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LIQUIDITY SERVICES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS This document contains forward-looking statements. These statements are only predictions. The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These risks and other factors include but are not limited to the factors set forth in our Annual Report on Form 10-K for the year ended September 30, 2012 and subsequent filings with the Securities and Exchange Commission. You can identify forward-looking statements by terminology such as "may," "will," "should," "could," "would," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continues" or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. There may be other factors of which we are currently unaware or deem immaterial that may cause our actual results to differ materially from the forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this document and are expressly qualified in their entirety by the cautionary statements included in this document. Except as may be required by law, we undertake no obligation to publicly update or revise any forward-looking statement to reflect events or circumstances occurring after the date of this document or to reflect the occurrence of unanticipated events. The following discussion should be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this document. Overview About us. We operate leading auction marketplaces for surplus and salvage assets. We enable buyers and sellers to transact in an efficient, online auction environment offering over 500 product categories. Our marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with customer focused information including digital images and other relevant product information along with services to efficiently complete the transaction. Additionally, we enable our corporate and government sellers to enhance their financial return on excess assets by providing liquid marketplaces and value-added services that integrate sales and marketing, logistics and transaction settlement into a single offering. We organize our products into categories across major industry verticals such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware, energy equipment, industrial capital assets, fleet and transportation equipment and specialty equipment. Our online marketplaces are www.liquidation.com, www.govliquidation.com, www.govdeals.com, www.networkintl.com, www.truckcenter.com, and www.secondipity.com, and www.go-dove.com. We believe our ability to create liquid marketplaces for surplus and salvage assets generates a continuous flow of goods from our corporate and government sellers. This flow of goods in turn attracts an increasing number of professional buyers to our marketplaces. During the 12 months ended March 31, 2013, the number of registered buyers grew from approximately 1,711,000 to approximately 2,307,000, or 34.8%. Recent initiatives. On November 1, 2012, we completed the acquisition of the assets of National Electronic Service Association (NESA). The acquisition price includes an upfront cash payment of approximately $18,300,000 and an earn-out payment. Under the terms of the agreement, the earn-out is based on EBITDA earned by NESA during the 36-48 months after closing. Our estimate of the fair value of the earn-out as of the date of acquisition was $18.0 million. NESA is a Canadian provider of returns management, refurbishment and reverse logistics services for high-value consumer products. NESA provides expertise and focused services to Fortune 1000 companies in the management of Consumer Electronics, Telecommunications, and Information Technology products. During the three months ended March 31, 2013, we made significant progress implementing our restructuring plan for GoIndustry, which we acquired in July 2012. We closed non performing locations and rationalized the remaining supporting infrastructure, while maintaining the key elements of the organization that have consistently provided a high level of service to our Fortune 1,000 clients. We expect to complete our restructuring plan over the next six months, and we believe these changes will enable the GoIndustry marketplace to achieve profitable operations in fiscal year 2014. 18 -------------------------------------------------------------------------------- Table of Contents Our revenue. We generate substantially all of our revenue by retaining a percentage of the proceeds from the sales we manage for our sellers. We offer our sellers three primary transaction models: a profit-sharing model, a consignment model and a purchase model. † Profit-sharing model. Under our profit-sharing model, we purchase inventory from our suppliers and share with them a portion of the profits received from a completed sale in the form of a distribution. Distributions are calculated based on the value received from the sale after deducting direct costs, such as sales and marketing, technology and operations and other general and administrative costs. Because we are the primary obligor, and take general and physical inventory risks and credit risk under this transaction model, we recognize as revenue the sale price paid by the buyer upon completion of a transaction. Revenue from our profit-sharing model accounted for approximately 13.6% and 13.1 % of our total revenue for the three and six months ended March 31, 2013. The merchandise sold under our profit-sharing model accounted for approximately 6.8% and 6.7% of our gross merchandise volume, or GMV, for the three and six months ended March 31, 2013. † Consignment model - fee revenue. Under our consignment model, we recognize commission revenue from sales of merchandise in our marketplaces that is owned by others. These commissions, which we refer to as seller commissions, represent a percentage of the sale price the buyer pays upon completion of a transaction. We vary the percentage amount of the seller commission depending on the various value-added services we provide to the seller to facilitate the transaction. For example, we generally increase the percentage amount of the commission if we take possession, handle, ship or provide enhanced product information for the merchandise. We collect the seller commission by deducting the appropriate amount from the sales proceeds prior to their distribution to the seller after completion of the transaction. Revenue from our consignment model, as well as other fee revenue, accounted for approximately 18.5% and 17.8% of our total revenue for the three and six months ended March 31, 2013. The merchandise sold under our consignment model accounted for approximately 59.1% and 58.4% of our GMV for the three and six months ended March 31, 2013. † Purchase model. Under our purchase model, we offer our sellers a fixed amount or the option to share a portion of the proceeds received from our completed sales in the form of a distribution. Distributions are calculated based on the value we receive from the sale after deducting a required return to us that we have negotiated with the seller. Because we are the primary obligor, and take general and physical inventory risks and credit risk under this transaction model, we recognize as revenue the sale price paid by the buyer upon completion of a transaction. Revenue from our purchase model accounted for approximately 67.9% and 69.1% of our total revenue for the three and six months ended March 31, 2013. The merchandise sold under our purchase model accounted for approximately 34.1% and 34.9% of our GMV for the three and six months ended March 31, 2013. We collect a buyer premium on substantially all of our transactions under all of our transaction models. Buyer premiums are calculated as a percentage of the sale price of the merchandise sold and are paid to us by the buyer. Buyer premiums are in addition to the price of the merchandise. Under our profit-sharing model, we typically share the proceeds of any buyer premiums with our sellers. Industry trends. We believe there are several industry trends impacting the growth of our business including: (1) the increase in the adoption of the Internet by businesses to conduct e-commerce both in the United States and abroad; (2) product innovation in the retail supply chain that has increased the pace of product obsolescence and, therefore, the supply of surplus assets; (3) the increase in the volume of returned merchandise handled by both online and offline retailers; (4) the increase in government regulations necessitating verifiable recycling and remarketing of surplus assets; (5) the increase in outsourcing by corporate and government organizations of disposition activities for surplus and end-of-life assets; and (6) as a result of the economic downturn, an increase in buyer demand for surplus merchandise as consumers trade down by purchasing less expensive goods and seek greater value from their purchases, which results in lower per unit prices and margins in our retail goods business. 19 -------------------------------------------------------------------------------- Table of Contents Our Seller Agreements Our DoD agreements. We have two contracts with the DoD pursuant to which we acquire, manage and sell excess property: † Surplus Contract. In June 2001, we were awarded the original Surplus Contract, a competitive-bid exclusive contract under which we acquire, manage and sell all usable DoD surplus personal property turned into the DLA Disposition Services. Surplus property generally consists of items determined by the DoD to be no longer needed, and not claimed for reuse by, any federal agency, such as computers, electronics, office supplies, scientific and medical equipment, aircraft parts, clothing and textiles. On November 6, 2008, the DoD extended the original Surplus Contract through December 17, 2008, the original Contract wind down period was completed during fiscal year 2010. We responded to a RFP from the DLA Disposition Services regarding a renewal of the Surplus Contract, and we were awarded the contract. We executed the new Contract on December 18, 2008. The new Surplus Contract expires in February 2014. Revenue from our Surplus Contract (including buyer premiums) accounted for approximately 28.9% and 28.2% of our total revenue for the three and six months ended March 31, 2013. The property sold under our Surplus Contract accounted for approximately 14.5% and 14.5% of our GMV for the three and six months ended March 31, 2013. † Scrap Contract. In June 2005, we were awarded a competitive-bid exclusive contract under which we acquire, manage and sell substantially all scrap property of the DoD turned into the DLA Disposition Services. Scrap property generally consists of items determined by the DoD to have no use beyond their base material content, such as metals, alloys, and building materials. We were required to pay $5.7 million to the DoD in fiscal 2005 for the right to manage the operations and remarket scrap material in connection with the Scrap Contract. Following the DoD's exercise of its first two renewal options, the Scrap Contact expires in June 2014. Revenue from our Scrap Contract (including buyer premiums) accounted for approximately 13.6% and 13.1% of our total revenue for the three and six months ended March 31, 2013. The property sold under our Scrap Contract accounted for approximately 6.8% and 6.7% of our GMV for the three and six months ended March 31, 2013. Under the new Surplus Contract, as amended, we are obligated to purchase all DoD surplus property at 1.8% of Disposition Services' original acquisition value. The DoD has broad discretion to determine what property will be made available for sale to us under the new Surplus Contract and may retrieve or restrict property previously sold to us for national security reasons or if the property is otherwise needed to support the mission of the DoD. Under the Scrap Contract, we acquire scrap property at a per pound price. We refer to these disbursement payments to the DoD as profit-sharing distributions. As a result of these arrangements, we recognize as revenue the gross proceeds from these sales. The DoD also reimburses us for actual costs incurred for packing, loading and shipping property under the Scrap and original Surplus Contracts that we are obligated to pick up from non-DoD locations. We also have a small business performance incentive based on the number of scrap buyers that are small businesses that allows us to receive up to an additional 2% of the profit sharing distribution. On May 21, 2007, we entered into a bilateral contract modification under which the DoD agreed to increase our profit-sharing distribution for the Scrap Contract from 20% to 23% effective June 1, 2007, in exchange for our agreement to implement additional inventory assurance processes and procedures with respect to the mutilation of demilitarized scrap property sold. During April 2013, the DoD issued a Request For Information (RFI) for the Surplus and Scrap Contracts. Our Wal-Mart Contracts. We have various contracts with Wal-Mart Stores, Inc., pursuant to which we have the exclusive right to purchase certain consumer products from Wal-Mart that have been removed from the sales stream of its retail operations. All of these agreements have customary commercial terms, which generally expire within a year and allow both parties to terminate for convenience with reasonable notice. As a result of the Jacobs Trading acquisition, we also have a long-term contract with Wal-Mart that does not provide for termination for convenience. The term of this agreement expires on May 16, 2016 and thereafter continues on a month to month basis. Our commercial agreements. We have over 600 corporate clients each of which has sold in excess of $10,000 of surplus and salvage assets in our marketplaces during the last twelve months. Our agreements with these clients are generally terminable at will by either party. 20 -------------------------------------------------------------------------------- Table of Contents Key Business Metrics Our management periodically reviews certain key business metrics for operational planning purposes and to evaluate the effectiveness of our operational strategies, allocation of resources and our capacity to fund capital expenditures and expand our business. These key business metrics include: Gross merchandise volume. Gross merchandise volume, or GMV, is the total sales value of all merchandise sold through our marketplaces during a given period. We review GMV because it provides a measure of the volume of goods being sold in our marketplaces and thus the activity of those marketplaces. GMV also provides a means to evaluate the effectiveness of investments that we have made and continue to make, including in the areas of customer support, value-added services, product development, sales and marketing, and operations. The GMV of goods sold in our marketplaces during the three and six months ended March 31, 2013 totaled $259.1 million and $492.5 million, respectively. Completed transactions. Completed transactions represents the number of auctions in a given period from which we have recorded revenue. Similar to GMV, we believe that completed transactions is a key business metric because it provides an additional measurement of the volume of activity flowing through our marketplaces. During the three and six months ended March 31, 2013, we completed approximately 138,000 and 267,000 transactions, respectively. Total registered buyers. We grow our buyer base through a combination of marketing and promotional efforts. A person becomes a registered buyer by completing an online registration process on one of our marketplaces. As part of this process, we collect business and personal information, including name, title, company name, business address and contact information, and information on how the person intends to use our marketplaces. Each prospective buyer must also accept our terms and conditions of use. Following the completion of the online registration process, we verify each prospective buyer's e-mail address and confirm that the person is not listed on any banned persons list maintained internally or by the U.S. federal government. After the verification process, which is completed generally within 24 hours, the registration is approved and activated and the prospective buyer is added to our registered buyer list. Total registered buyers, as of a given date, represents the aggregate number of persons or entities who have registered on one of our marketplaces. We use this metric to evaluate how well our marketing and promotional efforts are performing. Total registered buyers excludes duplicate registrations, buyers who are suspended from utilizing our marketplaces and those buyers who have voluntarily removed themselves from our registration database. In addition, if we become aware of registered buyers that are no longer in business, we remove them from our database. As of March 31, 2013, we had approximately 2,307,000 registered buyers. Total auction participants. For each auction we manage, the number of auction participants represents the total number of registered buyers who have bid one or more times in that auction. As a result, a registered buyer who bids, or participates, in more than one auction is counted as an auction participant in each auction in which he or she participates. Thus, total auction participants for a given period is the sum of the auction participants in each auction conducted during that period. We use this metric to allow us to compare our online auction marketplaces to our competitors, including other online auction sites and traditional on-site auctioneers. In addition, we measure total auction participants on a periodic basis to evaluate the activity level of our base of registered buyers and to measure the performance of our marketing and promotional efforts. For the three and six months ended March 31, 2013, approximately 643,000 and 1,209,000 total auction participants participated in auctions on our marketplaces, respectively. 21 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Financial Measures EBITDA and adjusted EBITDA. EBITDA is a supplemental non-GAAP financial measure and is equal to net income plus interest and other expense (income), net; provision for income taxes; amortization of contract intangibles; and depreciation and amortization. Our definition of adjusted EBITDA differs from EBITDA because we further adjust EBITDA for stock-based compensation expense and acquisition costs. We believe EBITDA and adjusted EBITDA are useful to an investor in evaluating our performance for the following reasons: † The amortization of contract intangibles relates to amortization of the Scrap Contract beginning in June 2005 and the contract related intangible assets associated with the Jacobs Trading acquisition on October 1, 2011 and the NESA acquisition on November 1, 2012. Depreciation and amortization expense primarily relates to property and equipment. Both of these expenses are non-cash charges that have fluctuated significantly over the past five years. As a result, we believe that adding back these non-cash charges to net income is useful in evaluating the operating performance of our business on a consistent basis from year-to-year. † As a result of varying federal and state income tax rates, we believe that presenting a financial measure that adjusts net income for provision for income taxes is useful to investors when evaluating the operating performance of our business. † The authoritative guidance requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their estimated fair values. Accordingly, we believe adjusting net income for this non-cash stock based compensation expense is useful to investors when evaluating the operating performance of our business. † The authoritative guidance related to business combinations requires the recognition of contingent consideration so that it is recognized at the time of acquisition rather than when it is probable and disallows the capitalization of transaction costs. Accordingly, we believe adjusting net income for these acquisition related expenses is useful to investors when evaluating the operating performance of our business on a consistent basis from year-to-year. † We believe these measures are important indicators of our operational strength and the performance of our business because they provide a link between profitability and operating cash flow. † We also believe that analysts and investors use EBITDA and adjusted EBITDA as supplemental measures to evaluate the overall operating performance of companies in our industry. Our management uses EBITDA and adjusted EBITDA: † as measurements of operating performance because they assist us in comparing our operating performance on a consistent basis as they remove the impact of items not directly resulting from our core operations; † for planning purposes, including the preparation of our internal annual operating budget; † to allocate resources to enhance the financial performance of our business; † to evaluate the effectiveness of our operational strategies; and † to evaluate our capacity to fund capital expenditures and expand our business. 22 -------------------------------------------------------------------------------- Table of Contents EBITDA and adjusted EBITDA as calculated by us are not necessarily comparable to similarly titled measures used by other companies. In addition, EBITDA and adjusted EBITDA: (a) do not represent net income or cash flows from operating activities as defined by GAAP; (b) are not necessarily indicative of cash available to fund our cash flow needs; and (c) should not be considered as alternatives to net income, income from operations, cash provided by operating activities or our other financial information as determined under GAAP. We prepare adjusted EBITDA by adjusting EBITDA to eliminate the impact of items that we do not consider indicative of our core operating performance. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. As an analytical tool, adjusted EBITDA is subject to all of the limitations applicable to EBITDA. Our presentation of adjusted EBITDA should not be construed as an implication that our future results will be unaffected by unusual or non-recurring items. The table below reconciles net income to EBITDA and adjusted EBITDA for the periods presented. Three Months Six Months Ended March 31, Ended March 31, 2013 2012 2013 2012 (in thousands) (unaudited) Net income $ 12,698 $ 18,762 $ 19,407 $ 27,888Interest and other expense (income), net 96 583 (828 ) 1,108 Provision for income taxes 8,824 12,508 13,296 19,116 Amortization of contract intangibles 2,407 2,020 4,617 4,039 Depreciation and amortization 1,980 1,505 3,967 3,031 EBITDA 26,005 35,378 40,459 55,182 Stock compensation expense 2,935 2,493 7,302 5,118 Acquisition costs 212 (6,989 ) 5,588 (6,671 ) Adjusted EBITDA $ 29,152 $ 30,882 $ 53,349 $ 53,629 Critical Accounting Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. A "critical accounting estimate" is one which is both important to the portrayal of our financial condition and results and requires management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We continuously evaluate our critical accounting estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Revenue recognition. For transactions in our online marketplaces, which generate substantially all of our revenue, we recognize revenue when all of the following criteria are met: † a buyer submits the winning bid in an auction and, as a result, evidence of an arrangement exists and the sale price has been determined; † title has passed to a buyer and the buyer has assumed risks and rewards of ownership; and † collection is reasonably assured. Substantially all of our sales are recorded subsequent to payment authorization being received, utilizing credit cards, wire transfers and PayPal, an Internet based payment system, as methods of payments. As a result, we are not subject to significant collection risk, as goods are generally not shipped before payment is received. 23 -------------------------------------------------------------------------------- Table of Contents Revenue is also evaluated for reporting revenue of gross proceeds as the principal in the arrangement or net of commissions as an agent. In arrangements in which we are deemed to be the primary obligor, bear physical and general inventory risk, and credit risk, we recognize as revenue the gross proceeds from the sale, including buyer's premiums. Arrangements in which we act as an agent or broker on a consignment basis, without taking general or physical inventory risk, revenue is recognized based on the sales commissions that are paid to us by the sellers for utilizing our services; in this situation, sales commissions represent a percentage of the gross proceeds from the sale that the seller pays to us upon completion of the transaction. We have evaluated our revenue recognition policy related to sales under our profit-sharing model and determined it is appropriate to account for these sales on a gross basis. The following factors were most heavily relied upon in our determination: † We are the primary obligor in the arrangement. † We are the seller in substance and in appearance to the buyer; the buyer contacts us if there is a problem with the purchase. Only we and the buyer are parties to the sales contract and the buyer has no recourse to the supplier. If the buyer has a problem, he or she looks to us, not the supplier. † The buyer does not and cannot look to the supplier for fulfillment or for product acceptability concerns. † We have general inventory risk. † We take title to the inventory upon paying the amount set forth in the contract with the supplier. Such amount is generally a percentage of the supplier's original acquisition cost and varies depending on the type of the inventory purchased or a fixed price per pound under our Scrap Contract. † We are at risk of loss for all amounts paid to the supplier in the event the property is damaged or otherwise becomes unsaleable. In addition, as payments made for inventory are excluded from the calculation for the profit-sharing distribution under our DoD contracts, we effectively bear inventory risk for the full amount paid to acquire the property (i.e., there is no sharing of inventory risk). Business Combinations. We recognize all of the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. Acquisition-related costs are recognized separately from the acquisition and expensed as incurred. Generally, restructuring costs incurred in periods subsequent to the acquisition date are expensed when incurred. Subsequent changes to the purchase price (i.e., working capital adjustments) or other fair value adjustments determined during the measurement period are recorded as an adjustment to goodwill. All subsequent changes to a valuation allowance or uncertain tax position that relate to the acquired company and existed at the acquisition date that occur both within the measurement period and as a result of facts and circumstances that existed at the acquisition date are recognized as an adjustment to goodwill. All other changes in valuation allowances are recognized as a reduction or increase to income tax expense or as a direct adjustment to additional paid-in capital as required. Valuation of goodwill and other intangible assets. We identify and value intangible assets that we acquire in business combinations, such as customer arrangements, customer relationships and non-compete agreements, that arise from contractual or other legal rights or that are capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. The fair value of identified intangible assets is based upon an estimate of the future economic benefits expected to result from ownership, which represents the amount at which the assets could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. We test our goodwill and other intangible assets for impairment annually or more frequently if events or circumstances indicate impairment may exist. Examples of such events or circumstances could include a significant change in business climate or a loss of significant customers. We apply a two-step fair value-based test to assess goodwill for impairment. The first step compares the fair value of a reporting unit to its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, the second step is then performed. The second step compares the carrying amount of the reporting unit's goodwill to the fair value of the goodwill. If the fair value of the goodwill is less than the carrying amount, an impairment loss would be recorded in our statements of operations. Intangible assets with definite lives are amortized over their estimated useful lives and are also reviewed for impairment if events or changes in circumstances indicate that their carrying amount may not be realizable. 24 -------------------------------------------------------------------------------- Table of Contents Our management makes certain estimates and assumptions in order to determine the fair value of net assets and liabilities, including, among other things, an assessment of market conditions, projected cash flows, cost of capital and growth rates, which could significantly impact the reported value of goodwill and other intangible assets. Estimating future cash flows requires significant judgment, and our projections may vary from cash flows eventually realized. The valuations employ a combination of present value techniques to measure fair value, corroborated by comparisons to estimated market multiples. These valuations are based on a discount rate determined by our management to be consistent with industry discount rates and the risks inherent in our current business model. We cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill and other intangible assets, which totaled $244.3 million at March 31, 2013. Such events may include strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on our base of buyers and sellers or material negative changes in our relationships with material customers. Income taxes. We account for income taxes using the asset and liability approach for measuring deferred taxes based on temporary differences between the financial statement and income tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for the years in which the taxes are expected to be paid or recovered. A valuation allowance is provided to reduce the deferred tax assets to a level that we believe will more likely than not be realized. The resulting net deferred tax asset reflects management's estimate of the amount that will be realized. We apply the guidance related to accounting for uncertainty in income taxes. We concluded that there were no uncertain tax positions identified during its analysis. We provide for income taxes based on our estimate of federal and state tax liabilities. These estimates include, among other items, effective rates for state and local income taxes, estimates related to depreciation and amortization expense allowable for tax purposes, and the tax deductibility of certain other items. Our estimates are based on the information available to us at the time we prepare the income tax provision. We generally file our annual income tax returns several months after our fiscal year-end. Income tax returns are subject to audit by federal, state and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. Stock-based compensation. We recognize in the statements of operations all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their estimated fair values. We use the Black-Scholes option pricing model to estimate the fair values of share-based payments. The above list is not intended to be a comprehensive list of all of our accounting estimates. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with little need for management's judgment in their application. There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result. See our audited financial statements and related notes, which contain accounting policies and other disclosures required by GAAP. Components of Revenue and Expenses Revenue. We generate substantially all of our revenue from sales of merchandise held in inventory and by retaining a percentage of the proceeds from the sales. Our revenue recognition practices are discussed in more detail in the section above entitled "Critical Accounting Estimates." Cost of goods sold (excluding amortization). Cost of goods sold includes the costs of purchasing and transporting property for auction, as well as credit card transaction fees. Profit-sharing distributions. Our Scrap Contract with the DoD has been structured as a profit-sharing arrangement in which we purchase and take possession of all goods we receive from the DoD at a contractual per pound price. After deducting allowable operating expenses, we disburse to the DoD on a monthly basis a percentage of the profits of the aggregate monthly sales. We retain the remaining percentage of these profits after the DoD's disbursement. We refer to these disbursement payments to the DoD as profit-sharing distributions. Technology and operations. Technology expenses consist primarily of personnel costs related to our programming staff who develop and deploy new marketplaces and continuously enhance existing marketplaces. These personnel also develop and upgrade the software systems that support our operations, such as sales processing. Because our marketplaces and support systems require frequent upgrades and enhancements to maintain viability, we have determined that the useful life for substantially all of our internally developed software is less than one year. As a result, we expense these costs as incurred. 25 -------------------------------------------------------------------------------- Table of Contents Operations expenses consist primarily of operating costs, including buyer relations, shipping logistics and distribution center operating costs. Sales and marketing. Sales and marketing expenses include the cost of our sales and marketing personnel as well as the cost of marketing and promotional activities. These activities include online marketing campaigns such as paid search advertising. General and administrative. General and administrative expenses include all corporate and administrative functions that support our operations and provide an infrastructure to facilitate our future growth. Components of these expenses include executive management and staff salaries, bonuses and related taxes and employee benefits; travel; headquarters rent and related occupancy costs; and legal and accounting fees. The salaries, bonus and employee benefits costs included as general and administrative expenses are generally more fixed in nature than our operating expenses and do not vary directly with the volume of merchandise sold through our marketplaces. Amortization of contract intangibles. Amortization of contract intangibles expense consists of the amortization of our Scrap Contract awarded during June 2005 and our contract intangibles associated with the Jacobs Trading acquisition on October 1, 2011, and the NESA transaction on November 1, 2012. The Scrap Contract required us to purchase the rights to operate the scrap operations of the DoD during the seven year base term of the contract. The intangible asset created from the $5.7 million purchase is being amortized over 84 months on a straight-line basis. The amortization period is correlated to the base term of the contract, exclusive of renewal periods. The intangible asset created in conjunction with the acquisition of Jacobs Trading is valued at $33.3 million and is being amortized over 55 months on a straight-line basis. The amortization period is correlated to the base term of the Wal-Mart contract from the acquisition date, exclusive of renewal periods. The vendor contract intangible asset created in conjunction with the NESA acquisition is valued at $3.9 million and is being amortized over 20 months, on a straight-line basis. The amortization period is correlated to the base term of the contract, from the acquisition date, exclusive of renewal periods. Depreciation and amortization. Depreciation and amortization expenses consist primarily of the depreciation and amortization of amounts recorded in connection with the purchase of furniture, fixtures and equipment. Acquisition costs. Acquisition costs consist of expenses incurred to complete a business combination and adjustments to the fair value of earn-outs. Interest and other (expense) income, net. Interest expense and other expense, net consists primarily of interest expense on borrowings under our subordinated note payable. Income taxes. During fiscal years 2011 and 2012, we had an effective income tax rate for continuing operations of approximately 43% and 40%, respectively, which included federal, state and foreign income taxes. We estimate that our future effective income tax rate will be approximately 41%. 26 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, for the periods indicated, selected statement of operations data expressed as a percentage of revenue. Three Months Ended Six Months Ended March 31, March 31, 2013 2012 2013 2012 Revenue 100.0 % 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of goods sold (excluding amortization) 38.3 43.8 38.4 42.4 Profit-sharing distributions 7.6 9.1 7.3 10.3 Technology and operations 17.2 12.6 17.8 13.6 Sales and marketing 7.6 5.5 8.0 5.8 General and administrative 9.1 6.5 10.2 6.9 Amortization of contract intangibles 1.8 1.6 1.8 1.7 Depreciation and amortization 1.5 1.2 1.6 1.4 Acquisition costs 0.2 (5.6 ) 2.2 (2.9 ) Total costs and expenses 83.3 74.7 87.3 79.2 Income from operations 16.6 25.3 12.7 20.8 Interest and other (expense) income, net (0.1 ) (0.5 ) 0.3 (0.5 ) Income from operations before provision for income taxes 16.5 24.8 13.0 20.3 Provision for income taxes (6.8 ) (9.9 ) (5.3 ) (8.3 ) Income from operations 9.7 % 14.9 % 7.7 % 12.0 % Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012 Revenue. Revenue increased $4.6 million, or 3.7%, to $130.3 million for the three months ended March 31, 2013 from $125.7 million for the three months ended March 31, 2012. This was primarily due to (1) a 14.3% increase, or $4.7 million, in our Surplus Contract, as a result of increasing property flow from the DoD and a higher mix of high value capital assets such as rolling stock, offset in part by an 8.4% decrease, or $1.6 million, in our DoD Scrap Contract; and (2) a 2.1% increase, or $1.5 million, in our U.S. commercial business as a result of the acquisitions of Go-Industry on July 1, 2012, and NESA on November 1, 2012. The amount of gross merchandise volume increased $40.7 million, or 18.7%, to $259.1 million for the three months ended March 31, 2013 from $218.4 million for the three months ended March 31, 2012, primarily due to the growth in our DoD Surplus Contract and the acquisition of Go-Industry discussed above. Cost of goods sold (excluding amortization). Cost of goods sold (excluding amortization) decreased $5.1 million, or 9.2%, to $49.9 million for the three months ended March 31, 2013 from $55.0 million for the three months ended March 31, 2012. As a percentage of revenue, cost of goods sold (excluding amortization) decreased to 38.3% from 43.8%. These decreases are primarily due to the acquisition of Go-Industry which utilizes the consignment model. Profit-sharing distributions. Profit-sharing distributions decreased $1.5 million, or 12.7%, to $9.9 million for the three months ended March 31, 2013 from $11.4 million for the three months ended March 31, 2012. As a percentage of revenue, profit-sharing distributions decreased to 7.6% from 9.1%. These decreases are primarily due to a slight decline in the Scrap Contract discussed above. 27 -------------------------------------------------------------------------------- Table of Contents Technology and operations expenses. Technology and operations expenses increased $6.6 million, or 41.8%, to $22.4 million for the three months ended March 31, 2013 from $15.8 million for the three months ended March 31, 2012. As a percentage of revenue, technology and operations expenses increased to 17.2% from 12.6%. These increases are primarily due to (1) expenses of $4.7 million from the acquisitions of Go-Industry and NESA; and (2) expenses of $1.9 million in staff and temporary wages, including stock based compensation, and consultant fees associated with technology infrastructure projects. Sales and marketing expenses. Sales and marketing expenses increased $3.1 million, or 44.4%, to $10.0 million for the three months ended March 31, 2013 from $6.9 million for the three months ended March 31, 2012. As a percentage of revenue, sales and marketing expenses increased to 7.6% from 5.5%. These increases are primarily due to expenses of $3.1 million from the acquisitions of Go-Industry and NESA. General and administrative expenses. General and administrative expenses increased $3.6 million, or 44.1%, to $11.8 million for the three months ended March 31, 2013 from $8.2 million for the three months ended March 31, 2012. As a percentage of revenue, general and administrative expenses increased to 9.1% from 6.5%. These increases are primarily due to (1) expenses of $3.1 million from the acquisitions of Go-Industry and NESA; and (2) expenses of $0.5 million in staff wages, including stock based compensation, and overhead expenses. Amortization of contract intangibles. Amortization of contract intangibles was primarily related to the contract intangible asset created in conjunction with the Jacobs Trading acquisition which was valued at $33.3 million and is being amortized over 55 months on a straight-line basis. Depreciation and amortization expenses. Depreciation and amortization expenses increased $0.5 million, or 31.6%, to $2.0 million for the three months ended March 31, 2013 from $1.5 million for the three months ended March 2012, primarily due to (1) expenses of $0.4 million for the acquisitions of Go-Industry and NESA; and (2) additional depreciation expense resulting from the purchase of $6.8 million of property and equipment during the fiscal year ended September 30, 2012. Acquisition costs. Acquisition costs increased $7.2 million to $0.2 million of expense for the three months ended March 31, 2013 from $7.0 million of income for the three months ended March 31, 2012, primarily as a result of the reversal of the $7.0 million TruckCenter.com earn out liability. Interest and other (expense) income, net. Interest and other (expense) income, net decreased $0.5 million or 83.5% to $0.1 million for the three months ended March 31, 2013 from $0.6 million for the three months ended March 31, 2012, primarily due the payoff of the $40 million Jacobs Trading acquisition seller subordinated note in November 2012. Provision for income tax expense. Income tax expense decreased $3.7 million, or 29.5%, to $8.8 million for the three months ended March 31, 2013 from $12.5 million for the three months ended March 31, 2012, primarily due to the decrease in income before provision for income taxes. Net income. Net income decreased $6.1 million, or 32.3%, to $12.7 million for the three months ended March 31, 2013 from $18.8 million for the three months ended March 31, 2012. 28 -------------------------------------------------------------------------------- Table of Contents Six Months Ended March 31, 2013 Compared to Six Months Ended March 31, 2012 Revenue. Revenue increased $20.7 million, or 9.0%, to $252.5 million for the six months ended March 31, 2013 from $231.8 million for the six months ended March 31, 2012. This was primarily due to (1) a 17.4% increase, or $10.6 million, in our Surplus Contract, as a result of increasing property flow from the DoD and a higher mix of high value capital assets such as rolling stock, offset in part by an 18.6% decrease, or $7.6 million, in our DoD Scrap Contract; (2) a 13.6% increase, or $17.0 million, in our U.S. commercial business as a result of the acquisitions of Go-Industry on July 1, 2012, and NESA on November 1, 2012, as well as several new programs for large retailers and manufacturers; and (3) a 12.8% increase, or $0.7 million, in our state and local government (GovDeals) business. The amount of gross merchandise volume increased $94.9 million, or 23.9%, to $492.5 million for the six months ended March 31, 2013 from $397.6 million for the six months ended March 31, 2012, primarily due to (1) the growth in our DoD Surplus Contract, U.S. commercial, and state and local government businesses discussed above. Cost of goods sold (excluding amortization). Cost of goods sold (excluding amortization) decreased $1.2 million, or 1.3%, to $97.1 million for the six months ended March 31, 2013 from $98.3 million for the six months ended March 31, 2012. As a percentage of revenue, cost of goods sold (excluding amortization) decreased to 38.4% from 42.4%. These decreases are primarily due to the acquisition of Go-Industry which utilizes the consignment model. Profit-sharing distributions. Profit-sharing distributions decreased $5.5 million, or 23.1%, to $18.4 million for the six months ended March 31, 2013 from $23.9 million for the six months ended March 31, 2012. As a percentage of revenue, profit-sharing distributions decreased to 7.3% from 10.3%. These decreases are primarily due to a slight decline in our Scrap Contract. Technology and operations expenses. Technology and operations expenses increased $13.4 million, or 42.3%, to $45.0 million for the six months ended March 31, 2013 from $31.6 million for the six months ended March 31, 2012. As a percentage of revenue, technology and operations expenses increased to 17.8% from 13.6%. These increases are primarily due to (1) expenses of $9.9 million from the acquisitions of Go-Industry and NESA; and (2) expenses of $3.5 million in staff and temporary wages, including stock based compensation, and consultant fees associated with technology infrastructure projects. Sales and marketing expenses. Sales and marketing expenses increased $6.9 million, or 51.0%, to $20.3 million for the six months ended March 31, 2013 from $13.4 million for the six months ended March 31, 2012. As a percentage of revenue, sales and marketing expenses increased to 8.0% from 5.8%. These increases are primarily due to expenses of $6.4 million from the acquisitions of Go-Industry and NESA. General and administrative expenses. General and administrative expenses increased $9.8 million, or 61.0%, to $25.8 million for the six months ended March 31, 2013 from $16.0 million for the six months ended March 31, 2012. As a percentage of revenue, general and administrative expenses increased to 10.3% from 6.9%. These increases are primarily due to (1) expenses of $6.7 million from the acquisitions of Go-Industry and NESA; and (2) expenses of $3.1 million in staff wages, including stock based compensation, and overhead expenses. Amortization of contract intangibles. Amortization of contract intangibles was primarily related to the contract intangible asset created in conjunction with the Jacobs Trading acquisition which was valued at $33.3 million and is being amortized over 55 months on a straight-line basis. Depreciation and amortization expenses. Depreciation and amortization expenses increased $1.0 million, or 30.9%, to $4.0 million for the six months ended March 31, 2013 from $3.0 million for the six months ended March 31, 2012, primarily due to (1) expenses of $0.8 million for the acquisitions of Go-Industry and NESA; and (2) additional depreciation expense resulting from the purchase of $6.8 million of property and equipment during the fiscal year ended September 30, 2012. Acquisition costs. Acquisition costs increased $12.3 million to $5.6 million of expense for the six months ended March 31, 2013 from $6.7 million of income for the six months ending March 31, 2012, primarily due to (1) recording an additional $5.1 million for the Jacobs Trading earn out liability; and (2) the reversal of the $7.0 millionTruckCenter.com earn out liability. Interest and other (expense) income, net. Interest and other (expense) income, net, decreased $1.9 million to $0.8 million of income for the six months ended March 31, 2013 from $1.1 million of expense for the six months ended March 31, 2012, primarily due to the $1.0 million discount received for the early payoff of the $40 million Jacobs Trading acquisition seller subordinated note. 29 -------------------------------------------------------------------------------- Table of Contents Provision for income tax expense. Income tax expense decreased $5.8 million, or 30.4%, to $13.3 million for the six months ended March 31, 2013 from $19.1 million for the six months ended March 31, 2012, primarily due to the decrease in income before provision for income taxes. Net income. Net income decreased $8.5 million, or 30.4%, to $19.4 million for the six months ended March 31, 2013 from $27.9 million for the six months ended March 31, 2012. Liquidity and Capital Resources Historically, our primary cash needs have been working capital (including capital used for inventory purchases), which we have funded primarily through cash generated from operations. As of March 31, 2013, we had approximately $57.2 million in cash and cash equivalents and $70.5 million available under our $75.0 million senior credit facility, due to issued letters of credit for $4.5 million; $1.0 million of our availability under this facility is set aside as a contractual obligation under our DoD Scrap Contract. On December 2, 2008, our Board of Directors approved a $10.0 million share repurchase program. Under the program, we are authorized to repurchase the issued and outstanding shares of common stock. Share repurchases may be made through open market purchases, privately negotiated transactions or otherwise, at times and in such amounts as management deems appropriate. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions. The repurchase program may be discontinued or suspended at any time, and will be funded using our available cash. On each of February 2, 2010, November 30, 2010 and May 3, 2011, our Board of Directors approved the repurchase of up to an additional $10.0 million in shares under the share repurchase program, and on May 17, 2012, our Board of Directors approved the repurchase of up to an additional $30.0 million in shares under the share repurchase program. Our Board of Directors reviews the share repurchase program periodically, the last such review having occurred in May 2012. During the year ended September 30, 2009, 707,462 shares were purchased under the program for approximately $3,874,000. During the year ended September 30, 2010, 1,225,019 shares were purchased under the program for approximately $14,471,000. During the year ended September 30, 2011, 229,575 shares were purchased under the program for approximately $3,541,000. During the year ended September 30, 2012, 505,067 shares were purchased under the program for approximately $30,000,000. All repurchased shares have been retired. During the three months ended December 31, 2012 and the three months ended March 31, 2013, no shares were purchased under the program. As of March 31, 2013, approximately $18,114,000 may yet be expended under the program. Substantially all of our sales are recorded subsequent to receipt of payment authorization, utilizing credit cards, wire transfers and PayPal, an Internet based payment system, as methods of payments. As a result, we are not subject to significant collection risk, as goods are generally not shipped before payment is received. 30 -------------------------------------------------------------------------------- Table of Contents Changes in Cash Flows: Six Months Ended March 31, 2013 Compared to Six Months Ended March31, 2012 Net cash provided by operating activities was $10.4 million and $38.6 million for the six months ended March 31, 2013 and 2012, respectively. For the six months ended March 31, 2013, net cash provided by operating activities primarily consisted of net income of $19.4 million, depreciation and amortization expense of $8.6 million, stock compensation expense of $7.3 million, offset in part by a net increase in accounts receivable, inventory and prepaid assets of $7.7 million, a net decrease in accounts payable, accrued expenses and other liabilities of $10.0 million (including $11.4 million for the payment of the Jacobs Trading earn-out), provisions for inventory allowance, doubtful accounts, and incremental tax from exercises of common stock options of $6.2 million, net, and $1.0 million from early extinguishment of debt. For the six months ended March 31, 2012, net cash provided by operating activities primarily consisted of net income of $27.9 million, depreciation and amortization expense of $7.1 million, stock compensation expense of $5.1 million and a net decrease in accounts receivable, inventory and prepaid assets of $10.2 million, offset in part by a net decrease in accounts payable, accrued expenses and other liabilities of $2.2 million, and provisions for inventory allowance, doubtful accounts, and incremental tax from exercises of common stock options of $9.5 million, net. Net cash used in investing activities was $17.2 million and $82.1 million for the six months ended March 31, 2013 and 2012, respectively. Net cash used in investing activities for the six months ended March 31, 2013 consisted primarily of $14.7 million for the acquisition of NESA and capital expenditures of $2.5 million for purchases of equipment and leasehold improvements. Net cash used in investing activities for the six months ended March 31, 2012 consisted primarily of $80.0 million for the acquisition of Jacobs Trading and capital expenditures of $2.1 million for purchases of equipment and leasehold improvements. Net cash used in financing activities was $41.3 million for the six months ended March 31, 2013. Net cash provided by financing activities for the six months ended March 31, 2012 was $19.3 million. Net cash used in financing activities for the six months ended March 31, 2013 consisted primarily of $39.0 million for the repayment of the Jacobs Trading note payable and $8.2 million for the payment of the Jacobs Trading earn-out, offset in part by the proceeds from the exercise of common stock options including the tax benefit of $5.9 million. Net cash provided by financing activities for the six months ended March 31, 2012 consisted primarily of proceeds from the exercise of common stock options including the tax benefit of $19.3 million. Capital Expenditures. Our capital expenditures consist primarily of computers and purchased software, office equipment, furniture and fixtures, and leasehold improvements. The timing and volume of such capital expenditures in the future will be affected by the addition of new customers or expansion of existing customer relationships. We expect capital expenditures to range from $6.0 million to $7.0 million in the fiscal year ending September 30, 2013. We intend to fund those expenditures primarily from operating cash flows. Our capital expenditures for the six months ended March 31, 2013 were $2.5 million. As of March 31, 2013, we had no outstanding commitments for capital expenditures. Senior credit facility. We maintain a $75.0 million senior credit facility due May 31, 2014. The senior credit facility bears an annual interest rate of 30 day LIBOR plus 1.25%. As of March 31, 2013, we had no outstanding indebtedness under our senior credit facility and our borrowing availability was $70.5 million due to issued letters of credit for $4.5 million; $1.0 million of our availability under this facility is set aside as a contractual obligation under our DoD Scrap Contract. The obligations under our senior credit facility are unconditionally guaranteed by us and each of our existing and subsequently acquired or organized subsidiaries (other than our subsidiary organized to service our DoD Scrap Contract) and secured on a first priority basis by security interests (subject to permitted liens) in substantially all assets owned by us, and each of our other domestic subsidiaries, subject to limited exceptions. The agreement contains certain financial and non-financial restrictive covenants including, among others, the requirements to maintain a minimum level of earnings before interest, income taxes, depreciation and amortization (EBITDA) and a minimum debt coverage ratio. Our credit agreement contains a number of affirmative and restrictive covenants including limitations on mergers, consolidations and dissolutions, sales of assets, investments and acquisitions, indebtedness and liens, and dividends and other restricted payments. As of March 31, 2013, we were in full compliance with the terms and conditions of our credit agreement. Subordinated note. In conjunction with the Jacobs Trading acquisition, we issued a $40,000,000 seller subordinated 5% unsecured note. We repaid this note in November 2012. 31 -------------------------------------------------------------------------------- Table of Contents We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors including our rate of revenue growth, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the development and deployment of new marketplaces, the introduction of new value added services and the costs to establish additional distribution centers. Although we are currently not a party to any definitive agreement with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. The sale of additional equity securities or convertible debt securities would result in additional dilution to our stockholders. Additional debt would result in increased interest expense and could result in covenants that would restrict our operations. There is no assurance that such financing, if required, will be available in amounts or on terms acceptable to us, if at all. Off-Balance Sheet Arrangements We do not have any transactions, obligations or relationships that could be considered material off-balance sheet arrangements. |