. Under this program, we repurchased 2.1 million shares of our stock in the open market at an average price of $8.96 per share, for a total price of $18.9 million, during the six months ended June 30, 2012. All shares were retired upon repurchase. On June 12, 2012 we completed the program. We also had repurchases of common stock in connection with the surrender of these shares by employees to satisfy tax withholding obligations related to the vesting of restricted stock awards of $1.9 million. These uses of cash were partially offset by the proceeds from the issuance of common stock under our restricted stock and employee stock purchase plan of $295,000. Net cash used in financing activities was $61.4 million for the nine months ended September 30, 2011. This was driven by repurchases of our common stock under our Board-approved stock repurchase programs. On February 25, 2011, we entered into a stock purchase agreement with Macy's, pursuant to which we agreed to repurchase 3.7 million shares of our common stock held by Macy's. The aggregate purchase price of the transaction was $37.7 million, based on the closing price of $10.26 per share for our common stock on the date of the agreement. The shares repurchased represent 10.7% of our outstanding common stock. We also repurchased 2.4 million shares of our stock on the open market at an average price of $9.22 per share, for a total price of $22.5 million. The shares repurchased on the open market represent 7.1% of our outstanding common stock. All shares were retired upon repurchase. We also had repurchases of common stock in connection with the surrender of these shares by employees to satisfy tax withholding obligations related to the vesting of restricted stock awards of $1.5 million. We also made a loan to an equity method investee of $125,000. These uses of cash were offset by the proceeds from the issuance of common stock in connection with the exercise of stock options and warrants and the employee stock purchase plan of $346,000. 32 Off-Balance Sheet Arrangements As of September 30, 2012, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Seasonality We believe that the impact of the frequency of weddings varying from quarter to quarter results in lower registry services and merchandise revenues in thefirst and fourth quarters. Critical Accounting Policies Our discussion of results of operations and financial condition relies on our consolidated financial statements, which are prepared based on certain critical accounting policies that require management to make judgments and estimates that are subject to varying degrees of uncertainty. We believe that investors need to be aware of these policies and how they impact our financial statements as a whole, as well as our related discussion and analysis presented herein. While we believe that these accounting policies are based on sound measurement criteria, actual future events can result in outcomes that may be materially different from these estimates or forecasts. The accounting policies and related risks described in our Annual Report on Form 10-K for the year ended December 31, 2011 are those that depend most heavily on these judgments and estimates. As of September 30, 2012, there have been no material changes to any of the critical accounting policies contained therein except for the assets held for sale described in Note 1 of the Condensed Consolidated Financial Statements included herein. Recently Adopted Accounting Pronouncements In May 2011, the accounting standard relating to fair value measurements was amended to develop common requirements and comparability for fair value measurements between U.S. GAAP and the International Financial Reporting Standards. Additional disclosures required by this updated standard include additional information about transfers in and out of Levels 1 and 2, additional information surrounding the sensitivity of Level 3 items, and the categorization by level of the fair value hierarchy for items not measured at fair value. This updated standard is effective for all interim and annual periods beginning after December 15, 2011. The adoption of this updated standard did not result in a material impact on our condensed consolidated financial statements. In June 2011, the accounting standard relating to the presentation of comprehensive income was amended to eliminate the option to present other comprehensive income and its components in the statement of stockholders' equity. We can elect to present the items of net income and other comprehensive income in a continuous statement of comprehensive income or in two separate, but consecutive, single statements. Under either method, the statement would need to be presented with equal prominence as the other primary financial statements. The amended guidance, which must be applied retroactively, is effective for the interim and annual periods in 2012. We adopted this guidance effective January 1, 2012 and have included the presentation of comprehensive income in a separate statement that immediately follows the Condensed Consolidated Statements of Operations in this Quarterly Report on Form 10-Q. In September 2011, the accounting standard relating to intangibles and goodwill was updated to address the cost and complexity of performing the two-step goodwill impairment test required under Topic 350. The amendments to this standard allow an entity to perform a qualitative approach to test goodwill in order to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. This updated standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this update did not result in a material impact on our condensed consolidated financial statements. Recently Issued Accounting Pronouncements In July 2012, the accounting standard relating to indefinite-lived intangible assets was updated to reduce the cost and complexity of performing an impairment test on such assets required under Topic 350. The amendment to the standard allows an entity to first assess the qualitative factors to determine if the indefinite-lived intangible asset is impaired as a basis to determine whether or not to perform the quantitative impairment test. This updated standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. This is not expected to have a material impact on our financial statements. 33 In October 2012, the accounting standard relating to entertainment films was updated to require that if there is evidence of a potential write-down of unamortized film costs, which occurs after the date of the balance sheet, but before the financial statements are issued, there is a potential write-off as of the balance sheet date. This updated standard is effective for impairment assessments performed on or after December 15, 2012. This is not expected to have a material impact on our financial statements. |