[March 18, 2013] TANGOE INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes and other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, include forward-looking statements that involve risks and uncertainties. You should review the "Risk Factors" and "Forward-Looking Statements" sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview Tangoe is a leading global provider of communications lifecycle management, or CLM, software and services to a wide range of large and medium-sized commercial enterprises and governmental agencies. CLM encompasses the entire lifecycle of an enterprise's communications assets and services, including planning and sourcing, procurement and provisioning, inventory and usage management, mobile device management, real-time telecommunications expense management, invoice processing, expense allocation and accounting, and asset decommissioning and disposal. Our on-demand Communications Management Platform is a suite of software designed to manage and optimize the complex processes and expenses associated with this lifecycle for both fixed and mobile communications assets and services. Our customers can engage us through our client services group to manage their communications assets and services using our Communications Management Platform. Our solution can provide a significant return on investment by enabling an enterprise to identify and resolve billing errors, to optimize communications service plans for its usage patterns and needs, and to manage used and unused communications assets and services. Our solution allows enterprises to improve the productivity of their employees by automating the provisioning of communications assets and services, and to reduce costs by controlling and allocating communications expenses. It also allows enterprises to enforce regulatory requirements and internal policies governing the use of communications assets and services. We designed our business model to sell recurring technology and services leveraging our Communications Management Platform. We review four key business metrics to help us monitor the performance of our business model and to identify trends affecting our business. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows: Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) plus interest expense, other expense, income tax provision, depreciation and amortization, amortization of marketing agreement intangible assets, stock-based compensation expense and increase in fair value of warrants for redeemable convertible preferred stock; less amortization of leasehold interest, interest income and other income, and also include in Adjusted EBITDA adjustments for other non-cash and non-recurring items applicable for the periods presented. Our management uses Adjusted EBITDA to measure our operating performance because it does not include the impact of items not directly resulting from our core business and certain non-cash expenses such as depreciation and amortization and stock-based compensation. We believe that this measure provides us with additional useful information to measure and understand our performance on a consistent basis, particularly with respect to changes in performance from period to period. We use Adjusted EBITDA in the preparation of our annual operating budgets and to measure and evaluate the effectiveness of our business strategies. Adjusted EBITDA is not calculated in accordance with generally accepted accounting principles in the United States of America, or GAAP, and is not a substitute for or superior to financial measures determined in accordance with GAAP. Other companies in our industry may calculate Adjusted EBITDA in a manner 43 -------------------------------------------------------------------------------- Table of Contents differently from us, which reduces its usefulness as a comparative measure. Our Adjusted EBITDA has increased annually for each fiscal year since 2007 and we expect it to continue to increase in our fiscal year ending December 31, 2013. For further discussion regarding Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net loss, see footnote 2 to the "Selected Financial Data" section of this Annual Report on Form 10-K. Recurring technology and services revenue growth. In 2006, we began a strategic initiative to transition our business model from selling transactional software licenses to providing recurring technology-enabled services leveraging both our technology and communications industry experience. We further implemented this initiative with the acquisition of Traq Wireless, Inc., or Traq, as discussed below. Traq's revenue base was primarily recurring, which substantially increased our 2007 recurring revenue. We regularly review our recurring revenue growth to measure our success. We intend to continue to focus our sales and marketing efforts on increasing our recurring technology and services-related customer base, and we expect that our recurring technology and services revenue will increase in absolute dollars and as a percentage of total revenue over the next 12 months due to our expectation that we will be able to: º • º retain a high percentage of the revenue we currently derive from our existing customers; º • º sell additional product and service offerings to our existing customers; and º • º add a significant number of new customers. We believe that we will be able to retain a high percentage of our existing recurring technology and services revenue due to our revenue retention rates, and the current levels of customer usage of our products and services, which we review on a monthly basis to provide an indication of impending increases or decreases in billed revenue for future periods. We believe that we will be able to sell additional product and service offerings to our existing customers in the next year based on our analysis of revenue on a per-customer basis for the last 12 months, which indicates that our customers on an aggregate basis have generally increased their usage of our solution on a quarterly basis. We believe that we will be able to add a significant number of new customers over the next 12 months as we continue to expand internationally and increase our share of the domestic market. Deferred revenue. Our deferred revenue consists of the amounts that have been invoiced but that have not yet been recognized as revenue, including advanced billed and undelivered portions of our Communication Management Platform subscriptions and related services, maintenance on our software licenses and implementation fees. We invoice our services to many of our customers in advance, with the intervals ranging from 1 to 12 months. We monitor our deferred revenue balance as this balance represents revenue to be recognized over the next 12 months except for a portion of implementation and software subscription fees. Implementation fees are recognized ratably over twice the term of the contract, which we estimate to be the expected life of the customer relationship. Software subscription fees are recognized ratably over the service period. As of December 31, 2012, implementation fees and subscription fees represented $2.0 million and $0.5 million, respectively, of the $11.1 million deferred revenue balance. Revenue retention rates. In addition, we consider our revenue retention rates. Since we began to fully realize the benefits of our recurring revenue model in 2009, our revenue retention rates have been higher than 90%. We measure revenue retention rates by assessing on a dollar basis the recurring technology and services revenue we retain for the same customer and product set in a given period versus the prior year period. We cannot predict our revenue retention rates in future periods. Our use of a revenue retention rate has limitations as an analytical tool, and you should not consider it in isolation. Other companies in our industry may calculate revenue retention rates differently, which reduces its usefulness as a comparative measure. 44 -------------------------------------------------------------------------------- Table of Contents We also review a number of other quantitative and qualitative trends in monitoring our performance, including our share of the CLM market, our customer satisfaction rates, our ability to attract, hire and retain a sufficient number of talented employees to staff our growing business and the development and performance of our solutions. Our review of these factors can affect aspects of our business and operations on an on-going basis, including potential acquisition strategies and investment in specific areas of product development or service support. Certain Trends and Uncertainties The following represents a summary of certain trends and uncertainties, which could have a significant impact on our financial condition and results of operations. This summary is not intended to be a complete list of potential trends and uncertainties that could impact our business in the long or short term. This summary, however, should be considered along with the factors identified in the "Risk Factors" section of this Annual Report on Form 10-K. º • º The CLM market is characterized by rapid technological change and frequent new product and service introductions, including frequent introductions of new technologies and devices. To achieve and maintain market acceptance for our solution, we must effectively anticipate these changes and offer software products and services that respond to them in a timely manner. If we fail to develop software products and services that satisfy customer preferences in a timely and cost-effective manner, our ability to renew our agreements with existing customers and our ability to create or increase demand for our solution will be harmed. º • º We believe that competition will continue to increase. Increased competition could result from existing competitors or new competitors that enter the market because of the potential opportunity. We will continue to closely monitor competitive activity and respond accordingly. Increased competition could have an adverse effect on our financial condition and results of operations. º • º We continue to closely monitor current economic conditions, as any decline in the general economic environment that negatively affects the financial condition of our customers could have an adverse effect on our financial condition and results of operations. For example, during the most recent economic downturn, our customer cancellation rate during the first quarter of 2009 increased to a quarterly rate of over three times the average of the prior four quarters, partly as a result of customer bankruptcies. Although economic conditions have generally improved, there has not been a full recovery to the levels that generally existed prior to the downturn. If economic conditions in the United States and other countries do not continue to improve, we may face greater risks in operating our business. Acquisitions On January 25, 2011, we acquired substantially all of the assets of HCL Expense Management Services Inc., or HCL-EMS, a provider of telecommunications expense management, invoice processing and mobility management solutions, for $3.0 million in cash plus potential earn-out payments, which we currently estimate will amount to approximately $3.4 million, based on revenues derived from providing selected services to former HCL-EMS customers over the two years following the acquisition as well as transaction costs of approximately $140,000. These transaction costs were expensed as incurred. The earn-out payments are subject to set-off rights of ours with respect to indemnities given by HCL-EMS under our Asset Purchase Agreement for HCL-EMS. In May 2012, we agreed with HCL-EMS that the gross amount of the first year earn-out would be $1.9 million, and we paid a portion of that amount to HCL-EMS. We paid the remaining portion of the first year earn-out in November 2012. 45 -------------------------------------------------------------------------------- Table of Contents On March 16, 2011, we acquired substantially all of the assets of the telecommunications expense management division of Telwares, Inc. and its subsidiary Vercuity Solutions, Inc., or Telwares, for $4.5 million in cash (excluding working capital adjustments) plus deferred cash of up to an additional $2.5 million payable in installments of $1.25 million each on March 16, 2012 and March 16, 2013. The deferred cash is subject to set-off rights that we hold with respect to indemnities given by Telwares under the purchase agreement for the acquisition. Among other things, these indemnity obligations relate to representations and warranties given by Telwares under the purchase agreement. Certain of these indemnities are subject to limitations, including certain caps and limited survival periods. We paid the first installment of $1.25 million on March 16, 2012. The installment payable on March 16, 2013 was subject to a potential reduction of up to $500,000 relating to the achievement of certain recurring revenue goals during the three months ending June 30, 2012. We have agreed with Telwares that the amount of the reduction will be $350,000. In addition, we incurred transaction costs of approximately $200,000 in connection with the transaction. These transaction costs were immaterial and expensed as incurred. On December 19, 2011, we acquired ProfitLine, Inc., or ProfitLine, a provider of telecommunications expense management, invoice processing and mobility management solutions, through a merger with one of our subsidiaries for $14.5 million in cash paid at the closing plus deferred cash of an additional $9.0 million payable in cash installments of $4.5 million on each of December 19, 2012 and June 19, 2013, subject to set-off rights that we and ProfitLine, as our wholly owned subsidiary following the acquisition, hold with respect to indemnities given by the former stockholders of ProfitLine under the merger agreement for the acquisition. Among other things, these indemnity obligations relate to representations and warranties given by ProfitLine under the merger agreement. Certain of these indemnities are subject to limitations, including a threshold, certain caps and a limited survival period. We paid the former stockholders of ProfitLine $4.1 million in December 2012, consisting of the first installment of $4.5 million less indemnity claims of $0.4 million. Under the merger agreement, we are required to make an advance deposit into escrow of the deferred consideration under certain circumstances, including in the event that our cash and cash equivalents, less bank and equivalent debt (which excludes capital lease obligations and deferred consideration payable in connection with acquisitions) is below $15.0 million at any time after payment of the first and before the payment of the second $4.5 million installment of deferred consideration. The transaction costs were immaterial and were expensed as incurred. On January 10, 2012, we acquired all of the outstanding equity of Anomalous Networks Inc., or Anomalous, a provider of real-time telecommunications expense management solutions. The aggregate purchase price was approximately $9.0 million, which consisted of approximately $3.5 million in cash paid at the closing, approximately $1.0 million in cash payable on the first anniversary of the closing, 165,775 unregistered shares of our common stock and 132,617 unvested and unregistered shares of our common stock with vesting based on achievement of revenue targets relating to sales of Anomalous products and services for periods through January 31, 2013. We paid the $1.0 million in deferred cash consideration in January 2013. The unvested shares remain subject to set-off rights that we held with respect to indemnities given by the former shareholders of Anomalous under the purchase agreement for the acquisition. Among other things, these indemnity obligations relate to representations and warranties given by Anomalous under the purchase agreement. The indemnities are subject to limitations, including a threshold, certain caps and limited survival periods. The unvested shares are subject to a lock-up unless and until they become vested following January 31, 2013 and are subject to the set-off rights described above. The transaction costs were immaterial and were expensed as incurred. 46 -------------------------------------------------------------------------------- Table of Contents On February 21, 2012, we acquired all of the issued share capital of ttMobiles Limited, or ttMobiles, a provider of mobile communications management solutions and services based in the United Kingdom. The purchase price was 5.5 million pounds sterling, which consisted of 4.0 million pounds sterling in cash paid at the closing and 1.5 million pounds sterling in cash payable on the first anniversary of the closing. We paid the 1.5 million pounds sterling in deferred cash consideration in February 2013. The purchase price was subject to a net asset adjustment pursuant to which the purchase price would be increased or decreased to the extent that the net asset position of ttMobiles was more or less than a specified target by an amount that exceeded 5% of the target. The deferred consideration in the transaction was subject to set-off rights that we held with respect to claims for breach of warranties and certain indemnities given under the purchase agreement for the transaction by the former holders of the issued share capital of ttMobiles until the deferred consideration was paid. The breach claims and indemnities are subject to limitations, including a threshold, certain baskets, caps and limited survival periods. The transaction costs were immaterial and were expensed as incurred. On August 8, 2012, we acquired substantially all of the assets of the telecommunications expense management division of Symphony Teleca Services, Inc., or Symphony, pursuant to an asset purchase agreement, or the Symphony Purchase Agreement. On the same date, a newly formed subsidiary of ours, Tangoe India Softek Services Private Limited, an Indian private limited company, or Tangoe India, entered into a business purchase agreement, or the Indian Purchase Agreement, with Symphony Services Corporation (India) Private Limited, or Symphony India, with respect to the purchase of certain assets and employees of the acquired business located in India. The net purchase price was $40.2 million, which consisted of $29.2 million in cash paid at the closing, approximately $4.4 million in cash payable on the six-month anniversary of the closing, and approximately $6.4 million in cash payable on the one-year anniversary of the closing. In addition, the acquisition consideration included an earn-out payable in the amount of up to $4.0 million based on achievement of revenue targets for the acquired business for periods through June 30, 2013. We made the six-month anniversary payment of $4.4 million in February 2013. The full installment due on August 8, 2013 of approximately $6.4 million, and amounts that potentially become payable under the earn-out are subject to set-off rights that we have with respect to indemnities given by Symphony under the Symphony Purchase Agreement. Among other things, these indemnity obligations relate to representations and warranties given by Symphony under the Symphony Purchase Agreement and by Symphony India under the Indian Purchase Agreement. Certain of the indemnities are subject to limitations, including a threshold and deductible, certain caps and limited survival periods. During a post-closing transition period that lasted through February 2013, Symphony and Symphony India provided to us certain transition services, including making available to us on a continuing basis the services previously provided by Symphony India to Symphony, pending completion of the opening of certain Tangoe India facilities, the procurement of certain Indian tax registrations and the subsequent transfer to Tangoe India of the Indian assets and employees being hired. The transaction costs were immaterial and were expensed as incurred. We continue to migrate to our platforms the customers of several of the businesses that we acquired during 2011 and 2012. We have completed the migration of the Telwares customers, and the migration of the HCL-EMS, ProfitLine and Symphony customers are in various stages of completion. While to date we have successfully migrated a number of these customers, there can be no assurance that we will complete these migrations in a timely manner or at all and the cost of these migrations may be more significant than we have estimated. We may pursue additional acquisitions of, or investments in, businesses, services and technologies that will expand the functionality of our solution, provide access to new markets or customers, or otherwise complement our existing operations. 47 -------------------------------------------------------------------------------- Table of Contents Sources of Revenue Recurring technology and services revenue. We derive our recurring technology and services revenue primarily from subscriptions and services related to our Communications Management Platform. We recognize revenue for software and related services when all of the following conditions are met: (a) there is persuasive evidence of an arrangement; (b) the service has been provided to the customer; (c) the collection of the contracted fee is probable; and (d) the amount of the fees to be paid by the customer is fixed and determinable. These services include help desk, asset procurement and provisioning, and carrier dispute resolution. The recurring technology and services revenue is recognized ratably over the contract term. In 2006, we began a strategic initiative to transition our business model from selling non-recurring transactional software licenses to providing recurring technology and services leveraging both our technology and communications industry experience. We license our on-demand software and sell related services primarily on a subscription basis under agreements that typically have terms ranging from 24 to 60 months. Our recurring technology and services revenue is driven primarily by the amount of communications spend that we manage for fixed line contracts and by the number of mobile devices that we manage for mobile device contracts. Our customers are typically subject to a minimum charge for up to a specified threshold amount of communications spend or number of mobile devices under management and additional charges to the extent those specified thresholds are exceeded. Prior to 2010, as a result of limited history regarding customer renewals, implementation fees related to subscription agreements for our Communications Management Platform with terms equal to or less than 36 months were recognized over 36 months and implementation fees related to subscription agreements with terms exceeding 36 months were recognized over the life of the agreement. In 2010, due to having greater evidence regarding customer renewals, we believed it was appropriate to extend the estimated expected life of the customer relationship to be equal to twice the contract life calculated on a per-customer basis and to recognize implementation fees ratably over this period. This change did not have a material impact on our consolidated financial statements. Many of our subscription contracts are non-cancelable, although customers have the right to terminate for cause if we materially fail to perform. In 2010, we began to amortize the value of a warrant to purchase common stock issued to IBM as part of a strategic relationship agreement. This related charge will be recorded as contra-revenue in proportion to total expected revenue from the agreement. We recorded $26,086, $91,806 and $174,451 of amortization as a contra-revenue charge during the years ended December 31, 2010, 2011 and 2012, respectively. Strategic consulting, software licenses and other revenue. In addition to our subscription fees, revenue is generated to a lesser extent by strategic consulting, software licenses, mobile device activation fees and sales of telecommunication accessories. Strategic consulting consists primarily of fees charged for contract negotiations and bill audits. Contract negotiation fees include both fixed project fees and incentive fees driven by the amount of savings that we are able to generate over the customer's existing communications rates. These fees are recognized when fixed and determinable, usually when the customer and carrier execute the contract. Bill audit fees are driven by the amount of savings that we are able to generate by reviewing current and prior communications invoices against the customer's existing contracts. These fees are recognized when fixed and determinable, usually when the carrier agrees to issue a credit or refund to our customer. On occasion, we license our Communications Management Platform to our customers on a perpetual basis. If we are able to derive vendor-specific objective evidence on the undelivered elements, the software portion is recognized when the revenue recognition criteria is met; otherwise the contract is recognized ratably over the contract life. Other professional services are recognized as the services are performed. We have an agreement with a carrier whereby we receive an activation fee for 48 -------------------------------------------------------------------------------- Table of Contents procuring a mobile device. The activation revenue is recognized upon confirmation from the carrier that the device has been procured. The revenue related to the sale of telecommunication accessories is recognized upon shipment of the accessories to the customer. We expect our strategic consulting, software licenses and other revenue to remain relatively constant in absolute dollars, but to decrease as a percentage of total revenue, as we continue to focus our sales and marketing efforts on our recurring technology and services revenue model. We historically have derived substantially all of our revenue from United States-based customers. We intend to build our international sales operations by increasing our direct sales force abroad. We expect our international revenue to increase in absolute dollars and as a percentage of total revenue. Cost of Revenue and Gross Profit Cost of recurring technology and services revenue. Cost of recurring technology and services revenue consists primarily of costs associated with our data center operations, customer product support centers and client services group. This includes personnel-related costs such as salary, stock-based compensation and other compensation-related costs, subcontractor fees, hosting fees, communications costs and royalties related to third-party software included in our solution when our solution is licensed on a non-perpetual basis. Cost of strategic consulting, software licenses and other revenue. Cost of strategic consulting, software licenses and other revenue consists primarily of personnel-related costs, including salary, stock-based compensation and other compensation-related costs and subcontractor fees directly related to delivering the service and to a lesser extent, the cost of the telecommunications accessories sold. As our customer base continues to grow, we expect our cost of revenue to increase in absolute dollars as we expand our data center and customer support operations to support our continued growth. Our cost of revenue could fluctuate as a percentage of revenue on a quarterly basis but remain relatively stable on an annual basis based on the mix of software and services sold and average contractual selling price. Gross profit. Gross profit as a percentage of revenue is affected by two main factors-the mix of software and services sold and the average contractual selling price. We expect our gross profit in absolute dollars to increase, but that our gross profit as a percentage of revenue will be affected as we integrate the businesses of our recent acquisitions, which have historically operated with lower margins than our business. We believe that over time we will achieve improvements in those margins as we integrate the acquired operations and capture the operating efficiencies of the overall business. Operating Expense Operating expense consists of sales and marketing, general and administrative, research and development and depreciation and amortization. Other than for depreciation and amortization expense, personnel-related costs are the most significant component of all of these operating expenses. We expect to continue to hire a significant number of new employees in order to support our overall growth. In any particular period, the timing of additional hires could materially affect our operating results, both in absolute dollars and as a percentage of revenue. Sales and marketing. Sales and marketing expense consists primarily of personnel-related costs, including salary, stock-based compensation and other compensation-related costs for our sales, marketing and business development employees, the cost of marketing programs such as on-line lead generation, promotional events, such as trade shows, seminars and webinars, the cost of business development programs and sales commissions. Sales commission rates are calculated at the time a contract is signed. The sales commission rate is applied to the contract's first year of revenue to 49 -------------------------------------------------------------------------------- Table of Contents calculate sales commission expense. Sales commission expense is accrued and expensed at the time we invoice the customer and is paid to the salesperson when the invoice is collected. Generally, new sales personnel require time to become familiar with our software and services and do not begin to generate sales immediately, which can result in increased sales and marketing expense without any immediate increase in revenue. We expect sales and marketing expense to increase in absolute dollars, but remain relatively constant as a percentage of revenue in the near term, as we continue to hire sales and marketing personnel in the United States and internationally to expand our solution globally. General and administrative. General and administrative expense consists of personnel-related costs, including salary, stock-based compensation and other compensation-related costs for finance and accounting, executive, human resources and information technology personnel, rent and facility costs, legal and other professional fees, and other corporate expenses. We are incurring and will continue to incur costs associated with being a public company, including corporate insurance costs as well as certain personnel costs and professional fees, including legal and accounting fees as they relate to financial reporting and maintaining compliance with Section 404 of the Sarbanes-Oxley Act. We expect general and administrative expense to remain at approximately its current level in the near term and to decrease as a percentage of revenue. Research and development. Research and development expense primarily consists of personnel-related costs, including salary, stock-based compensation and other compensation-related costs for development personnel, and fees to our outside contract development vendors. We anticipate that our research and development team will continue to focus on expanding our software and services and increasing the functionality of our current offerings. We expect research and development expense to increase in absolute dollars, but that the investment will likely be lower than the rate of growth in our revenue in the near term. Depreciation and amortization. Depreciation and amortization expense primarily consists of the non-cash write-down of tangible and intangible assets over their expected economic lives. We expect this expense to continue to grow in absolute dollars and potentially as a percentage of revenue as we continue to grow and incur capital expenditures to improve our technological infrastructure and acquire assets through potential future acquisitions. Other Income (Expense), Net Other income (expense), net consists primarily of interest expense on our short and long-term debt, interest income on our cash and cash equivalents balance and changes in fair value of warrant to purchase redeemable convertible preferred stock. We have historically invested our cash in money market investments. We expect our interest income to vary in each reporting period depending on our average cash balances and interest rates. Income Tax Provision Income tax provision consists of federal and state corporate income taxes resulting from our operations in the United States. We expect income tax expense to vary each reporting period depending upon taxable income fluctuations and our availability of tax benefits from net loss carryforwards. As of December 31, 2012, we had U.S. federal net operating loss carryforwards of approximately $98.0 million, which, if unused, expire from 2020 to 2032, and U.S. federal research and development tax credit carryforwards of approximately $3.0 million, which expire through 2029. We have engaged in several transactions since our inception that have resulted in a change in control as defined by Section 382 of the Internal Revenue Code, which limits our ability to utilize these net operating loss and tax credit carryforwards in the future. As of December 31, 2012, $33.0 million of our net operating 50 -------------------------------------------------------------------------------- Table of Contents loss and tax credit carryforwards were so limited. At December 31, 2012, we recorded a valuation allowance against the full amount of our deferred tax assets, as our management believes it is uncertain that they will be fully realized. If we determine in the future that we will be able to realize all or a portion of our net operating loss or tax credit carryforwards, an adjustment to our net operating loss or tax credit carryforwards would increase net income in the period in which we make such a determination. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. The preparation of our financial statements and related disclosures requires us to make estimates, assumptions and judgments that affect the reported amount of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates and assumptions on historical experience and other factors that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions and conditions. Our most critical accounting policies are summarized below. See Note 2 to our financial statements included elsewhere in this Annual Report on Form 10-K for additional information about these critical accounting policies, as well as a description of our other significant accounting policies. Revenue recognition. Recurring technology and services revenue consists of subscription-based fees, software subscription license fees, software maintenance fees and hosting fees related to the use of our solution to manage our customers' communications expenses. Strategic consulting, software licenses and other revenue consists of fees for perpetual software licenses, professional services, contract negotiations and bill audits. We recognize revenue when persuasive evidence of an arrangement exists, pricing is fixed and determinable, collection is reasonably assured and delivery or performance of service has occurred. Recurring technology and services subscription-based fees, software subscription license fees, software maintenance fees and hosting fees are recognized ratably over the term of the period of service. The subscription-based services we provide include help desk, asset procurement and provisioning, and carrier dispute resolution services. Implementation fees associated with recurring technology and services engagements are recognized ratably over the estimated expected life of the customer relationship which is estimated to be equal to twice the contract life. Software license fees consist of fees paid for a perpetual license agreement for our technology, which are recognized in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC 605, Software Revenue Recognition, as amended. When contracts contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we account for the delivered elements in accordance with the residual method prescribed by the authoritative guidance. Vendor specific objective evidence of fair value for maintenance and support is established by a stated renewal rate included in the license arrangement or rates charged for stand-alone sales of maintenance and support. If software maintenance fees are provided for in the license fee or at a discount pursuant to a license agreement, a portion of the license fee equal to the fair market value of these amounts is allocated to software maintenance revenue based on the value established by independent sales of such maintenance services to customers. Professional services related to the implementation of our software products, which we refer to as consulting services, are generally performed on a fixed fee basis under separate service arrangements. Consulting services revenue is recognized as the services are performed by measuring progress towards completion based upon either costs or the achievement of certain milestones. We also provide contract negotiation and bill audit services, which we refer to as strategic sourcing services, on behalf of our customers, which are generally performed on a contingency fee basis, with our fees being based on a percentage of the savings we achieve for the customer. Revenue from strategic sourcing services engagements is recognized as savings are secured for the customer, based upon the amount of savings secured multiplied by the contingency fee percentage to which we are entitled. 51 -------------------------------------------------------------------------------- Table of Contents In accordance with ASC 605 , Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses, we classify reimbursed expenses as revenue and the related expense within cost of revenue in the accompanying consolidated statements of operations. For the years ended December 31, 2010, 2011 and 2012 reimbursed expenses of $148,407, $272,100 and $239,400, respectively, were included in revenue. Purchase accounting. We accounted for the acquisitions of HCL-EMS, Telwares, ProfitLine, Anomalous, ttMobiles and Symphony using the purchase method of accounting for acquisitions . As a result, the purchase price for each of the transactions has been or will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values at the date of acquisition. We applied significant judgment and estimates in determining the fair values of the assets acquired and their useful lives. The excess of the purchase price over the fair value of assets and liabilities was assigned to goodwill, which is not amortized for accounting purposes, but is subject to testing for impairment annually and more frequently if certain events occur. In the process of our annual impairment review, we use the income approach methodology of valuation that includes the discounted cash flow method to determine the fair value of our intangible assets. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow method of valuation. The estimates that we have used are consistent with the plans and estimates that we use to manage our business. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur impairment charges. Software development costs. We expense research and development costs as incurred. We evaluate the establishment of technological feasibility of our software in accordance with ASC 985, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed. We have concluded that technological feasibility is not established until the development stage of the software is nearly complete. The time period during which costs could be capitalized from the point of reaching technological feasibility until the time of general release is very short and, consequently, the amounts that could be capitalized are not material to our consolidated financial statements. Therefore, we charge all such costs to research and development in the period incurred. Impairment of goodwill. As required by ASC 350, Goodwill and Other Intangible Assets, we test goodwill for impairment. Goodwill is not amortized, but instead tested for impairment at the reporting unit level at least annually and more frequently upon the occurrence of certain events. We have one reporting unit. The annual goodwill impairment test is a two-step process. First, we determine if the carrying value of its related reporting unit exceeds fair value, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we compare the implied fair value of the goodwill to its carrying amount to determine if there is an impairment loss. In September 2011, the FASB issued Accounting Standard Update ("ASU") 2011-08, which amends ASC 350 for testing goodwill for impairment. The guidance provides an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test otherwise, no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test. We have determined that goodwill was not impaired as of December 31, 2012. 52 -------------------------------------------------------------------------------- Table of Contents Impairment of other long-lived assets. We assess the impairment of these assets, or the need to accelerate amortization, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our judgments regarding the existence of impairment indicators are based on legal factors, market conditions and operational performance of our long-lived assets and other intangibles. Future events could cause us to conclude that impairment indicators exist and that the assets should be reviewed to determine their fair value. We assess the assets for impairment based on the estimated future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment loss is recorded for the excess of the asset's carrying amount over its fair value. Fair value is generally determined based on a valuation process that provides an estimate of a fair value of these assets using a discounted cash flow model, which includes many assumptions and estimates. Once the valuation is determined, we will write-down these assets to their determined fair value, if necessary. Any write-down could have a material adverse effect on our consolidated financial statements. We have determined that our long-lived assets including intangible assets were not impaired as of December 31, 2012. Stock-based compensation. We follow ASC 718, Share-Based Payment for recording stock-based compensation. ASC 718 supersedes Accounting Principles Board No. 25, Accounting for Stock Issued to Employees, and related interpretations. ASC 718 requires all stock-based compensation to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable service period. We estimate the fair value of the stock-based awards, including stock options, using the Black-Scholes valuation model. Determining the fair value of stock-based awards requires the use of highly subjective assumptions, including the expected term of the award and expected stock price volatility. The assumptions used in calculating the fair value of stock-based awards granted in 2010, 2011 and 2012 are set forth below: 2010 2011 2012 Expected dividend yield 0% 0% 0% Risk-free interest rate 1.80% to 2.87% 1.25% to 2.6% 0.79% to 1.16% Expected term (in years) 5.5 - 6.1 years 5.5 - 6.2 years 5.5 - 6.1 years Expected volatility 62.51% - 64.67% 59.74% - 60.88% 58.09% - 59.92% The assumptions used in determining the fair value of stock-based awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if factors change and we use different assumptions, our stock-based compensation could be materially different in the future. The risk-free interest rate used for each grant is based on a U.S. Treasury instrument with a term similar to the expected term of the stock-based award. The expected term of options has been estimated utilizing the vesting period of the option, the contractual life of the option and our option exercise history. Because there had been no public market for our common stock prior to our initial public offering, we believe that we have insufficient data from our limited public trading history to appropriately utilize company-specific historical and implied volatility information. Therefore, we estimate our expected stock volatility based on that of publicly traded peer companies, and we expect to continue to use this methodology until such time as we have adequate historical data regarding the volatility of our publicly traded stock price. Also, ASC 718 requires that we recognize compensation expense for only the portion of options that are expected to vest. Accordingly, we have estimated expected forfeitures of stock options upon the adoption of ASC 718 based on our historical forfeiture rate and used these rates in developing a future forfeiture rate. If our actual forfeiture rate varies from our historical rates and estimates, additional adjustments to compensation expense may be required in future periods. Common Stock Warrant. We accounted for the shares of common stock issuable upon exercise of a warrant that we issued to IBM in accordance with ASC 505, Equity-Based Payments to Non-Employee. 53 -------------------------------------------------------------------------------- Table of Contents We issued the warrant to IBM in connection with the entry into a five-year strategic relationship agreement. Under the terms of the agreement, certain shares of common stock underlying the warrant vested at the time the agreement was signed, which we valued using the Black-Scholes valuation model at the time of the signing of the agreement and recorded the amount to equity and to intangible assets. Additional shares of common stock underlying the warrant were set to vest based on the achievement of specified contractual billing thresholds over a three-year period. In June 2011, we amended the terms of the warrant to change the number of shares that were subject to vesting and the thresholds for achieving vesting. Under the terms of the amendment, certain shares of common stock underlying the warrant vested at the time the amendment was signed. These shares were valued using the Black-Scholes valuation model based on inputs as of the time of the signing of the amendment. Additional shares of common stock underlying the warrant were set to vest based on the achievement of specified contractual annual recurring revenue thresholds over a period from June 8, 2011 to June 30, 2012. As of June 30, 2012, the vesting terms of the amended agreement expired with IBM earning no additional warrant shares. As a result, no further warrants shares are issuable under this warrant agreement. In the first quarter of 2010, we began to amortize the asset, with the related charge recorded as contra-revenue. The related charge to revenue was in proportion to expected revenue from the agreement. Preferred Stock Warrants. In connection with our acquisition of Traq and various financing arrangements, we issued warrants to purchase redeemable convertible preferred stock. In accordance with ASC 480, Distinguishing Liabilities from Equity, we classified these warrants as a liability on our consolidated balance sheet, and each reporting period the carrying value of the warrants was adjusted to its then-current fair value, with any resulting gain or loss reflected in the consolidated statement of operations as a component of "Increase in fair value of warrants for redeemable convertible preferred stock". As a result of our initial public offering, all warrants to purchase redeemable convertible preferred stock became exercisable for shares of common stock. Income Taxes. We are subject to income taxes in the United States, and we use estimates in determining our income tax provisions. We account for income taxes in accordance with ASC 740, Accounting for Uncertainty in Income Taxes, which is the asset and liability method for accounting and reporting for income taxes. Under ASC 740, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. We assess the likelihood that deferred tax assets will be realized, and we recognize a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be realized. This assessment requires judgment as to the likelihood and amounts of future taxable income by tax jurisdiction. At December 31, 2012, we had a full valuation allowance against substantially all our deferred tax assets. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment that is subject to audit by tax authorities in the ordinary course of business. ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position's sustainability and is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized tax benefit is still appropriate. The recognition and 54 -------------------------------------------------------------------------------- Table of Contents measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Allowances for Bad Debt. We estimate and record allowances for potential bad debts and customer credits based on factors such as the write-off percentages, the current business environment and known concerns within our accounts receivable balances. The allowance for bad debts is our estimate of bad debt expense that could result from the inability or refusal of our customers to pay for our services. Additions to the estimated allowance for bad debts are recorded as an increase in general and administrative expense and are based on factors such as historical write-off percentages, the current business environment and the known concerns within the current aging of accounts receivable. Reductions in the estimated allowance for bad debts due to subsequent cash recoveries are recorded as a decrease in general and administrative expenses. As specific bad debts are identified, they are written-off against the previously established estimated allowance for bad debts and have no impact on operating expenses. This allowance also includes our estimate of adjustments for services that do not meet our customers' requirements. Additions to the estimated allowance for customer credits are recorded as a reduction in revenue and are based on a customer by customer basis of known concerns within the current aging. Reductions in the estimated allowance for customer credits are recorded as an increase in revenue. As specific customer credits are identified, they are written-off against the previously established estimated allowance for customer credits and have no impact on revenue. If there is a decline in the general economic environment that negatively affects the financial condition of our customers or an increase in the number of customers that are dissatisfied with our software or services, additional estimated allowances for bad debts and customer credits may be required and the impact on our consolidated financial statements could be material. 55 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth selected statements of operations data for the periods indicated. These consolidated results of operations are not necessarily indicative of the consolidated results of operations that will be achieved in any future period. Years Ended December 31, (in thousands, except percentages) 2010 2011 2012 Revenue: Recurring technology and services $ 57,703 $ 93,671 $ 137,979 Strategic consulting, software licenses and other 10,771 11,270 16,533 Total revenue 68,474 104,941 154,512 Cost of revenue: Recurring technology and services 26,349 44,814 63,976 Strategic consulting, software licenses and other 3,874 5,165 6,627 Total cost of revenue(1) 30,223 49,979 70,603 Gross profit 38,251 54,962 83,909 Operating expense: Sales and marketing(1) 12,281 16,648 24,840 General and administrative(1) 11,709 17,777 29,317 Research and development(1) 9,321 11,860 16,696 Depreciation and amortization 3,529 4,551 8,666 Restructuring charge - 1,549 - Income from operations 1,411 2,577 4,390 Other income (expense), net: Interest expense (2,007 ) (3,047 ) (943 ) Interest income 19 45 80 Other income (expense) 3 - (9 ) Increase in fair value of warrants for redeemable convertible preferred stock (884 ) (1,996 ) - (Loss) income before income tax provision (1,458 ) (2,421 ) 3,518 Income tax provision 294 534 480 Net (loss) income $ (1,752 ) $ (2,955 ) $ 3,038 -------------------------------------------------------------------------------- º (1) º Amounts in table above include stock-based compensation expense, as follows: Cost of revenue $ 323 $ 669 $ 1,347 Sales and marketing 425 1,201 2,133 General and administrative 1,032 1,934 5,105 Research and development 148 176 580 $ 1,928 $ 3,980 $ 9,165 56 -------------------------------------------------------------------------------- Table of Contents Years Ended December 31, 2011 and 2012 Revenue The following table presents our components of revenue for the periods presented: Years Ended December 31, Increase (in thousands, except percentages) 2011 2012 $ % Recurring technology and services $ 93,671 $ 137,979 $ 44,308 47 % Strategic consulting, software licenses and other 11,270 16,533 5,263 47 % Total revenue $ 104,941 $ 154,512 $ 49,571 47 % Our recurring technology and services revenue increased $44.3 million, or 47%, for the year ended December 31, 2012 as compared to the prior year, primarily due to an increase in the volume of fixed and mobile communications assets and service offerings being managed or provided through our on-demand communication management platform for current existing and new customers, combined with revenue attributable to customers acquired through our HCL-EMS, Telwares, ProfitLine, Anomalous, ttMobiles and Symphony strategic acquisitions. Our strategic consulting, software licenses and other revenue increased $5.3 million, or 47%, for the year ended December 31, 2012 as compared to the prior year, primarily due to increases in strategic sourcing revenue of $3.2 million, telecommunication accessories sales revenue of $1.5 million, software license fees of $0.5 million and mobile activation revenue of $0.4 million. These increases in revenue are attributable to current existing and new customers, combined with revenue attributable to customers acquired through our HCL-EMS, Telwares, ProfitLine, Anomalous, ttMobiles and Symphony strategic acquisitions. These increases were partially offset by a decrease of $0.3 million in consulting and other revenues. Cost of Revenue and Gross Profit The following table presents our cost of revenue and gross profit for the periods presented: Years Ended December 31, Increase (in thousands, except percentages) 2011 2012 $ % Recurring technology and services $ 44,814 $ 63,976 $ 19,162 43 % Strategic consulting, software licenses and other 5,165 6,627 1,462 28 % Total cost of revenue $ 49,979 $ 70,603 $ 20,624 41 % Gross profit $ 54,962 $ 83,909 $ 28,947 53 % Gross margin 52% 54% Our recurring technology and services cost of revenue increased $19.2 million for the year ended December 31, 2012 as compared to the prior year. This increase is primarily due to an increase in personnel-related costs, including an increase in salary and other compensation-related costs, of $16.1 million, an increase in third-party contractor costs of $2.9 million and increases in other operational costs of $0.8 million. The increases in personnel-related, third-party contractor costs and other operational costs were primarily attributable to providing support for customer growth in our recurring technology and services business. These increases were partially offset by a reduction in third-party licensing fees of $0.6 million as acquired customers have migrated to our platforms. 57 -------------------------------------------------------------------------------- Table of Contents Our strategic consulting, software licenses and other cost of revenue increased $1.5 million for the year ended December 31, 2012 as compared to the prior year, primarily as a result of a $1.3 million increase in the costs associated with our sales of mobile telecommunication accessories as a result of increased sales volume and a $0.2 million increase in strategic sourcing personnel costs to support our growth in strategic sourcing revenue . As a percentage of revenue, gross profit increased to 54% for the year ended December 31, 2012 as compared to 52% for the prior year. This increase in gross margin was primarily due to the migration of customers acquired in the HCL-EMS and Telwares acquisitions onto our platforms, which operate at a higher gross margin than the legacy HCL-EMS and Telwares platforms on which we serviced these customers immediately following the HCL-EMS and Telwares acquisitions. The $28.9 million increase in gross profit in absolute dollars was primarily due to increased revenue. Operating Expense The following table presents our components of operating expense for the periods presented: Years Ended December 31, 2011 2012 % of % of Change (in thousands, except percentages) Amount Revenue Amount Revenue $ % Sales and marketing $ 16,648 16% $ 24,840 16% $ 8,192 49% General and administrative 17,777 17% 29,317 19% 11,540 65% Research and development 11,860 11% 16,696 11% 4,836 41% Depreciation and amortization 4,551 4% 8,666 6% 4,115 90% Restructuring charge 1,549 1% - - (1,549 ) * Total operating expense $ 52,385 50% $ 79,519 51% $ 27,134 52% -------------------------------------------------------------------------------- º * º Not meaningful Sales and marketing expense. Our sales and marketing expense increased $8.2 million for the year ended December 31, 2012 as compared to the prior year, primarily due to increases in personnel-related costs, including salary and other compensation-related costs, of $6.5 million, which includes an increase in stock-based compensation of $0.9 million. The increases were primarily due to an increase in the number of direct and indirect sales force employees to accommodate growth in sales opportunities, and the value of the stock-based equity awards, $1.0 million in travel expense as a result of the increased headcount and $0.5 million in marketing expense. The increase in marketing expenses was primarily attributable to attending several trade shows, market research and website expansion in an effort to expand brand awareness and increase lead generation. General and administrative expense. Our general and administrative expenses increased $11.5 million for the year ended December 31, 2012 as compared to the prior year, primarily as a result of an increase in personnel-related costs, including salary and other compensation-related costs, of $5.7 million, which includes an increase in stock-based compensation of $3.2 million and employee compensation and benefits of $2.5 million and an increase in third-party contractor expenses of $0.5 million. These increases were primarily due to an increase in headcount and the value of stock-based equity awards. In addition, we incurred a $3.8 million increase in facility and overhead costs, primarily attributable to the rent and overhead costs associated with additional facilities, and an increase in professional fees of $1.5 million, primarily attributable to the Anomalous, ttMobiles and Symphony acquisitions and operating as a public company. Research and development expense. Our research and development expenses increased $4.8 million for the year ended December 31, 2012 as compared to the prior year, primarily due to increased 58 -------------------------------------------------------------------------------- Table of Contents personnel-related costs, including salary and other compensation-related costs, of $3.0 million, which includes an increase in stock-based compensation of $0.4 million and employee compensation and benefits of $2.6 million, primarily arising from increased headcount and the value of stock-based equity awards. In addition, we incurred a $1.8 million increase in third-party contractor expenses. The higher costs were primarily the result of an initiative to enhance the functionality of our products and improve our ability to scale to increased demand. Depreciation and amortization expense. Depreciation and amortization expenses increased $4.1 million for the year ended December 31, 2012 as compared to the prior year, primarily due to an increase in amortization expense of $3.5 million and depreciation expense of $0.6 million. The increase in amortization expense was result of higher intangible assets as result of the Telwares, ProfitLine, Anomalous, ttMobiles and Symphony acquisitions. The increase in depreciation expense was primarily due to an increase in capital expenditures to support our overall growth. Restructuring charge. The restructuring charge recorded during the year ended December 31, 2011 was a result of the consolidation of office space in New Jersey. The consolidation of office space eliminated redundant office space acquired in the HCL-EMS and Telwares acquisitions. This charge reflects the fair value of the remaining rent payments for the office space we ceased using, net of estimated sublease income plus real estate commissions, and office relocation costs. Although we continue to attempt to sublet the office space, we do not know how long it will take to locate a subtenant or to come to terms on a sublease agreement or the terms on which we may be able to sublease the office space, which might not be favorable to us. Any differences between the estimated sublease income and the actual agreement will be recorded monthly over the life of the original lease. Other Income (Expense), Net The following table presents our components of other income (expense), net for the periods presented: Years Ended December 31, Change (in thousands, except percentages) 2011 2012 $ % Interest expense $ (3,047 ) $ (943 ) 2,104 -69% Interest income 45 80 35 78% Other expense - (9 ) (9 ) * Increase in fair value of warrants for redeemable convertible preferred stock (1,996 ) - 1,996 -100% -------------------------------------------------------------------------------- º * º Not meaningful Interest expense. Interest expense decreased $2.1 million for the year ended December 31, 2012 as compared to the prior year, which was a result of higher average debt balances in 2011 as a result of an outstanding term loan related to the HCL-EMS and Telwares acquisitions. Interest income. The increase in interest income for the year ended December 31, 2012 as compared to the prior year was a result of higher average cash balances in interest bearing bank accounts. Increase in fair value of warrants to purchase redeemable convertible preferred stock. The elimination of the increase in the fair value of warrants to purchase redeemable convertible preferred stock of $2.0 million for the year ended December 31, 2012 as compared to the prior year was the result of all warrants to purchase redeemable convertible preferred stock being converted to warrants to purchase common stock upon the completion of our initial public offering in August 2011. 59 -------------------------------------------------------------------------------- Table of Contents Income tax provision: Our income tax provision was comparable at $0.5 million for each of the years ended December 31, 2012 and 2011. Years Ended December 31, 2010 and 2011 The following table presents our components of revenue for the periods presented: Revenue Years Ended December 31, Increase (in thousands, except percentages) 2010 2011 $ % Recurring technology and services $ 57,703 $ 93,671 $ 35,968 62% Strategic consulting, software licenses and other 10,771 11,270 499 5% Total revenue $ 68,474 $ 104,941 $ 36,467 53% Our recurring technology and services revenue increased $36.0 million, or 62%, for the year ended December 31, 2011 as compared to the prior year, primarily due to an increase in the volume of fixed and mobile communications assets and service offerings being managed or provided through our on-demand communication management platform for current existing and new customers, combined with revenue attributable to customers acquired through our HCL-EMS and Telwares strategic acquisitions. The increase in strategic consulting, software licenses and other revenue was primarily due to increases of $1.0 million in strategic sourcing. This increase in revenue is attributable to current existing and new customers, combined with revenue attributable to customers acquired through our HCL-EMS and Telwares strategic acquisitions. These increases were partially offset by a decrease in software licenses revenue of $0.5 million. Cost of Revenue and Gross Profit The following table presents our cost of revenue and gross profit for the periods presented: Years Ended December 31, Increase (in thousands, except percentages) 2010 2011 $ % Recurring technology and services $ 26,349 $ 44,814 $ 18,465 70% Strategic consulting, software licenses and other 3,874 5,165 1,291 33% Total cost of revenue $ 30,223 $ 49,979 $ 19,756 65% Gross profit $ 38,251 $ 54,962 $ 16,711 44% Gross margin 56% 52% As a percentage of recurring technology and services revenue, recurring technology and services cost of revenue increased to 48% for the year ended December 31, 2011 as compared to 46% for the prior year. This increase as a percentage of revenue was primarily due to increased costs associated with implementing new customers with revenue being recognized later and due to the HCL-EMS and Telwares acquisitions, as those businesses operate with higher cost of revenues than our other businesses. We expect gross margins on recurring technology and services to continue to be lower than in 2010 until we integrate these businesses and subsequently acquired businesses to our platform. The 60 -------------------------------------------------------------------------------- Table of Contents $18.5 million increase in absolute dollars was primarily due to an increase in personnel-related costs, including salary and other compensation-related costs, of $12.9 million, an increase of $4.1 million in outside contractor costs, and an increase of $1.3 million in travel and other infrastructure costs. The increases in personnel-related, outside contractor, travel and other infrastructure costs excluding the effects of the three acquisitions were primarily attributable to providing support for customer growth in our recurring technology and services business. On an absolute dollars basis, strategic consulting, software licenses and other cost of revenue for the year ended December 31, 2011 increased $1.3 million to $5.2 million as compared to $3.9 million for the prior year primarily as a result of an increase in personnel-related costs, including salary and other compensation-related costs, of $1.0 million and increased consulting costs of $0.3 million, as a result of the increase in consulting revenue and the cost of implementing new software license customers with revenue being recognized later, and $0.2 million of third party contractor costs in 2011 related to a strategic consulting engagement. As a percentage of revenue, gross profit decreased to 52% for the year ended December 31, 2011 from 56% for the prior year. The decrease in gross margin was primarily due to the HCL and Telwares acquisitions, as those businesses operate with lower gross margins than our other businesses. We expect gross margins to continue to be lower than the gross margins in 2010 until we integrate these businesses and subsequently acquired businesses to our platform. Gross profit increased in absolute dollars to $55.0 million for the year ended December 31, 2011 as compared to $38.3 million for the prior year. The increase in gross profit in absolute dollars was primarily due to increased revenue. Operating Expense The following table presents our components of operating expense for the periods presented: Years Ended December 31, 2010 2011 % of % of Change (in thousands, except percentages) Amount Revenue Amount Revenue $ % Sales and marketing $ 12,281 18% $ 16,648 16% $ 4,367 36% General and administrative 11,709 17% 17,777 17% 6,068 52% Research and development 9,321 14% 11,860 11% 2,539 27% Depreciation and amortization 3,529 5% 4,551 4% 1,022 29% Restructuring charge - - 1,549 1% 1,549 * Total operating expense $ 36,840 54% $ 52,385 50% $ 15,545 42% -------------------------------------------------------------------------------- º * º Not meaningful Sales and marketing expense. The increase in sales and marketing expense was primarily due to increases of $4.5 million in personnel-related costs, including salary and other compensation-related costs, as we increased the number of direct and indirect sales force employees to accommodate growth in sales opportunities, $0.3 million in travel expense and $0.2 million in marketing expense primarily attributable to attending several trade shows in an effort to increase lead generation. These increases were partially offset by lower contractor costs of $0.8 million. General and administrative expense. The increase in general and administrative expense was primarily attributable to an increase in facility, equipment and communications costs of $2.7 million and an increase in personnel-related costs, including salary and other compensation-related costs, of $2.6 million, consisting of increased employee compensation and benefits of $1.7 million and increased stock-based compensation expense of $0.9 million as a result of increased headcount. In addition, we 61 -------------------------------------------------------------------------------- Table of Contents incurred an increase in accounting fees and other professional fees of $0.2 million primarily attributable to the HCL, Telwares and ProfitLine acquisitions and operating as a public company. Research and development expense. The increase in research and development expense was primarily attributable to an increase in personnel-related costs, including salary and other compensation-related costs, of $1.7 million primarily arising from increased headcount, consisting of increased employee compensation and benefits of $2.2 million partially offset by a $0.5 million increase in the allocation of technology personnel and information technology expenses to cost of revenue. In addition, we incurred a $0.8 million increase in third-party consultant expenses. The higher costs were primarily the result of an initiative to enhance the functionality of our products and improve our ability to scale to increased demand. Depreciation and amortization expense. The increase in depreciation and amortization expense was due to an increase in amortization expense of $0.7 million and an increase in depreciation expense of $0.3 million. The increase in amortization expense was a result of higher intangible assets as result of the HCL, Telwares and ProfitLine acquisitions. The increase in depreciation expense was primarily due to an increase in capital expenditures to support our overall growth. Restructuring charge. The restructuring charge recorded during the year ended December 31, 2011 was a result of the consolidation of office space in New Jersey. The consolidation of office space eliminated redundant office space acquired in the HCL-EMS and Telwares acquisitions. This charge reflects the fair value of the remaining rent payments for the office space we ceased using, net of estimated sublease income plus real estate commissions, and office relocation costs. Although we continue to attempt to sublet the office space, we do not know how long it will take to locate a subtenant or to come to terms on a sublease agreement or the terms on which we may be able to sublease the office space, which might not be favorable to us. Any differences between the estimated sublease income and the actual agreement will be recorded monthly over the life of the original lease. Other Income (Expense), Net The following table presents our components of other income (expense), net for the periods presented: Years Ended December 31, Change (in thousands, except percentages) 2010 2011 $ % Interest expense $ (2,007 ) $ (3,047 ) (1,040 ) 52% Interest income 19 45 26 137% Increase in fair value of warrants for redeemable convertible preferred stock (884 ) (1,996 ) (1,112 ) 126% Other income (expense) 3 - (3 ) -100% Interest expense. The increase in interest expense was due to higher average debt balances, increased amortization of debt discounts as a result of the debt related to the HCL-EMS, Telwares and ProfitLine acquisitions and loan prepayment fees. Interest income. The increase in interest income was primarily as a result of higher average cash balances due to holding the net proceeds from our initial public offering in interest bearing bank accounts. Increase in fair value of warrants to purchase redeemable convertible preferred stock. The net increase in the fair value of warrants to purchase redeemable convertible preferred stock for the year ended December 31, 2011 was $2.0 million as compared to a $0.9 million increase in the fair value of warrants for the year ended December 31, 2010. The increase was the result of a larger increase in the 62 -------------------------------------------------------------------------------- Table of Contents fair value of the underlying shares of preferred stock during the year ended December 31, 2011 as compared to the year ended December 31, 2010. Upon completion of our initial public offering in August 2011, all warrants to purchase redeemable convertible preferred stock were converted to warrants to purchase common stock. Income tax provision Our income tax provision increased $0.2 million to $0.5 million for the year ended December 31, 2011 as compared to $0.3 million for the year ended December 31, 2010. The increase was due to increases in state income taxes as a result of increased state taxable income and an increase in our deferred income taxes related to our acquisitions of HCL-EMS and Telwares. Liquidity and Capital Resources Sources of Liquidity Since our inception, we have funded our operations primarily from cash from operations, private placements of preferred stock, subordinated notes, term loans and revolving credit facilities. In addition, in August 2011 we raised approximately $66.0 million in net proceeds through an initial public offering of our common stock and in April 2012, we raised an additional $37.7 million in net proceeds through a follow-on public offering of our common stock. We intend to use the proceeds from the follow-on public offering for working capital and other general corporate purposes, which may include financing our growth, developing new solutions and funding capital expenditures, acquisitions and investments. As of December 31, 2012, we had cash and cash equivalents of $50.2 million, accounts receivable of $38.3 million and amounts due under various debts and credit facilities of $22.6 million. Amounts due under various debts and credit facilities of $22.6 million relates to the deferred consideration for the HCL-EMS, Telwares, ProfitLine, Anomalous, ttMobiles and Symphony acquisitions and capital lease and other obligations. We believe that our existing cash and cash equivalents and our cash flow from operating activities will be sufficient to meet our anticipated cash needs for at least the next twelve months. To the extent our cash and cash equivalents and cash flow from operating activities are insufficient to fund our future activities, we may need to raise additional funds through bank credit arrangements or public or private equity or debt financings. We also may need to raise additional funds in the event we determine in the future to effect one or more acquisitions of, or investments in, businesses, services or technologies. If additional funding is required, we may not be able to obtain bank credit arrangements or to effect an equity or debt financing on terms acceptable to us or at all. The following table sets forth our cash and cash equivalents and the major sources and uses of cash for each of the periods set forth below: As of December 31, (in thousands) 2010 2011 2012 Cash and cash equivalents $ 5,913 $ 43,407 $ 50,211 Years Ended December 31, (in thousands) 2010 2011 2012 Net cash provided by operating activities $ 3,400 $ 10,147 $ 16,688 Net cash used in investing activities (367 ) (23,047 ) (40,230 ) Net cash (used in) provided by financing activities (3,283 ) 50,394 30,398 Effect of exchange rate on cash - - (52 ) Net (decrease) increase in cash and cash equivalents $ (250 ) $ 37,494 $ 6,804 63 -------------------------------------------------------------------------------- Table of Contents Cash Flows from Operating Activities Operating activities provided $16.7 million of net cash during the year ended December 31, 2012, which resulted from our net income of $3.0 million for the year ended December 31, 2012 principally supplemented by non-cash charges of stock-based compensation of $9.2 million, depreciation and amortization of $8.7 million and debt discount amortization of $0.8 million and cash provided by an increase in accounts payable and accrued expenses of $2.2 million and prepaid expenses and other current assets of $0.2 million. Cash provided by operating activities was adversely impacted by a $5.9 million increase in accounts receivable and a $1.9 million decrease in deferred revenue during the year ended December 31, 2012. Operating activities provided $10.1 million of net cash during the year ended December 31, 2011. We incurred a net loss of $3.0 million for the year ended December 31, 2011 that was offset by a $3.1 million increase in accounts payable and a $1.2 million increase in deferred revenue, which was attributable primarily to increased sales of our software products and related services, and non-cash charges of depreciation and amortization of $4.6 million, stock-based compensation of $4.0 million, an increase in fair value of warrants for redeemable convertible preferred stock of $2.0 million, restructuring charge of $1.5 million and amortization of debt discount of $1.3 million. Cash provided by operating activities was adversely impacted by a $4.4 million increase in accounts receivable during the year ended December 31, 2011. Operating activities provided $3.4 million of net cash during the year ended December 31, 2010. We incurred a net loss of $1.8 million for the year ended December 31, 2010 that was offset by a $2.3 million increase in deferred revenue, which was attributable primarily to increased sales of our software products and related services, and non-cash charges of depreciation and amortization of $3.5 million, stock-based compensation of $1.9 million and an increase in fair value of warrants for redeemable convertible preferred stock of $0.9 million. Cash provided by operating activities was adversely impacted by a $3.0 million increase in accounts receivable during the year ended December 31, 2010. Cash Flows from Investing Activities Cash used in investing activities totaled $40.2 million during the year ended December 31, 2012 and consisted of $38.4 million paid in connection with the Anomalous, ttMobiles and Symphony acquisitions and capital expenditures of $1.8 million primarily related to the purchase of computer equipment and software. Cash used in investing activities totaled $23.0 million during the year ended December 31, 2011 and consisted of $22.2 million paid in connection with the HCL-EMS, Telwares and ProfitLine acquisitions, net of cash received, and capital expenditures of $0.8 million primarily related to the purchase of computer equipment and software. Cash used in investing activities totaled $0.4 million during the year ended December 31, 2010 and consisted solely of cash paid for capital expenditures primarily related to the purchase of computer equipment and software. Cash Flows from Financing Activities Cash flows provided by financing activities totaled $30.4 million during the year ended December 31, 2012 primarily due to $37.7 million of net proceeds from our follow-on offering, net of underwriting discounts and commissions and offering costs, and $4.2 million in proceeds from the exercise of stock options and stock warrants. Cash provided by financing activities was adversely impacted by net debt repayments of $8.9 million and $2.7 million of cash used to repurchase our common stock. 64 -------------------------------------------------------------------------------- Table of Contents Cash flows provided by financing activities totaled $50.4 million during the year ended December 31, 2011 primarily due to $67.0 million of net proceeds from our initial public offering, net of underwriting discounts and commissions and offering costs, and $1.6 million in proceeds from the exercise of stock options and stock warrants. Cash provided by financing activities was adversely impacted by net repayments under our credit facilities of $18.0 million. Cash flows used in financing activities totaled $3.3 million during the year ended December 31, 2010 primarily consisting of principal payments under our credit and subordinated debt facilities, capital lease obligations and the payment of $1.0 million of debt related to our acquisition of InterNoded in 2008. Contractual Obligations The following table summarizes our material contractual obligations at December 31, 2012 and the effect such obligations are expected to have on our liquidity and cash flows in future periods. Payments due by period Less than More than (dollars in thousands) Total 1 year 1 - 3 years 3 - 5 years 5 Years Operating lease obligations $ 20,963 $ 6,827 $ 13,058 $ 1,078 - Capital leases and other obligations 804 672 132 - - Interest on capital lease obligations 40 34 6 - - Symphony deferred purchase price 10,662 10,662 - - - ProfitLine deferred purchase price 4,438 4,438 - - - ttMobiles deferred purchase price 2,420 2,420 - - - HCL-EMS contingent consideration 2,046 2,046 - - - Telwares deferred purchase price 1,226 1,226 - - - Anomalous deferred purchase price 978 978 - - - $ 43,577 $ 29,303 $ 13,196 $ 1,078 $ - º • º Operating lease obligations include minimum lease obligations with remaining terms in excess of one year primarily related to office space as well as certain equipment. º • º Capital lease and other obligations include minimum lease obligations with remaining terms in excess of one year related to computer hardware and software. º • º Symphony deferred purchase price includes payments of $4.4 million payable on February 8, 2013 and $6.4 million payable on August 8, 2013. The $4.4 million payment was made in February 2013. º • º ProfitLine deferred purchase price includes an installment of $4.5 million payable on June 19, 2013. º • º ttMobiles deferred purchase price includes an installment of $2.4 million payable on February 21, 2013, which payment was made in February 2013. º • º HCL-EMS contingent consideration includes a payment payable following the second anniversary of the HCL-EMS closing date of January 25, 2011. º • º Telwares deferred purchase price includes an installment of $1.25 million payable on March 16, 2013. º • º Anomalous deferred purchase price includes an installment of $ 979,000 payable on January 10, 2013, which was paid in January 2013. 65 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financing activities, nor do we have any interest in entities referred to as variable interest entities. Recent Accounting Pronouncements In July 2012, the FASB issued ASU No. 2012-02, "Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment." This ASU states that an entity has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that an indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Codification Subtopic 350-30, Intangibles-Goodwill and Other, General Intangibles Other than Goodwill. The amendments in this ASU are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity's financial statements for the most recent annual or interim period have not yet been issued. We elected early adoption of this update and it had no impact on our consolidated financial statements. [ Back To TMCnet.com's Homepage ]