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BLUCORA, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements in this report that are not purely historical are 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 forward-looking statements include, but are not limited to: statements regarding projections of our future financial performance; trends in our businesses; our future business plans and growth strategy, including our plans to expand, develop, or acquire particular operations, businesses, or assets; and the sufficiency of our cash balances and cash generated from operating, investing, and financing activities for our future liquidity and capital resource needs. Forward-looking statements are subject to known and unknown risks, uncertainties, and other factors that may cause our results, levels of activity, performance, achievements, prospects, and other characterizations of future events or circumstances, to be materially different from those expressed or implied by such forward-looking statements. These risks, uncertainties, and other factors include, among others, those identified under Part II, Item 1A, "Risk Factors" and elsewhere in this report. You should not rely on forward-looking statements included herein, which speak only as of the date of this Quarterly Report on Form 10-Q or the date specified herein. We do not undertake any obligation to update publicly any forward-looking statement to reflect new information, events, or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events. Overview Blucora, Inc. ("Blucora," "Company," or "us") owns and operates two primary businesses: the InfoSpace online search business and the TaxACT tax preparation online services and software business. The InfoSpace business is primarily a B2B service that provides search technology, aggregated search content, and monetization solutions to its distribution partners for use on those distribution partners' own web properties. InfoSpace also offers search services directly to consumers through its owned internet search properties. The TaxACT tax preparation business, acquired on January 31, 2012, consists of an online tax preparation service for individuals, tax preparation software for individuals and professional tax preparers, and ancillary services. Following the acquisition of the TaxACT business, we determined that we have two reporting segments: Search and Tax Preparation. Search The majority of our revenues are generated by our Search segment. Our Search business primarily offers search services through the web properties of its distribution partners, which are generally private-labeled and customized to address the unique requirements of each distribution partner. The Search business also distributes aggregated search content through its own websites, such as Dogpile.com and WebCrawler.com. The InfoSpace search business does not generate its own search content, but instead aggregates search content from a number of content providers. Our metasearch technology selects search results from several search engine content providers, including Google, Yahoo!, and Bing, among others, and aggregates, filters, and prioritizes the results. This combination provides a more relevant search results page and leverages the investments made by our search engine content providers to continually improve the user experience. Some of these content providers, such as Google and Yahoo!, pay us to distribute their content, and those providers are referred to as Search Customers. Revenue from our Search segment is generated primarily as a result of end users of our services clicking on paid search results displayed on our own branded websites or those of our distribution partners. These paid search results are provided to us by our Search Customers. The Search Customer that provided the paid search result receives a fee from the advertiser who paid for the click and the Search Customer pays us a portion of that fee. If the click originated from one of our distribution partners' web properties, we share a portion of the fee we receive with the partner. Revenue is recognized in the period in which such paid clicks occur and is based on the amounts earned and remitted to us by our Search Customers for such clicks. Revenue from Google accounts for approximately 89% of our Search segment revenue for the quarter ended March 31, 2013. Tax Preparation Our Tax Preparation segment generates its revenue through three primary methods: the sale of state and upgraded federal income tax preparation services and software to consumers and small businesses, the sale of ancillary services to consumers, and - 17 - -------------------------------------------------------------------------------- Table of Contents the sale of its professional edition income tax preparation software to professional tax preparers. The majority of the TaxACT business's revenue is generated by the online service at www.taxact.com. The TaxACT business's basic federal tax preparation online software service is "free for everyone," meaning that any taxpayer can use the services to file his or her federal income taxes without paying for upgraded services. This free offer differentiates TaxACT's offerings from many of its competitors who have limited free software and/or services offerings. The TaxACT business generates revenue from a percentage of these "free" users who choose to upgrade for a fee to the deluxe product and/or ancillary services and/or to file their state income tax returns, which are not free, with TaxACT. The ancillary services include, among other things, taxpayer phone support, data archiving, a deferred payment option, a bank card product, and e-filing services for professional tax preparers and consumers of our packaged software. TaxACT is the generally accepted value player in the digital do it yourself space, offering comparable software and/or services at a lower cost to the end-user compared to larger competitors. This, coupled with its "free for everyone" offer, provides TaxACT a valuable marketing position. TaxACT's professional tax preparer software allows professional tax preparers to file individual returns for their clients. Revenue from professional tax preparers has historically constituted a relatively small percentage of the TaxACT business's overall revenue, and requires relatively modest incremental development costs as the basic software is substantially similar to the consumer-facing software and online service. Seasonality Our Tax Preparation segment is highly seasonal. Revenue from our Tax Preparation segment tends to be highest during our first and second quarters as a result of significantly higher sales of income tax preparation products and services during the period from January through April. During the third and fourth quarter, the Tax Preparation segment typically reports losses because revenue from the segment is minimal while core operating expenses continue at relatively consistent levels. Use of Cash As of March 31, 2013, we had $401.7 million in cash, cash equivalents, and short-term investments. We may use these amounts in the future on investment in our current businesses, in acquiring new businesses or assets, for repayment of debt, or share repurchases. Such businesses or assets may not be related to search or tax preparation, and such acquisitions will result in us incurring further transaction related costs. Overview of Operating Results The following is an overview of our operating results for the quarter ended March 31, 2013 compared to the quarter ended March 31, 2012. A more detailed comparison of our operating results for these periods is included under the heading "Results of Operations for the Quarters Ended March 31, 2013 and 2012" in this Management's Discussion and Analysis of Financial Condition and Results of Operations. In most cases, fluctuations between the results for the quarters ended March 31, 2013 and 2012 were as a result of the acquisition of TaxACT Holdings and its subsidiary, 2nd Story, operator of the TaxACT income tax preparation business, on January 31, 2012. As a result of the timing of the acquisition, the quarter ended March 31, 2013 reflects three months of TaxACT activity, whereas the quarter ended March 31, 2012 reflects only two months of TaxACT activity. Several of our key operating financial measures for the quarters ended March 31, 2013 and 2012 in total dollars (in thousands) and as a percentage of associated revenue are presented below: Quarters ended March 31, 2013 2012 Revenues $ 165,338 $ 115,696 % of % of total revenues total revenues Gross profit $ 86,663 52.4 % $ 56,149 48.5 % Net income $ 23,608 14.3 % $ 11,406 9.9 % Revenues. The increase in revenues for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012, was primarily driven by an increase in Tax Preparation segment revenue, primarily reflecting a full quarter of results for this segment in 2013 compared to a partial quarter in 2012 due to the timing of the TaxACT acquisition on January 31, 2012, as well as an increase in Search segment revenue primarily due to growth in revenues generated from our distribution partners. Gross profit. The increase in gross profit as a percentage of revenues for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012, is primarily due to the timing of our acquisition of the TaxACT business. As previously noted, due to the seasonality of the TaxACT business, its results contribute significantly to margin in the first quarter of the year. Net income. The increase in net income as a percentage of revenues for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012, is due primarily to higher gross profit as a percentage of revenues as described above and a decrease in stock-based compensation expense in the first quarter of 2013. In 2012, we recorded $5.2 million in stock-based compensation relating to the modification of an outstanding warrant and vesting of non-employee stock options due to the acquisition of the TaxACT business. - 18 --------------------------------------------------------------------------------- Table of Contents Results of Operations for the Quarters Ended March 31, 2013 and 2012 Business Segment Results The following information presents the results of operations of our two reporting segments. Segment expenses do not include certain costs such as certain general and administrative (including certain personnel and overhead costs), stock-based compensation, depreciation, amortization of intangible assets, other loss, net or income tax expense to the reportable segments. Search Search segment results are as follows (in thousands): Quarters ended March 31, Change Percent of Percent of from 2013 Revenue 2012 Revenue 2012 Search Revenue: Revenue from existing distribution partners (launched prior to the then-current year) $ 87,301 87 % $ 64,027 85 % $ 23,274 Revenue from new distribution partners (launched during the then-current year) 1,171 1 % 1,733 2 % (562 ) Revenue from distribution partners 88,472 88 % 65,760 87 % 22,712 Revenue from owned and operated properties 12,129 12 % 9,535 13 % 2,594 Total Search Revenue 100,601 75,295 25,306 Cost of revenue 70,618 53,106 17,512 Operating expense 11,713 8,816 2,897 Segment income $ 18,270 $ 13,373 $ 4,897 Segment margin 18.2 % 17.8 % Search Revenue. Our ability to increase the revenue generated from our distribution partners' web properties is dependent on our ability to attract and retain distribution partners, which relies on providing a satisfying end user experience and an attractive monetization proposition to our distribution partners. Our ability to increase our online search services revenue in our metasearch engine sites and our installed application user base relies in part on our ability to attract and retain end users by providing a satisfying user experience. We manage our online direct marketing initiatives by projecting a desired return on our marketing expenditures and attempting to market according to that projected return. Revenue growth for our online direct marketing initiatives is dependent on our ability to execute to that projected return. The increase in our search services revenue for the quarter ended March 31, 2013, as compared to the quarter ended March 31, 2012, is primarily due to increases in revenue generated by our distribution partners. We experienced a 35% increase in revenue generated from our distribution partners, for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012. We expect revenue growth in our distribution partner network to slow, possibly significantly in the second half of the 2013, as the impact of the policy changes implemented in the current quarter by our most significant search customer, Google, take effect. The policy changes affect our distribution partners that acquire end-users of our search services through downloadable applications. Revenue from these distribution partners currently and historically represents less than 50% of total search segment revenue. Although these changes were implemented in the first quarter, we believe that these changes may have longer term impacts beyond the second quarter 2013. We generated 43% and 51% of our search services revenue through our top five distribution partners for the quarters ended March 31, 2013 and 2012, respectively. The web properties of our top five distribution partners for the quarter ended March 31, 2013 generated 47% of our search services revenue for the quarter ended March 31, 2012. Revenue generated from our owned and operated properties increased in the current quarter primarily due to an increase in revenue from our online direct marketing initiatives, offset in part by continued user attrition in our metasearch engine sites and installed user base, resulting in fewer paid clicks. Search Cost of revenue. The Search segment's cost of revenue primarily consists of amounts paid under our revenue sharing arrangements with our distribution partners and usage-based content fees. The increase in cost of revenue for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was primarily due to an increase in the revenue generated from our distribution partners' web properties, with the resulting increase in shared revenue. - 19 --------------------------------------------------------------------------------- Table of Contents Because we share revenue with our distribution partners, the search segment's cost of revenue will increase if search services revenue generated through our distribution partners' web properties increases. In addition, cost of revenue from distribution can be impacted by the mix of revenue generated by distribution partners. We expect that revenue from searches conducted by end users on sites of our distribution partners will continue to be an increasing majority of our search services revenue. Search Operating expense. The increase in operating expense for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was primarily due to the increase in spending on our online direct marketing initiatives. Tax Preparation Tax Preparation segment results are as follows (in thousands): Quarters ended Change March 31, from 2013 2012 2012 Revenue $ 64,737 $ 40,401 $ 24,336 Cost of revenue 2,214 2,579 (365 ) Operating expense 31,739 15,687 16,052 Segment income $ 30,784 $ 22,135 $ 8,649 Segment margin 47.6 % 54.8 % Tax Preparation Revenue. Our ability to generate tax preparation revenue is dependent on our ability to effectively market our consumer tax preparation software and online services and our ability to sell the related deluxe and ancillary services to our customers. We also generate revenue through the professional tax preparer software that we sell to professional tax preparers, who use it to prepare and file individual returns for their clients. Revenue from professional tax preparers has historically constituted a relatively small percentage of the overall revenue for the TaxACT business. The increase in Tax Preparation revenue for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 primarily relates to a full quarter of results for this segment in 2013 compared to a partial quarter in 2012 due to the timing of the TaxACT acquisition on January 31, 2012. Consumer tax preparation revenue is largely driven by our ability to acquire new users of the service, retain existing users, and upsell users to paid products and services. We measure our individual tax preparation customers using the number of federal tax accepted e-filings made through our software and services, and we refer to such tax filings as "e-files". We consider growth in the number of e-files to be the most important non-financial metric in measuring the performance of the Tax Preparation business. Overall revenue is driven more by growth in e-files than by growth in revenue per user, which has historically grown modestly, as we have not made significant pricing adjustments. Given the proximity of our quarter to the end of the tax season, e-file metrics for quarter ended March 31 and the tax season are as follows (in thousands): Quarters ended March 31, Tax season ended 2013 2012 (1) % change April 16, 2013 April 18, 2012 (1) % change TaxACT desktop e-files 190 182 4 % 270 256 5 % TaxACT online e-files 3,855 3,605 7 % 4,865 4,490 8 % TaxACT sub-total e-files 4,045 3,787 7 % 5,135 4,746 8 % TaxACT File Alliance e-files 111 124 (10 )% 147 160 (8 )% TaxACT total e-files (2) 4,156 3,911 6 % 5,282 4,906 8 % (1) We acquired the TaxACT business on January 31, 2012. Rather than presenting consumer tax unit metrics for only the portion of the first quarter of 2012 following the TaxACT acquisition, we have presented our consumer tax preparation TaxACT unit performance for the first quarter of 2012 on a comparable basis, assuming the acquisition occurred on January 1, 2012. We believe this is a more accurate indication of the year-over-year performance of the TaxACT business from the standpoint of our most important operational metric. (2) We have redefined e-files in this Quarterly Report to exclude e-filed extensions as we believe this is a more accurate metric in evaluating performance of the Tax Preparation segment. The figures set forth above for 2012 and 2013 reflect this change. We primarily derive revenue from the professional tax preparation product in two ways: from the per-unit licensing of the software and from amounts that we charge to e-file through the software. Thus professional tax preparation revenue is dependent upon both the number of tax professionals purchasing the product and the number of e-filed returns made through this product. For the 2012 tax season, the number of e-filed returns made through our professional product increased 10% compared to the prior year and we experienced a slight increase in the professional units sold. - 20 --------------------------------------------------------------------------------- Table of Contents Tax Preparation Cost of revenue. The Tax Preparation segment cost of revenue primarily consists of royalties, payment processing fees for customer transactions, and bank service fees. The decrease in cost of revenue for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 is due to an $818,000 increase in credit card processing fees due to timing of the acquisition on January 31, 2012, offset by a $783,000 decrease in bank service fees on our bank card product and a $425,000 decrease in royalties. Tax Preparation Operating expense. The increase in operating expenses for the Tax Preparation segment for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 primarily relates to a full quarter of results for this segment in 2013 compared to a partial quarter in 2012, amplified by the fact that a relatively high percentage of tax season advertising occurs in January, a month that is included in 2013 results but not in 2012 results. The Tax Preparation segment is highly seasonal; almost all of its annual revenue is generated in the first four months of the calendar year, as are the majority of the variable costs related to such revenue, such as payment processing fees, royalties, and advertising and marketing expenses. As a result, we expect revenues to decline in the second quarter and to further decline in the third and fourth quarters, while fixed costs remain relatively constant. Consolidated Results Cost of sales. Cost of sales consists of the Search and Tax Preparation segments' cost of revenue, amortization of acquired intangible assets, and certain costs associated with customer service and the operation of the data centers that serve our businesses, which include personnel expenses (which include salaries, benefits and other employee related costs, and stock-based compensation expense), the cost of temporary help and contractors to augment our staffing, bandwidth costs, and depreciation. Cost of sales in total dollars (in thousands) and as a percentage of total revenues for the quarters ended March 31, 2013 and 2012 are presented below: Quarters ended Change March 31, from 2013 2012 2012 Search segment cost of revenue $ 70,618 $ 53,106 $ 17,512 Tax Preparation segment cost of revenue 2,214 2,579 (365 ) Amortization of acquired intangible assets 1,940 1,511 429 Data center operations 3,198 1,855 1,343 Depreciation 486 416 70 Other 219 80 139 Total cost of sales $ 78,675 $ 59,547 $ 19,128 Percentage of revenues 47.6 % 51.5 % The decrease in cost of sales as a percentage of revenues for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012, was primarily due to the timing of the TaxACT acquisition in 2012. As previously noted, the TaxACT business is highly seasonal and their results contribute significantly to revenue and cost of sales in the first quarter of a year. Engineering and technology expenses. Engineering and technology expenses are associated with the research, development, support, and ongoing enhancements of our offerings, including personnel expenses (which include salaries, stock-based compensation expense, and benefits and other employee related costs), software support and maintenance, and professional service fees. Engineering and technology expenses in total dollars (in thousands) and as a percentage of total revenues for the quarters ended March 31, 2013 and 2012 are presented below: Quarters ended Change March 31, from 2013 2012 2012 Engineering and technology expenses $ 2,538 $ 2,573 $ (35 ) Percentage of revenues 1.5 % 2.2 % Engineering and technology expenses were comparable for the quarters ended March 31, 2013 and 2012. - 21 - -------------------------------------------------------------------------------- Table of Contents Sales and marketing expenses. Sales and marketing expenses consist principally of marketing expenses associated with our TaxACT website (which includes the following channels: television, radio, online banner ads, and email), our owned and operated web search properties (which consist of traffic acquisition, including our online direct marketing initiatives, which involve the purchase of online advertisements that drive traffic to an owned and operated website, agency fees, brand promotion expense, and market research expense), and personnel costs (which include salaries, stock-based compensation expense, and benefits and other employee related costs). Sales and marketing expenses in total dollars (in thousands) and as a percentage of total revenues for the quarters ended March 31, 2013 and 2012 are presented below: Quarters ended Change March 31, from 2013 2012 2012 Sales and marketing expenses $ 36,796 $ 19,443 $ 17,353 Percentage of revenues 22.3 % 16.8 % The increase for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was primarily attributable to a $17.0 million increase in advertising costs, primarily due to the timing of the TaxACT acquisition on January 31, 2012, and to a lesser extent an increase in spending related to our search online direct marketing initiatives. General and administrative expenses. General and administrative ("G&A") expenses consist primarily of personnel expenses (which include salaries, stock-based compensation expense, and benefits and other employee related costs), professional service fees (which include legal, audit, and tax fees), general business development and management expenses, occupancy and general office expenses, taxes and insurance expenses. General and administrative expenses in total dollars (in thousands) and as a percentage of total revenues for the quarters ended March 31, 2013 and 2012 are presented below: Quarters ended Change March 31, from 2013 2012 2012 General and administrative expenses $ 6,384 $ 11,066 $ (4,682 ) Percentage of revenues 3.9 % 9.6 % The decrease in G&A expenses for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was primarily attributable to a $5.2 million stock-based compensation expense incurred during the quarter ended March 31, 2012 related to the modification of the Warrant and vesting of non-employee stock options due to the acquisition of the TaxACT business. Depreciation and amortization of intangible assets.Depreciation of property and equipment includes depreciation of computers, software, office equipment and fixtures, and leasehold improvements not recognized in cost of sales. Amortization of definite-lived intangible assets represents the amortization of customer relationships, which are amortized over their estimated lives. Depreciation and amortization of intangible assets in total dollars (in thousands) and as a percentage of total revenues for the quarters ended March 31, 2013 and 2012 are presented below: Quarters ended Change March 31, from 2013 2012 2012 Depreciation $ 517 $ 535 $ (18 ) Amortization of intangible assets 3,169 2,113 1,056 Total depreciation and amortization of intangible assets $ 3,686 $ 2,648 $ 1,038 Percentage of revenues 2.2 % 2.3 % The increase in amortization of intangible assets for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was primarily due to TaxACT acquisition on January 31, 2012. There was no material difference in the depreciation of property and equipment. - 22 --------------------------------------------------------------------------------- Table of Contents Other loss, net. Other loss, net for the quarters ended March 31, 2013 and 2012 is presented below (in thousands): Quarters ended Change March 31, from 2013 2012 2012 Interest income $ (55 ) $ (9 ) $ (46 ) Interest expense 1,148 844 304 Amortization of debt issuance costs 107 331 (224 ) Accretion of debt discount 161 135 26 (Gain) loss on derivative instruments (348 ) 272 (620 ) Other (8 ) (18 ) 10 Other loss, net $ 1,005 $ 1,555 $ (550 ) The decrease in other loss for the quarter ended March 31, 2013 compared to the quarter ended March 31, 2012 was primarily due to a gain on the decrease in fair value of the Warrant outstanding (for further detail, see "Note 9: Derivative Instruments and Hedging Activities" to the Unaudited Condensed Consolidated Financial Statements in Part I, Item 1 of this report). In the quarter ended March 31, 2012, we recorded a loss on the increase of the fair value of this Warrant. Income Tax Expense. We recorded income tax expense of $12.6 million and $7.5 million in the quarters ended March 31, 2013 and 2012, respectively. In the quarter ended March 31, 2013, income tax expense did not significantly differ from the taxes at the statutory rates. In the quarter ended March 31, 2012, income tax expense differed from the taxes at the statutory rates primarily due to non-deductible stock compensation. Non-GAAP Financial Measures We define Adjusted EBITDA as net income, determined in accordance with the accounting principles generally accepted in the United States of America ("GAAP"), excluding the effects of discontinued operations (which includes loss from discontinued operations, net of taxes, and loss on sale of discontinued operations, net of taxes), income taxes, depreciation, amortization of intangible assets, stock-based compensation expense, and other loss (income), net (which includes such items as interest expense, interest income, gains or losses on derivative instruments, foreign currency gains or losses, gains or losses from the disposal of assets, adjustments to the fair values of contingent liabilities related to business combinations, gains on resolution of contingencies, and litigation settlements). We believe that Adjusted EBITDA provides meaningful supplemental information regarding our performance. We use this non-GAAP financial measure for internal management and compensation purposes, when publicly providing guidance on possible future results, and as a means to evaluate period-to-period comparisons. We believe that Adjusted EBITDA is a common measure used by investors and analysts to evaluate our performance, that it provides a more complete understanding of the results of operations and trends affecting our business when viewed together with GAAP results, and that management and investors benefit from referring to this non-GAAP financial measure. Items excluded from Adjusted EBITDA are significant and necessary components to the operations of our business and, therefore, Adjusted EBITDA should be considered as a supplement to, and not as a substitute for or superior to, GAAP net income. Other companies may calculate Adjusted EBITDA differently and, therefore, our Adjusted EBITDA may not be comparable to similarly titled measures of other companies. A reconciliation of our Adjusted EBITDA to net income, which we believe to be the most comparable GAAP measure, is presented for the quarters ended March 31, 2013 and 2012 below (in thousands): Quarters ended March 31, 2013 2012 Net income $ 23,608 $ 11,406 Depreciation and amortization of intangible assets 6,112 4,575 Stock-based compensation 2,485 6,708 Other loss, net 1,005 1,555 Income tax expense 12,646 7,458 Adjusted EBITDA $ 45,856 $ 31,702 Adjusted EBITDA. The increase in Adjusted EBITDA as a percentage of revenue for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012, was primarily due to an increase in segment margin of $13.5 million offset by a $608,000 decrease in corporate expenses primarily related to professional services incurred during the acquisition of the TaxACT business in January 2012. The increase in segment margin for the Search and Tax Preparation segments for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012 was $4.9 million and $8.6 million, respectively. - 23 --------------------------------------------------------------------------------- Table of Contents We define non-GAAP net income differently for this report than we have defined it in the past, due to issuance of the Notes in March 2013. For this report, we define non-GAAP net income as net income, determined in accordance with GAAP, excluding the effects of loss from discontinued operations, net of taxes, stock-based compensation expense, amortization of acquired intangible assets, accretion of debt discount on the Notes, gain or loss on derivative instruments, and the related cash tax impact of those adjustments, and non-cash income taxes from continuing operations. Non-cash income tax expense represents a reduction to cash taxes payable associated with the utilization of deferred tax assets, which primarily consist of U.S. federal net operating losses. The majority of these deferred tax assets will expire if unutilized in 2020. We believe that non-GAAP net income and non-GAAP earnings per share provide meaningful supplemental information to management, investors and analysts regarding our performance and the valuation of our business by excluding items in the statement of operations that we do not consider part of our ongoing operations or have not been, or are not expected to be, settled in cash. Additionally, we believe non-GAAP net income and non-GAAP earnings per share are common measures used by investors and analysts to evaluate our performance and the valuation of our business. Non-GAAP net income should be evaluated in light of our financial results prepared in accordance with GAAP, and should be considered as a supplement to, and not as a substitute for or superior to, GAAP net income. Other companies may calculate non-GAAP net income differently, and therefore our non-GAAP net income may not be comparable to similarly titled measures of other companies. A reconciliation of our non-GAAP net income to net income, which we believe to be the most comparable GAAP measure, is presented for the quarters ended March 31, 2013 and 2012 below (in thousands): Quarters ended March 31, 2013 2012 Net income $ 23,608 $ 11,406 Stock-based compensation 2,485 6,708 Amortization of acquired intangible assets 5,109 3,624 Accretion of debt discount on convertible notes 132 - (Gain) loss on derivative instrument (348 ) 272 Cash tax impact of adjustments to GAAP net income (163 ) (90 ) Non-cash income tax expense 11,174 6,597 Non-GAAP net income $ 41,997 $ 28,517 Net income - diluted $ 0.53 $ 0.28 Stock-based compensation - diluted 0.06 0.16 Amortization of acquired intangible assets - diluted 0.11 0.09 Accretion of debt discount on convertible notes - diluted 0.00 0.00 (Gain) loss on derivative instrument - diluted 0.00 0.01 Cash tax impact of adjustments to GAAP net income - diluted 0.00 0.00 Non-cash income tax expense per share - diluted 0.25 0.16 Non-GAAP net income per share - diluted $ 0.95 $ 0.70 Our new definition of non-GAAP net income does not impact presentation of this non-GAAP financial measure for prior periods. Non-GAAP net income. The increase in non-GAAP net income as a percentage of net income for the quarter ended March 31, 2013 compared to the quarter ended March 31, 2012, was primarily due to an increase in the Tax Preparation segment due to the timing of the TaxACT acquisition in 2012. Liquidity and Capital Resources Cash, Cash Equivalents, and Short-Term Investments Our principal source of liquidity is our cash, cash equivalents and short-term investments. As of March 31, 2013, we had cash and marketable investments of $401.7 million, consisting of cash and cash equivalents of $264.6 million and available-for-sale short-term investments of $137.0 million. We generally invest our excess cash in high quality marketable investments. These investments include securities issued by U.S. government agencies, commercial paper, money market funds, and municipal bonds. All of our financial instrument investments held at March 31, 2013 have minimal default risk and short-term maturities. - 24 --------------------------------------------------------------------------------- Table of Contents On January 31, 2012, we acquired TaxACT Holdings and its subsidiary 2nd Story, operator of the TaxACT income tax preparation business for $287.5 million in cash, less certain transaction expenses, and subject to certain specified working capital adjustments. The acquisition of the TaxACT business was funded from our cash reserves and from the net proceeds of borrowings under a $105 million credit facility (of which $100 million was drawn at the transaction's close), which facility consists of a $95 million term loan and a $10.0 million revolving credit facility. The credit facility is secured by the TaxACT business's operations and the equity of 2nd Story Software, Inc. The terms of the credit facility allow us to repay amounts owed before its term is complete, and during the year ended December 31, 2012, we repaid $25.5 million outstanding under the credit facility, including all of the amounts owed under the revolving credit facility portion of the debt. Although we do not currently anticipate drawing on the revolving credit facility in the future, all $10 million of that revolving credit facility is available for future use. The terms of the credit facility required us to hedge a portion of the interest rate risk associated with the amounts outstanding under the term loan, and that requirement was met on May 1, 2012 (for further detail, see "Note 8: Debt" of the Notes to the Unaudited Condensed Consolidated Financial Statements in Part I, Item 1 of this report). We plan to use our cash to fund operations, develop technology, advertise, market and distribute our products and services, and continue the enhancement of our network infrastructure. An important component of our strategy for future growth is to acquire technologies and businesses, and we plan to use our cash to acquire and integrate acceptable targets that we may identify. These targets may include businesses, products, or technologies unrelated to search or tax preparation. We may use a portion of our cash for special dividends or for common stock repurchases. During the quarter ended March 31, 2013, we purchased 67,700 shares in open market transactions at a total cost of $1.1 million. Due to timing of the repurchase, $1.1 million is included in accrued expenses and other current liabilities at March 31, 2013. We believe that existing cash, cash equivalents, short-term investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months, but the underlying levels of revenues and expenses that we project may not prove to be accurate. For further discussion of the risks to our business related to liquidity, see the paragraph in our Risk Factors (Part II, Item 1A of this quarterly report) under the heading "Existing cash and cash equivalents, short-term investments, and cash generated from operations may not be sufficient to meet our anticipated cash needs for working capital and capital expenditures." Recent Financing Transactions On March 15, 2013, we issued $201.25 million principal amount of Notes. The Notes mature on April 1, 2019, unless earlier purchased, redeemed, or converted in accordance with their terms. The Notes bear interest at a rate of 4.25% per year, which began to accrue on March 15, 2013 and is payable semi-annually in arrears on April 1 and October 1 of each year beginning on October 1, 2013. We received net proceeds from the offering of approximately $194.9 million after adjusting for debt issuance costs, including the underwriting discount. The Notes were issued under an indenture dated March 15, 2013 (the "Indenture") by and between us and The Bank of New York Mellon Trust Company, N.A., as Trustee. There are no financial or operating covenants relating to the Notes. On or before June 30, 2013, holders may not convert their Notes under any circumstances. After June 30, 2013 and prior to the close of business on the business day immediately preceding October 1, 2018 holders may convert all or a portion their Notes at their option, in multiples of $1,000 principal amount, only under the following circumstances: • during any fiscal quarter commencing after the calendar quarter ending on June 30, 2013 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; • during the five business day period after any five consecutive trading day period (the "measurement period") in which the trading price per $1,000 principal amount of the Notes for each trading day of the measurement period was less than 98% of the product of the last reported sales price of our common stock and the conversion rate on each trading day; • if we call any or all of the Notes for redemption; • upon the occurrence of specified corporate events, including a merger or a sale of all or substantially all of our assets; or • at any time if we have not received stockholder approval to settle conversions in cash, shares of common stock, or any combination thereof. On or after October 1, 2018 until the close of business on the second scheduled trading day immediately preceding the maturity date of April 1, 2019, holders may convert their Notes, in multiples of $1,000 principal amount, at the option of the holder regardless of the foregoing circumstances. - 25 --------------------------------------------------------------------------------- Table of Contents The conversion rate for the Notes is initially 46.1723 shares per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $21.66 per share of our common stock). The conversion rate is subject to customary adjustment for certain events as described in the Indenture. At the time we issued the Notes and at March 31, 2013, we were only permitted to settle conversions with shares of our common stock. We are seeking shareholder approval at our annual meeting in May 2013 to allow for "flexible settlement", which would allow us to have the option to settle conversions in cash, shares of common stock, or any combination thereof. If shareholder approval is received, our intention is to satisfy conversion of the Notes with cash for the principal amount of the debt and shares of common stock for any related conversion premium. We may not redeem the Notes prior to April 6, 2016. After April 6, 2016, we may, at our option, redeem for cash all or part of the Notes plus accrued and unpaid interest to, but not including, the redemption date. If the Company undergoes a fundamental change, (as described in the Indenture), subject to certain conditions, holders may require us to repurchase for cash all or part of their Notes in principal amounts of $1,000 or an integral multiple thereof. The fundamental change repurchase price will be equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. However, if a fundamental change occurs and a holder elects to convert the Notes, we will, under certain circumstances, increase the applicable conversion rate for the Notes surrendered for conversion by a number of additional shares of common stock, based on the date on which the fundamental change occurs or becomes effective and the price paid per share of our common stock in the fundamental change as specified in the Indenture. The Notes are unsecured and unsubordinated obligations of ours and rank senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the Notes, and equal in right of payment to any of our existing and future unsecured indebtedness that is not subordinated. The Notes are effectively junior in right of payment to any of our secured indebtedness (to the extent of the value of assets securing such indebtedness) and structurally junior to all existing and future indebtedness and other liabilities, including trade payables, of our subsidiaries. The Indenture does not limit the amount of debt that we or our subsidiaries may incur, including senior secured indebtedness. The Notes are not guaranteed by us or any of our subsidiaries. As stated above, we are seeking shareholder approval for flexible settlement at the 2013 annual meeting of stockholders, which would allow us to satisfy conversions of the Notes in cash and shares of common stock. As a result, the Notes contain liability and equity components which were bifurcated and accounted for separately. The liability component of the Notes, as of the issuance date, was calculated by estimating the fair value of a similar liability issued at a 6.5% effective interest rate, which was determined by considering the rate of return investors would require in our debt structure. The amount of the equity component was calculated by deducting the fair value of the liability component from the principal amount of the Notes, resulting in the initial recognition of $22.3 million as the debt discount recorded in additional paid in capital for the Notes. The carrying amount of the Notes will be accreted to the principal amount over the remaining term to maturity and we will record a corresponding interest expense. We incurred debt issuance costs of $6.4 million related to the Notes and allocated $5.7 million of debt issuance costs to the liability component of the Notes. These costs will be amortized to interest expense over the six year term of the Notes or the date of conversion, if any. Contractual Obligations and Commitments There have been no material changes during the period covered by this 10-Q, outside of the ordinary course of our business, to the contractual obligations specified in the table of contractual obligations included in the 10-K, other than the potential repayment related to the convertible debt as disclosed in "Recent Financing Transactions", above, and the lease extension as disclosed in Note 7: "Commitments and Contingencies". Off-balance sheet arrangements We have no off-balance sheet arrangements other than operating leases. We do not believe that our operating leases are material to our current or future financial position, results of operations, revenues or expenses, liquidity, capital expenditures or capital resources. - 26 --------------------------------------------------------------------------------- Table of Contents Cash Flows Our net cash flows were comprised of the following for the quarters ended March 31, 2013 and 2012 (in thousands): Quarters ended March 31, 2013 2012 Net cash provided by operating activities $ 31,755 $ 19,048 Net cash used by investing activities (48,671 ) (94,909 ) Net cash provided by financing activities 213,273 95,804 Net increase in cash and cash equivalents $ 196,357 $ 19,943 Net cash provided by operating activities. Net cash provided by operating activities was $31.8 million and $19.0 million for the quarters ended March 31, 2013 and 2012, respectively. Our operating cash flows result primarily from net income offset by certain adjustments not affecting current period cash flows and the effect of changes in our operating assets and liabilities. Net cash used by investing activities. Net cash used by investing activities was $48.7 million and $94.9 million for the quarters ended March 31, 2013 and 2012. For the quarter ended March 31, 2013, cash used by investing activities primarily consisted of $62.1 million for purchases of investments, a $4.0 million investment in a privately-held company, and $1.5 million in purchases of property and equipment, partially offset by $18.7 million in proceeds from the maturities of our investments. For the quarter ended March 31, 2012, cash used by investing activities primarily consisted of $279.4 million used to purchase the TaxACT business. Partially offsetting this decrease are proceeds received on sales and maturities of investments of $183.9 million and a change in restricted cash of $767,000. Net cash provided by financing activities. Net cash provided by financing activities was $213.3 million and $95.8 million for the quarters ended March 31, 2013 and 2012. For the quarter ended March 31, 2013, cash provided by financing activities primarily consisted of net proceeds from the issuance of the Notes of $195.2 million, $17.8 million of excess tax benefits from stock-based award activity, and $754,000 from the exercise of options and the issuance of stock through our employee stock purchase plan. For the quarter ended March 31, 2012, net cash provided by financing activities consisted of net proceeds of $96.7 million from the credit facility related to the acquisition of the TaxACT business, $12.1 million of excess tax benefits from stock-based award activity, and $2.1 million from the exercise of options, offset by $15.0 million of term debt repayments. Critical Accounting Policies and Estimates The preparation of our financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and disclosure of contingent assets and liabilities. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. Our critical accounting policies, estimates, and methodologies for the quarters ended March 31, 2013 are consistent with those in Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates in Part II, Item 7, of our Annual Report on Form 10-K for the year ended December 31, 2012, along with those presented below. Revenue recognition: We recognize revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists, we have delivered the product or performed the service, the fee is fixed or determinable, and collectability is probable. Determining whether and when these criteria have been satisfied involves exercising judgment and using estimates and assumptions that can have an impact on the timing and amount of revenue that we recognize. We also evaluate whether revenue should be presented on a gross basis, which is the amount that a customer pays for the service or product, or on a net basis, which is the customer payment less amounts we pay to suppliers. In making that evaluation, we consider indicators such as whether we are the primary obligor in the arrangement and assume the risks and rewards as a principal in the customer transaction, including the credit risk, and whether we can set the sales price and select suppliers. GAAP clearly indicate that the evaluation of these factors, which at times can be contradictory, are subject to significant judgment and subjectivity. Search services revenue recognition: The majority of our revenues are generated from our web search services. We generate search services revenue when an end user of such services clicks on a paid search link provided by a Search Customer and displayed on a distribution partners' web property or on one of our owned and operated web properties. The Search Customer that provided the paid search link receives a fee from the advertiser who paid for the click and the Search Customer pays us a portion of that fee. Revenue is recognized in the period in which the services are provided (e.g., a paid search occurs) and is based on the amounts earned by and ultimately remitted to us. This revenue is recorded in the Search segment. - 27 - -------------------------------------------------------------------------------- Table of Contents Under our agreements with our Search Customers and our distribution partners, we are the primary obligor, separately negotiate each revenue or unit pricing contract independent of any revenue sharing arrangements, and assume the credit risk for amounts invoiced to our Search Customers. For search services, we determine the paid search results, content, and information directed to our owned and operated websites and our distribution partners' web properties. We earn revenue from our Search Customers by providing paid search results generated from our owned and operated web properties and from our distribution partners' web properties based on separately negotiated and agreed-upon terms with each distribution partner. Consequently, we record search services revenue on a gross basis. Tax preparation revenue recognition: We derive revenue from the sale of tax preparation online services, ancillary service offerings, packaged tax preparation software products, and multiple element arrangements that may include a combination of these items. Ancillary service offerings include tax preparation support services, data archive services, bank or reloadable pre-paid debit card services, e-filing services, and other value-added services. This revenue is recorded in the Tax Preparation segment. Our tax preparation segment service revenue consists primarily of hosted tax preparation online services, tax preparation support services, data archive services, and e-filing services. We recognize revenue from these services as the services are performed and the four revenue recognition criteria described above are met. We recognize revenue from the sale of our packaged software products when legal title transfers. This is generally when our customers download products from the Web or when the products ship. The bank or reloadable prepaid debit card services are offered to taxpayers as an option to receive their tax refunds in the form of a prepaid bank card or to have the fees for the product and/or services purchased by the customers deducted from their refunds. Other value-added service revenue consists of revenue from revenue sharing and royalty arrangements with third party partners. Revenue for these transactions is recognized when the four revenue recognition criteria described above are met; for some arrangements that is upon filing and for other arrangements that is upon our determination of when collectibility is probable. For products and/or services that consist of multiple elements, we must: (1) determine whether and when each element has been delivered; (2) determine the fair value of each element using the selling price hierarchy of vendor-specific objective evidence ("VSOE") of fair value if available, third-party evidence ("TPE") of fair value if VSOE is not available, and estimated selling price ("ESP") if neither VSOE nor TPE is available; and (3) allocate the total price among the various elements based on the relative selling price method. Once we have allocated the total price among the various elements, we recognize revenue when the revenue recognition criteria described above are met for each element. VSOE generally exists when we sell the deliverable separately and is normally able to establish VSOE for all deliverables in these multiple element arrangements; however, in certain instances VSOE cannot be established. This may be because we infrequently sell each element separately, or have a limited sales history. When VSOE cannot be established we attempt to establish a selling price for each element based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. When we are unable to establish selling price using VSOE or TPE, we use ESP in our allocation of arrangement consideration. ESP is the estimated price at which we would sell a product or service if it were sold on a stand-alone basis. We determine ESP for a product or service by considering multiple factors including, but not limited to, historical stand-alone sales, pricing practices, market conditions, competitive landscape, internal costs, and gross margin objectives. In some situations, we receive advance payments from our customers. We defer revenue associated with these advance payments and recognize the allocated consideration for each element when we ship the products or perform the services, as appropriate. Advance payments related to data archive services are deferred and recognized over the related contractual term. Debt Issuance Costs and Debt Discount: Debt issuance costs and debt discounts are deferred and amortized as interest expense under the effective interest method over the contractual term of the related debt, adjusted for prepayments in the case of our credit facility. Debt issuance costs related to the Notes issued in 2013 were allocated to the liability and equity components of the instrument. The debt issuance costs allocated to the liability are amortized to interest expense through the earlier of the maturity date of the Notes or the date of conversions, if any. The debt issuance costs allocated to the equity component of the Notes were recorded as an offset to additional paid in capital. Recent Accounting Pronouncements Changes to GAAP are established by the FASB in the form of ASUs to the FASB's Accounting Standards Codification. We consider the applicability and impact of all recent ASUs. - 28 - -------------------------------------------------------------------------------- Table of Contents In February 2013, the FASB issued an update to the authoritative guidance related to the reporting of amounts reclassified out of accumulated other comprehensive income. This new requirement about presenting information about amounts reclassified out of accumulated other comprehensive income and their corresponding effect on net income will present, in one place, information about significant amounts reclassified and, in some cases, cross-references to related footnote disclosures. We adopted this guidance in the first quarter of 2013, and the adoption of these disclosure requirements did not have a material impact on our consolidated financial statements. There were no material realized gains or losses recorded in the quarters ended March 31, 2013 or 2012. |