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LYRIS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended June 30, 2012, or fiscal year 2012, included in our Annual Report on Form 10-K for fiscal year 2012, filed with the SEC on September 14, 2012 . This Quarterly Report on Form 10-Q, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements identify prospective information, particularly statements referencing our expectations regarding revenue and operating expenses, cost of revenue, tax and accounting estimates, cash, cash equivalents and cash provided by operating activities, the demand and expansion opportunities for our products, our customer base, our competitive position and the impact of the current economic environment on our business. In some cases, forward-looking statements can be identified by the use of words such as "may," "could," "would," "might," "will," "should," "expect," "forecast," "predict," "potential," "continue," "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "is scheduled for," "targeted," and variations of such words and similar expressions. Such forward-looking statements are based on current expectations, estimates, and projections about our industry, management's beliefs, and assumptions made by management. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under "Risk Factors" or included elsewhere in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. 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. Lyris ONE is our next-generation cloud-based platform for data-driven digital marketing automation released in September of 2012. Lyris ONE analyzes customer interactive data from structured and unstructured sources, including social, email, mobile and hundreds of enterprise applications, to power digital marketing campaigns that facilitate superior customer engagement and drive revenue. By natively integrating deep customer analytics with real-time data processing and campaign automation, Lyris ONE maximizes the relevancy and value of every customer interaction. Lyris ONE is targeted at the enterprise market. Lyris HQ is our proven cloud-based digital marketing solution that combines enterprise-class email marketing with web analytics. Lyris HQ helps marketers manage complex email marketing campaigns and provides real-time access to revenue and conversion events to inform message targeting, relevancy, and timeliness. Lyris HQ is targeted at Mid-to-large size enterprise companies. Lyris ListManager is our on-premises solution for advanced email marketing. It includes powerful automation features and reporting capabilities, and its flexible and configurable architecture integrates seamlessly with in-house databases so that digital marketers can leverage existing data stores to target customers and prospects more effectively. Lyris ListManager is targeted atthe SMB market. 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 revenues are recurring, comprised of subscription and support and maintenance. We derive revenue from subscriptions to our SaaS solutions (Lyris HQ and Lyris ONE), 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. 18 Critical Accounting Policies and Use of Estimates Our unaudited condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP"). The preparation of these condensed 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. Accordingly, actual results could differ significantly from the estimates made by our management. 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 our 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 with our audit committee, these critical accounting policies, our use of estimates and any related disclosures. 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. ASU No. 2009-13 significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. We adopted ASU No. 2009-13 in the first quarter of fiscal year 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 generally recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) 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); (3) the amount of fees to be paid by the customer is fixed or determinable; and (4) 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. In October 2009, the Financial Accounting Standards Board (''FASB'') issued an Accounting Standards Update 2009-13, Multiple-Deliverable Revenue Arrangements a consensus of the FASB Emerging Issues Task Force (''ASU No. 2009-13'') which amended the accounting standards for revenue recognition for multiple deliverable revenue arrangements to: · Provide updated guidance on how the deliverables of an arrangement should be separated and how the consideration should be allocated; · Eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method; and · 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: · VSOE-the price at which the element is sold in a separate stand-alone transaction · TPE-evidence from Lyris or other companies of the value of a largely interchangeable element in a transaction · ESP-our best estimate of the selling price of an element in a transaction 19 We adopted ASU No. 2009-13 for fiscal year 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 year 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: · 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. · 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. · 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, Lyris allocates consideration in multiple-element arrangements based on the relative selling prices. Revenue is then recognized as appropriate for each separate element based on our fair value. For the three and six month ended December 31, 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 after July 1, 2010. 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 three and six months ended December 31, 2012 and fiscal year 2012 and is not anticipated to become material for the remainder of fiscal year 2013. 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 (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 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 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. 20 Software Revenue We enter into certain revenue arrangements for which it is obligated to deliver multiple products and/or services (multiple elements). For these arrangements, which generally include software products, technical (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 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 elementof 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. Financial Results of Operations Three and Six Months Ended December 31, 2012 Compared to Three and Six Months Ended December 31, 2011 The following tables set forth our condensed consolidated statements of operations data as a percentage of total revenue for the three and six months ended December 31, 2012 and 2011: Three Months Ended Six Months Ended December 31, December 31, 2012 2011 2012 2011 Subscription revenue 76 % 72 % 78 % 73 %Support and maintenance revenue 10 % 9 % 10 % 9 % Professional services revenue 6 % 13 % 7 % 13 % Software revenue 8 % 6 % 5 % 5 % Total revenue 100 % 100 % 100 % 100 % Cost of revenue 37 % 36 % 39 % 37 % Gross profit 63 % 64 % 61 % 63 % Operating expenses: Sales and marketing 26 % 21 % 25 % 27 % General and administrative 20 % 23 % 23 % 24 % Research and development 9 % 18 % 11 % 17 % Amortization of customer relationships and trade names 1 % 10 % 1 % 6 % Impairment of goodwill 0 % 85 % 0 % 45 %Impairment of capitalized software 0 % 4 % 0 % 2 % Total operating expenses 56 % 161 % 60 % 121 % Income (loss) from operations 7 % -97 % 1 % -58 % Interest expense 0 % -1 % -1 % -1 % Interest income 0 % 0 % 0 % 0 %Other (expense) income, net 0 % 0 % 0 % 0 % Income (loss) from operations before income taxes 7 % -98 % 0 % -59 % Income tax provision 0 % -1 % -1 % -1 % Net income (loss) 7 % -99 % -1 % -60 % Less: Net loss attributable to noncontrolling interest 0 % 0 % 0 % 0 % Net income (loss) attributable to Lyris, Inc. 7 % -99 % -1 % -60 % 21 Revenue Three Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Subscription revenue Lyris HQ revenue 5,582 5,192 390 8 % Legacy revenue 1,757 2,380 (623 ) (26) %Total subscription revenue 7,339 7,572 (233 ) (3) % Support and maintenance revenue 997 934 63 7 % Professional services revenue 586 1,379 (793 ) (58) % Software revenue 743 682 61 9 % Total revenue $ 9,665 $ 10,567 $ (902 ) (9) % Six Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Subscription revenue Lyris HQ revenue $ 11,007 $ 10,031 $ 976 10 % Legacy revenue 3,460 4,774 (1,314 ) (28) % Total subscription revenue 14,467 14,805 (338 ) (2) %Support and maintenance revenue 1,928 1,883 45 2 % Professional services revenue 1,256 2,561 (1,305 ) (51) % Software revenue 986 981 5 1 % Total revenue $ 18,637 $ 20,230 $ (1,593 ) (8) % Subscription revenue Subscription revenue is primarily comprised of subscription fees from customers accessing our hosted services application and from customers purchasing additional offerings that are not included in the standard hosting agreement. Our subscription revenue includes revenue from our Lyris ONE, Lyris HQ product, and a variety of legacy products which are in the process of reaching their end of life. Subscription revenue was $7.3 million or 76% of our total revenue for the three months ended December 31, 2012, compared to $7.6 million or 72% of our total revenue for the three months ended December 31, 2011, a decrease of $0.3 million or 3%. Subscription revenue was $14.5 million or 78% of our total revenue for the six months ended December 31, 2012, compared to $14.8 million or 73% for the six months ended December 31, 2011. Subscription revenue related to Lyris HQ for the three and six months ended December 31, 2012 increased compared to the same period in fiscal year 2012, primarily as a result of sales to new customers, increased usage from our existing customers and migration from our legacy product to Lyris HQ. Subscription revenue related to Lyris ONE for the three and six months ended December 31, 2012 increased compared to the same period in fiscal year 2012, primarily as a result of our launching Lyris ONE in September, 2012. Subscription revenue related to legacy products decreased for the three and six months ended December 31, 2012 compared to the same period in fiscal year 2012, primarily due to ending contracts with low priced subscriptions and management's decision to end the life of low margin legacy products. Support and maintenance revenue Support and maintenance revenue is primarily comprised of customer service and support for our products. Support and maintenance revenue was $1.0 million or 10% of our total revenue for the three months ended December 31, 2012 compared to $0.9 million or 9% of our total revenue for the three months ended December 31, 2011. Support and maintenance revenue was $1.9 million or 10% of our total revenue for the six months ended December 31, 2012, compared to $1.9 million or 9% of our total revenue for the six months ended December 31, 2011, respectively. The slight increase for the three and six months ended in support and maintenance is a result of our proactive effort to update customer support, new customers and customer upsells. 22 Professional services revenue 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. Professional services revenue was $0.6 million or 6% of our total revenue for the three months ended December 31, 2012, compared to $1.4 million or 13% of our total revenue for three months ended December 31, 2011, a decrease of $0.8 million or 58%. Professional services revenue was $1.3 million or 7% of our total revenue for the six months ended December 31, 2012, compared to $2.6 million or 13% for the six months ended December 31, 2011, a decrease of $1.3 million or 51%. Professional services revenue decreased for the three and six months ended December 31, 2012 compared to the same periods in fiscal year 2012 primarily due to management's decision to terminate our low margin list building service from our Cogent acquisition in June 2011, customer turnover, and customers migrating from professional to subscription based service. Software revenue Software revenue is derived from perpetual licensing rights of our software that we sell to our customers. Software revenue was $0.7 million or 8% of our total revenue for the three months ended December 31, 2012 compared to $0.7 million and 6% of our total revenue for the three months ended December 31, 2011. Software revenue was $1.0 million or 5% of our total revenue for six months ended December 31, 2012 and 2011. Software revenue remained relatively flat for the three and six months ended December 31, 2012 as compared to the same period in fiscal year 2012 is primarily due to an increase in new sales and offset by existing customer turnover. Cost of revenue Cost of revenue consists primarily 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. Three Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Cost of revenue $ 3,541 $ 3,769 $ (228 ) (6) % Six Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Cost of revenue $ 7,344 $ 7,349 $ (5 ) (0) % Cost of revenue was $3.6 million for the three months ended December 31, 2012, compared to $3.8 million for the three months ended December 31, 2011, a decrease of $0.2 million or 6%. As a percentage of net revenue, cost of revenue increased to 37% for the three months ended December 31, 2012 from 36% for the three months ended December 31, 2011. The decrease in cost of revenue for the three months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to decrease of $0.4 million in facilities related to decrease in data centers, $0.1 million decrease in recruiting fees and $0.2 million decrease in overhead cost. Through our cost control efforts, we realized the benefit from our low-margin marketing service was insignificant and to reduce our cost, we terminated this service which resulted in a decrease of $0.2 million in publisher payments related to the Cogent acquisition in June, 2011. The decrease in cost of revenue was offset by the increase in amortization and depreciation expense of $0.3 million primarily due to amortization of our internally developed software and an increase in compensation expense of $0.4 million as a result from increasing our support and engineering team to support Lyris One. 23 Cost of revenue was $7.3 for the six months ended December 31, 2012, compared to $7.3 million for the six months ended December 31, 2011, a decrease of $5 thousand. As a percentage of net revenue, cost of revenue increased to 39% for the six months ended December 31, 2012 from 37% for the six months ended December 31, 2011. The slight decrease in cost of revenue for the six months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to decrease of $0.4 million in facilities related to decrease in data centers, $0.3 million decrease in overhead cost and 0.4 million in publisher payments resulted from our termination of low margin marketing service. The decrease in cost of revenue was offset by the increase in amortization and depreciation expense of $0.4 million primarily due to amortization of our internally developed software and an increase in compensation expense of $0.7 million as a result as a result from increasing our support and engineering team to support Lyris One. Gross profit Three Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Gross profit $ 6,124 $ 6,798 $ (674 ) (10) % Six Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Gross profit $ 11,293 $ 12,881 $ (1,588 ) (12) % Gross profit was $6.1 million for the three months ended December 31, 2012, compared to 6.8 million for the three months ended December 31, 2011, a decrease of $0.7 million or 10%. As a percentage of net revenue, gross profit decreased to 63% for the three months ended December 31, 2012 from 64% for the three month ended, December 31, 2011. Gross profit was $11.3 million for the six months ended December 31, 2012, compared to 12.9 million for the six months ended December 31, 2011, a decrease of $1.6 million or 12%. As a percentage of net revenue, gross profit decreased to 61% from 63% for the six months ended December 31, 2011. Decrease in gross profit is primarily related to decrease in cost of revenue. Operating expenses Three Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Sales and marketing $ 2,495 $ 2,187 $ 308 14 % General and administrative 1,939 2,358 (419 ) (18) % Research and development 836 1,933 (1,097 ) (57) % Amortization and impairment of customer relationships and trade names 50 1,013 (963 ) (95) % Impairment of goodwill - 9,000 (9,000 ) (100) % Impairment of capitalized software - 385 (385 ) (100) % Total operating expenses $ 5,320 $ 16,876 $ (11,556 ) (68) % 24 Six Months Ended December 31 Change 2012 2011 $ Percent (In thousands, except percentages) Sales and marketing $ 4,770 $ 5,296 $ (526 ) (10) % General and administrative 4,246 4,695 (449 ) (10) % Research and development 1,997 3,339 (1,342 ) (40) % Amortization and impairment of customer relationships and trade names 101 1,235 (1,134 ) (92) % Impairment of goodwill - 9,000 (9,000 ) (100) % Impairment of capitalized software - 385 (385 ) (100) % Total operating expenses $ 11,114 $ 23,950 $ (3,451 ) (14) % 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 was $2.5 million for the three months ended December 31, 2012, compared to $2.2 million for the three months ended December 31, 2011, an increase of $0.3 million or 14%. As a percentage of net revenue, sales and marketing expense increased to 26% for the three months ended December 31, 2012 from 21% for same period in fiscal year 2012. The increase in sales and marketing expense was primarily due to $0.3 million increase in our sales and marketing workforce due to a reorganization of our department during the three months ended December 31, 2011. The increase is also related to $0.1 million increase in overhead expense as a result of our increase in our sales and marketing expenses. The increase is offset by the decrease of $0.1 million in spending for advertising and other promotional programs. Sales and marketing expense was $4.8 million for the six months ended December 31, 2012, compared to $5.3 million for the six months ended December 31, 2011, a decrease of $0.5 million or 10%. As a percentage of net revenue, sales and marketing expense decreased to 25% for the six months ended December 31, 2012 from 27% for same period in fiscal year 2012. During the three months ended December 31, 2011, we had a reorganization of our sales and marketing department. The overall effect of the reorganization decreased $0.2 million in our sales and marketing workforce for the six months ended December 31, 2012 compared to December 31, 2011. The decrease in sales and marketing is also related to a decrease of $0.4 million reduction in spending for advertising and other promotional programs and is offset by increase of $0.1 million in overhead expenses. 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 was $1.9 million for the three months ended December 31, 2012, compared to $2.3 million for the three months ended December 31, 2011, a decrease of $0.4 million or 18%. As a percentage of net revenue, general and administrative expense decreased to 20% for the three months ended December 31, 2012 from 23% for the three months ended December 31, 2011. The decrease in general and administrative expense was primarily due to $0.3 million decrease in bad debt expense as a result of our improvement in collection, $0.1 decrease in finance fees for the filing, and subsequent withdrawal, of the S-1 registration statement and decrease of $0.2 in our overhead expense and was offset by an increase of $0.2 million in our salary expenses. General and administrative expense was $4.2 million for the six months ended December 31, 2012, compared to $4.7 million for the six months ended December 31, 2011, a decrease of $0.5 million or 10%. As a percentage of net revenue, general and administrative expense decreased to 23% for the six months ended December 31, 2012 from 24% for the six months ended December 31, 2011. The decrease in general and administrative expense was primarily due to $0.4 million decrease in bad debt expense, $0.2 million decrease in consulting and outside service expense and is offset by an increase of $0.1 decrease in finance fees for the filing, and subsequent withdrawal, of the S-1 registration statement. 25 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 engineering costs in cost of revenue if the expense is related to supporting on-going platforms and is more related to product support activities. Management's judgment is used to determine the allocation between these three categories, and we refer to these three categories in aggregate as ''product investment''. Research and development was $0.8 million expense for the three months ended December 31, 2012, compared to $1.9 million for the three months ended December 31, 2011, a decrease of $1.1 million or 57%. As a percentage of net revenue, research and development expense decreased to 9% for the three months ended December 31, 2012 from 18% for the three months ended December 31, 2011. The decrease in research and development expense for the three months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to a $1.3 million decrease in engineering compensation and benefits as we capitalized internally developed software related to Lyris ONE, followed by a $0.2 million increased allocation of facilities costs related to increased engineering headcount. Research and development expense was $2.0 million for the six months ended December 31, 2012, compared to $3.3 million for the six months ended December 31, 2011, a decrease of $1.3 million or 40%. As a percentage of net revenue, research and development expense decreased to 11% for the six months ended December 31, 2012 from 17% for the six months ended December 31, 2011. The decrease in research and development expense for the three months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to a $1.6 million decrease in engineering compensation and benefits as we capitalized internally developed software related to Lyris ONE, followed by a $0.3 million increased allocation of facilities costs related to increased engineering headcount. Amortization of customer relationships and trade names Amortization of customer relationships and trade names expenses consist of intangibles that we obtained through the acquisition of other businesses. Amortization of customer relationships and trade names expense was $50 thousand for the three months ended December 31, 2012, compared to $1.0 million for the three months ended December 31, 2011, a decrease of $0.9 million or 95%. As a percentage of net revenue, amortization of customer relationships and trade names expense decreased to 1% for the three months ended December 31, 2012 from 10% for the three months ended December 31, 2011. Amortization of customer relationships and trade names expense was $0.1 million for the six months ended December 31, 2012, compared to $1.2 million for the six months ended December 31, 2011, a decrease of $1.1 million or 92%. As a percentage of net revenue, amortization of customer relationships and trade names expense decreased to 1% for the six months ended December 31, 2012 from 6% for the same period in fiscal year 2012. The decrease in amortization of customer relationships and trade names expense for the three and six months ended December, 2012 compared to the same period in fiscal year 2012 was primarily due to an impairment of $0.8 million for the Uptilt and Sparklist trade names, net of amortization in same period for fiscal year 2012 and full amortization of three customers in October 2011. Impairment of goodwill Impairment of goodwill was $0 for the three and six months ended December 31, 2012 compared to $9.0 million for the three and six months ended, December 31, 2011, a decrease of $9 million or 100%. We recognized an impairment of $9.0 million during the three months ended, December 31, 2011; $6.8 million from Lyris Technologies and $2.2 million from EmailLabs. (See below "Goodwill, Long-lived assets and Other Intangible Assets") Impairment of capitalized software Impairment of capitalized software was $0 for the three and six months ended December 31, 2012 compared to $0.4 million for the three and six months ended December 31, 2011, a decrease of $0.4 million or 100%. A/B List internal-use software was intended to upgrade to Lyris HQ application. In the second quarter of fiscal year 2012, a reduction in headcount resulted in the re-grouping of teams working on each internal-use software project and management determined that it is no longer probably that A/B List will be completed and placed in service since it is not expected to provide any substantial service potential to Lyris HQ application. Thus, we recorded an impairment of $0.4 million during the three months ended, December 31, 2011, consist of a full impairment from our Lyris A/B List internal-use software. 26 Interest expense Three Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Interest expense $ (25 ) $ (131 ) $ 106 (81) % Six Months Ended December 31, Change 2012 2011 $ Percent (In thousands, except percentages) Interest expense $ (150 ) $ (188 ) $ 38 (20 )% Interest expense relates to our revolving line of credit with Comerica 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 was $25 thousand for the three months ended December 31, 2012, compared to $0.1 million for the three months ended December 31, 2011, a decrease of $0.1 million or 81%. The decrease in interest expense for the three months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to a lower average balance in our revolving line of credit of $0.9 million at December 31, 2012 compared to an average balance of $4.1 million at December 31, 2011. Interest expense was $0.2 million for the six months ended December 31, 2012 compared to $0.2 million for the six months ended December 31, 2011, a decrease of $37 thousand or 20%. The decrease in interest expense for the six months ended December 31, 2012 compared to the same period in fiscal year 2012 was primarily due to a lower average balance in our revolving line of credit of $1.6 million at December 31, 2012 compared to an average balance of $3.9 millionat December 31, 2011. Provision for income taxes Our effective tax rates for the six months ended December 30, 2012 and 2011 were 91.3% and (1.6 %), respectively. For additional information about income taxes, refer to Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q. Goodwill, Long-lived Assets and Other Intangible Assets We classify our intangible assets into three categories: (1) intangible assets with definite lives subject to amortization; (2) intangible assets with indefinite lives not subject to amortization; and (3) 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. ASU No. 2011-08 "Intangibles - Goodwill and Other (Topic 350) Testing Goodwill for Impairment" provides an entity the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test for goodwill impairment. If an entity believes, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than our carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. We adopted ASU No. 2011-08 in the first quarter of fiscal year 2012 and considered various events and circumstances when we evaluated whether it is more likely than not that the fair value of our reporting unit is less than our carrying value. We considered events and circumstances such as macroeconomic conditions, industry and market considerations, overall financial performance, entity-specific events, and our share price relative to our peers. Based on our assessment of relevant events and circumstances conducted on December 31, 2012, we concluded that there was no impairment of goodwill for the six months ended for fiscal year 2013. 27 Liquidity, Capital Resources and Financial Condition Our primary sources of liquidity to fund our operations as of December 31, 2012 was from the collection of accounts receivable balances generated from net sales and proceeds from our revolving line of credit. For additional operational funds requirements, we have available revolving lines of credit with Comerica Bank which mature on April 30, 2013. On October 17, 2012, we fully repaid and cancelled the Non-Formula Line of $2.5 million that William T. Comfort had guaranteed with our proceeds of $5 million from sale of 2,000,000 shares of our Series A Preferred Stock to Lyr, Ltd., a Bermuda corporation. Mr. Comfort is Chairman of Lyr, Ltd. As of October 17, 2012, we only have the Revolving Line outstanding with the Bank. (Refer to Note 6 and 12 of the Notes to Unaudited Condensed Consolidated Financial Statements for detail information). As of December 31, 2012, our availability under this credit facility was approximately $1.0 million. As of December 31, 2012, our cash and cash equivalents totaled $2.5 million compared to $1.6 million at December 31, 2011. As of December 31, 2012, our accounts receivable, less allowances, totaled $5.3 million compared to $4.9 million at June 30, 2012. Change December 31, 2012 June 30, 2012 $ Percent (In thousands, except percentages) Accounts Receivable $ 5,824 $ 5,620 $ 204 4 %Allowance for Doubtful Accounts (560 ) (686 ) 126 (18) % Total - Accounts receivable $ 5,264 $ 4,934 $ 330 7 % Accounts receivables increased $0.2 million or 4% for the six months ended December 31, 2012 due to a significant sale in our software and support and maintenance at the end of the quarter. Allowance for Doubtful Accounts ("Allowance") decreased by $0.1 thousand or 18% for the six months ended December 31, 2012 as a result of our routine evaluation of customer balances. We adjusted the Allowance as appropriate based upon the collectability of the receivables in light of historical trends, adverse situations that may affect our customers' ability to repay, and prevailing economic conditions. This evaluation was done in order to identify issues which may impact the collectability of receivables and reserve estimates. Revisions to the Allowance are recorded as an adjustment to bad debt expense. After appropriate collection efforts are exhausted, specific receivables deemed to be uncollectible are charged against the Allowance in the period they are deemed uncollectible. Recoveries of receivables previously written-off are recorded as credits tothe Allowance. Our short-term and long-term liquidity requirements primarily arise from: (i) interest and principal payments related to our debt obligations, (ii) working capital requirements, and (iii) capital expenditures, including periodic acquisitions. At June 30, 2012, our existing cash and cash equivalents, cash flow from operations, and the availability from our revolving credit facility, provides sufficient liquidity to fund our 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 we intend to continue building our cash reserves. See Notes 6 and "Credit Facility" of the Notes to Unaudited Condensed 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. While the second quarter of fiscal year 2013 had its challenges, we still expect to maintain long-term growth in our hosted revenue offerings, particularly with our new product, Lyris ONE and our existing product, Lyris HQ, and increase efficiency and aggressive management 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 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. 28 In summary, our cash flows were as follows for the six months ended December 31, 2012 and 2011 (in thousands): Six Months Ended December 31, 2012 2011 (In thousands)Net cash provided by (used in) operating activities $ 1,714 $ 576 Net cash provided by (used in) investing activities (2,835 ) (1,993 ) Net cash provided by (used in) financing activities 1,989 2,696 Effect of exchange rate changes on cash (2 ) 52 Increase (decrease) in cash and cash equivalents $ 866 $ 1,331Cash Flows for the Six Months Ended December 31, 2012 Compared to the Six Months Ended December 31, 2011 Operating Activities Net cash flows provided by operating activities was $1.7 million for the six months ended December 31, 2012 compared to net cash flows provided by operating activities of $0.6 million for the six months ended December 31, 2011. Adjustments had a $2.0 million positive effect on cash flows from operating activities for the six months ended December 31, 2012, including $0.5 million stock-based compensations, $1.4 million of depreciation and amortization, $0.1 million of provision for bad debt. Changes in assets and liabilities had a $0.3 million negative effect on cash flows provided by operating activities for the six months ended December 31, 2012 due to $0.5 million in accounts receivable, $0.1 million in prepaid expenses and other assets, $0.2 million in deferred revenue and is offset by $0.3 million increase in accounts payable and accrued expenses and $0.2 million in incomes taxes payable. Investing Activities Net cash flows used in investing activities were $2.8 million for the six months ended December 31, 2012 compared to $2.0 million for the six months ended December 31, 2011. Net cash flows used in investing activities primarily reflects capitalized software expenditures. The net cash flow used in investing activities for the six months ended December 31, 2012 consisted of a $2.4 million in capitalized software expenditures, $0.4 million used in purchasing property and equipment. Financing Activities Net cash flows used in financing activities was $2.0 million for the six months ended December 31, 2012 compared to net cash flows provided by financing activities of $2.7 million for the six months ended December 31, 2011. Financing cash flows for the six months ended December 31, 2012 consisted primarily proceeds from issuance of our Series A preferred stocks of $5 million, and proceeds of $0.2 million from issuance of our common stocks and was offset by our net payments over proceeds from our revolving line of credit with the Bank, of $2.8 million, and $0.4 payments under our capital lease obligations in connection with acquiring computer equipment for our data center operations. Off-Balance Sheet Arrangements As of December 31, 2012, we have $0.1 million in irrevocable letters of credit ("LOC") issued by Comerica Bank, consisting of a $100 thousand LOC in favor of the Hartford Insurance Company ("Hartford"), and a $40 thousand 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 revolving line of credit with Comerica 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 Comerica Bank thirty (30) days prior to the annual expiration date of the Hartford LOC that they have chosen not to extend the Hartford LOC for the next year. The current expiration of the Hartford LOC is September 1, 2013. As of the date of this report, 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. As of the date of this report, there have been no draw downs on this LOC. We do not have any interest in entities referred to as variable interest entities, which include special purpose entities and other structured finance activities. 29 Revolving Line of Credit For summary description of our revolving credit facility with Comerica Bank, please refer to Note 6 of the Notes to Unaudited Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q. |