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LIMELIGHT NETWORKS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the year ended December 31, 2012 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 1, 2013. This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include, among other things, statements as to industry trends, our future expectations, operations, financial condition and prospects, business strategies and other matters that do not relate strictly to historical facts. These statements are often identified by the use of words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," or "continue," and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" set forth in Part II, Item 1A of the Quarterly Report on Form 10-Q. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Prior period information has been modified to conform to current year presentation. Overview We were founded in 2001 as a provider of content delivery network services to deliver digital content over the Internet. We began development of our infrastructure in 2001 and began generating meaningful revenue in 2002. Today, we operate a globally distributed, high-performance computing platform (our global computing platform) and provide a suite of integrated services including content delivery, web and video content management, mobility, web application acceleration, cloud storage, and related consulting services that enable companies and other organizations to create, manage, and deliver a global digital presence. The integrated suite of services that we offer collectively comprises our Orchestrate Platform. We provide the Orchestrate Platform as SaaS and IaaS, which, other than content delivery services, are referred to collectively as VAS. We offer VAS both collectively as the end-to-end Orchestrate Platform and individually for customers that may not be inclined or able to adopt the entire platform. The Orchestrate Platform and services help our customers optimize and streamline their online digital presence across web, mobile, social, and large screen channels. The Orchestrate Platform and services enable our customers to remove the complexity of creating, managing, delivering, and optimizing their digital presence, which helps them to deliver a high quality online media experience, improve brand awareness, drive revenue, and enhance their customer relationships. The Orchestrate Platform and services provide advanced features which include website content management, personalization and targeting, video publishing, mobile enablement, content delivery, transcoding and cloud storage, combined with social media integration and reporting analytics. These services are provided through the cloud and leverage our global computing platform, which provides highly available, highly redundant storage, bandwidth, and computing resources, as well as connectivity to last-mile broadband network providers. Our professional consulting services team helps organizations assess their digital presence requirements and improve their digital presence activities. We derive revenue primarily from the sale of the Orchestrate Platform and its individual components as managed services. We also generate revenue through the sale of professional services and other infrastructure services, such as transit and rack space services. We provide our services to customers that we believe view Internet, mobile, and social initiatives as critical to their success, including traditional and emerging media companies operating in the television, music, radio, newspaper, magazine, movie, videogame, software, and social media industries, as well as to enterprises, technology companies, and government entities conducting business online. Our offerings enable organizations to remove the complexity of creating, managing, delivering, and optimizing their digital presence by streamlining processes and optimizing business results across all customer interaction channels, which helps them to deliver a high quality online media experience, improve brand awareness, drive revenue, and enhance their customer relationships. We provide services to customers in three geographic areas - North America, EMEA, and Asia Pacific, including Japan. As of March 31, 2013, we had 1,406 active customers worldwide. In addition to expanding our suite of VAS, we continue to expand the capacity and capabilities, and to enhance the performance and efficiency, of our global computing platform. Although we believe that we may have improved margins in our content delivery services as we expand our customer base and use a greater proportion of our capacity, we expect the majority of our margin increases to result from our VAS increasing as a percentage of our revenue. 19-------------------------------------------------------------------------------- Table of Contents On November 26, 2012, we announced the appointment of Robert A. Lento as interim Chief Executive Officer effective immediately. We had previously announced on November 1, 2012 that Jeffrey W. Lunsford would be stepping down as our Chief Executive Officer in January 2013 and that an executive search firm was engaged to recruit his successor. On January 22, 2013, we announced that the board of directors completed its executive search and appointed Mr. Lento as our President and Chief Executive Officer and that Mr. Lunsford had tendered his resignation as a board member and Chairman of the board of directors. On February 12, 2013, we announced George E. Vonderhaar as Chief Sales Officer and recently appointed Jonathan Smith as Managing Director and Vice President of Europe, Middle East and Africa. On February 19, 2013, we announced the appointment of Walter D. Amaral to serve as our non-executive Chairman of the board of directors. Mr. Amaral fills the Chairman role vacated by the resignation of Mr. Lunsford. On October 29, 2012, our board of directors authorized and approved a third common stock repurchase plan that authorized us to repurchase up to $10 million of our shares of common stock, exclusive of any commissions, markups or expenses, from time to time through May 9, 2013. During the three months ended March 31, 2013, we purchased and cancelled approximately 2.3 million shares under the third repurchase plan for approximately $5.5 million including commissions. Repurchased shares were cancelled and returned to authorized but unissued status. Our third common stock repurchase plan is now complete. Traffic on our network and our VAS offerings continued to grow during the three month period ended March 31, 2013. This traffic growth is primarily the result of growth in the traffic delivered to existing customers, and to a lesser extent to new customers. Our content delivery revenue is generated by charging for traffic delivered. Our content delivery revenue decreased during the three month period ended March 31, 2013, compared to the three month period ended March 31, 2012. The decrease was primarily due to a decrease in our reseller revenue from Global Crossing, whose reseller contract ended during the second quarter of 2012, and a decrease in our transit and colocation services revenue. Our VAS revenue represented substantially all of our revenue growth during the three month period ended March 31, 2013. During 2012, we continued to add new customers, experienced some attrition and elected not to renew some customers. During the three month period ended March 31, 2013, we continued with that same focus to add new customers and also elected to not renew some customers as we continue to focus on customer quality. Our customer churn has been higher than we would like and is an area of focus for us. While the rate is not significant, it is less than 1% per month for the quarter, which we still think is too high and led to a net customer loss during the quarter. Our average number of products per customer during the three month period ended March 31, 2013 was 1.8. For new customers added during the quarter we averaged 2.1 products. We continue to have success selling new products to our customer base. Our international revenue has continued to grow, and we expect this trend to continue as we focus on our strategy of expanding our network and customer base internationally. For the year ended December 31, 2012, revenue derived from customers outside North America accounted for approximately 31% of our total revenue. For the year ended December 31, 2012, we derived approximately 47% of our international revenue from EMEA, and approximately 53% of our international revenue from Asia Pacific. During 2012, two countries, Japan and the United States, accounted for 10% or more of our total revenues. For the three month periods ended March 31, 2013 and 2012, respectively, revenue derived from customers outside North America accounted for approximately 31%, respectively, of our total revenue. For the three month periods ended March 31, 2013 and 2012, respectively, we derived approximately 49%, respectively, of our international revenue from EMEA and approximately 51%, respectively, of our international revenue from Asia Pacific. For the three month periods ended March 31, 2013 and 2012, no single country outside of the United States accounted for 10% or more of our total revenue. We expect foreign revenue to continue to increase in absolute dollars in 2013. Our business is managed as a single segment, and we report our financial results on this basis. During any given fiscal period, a relatively small number of customers typically account for a significant percentage of our revenue. For example, in 2012, sales to our top 10 customers accounted for approximately 33% of our total revenue, and we had one customer, Netflix, which represented approximately 11% of our total revenue. For the three month periods ended March 31, 2013 and 2012, sales to our top 10 customers accounted for approximately 35% and 33%, respectively, of our total revenue. During the three month periods ended March 31, 2013 and 2012, Netflix represented approximately 13% and 11%, respectively, of our total revenue. In 2013, we anticipate that our top 10 customer concentration levels will remain consistent with 2012. In the past, the customers that comprised our top 10 customers have continually changed, and our large customers may not continue to be as significant going forward as they have been in the past. On September 21, 2006, we entered into a service agreement with Netflix. This agreement sets forth the terms by which our delivery of services will be subject if and when Netflix places a service order form with us for specified services, upon which such order form will be incorporated into the agreement. The term of the agreement continues until the expiration of Netflix's last active service order form and is cancellable by either party if the other party is in material breach of the agreement upon 30 days' prior notice. Netflix's last active service order form placed to date will expire on December 31, 2013. In addition to selling to our direct customers, we maintain relationships with a number of resellers that purchase our services for resale to their end customers. Revenue generated from sales to reseller customers accounted for approximately 3% of our total revenue for the year ended December 31, 2012. For the three month periods ended March 31, 2013 and 2012, revenue generated from sales to reseller customers accounted for approximately 3%, respectively, of our total revenue. 20 -------------------------------------------------------------------------------- Table of Contents In addition to the revenue-related business trends, our cost of revenue increased in absolute dollars and increased as a percentage of revenue for the three month period ended March 31, 2013, compared to the three month period ended March 31, 2012. The increase in absolute dollars was primarily due to increased aggregate bandwidth and co-locations fees, increased professional fees, and increased payroll and related employee costs. These increases were offset by a decrease in other costs of revenue and decreased fees and licenses. We enter into contracts with third party network and data center providers, with terms typically ranging from several months to several years. Our contracts related to transit bandwidth provided by network operators generally commit us to pay a fixed monthly fee or monthly fees, plus additional fees for bandwidth usage above a specified level. We entered into an agreement with Global Crossing in January 2009 for use of private lines for additional bandwidth and backbone services with a term of four years from installation. We executed subsequent amendments in September 2009, March 2011, and January 2012 for additional bandwidth and backbone services. The agreement and subsequent amendments required substantial prepayment for such services, and the amendments extended the original term for some services through June 2014. In addition to purchasing services from communications providers, we connect directly to approximately 600 broadband ISPs, generally without either party paying the other. This industry practice, known as settlement free peering, benefits us by allowing us to place content objects directly on user access networks, which helps us provide higher performance delivery for our customers, and eliminate paying transit bandwidth fees to network operators. This practice also benefits the ISP and its customers by allowing them to receive improved content delivery through our local servers and eliminate the cost of transit bandwidth associated with delivery receipt of the traffic. We do not consider these relationships to represent the culmination of an earnings process. Accordingly, we do not recognize as revenue the value to the ISPs associated with the use of our servers nor do we recognize as expense the value of the bandwidth received at discounted or no cost. These peering relationships are mutually beneficial and are not contractual commitments. In addition to settlement free peering, we incur costs for non-settlement free peering as well as costs associated with connecting to the ISPs. During 2012, we continued to reduce our network transit bandwidth delivery costs per gigabyte transferred by entering into new supplier contracts with lower pricing and amending existing contracts to take advantage of price reductions from our existing suppliers associated with higher purchase commitments. While we had increased traffic delivered over our network, our total transit bandwidth delivery costs decreased during 2012. We anticipate our overall transit bandwidth delivery costs will increase in absolute dollars as a result of expected higher traffic levels, and we expect this increase to be partially offset by continued reductions in bandwidth costs per unit. We expect that our overall transit bandwidth delivery costs as a percentage of revenue will increase slightly in 2013 compared to 2012. For the three month period ended March 31, 2013, operating expenses decreased in absolute dollars and decreased as a percentage of revenue compared to the three month period ended March 31, 2012. This decrease was primarily due to decreased general and administrative costs and decreased sales and marketing expenses. The decrease in general and administrative costs was primarily due to decreased professional fees for accounting and legal services, decreased share-based compensation, and the receipt of a non-income tax based refund of approximately $0.8 million. The decrease in sales and marketing expenses was primarily due to decreased payroll and related employee costs, including decreased variable compensation, decreased salaries, and decreased travel and travel related expenses. These decreases were offset by an increase in research and development costs. For the three month period ended March 31, 2013, research and development costs increased primarily as a result of increased payroll and related employee costs due to increased staffing. We make our capital investment decisions based upon careful evaluation of a number of variables, such as the amount of traffic we anticipate on our network, the cost of the physical infrastructure required to deliver that traffic, and the forecasted capacity utilization of our network. Our capital expenditures have varied over time, in particular as we purchased servers and other network equipment associated with our network build-out. For example, in 2012, 2011, and 2010 we made capital purchases of $18.4 million, $30.4 million, and $33.5 million, respectively, which represented 10%, 18% and 22%, respectively, of total revenue for each of those years. For the three month period ended March 31, 2013, we made capital investments of $2.6 million, which represented 6% of total revenue for that period. We expect to have ongoing capital expenditure requirements as we continue to invest in, refresh, and expand our global computing platform. Our future results will be affected by many factors identified in the section captioned "Risk Factors," in this Quarterly Report on Form 10-Q, including our ability to: • increase our revenue by adding customers and limiting customer cancellations and terminations, as well as increasing the amount of monthly recurring revenue that we derive from our existing customers; • manage the prices we charge for our services, as well as the costs associated with operating our network in light of increased competition; • successfully manage our litigation with Akamai Technologies, Inc. or Akamai to a favorable conclusion; • prevent disruptions to our services and network due to accidents or intentional attacks; • continued ability to deliver a significant portion of our traffic through settlement free peering relationships which significantly reduce our cost of delivery; 21 -------------------------------------------------------------------------------- Table of Contents • successfully integrate the businesses we have acquired; and • successfully manage the disposition of businesses we have divested from. As a result, we cannot assure you that we will achieve our expected financial objectives, including positive net income. Critical Accounting Policies and Estimates Our critical accounting policies and estimates are disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. During the three months ended March 31, 2013, there have been no significant changes in our critical accounting policies and estimates. However, we have supplemented our disclosures contained in our Annual Report on Form 10-K for the year ended December 31, 2012, as noted below. Goodwill and Other Intangible Assets We test goodwill for impairment on an annual basis or more frequently if events or changes in circumstances indicate that goodwill might be impaired. We have concluded that we have one reporting unit and have assigned the entire balance of goodwill to this reporting unit. The fair value of the reporting unit is determined using our market capitalization as of our annual impairment assessment date or each reporting date if circumstances indicate the goodwill might be impaired. Items that could reasonably be expected to negatively affect key assumptions used in estimating fair value include but are not limited to: • Sustained decline in our stock price due to a decline in our financial performance due to the loss of key customers, loss of key personnel, emergence of new technologies or new competitors • Decline in overall market/economic conditions leading to decline in our stock price • Decline in observed control premiums paid in business combinations involving comparable companies The estimated fair value of the reporting unit is determined using a market approach utilizing our market capitalization as adjusted for a control premium based on the estimated average and median control premiums of transactions involving companies comparable to us. As of the annual impairment testing date and at December 31, 2012, we determined that goodwill was not impaired. We also performed a similar analysis at March 31, 2013 and noted that the estimated fair value of our reporting unit exceeded carrying value by approximately $24 million or 9% using the market capitalization on March 31, 2013. Based on this analysis, management determined that goodwill continues to not be impaired at March 31, 2013. Results of Continuing Operations Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012 Revenue Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Revenue $ 45,813 $ 44,316 $ 1,497 3 % Revenue increased 3%, or $1.5 million, to $45.8 million for the three month period ended March 31, 2013 as compared to $44.3 million for the three month period ended March 31, 2012. The increase in revenue for the three month period ended March 31, 2013 as compared to the same period in the prior year was attributable to an increase in our VAS revenue of approximately $2.2 million. The increase in VAS revenue was primarily attributable to increases in our video publishing and acceleration service offerings. The increase in VAS revenue was offset by a decrease in our content delivery services revenue of approximately $0.7 million, even though we continued to increase the amount of traffic moving through our network. The decrease was primarily due to a decline in our reseller revenue from Global Crossing, whose reseller contract ended during the second quarter of 2012, and a decline in our transit and colocation services revenue. As of March 31, 2013, we had 1,406 customers as compared to 1,562 as of March 31, 2012. Our customer churn has been higher than we would like and is an area of focus for us. The decrease in customer count was primarily attributable to the loss of smaller revenue generating customers. In the past, the customers that comprise our top 10 customers have continually changed, and our large customers such as Netflix may not continue to be as significant going forward as they have been in the past. Netflix's last active service order form placed to date will expire on December 31, 2013. We anticipate revenues will increase in 2013. We expect to deliver more traffic on our network and expect continued growth in our VAS. We anticipate that our customer concentrations levels will be consistent with 2012. Cost of Revenue Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Cost of revenue $ 28,732 $ 27,330 $ 1,402 5 % Cost of revenue consists primarily of fees paid to network providers for bandwidth and backbone, costs incurred for non-settlement free peering and connection to ISPs, and fees paid to data center operators for housing of our network equipment in third party network data centers, also known as co-location costs. Cost of revenue also includes depreciation of network equipment used to deliver our content delivery services, payroll and related costs, and share-based compensation for our network operations and professional services personnel. Cost of revenue increased 5%, or approximately $1.4 million, to $28.7 million for the three month period ended March 31, 2013 as compared to $27.3 million for the three month period ended March 31, 2012. This increase was primarily due to an increase in aggregate bandwidth and co-location fees of approximately $1.2 million, primarily associated with increased peering costs of approximately $0.5 million, increased rack fees of approximately $0.4 million, and increased other costs of recurring services of approximately $0.2 million. Additionally, we had increases in professional fees and outside services of approximately $0.4 million, primarily due to an increase in outside consulting expense, and we had an increase in payroll and related employee costs of approximately $0.2 million due to increased staffing, primarily related to professional services. These increases were offset by a decrease in other costs of approximately $0.3 million, which was the result of a reduction in other costs of revenue and a decrease in fees and licenses. In addition, depreciation expense decreased approximately $0.1 million. Additionally, during the three month periods ended March 31, 2013 and 2012, cost of revenue included share-based compensation expense of approximately $0.5 million, respectively. 22 -------------------------------------------------------------------------------- Table of Contents Cost of revenue was composed of the following (in millions): For the Three Months Ended March 31, 2013 2012 Bandwidth and co-location fees $ 14.8 $ 13.6 Depreciation - network 6.7 6.8 Payroll and related employee costs 4.6 4.4 Professional fees and outside services 0.7 0.3 Share-based compensation 0.5 0.5 Royalty expenses 0.2 0.2 Travel and travel-related expenses 0.2 0.2 Other costs 1.0 1.3 Total cost of revenue $ 28.7 $ 27.3 We anticipate cost of revenue will increase in 2013. We expect to deliver more traffic on our network, which would result in higher expenses associated with increased bandwidth, peering, rack and co-location costs to support increased traffic; however, such costs are likely to be partially offset by lower bandwidth costs per unit. We anticipate depreciation expense related to our network equipment to decrease compared to 2012 in absolute dollars. Additionally, we expect an increase in payroll and related costs, as we continue to make investments in our network to service our expanding customer base as well as our increase in VAS personnel. We expect that share-based compensation expense will decrease in absolute dollars and remain consistent with 2012 as a percentage of revenue. General and Administrative Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) General and administrative $ 8,073 $ 8,320 $ (247 ) (3 )% General and administrative expenses consist primarily of the following components: • payroll, share-based compensation and other related costs, including related expenses for executive, finance, legal, business applications, internal network management, human resources, and other administrative personnel; • fees for professional services and litigation expenses; • rent and other facility-related expenditures for leased properties; • the provision for doubtful accounts; and • non-income based taxes. General and administrative expenses decreased 3%, or $0.2 million, to $8.1 million for the three month period ended March 31, 2013 as compared to $8.3 million for the three month period ended March 31, 2012. This decrease was primarily due to lower professional fees of approximately $0.4 million, which includes decreased accounting fees of approximately $0.3 million and decreased legal fees related to intellectual property of approximately $0.1 million. In addition, bad debt expense decreased $0.1 million. These decreases were offset by an increase in other costs of $0.3 million, which was primarily due to an increase in supplies and other employee costs, and an increase in payroll and related employee costs of approximately $0.2 million, which was primarily due to increased salaries. For the three month period ended March 31, 2013, other expenses included a refund of non-income based taxes of approximately $0.8 million. For the three months ended March 31, 2012, other expenses included the reversal of previously recorded contingent considerations of approximately $0.8 million. Other expenses include such items as rent, utilities, telephone, insurance, fees and licenses, office supplies, and non-income taxes. Additionally, general and administrative share-based compensation expense decreased $0.2 million for the three months ended March 31, 2013 compared to March 31, 2012. 23 -------------------------------------------------------------------------------- Table of Contents General and administrative expense was composed of the following (in millions): For the Three Months Ended March 31, 2013 2012 Payroll and related employee costs $ 2.8 $ 2.6 Professional fees 1.8 2.2 Share-based compensation 1.6 1.8 Litigation expenses - - Bad debt expense 0.3 0.4 Travel and travel-related expenses 0.2 0.2 Other expenses 1.4 1.1 Total general and administrative $ 8.1 $ 8.3 In 2013, we expect our general and administrative expenses to remain flat in absolute dollars and slightly decrease as a percentage of revenue. During 2013, we expect to see increased salaries and related employee costs and increased litigation expenses. These increases will be offset by lower recruiting, consulting, bad debt expense and lower non-income tax based taxes. We expect that share-based compensation expense will decrease in absolute dollars and decrease as a percentage of revenue compared to 2012. Sales and Marketing Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Sales and marketing $ 10,484 $ 11,632 $ (1,148 ) (10 )% Sales and marketing expenses consist primarily of payroll and related costs, share-based compensation and commissions for personnel engaged in marketing, sales, and service support functions, professional fees, travel and travel-related expenses, and advertising and promotional expenses. Sales and marketing expenses decreased 10%, or $1.1 million, to $10.5 million for the three month period ended March 31, 2013 compared to $11.6 million for the three month period ended March 31, 2012. The decrease in sales and marketing expenses was primarily due to a decrease in payroll and related employee costs of approximately $1.0 million, primarily due to decreased variable compensation costs of approximately $0.5 million and a decrease in salaries of approximately $0.4 million. In addition, our travel and travel-related expenses decreased approximately $0.3 million. These decreases were offset by an increase in other costs of approximately $0.3 million and an increase in marketing expenses of approximately $0.1 million. The increase in other costs was primarily due to increased fees and licenses and increased facility and facility-related costs. Additionally, sales and marketing share-based compensation expense decreased $0.1 million for the three months ended March 31, 2013 compared to March 31, 2012. Sales and marketing expense was composed of the following (in millions): For the Three Months Ended March 31, 2013 2012 Payroll and related employee costs $ 6.3 $ 7.3 Travel and travel-related expenses 0.7 1.0 Share-based compensation 0.7 0.8 Marketing programs 0.6 0.5 Professional fees and outside services 0.4 0.5 Other expenses 1.8 1.5 Total sales and marketing $ 10.5 $ 11.6 We anticipate our sales and marketing expenses will decrease in 2013 in absolute dollars and as a percentage of revenue compared to 2012. The decrease in absolute dollars is due to expected decreases in salaries and related employee costs and travel and entertainment expenses. These decreases are offset by expected increases in variable compensation on higher forecast sales, and an expected increase in facility and facility-related expenses for our sales and marketing personnel. We expect that share-based compensation expense will decrease slightly in absolute dollars and remain constant as a percentage of revenue in 2013 compared to 2012. 24-------------------------------------------------------------------------------- Table of Contents Research and Development Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Research and development $ 5,741 $ 5,166 $ 575 11 % Research and development expenses consist primarily of payroll and related costs and share-based compensation expense for research and development personnel who design, develop, test and enhance our services, network and software. Research and development expenses increased 11%, or $0.6 million, to $5.7 million for the three month period ended March 31, 2013 as compared to $5.2 million for the three month period ended March 31, 2012. The increase in research and development expenses was primarily due to an increase of approximately $0.4 million in payroll and related employee costs and an increase in professional fees of approximately $0.1 million, an increase in travel and travel-related expenses of $0.1 million and an increase in other costs of $0.1 million. The increase in payroll and related employee costs was primarily due to increased salaries as result of additional network, software engineering and product management personnel. Other expenses include such items as fees and licenses, telephone, and office supplies. Additionally, research and development share-based compensation expense decreased $0.2 million for the three months ended March 31, 2013 compared to March 31, 2012. Research and development expense was composed of the following (in millions): For the Three Months Ended March 31, 2013 2012 Payroll and related employee costs $ 4.3 $ 3.9 Share-based compensation 0.6 0.8 Professional fees and outside services 0.3 0.2 Travel and travel-related expenses 0.2 0.1 Other expenses 0.3 0.2 Total research and development $ 5.7 $ 5.2 We anticipate our research and development expenses will increase in 2013 in absolute dollars and slightly increase as a percentage of revenue as we continue to make investments in our core technology, refinements, and additions to our other service offerings. We expect increased payroll and related employee costs associated with continued hiring of research and development personnel. We expect that share-based compensation expense will decrease in both absolute dollars and as a percentage of revenue in 2013 compared to 2012. Depreciation and Amortization (Operating Expenses) Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Depreciation and amortization $ 1,450 $ 1,398 $ 52 4 % Depreciation expense consists of depreciation on equipment and furnishing used by general administrative, sales and marketing, and research and development personnel. Amortization expense consists of amortization of intangible assets acquired in business combinations. Depreciation and amortization expense was approximately $1.4 million, for each of the three month periods ended March 31, 2013 and 2012. General administrative depreciation and amortization expense was approximately $0.7 million, in each of the three month periods ended March 31, 2013 and 2012. Amortization of intangible assets was approximately $0.7 million, for each of the three month periods ended March 31, 2013 and 2012. Based on our intangible assets at March 31, 2013, we expect amortization of other intangible assets to be approximately $2.1 million for the remainder of 2013, and $2.2 million, $1.1 million, and $0.3 million for fiscal years 2014, 2015, and 2016, respectively. 25 -------------------------------------------------------------------------------- Table of Contents Interest Expense Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Interest expense $ 27 $ 50 $ (23 ) (46 )% Interest expense consists of interest accrued and paid. Interest expense decreased to $27,000 for the three month period ended March 31, 2013, as compared to $50,000 for the three month period ended March 31, 2012. Interest expense for the three month periods ended March 31, 2013 and 2012, was primarily comprised of interest paid on capital leases. As of March 31, 2013, with the exception of our capital leases, we had no outstanding credit facilities. Interest Income Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Interest income $ 70 $ 106 $ (36 ) (34 )% Interest income includes interest earned on invested cash balances and marketable securities. Interest income was approximately $0.1 million for each of the three month periods ended March 31, 2013 and 2012, respectively. Other Income (Expense) Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Other (expense) income $ 568 $ (86 ) $ (654 ) 760 % Other income was approximately $0.6 million for three month period ended March 31, 2013 compared to $0.1 million other expense for the three month period ended March 31, 2012. Other income for the three month period ended March 31, 2013 consists primarily of foreign currency transaction gains. Other expense for the three month period ended March 31, 2012, consists primarily of foreign currency transaction losses. Income Tax Expense Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands) Income tax expense $ 80 $ 137 $ (57 ) (42 )% Based on an estimated annual effective tax rate and discrete items, the estimated tax expense from continuing operations for the three months ended March 31, 2013 and 2012 was $80,000 and $137,000, respectively. Income tax expense on the loss from continuing operations before taxes was different than the statutory income tax rate primarily due to our providing for a valuation allowance on deferred tax assets in certain jurisdictions, and recording of state and foreign tax expense for the quarter. The effective income tax rate is based primarily upon forecasted income or loss for the year, the composition of the income or loss in different countries, and adjustments, if any, for the potential tax consequences, benefits, or resolutions for tax audits. 26-------------------------------------------------------------------------------- Table of Contents Income (loss) from Discontinued Operations Three months ended March 31, Increase Percent 2013 2012 (Decrease) Change (in thousands)Income (loss) from discontinued operations $ - $ (309 ) $ (309 ) (100 )% Discontinued operations relates to our EyeWonder and chors rich media advertising services. On September 1, 2011, we completed the sale of EyeWonder, LLC (EyeWonder) and chors GmbH (chors) to DG FastChannel, Inc. (currently Digital Generation, Inc.) (DG). See Note 4 of Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information about discontinued operations. Liquidity and Capital Resources To date, we have financed our operations primarily through the following transactions: • private sales of common and preferred stock and subordinated notes; • an initial public offering of our common stock in June 2007; • an underwritten public offering of our common stock in March 2011; • borrowing on capital leases; • borrowing on credit facilities; • sale of EyeWonder and chors in September 2011; • sale of our cost basis investment in Gaikai in August 2012; and • cash generated from operations. As of March 31, 2013, our cash, cash equivalents, and marketable securities classified as current totaled $120.2 million. Included in this amount is approximately $8.4 million of cash and cash equivalents held outside the United States. Operating Activities Net cash provided by operating activities of continuing operations increased by $4.6 million, with net cash provided by operating activities of continuing operations equaling $2.7 million for the three month period ended March 31, 2013, compared to net cash used in operating activities of continuing operations of approximately $1.9 million for the three month period ended March 31, 2012. The change in operating cash flows comparing the three month period ended March 31, 2013 to the three month period ended March 31, 2012 was primarily due to a larger net loss in 2012 compared to 2013 offset by changes in operating assets and liabilities. Cash used in operating activities of continuing operations related to changes in operating assets and liabilities was $0.1 million in the three months ended March 31, 2013, compared to $4.4 million in the three months ended March 31, 2012. The change relates primarily to changes in accounts receivable, prepaid expenses, other assets, income taxes payable, and deferred revenue during each period. We expect that cash provided by operating activities may not be sufficient to cover new purchases of property and equipment during 2013 and potential litigation expenses associated with patent litigation. The timing and amount of future working capital changes and our ability to manage our Days Sales Outstanding will also affect the future amount of cash used in or provided by operating activities. Investing Activities Cash used in investing activities of continuing operations was $17.8 million for the three months ended March 31, 2013, compared to $8.0 million for the three months ended March 31, 2012. Cash used in investing activities was principally comprised of cash generated from maturities of short-term marketable securities, off-set by the purchase of short-term marketable securities and capital expenditures primarily for computer equipment associated with the build-out and expansion of our global computing platform. We expect to have ongoing capital expenditure requirements as we continue to invest in and expand our global computing platform. 27-------------------------------------------------------------------------------- Table of Contents Financing Activities Net cash used in financing activities of continuing operations was approximately $7.3 million for the three month period ended March 31, 2013, compared to $1.7 million of cash used in financing activities of continuing operations for the three month period ended March 31, 2012. Net cash used in financing activities of continuing operations in the three months ended March 31, 2013 primarily related to payments made for the repurchase of our common stock of approximately $5.5 million, payments of employee tax withholdings related to restricted stock of approximately $1.4 million, and payments made on our capital lease obligations of approximately $0.4 million. Net cash used in financing activities of continuing operations was approximately $1.7 million for the three month period ended March 31, 2012. Net cash used in financing activities of continuing operations in the three months ended March 31, 2012 primarily related to payments made for the repurchase of our common stock of approximately $1.2 million, payments of employee tax withholdings related to restricted stock of approximately $0.3 million, and payments made on our capital lease obligations of approximately $0.4 million, off-set by cash received from the exercise of stock options of $0.1 million. As of March 31, 2013, the Company had no outstanding bank debt other than the aforementioned capital leases. On October 29, 2012, our board of directors authorized and approved a third common stock repurchase plan that authorized us to repurchase up to $10 million of our shares of common stock, exclusive of any commissions, markups or expenses, from time to time through May 9, 2013. During the three months ended March 31, 2013, we purchased and cancelled approximately 2.3 million shares under the third repurchase plan for approximately $5.5 million including commissions. Any repurchased shares were cancelled and returned to authorized but unissued status. Our third common stock repurchase plan is now complete. Changes in cash, cash equivalents, and marketable securities are dependent upon changes in, among other things, working capital items such as deferred revenues, accounts payable, accounts receivable, accrued provision for litigation, and various accrued expenses, as well as changes in our capital and financial structure due to debt repurchases and issuances, stock option exercises, sales of equity investments, and similar events. We believe that our existing cash, cash equivalents, and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. If the assumptions underlying our business plan regarding future revenue and expenses change, or if unexpected opportunities or needs arise, we may seek to raise additional cash by selling equity or debt securities. Contractual Obligations, Contingent Liabilities and Commercial Commitments In the normal course of business, we make certain long-term commitments for operating leases, primarily office facilities, bandwidth, computer rack space, and other purchase obligations. These leases and obligations expire on various dates ranging from 2013 to 2019. We expect that the growth of our business will require us to continue to add to and increase our long-term commitments in 2013 and beyond. As a result of our growth strategies, we believe that our liquidity and capital resources requirements will grow. The following table presents our contractual obligations and commercial commitments, as of March 31, 2013 over the next five years and thereafter (in thousands): Payments Due by Period Less than More than Contractual obligations as of March 31, 2013 Total 1 year 1-3 years 3-5 years 5 years Operating Leases Bandwidth leases $ 27,447 $ 19,302 $ 7,002 $ 1,143 $ - Rack space leases 45,980 17,720 27,643 617 - Real estate leases 15,235 3,908 5,811 3,712 1,804 Total operating leases 88,662 40,930 40,456 5,472 1,804 Capital leases 1,796 1,092 624 80 - Other purchase obligations 1,692 517 1,128 47 - Total commitments $ 92,150 $ 42,539 $ 42,208 $ 5,599 $ 1,804 Off Balance Sheet Arrangements As of March 31, 2013, we are not involved in any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. 28-------------------------------------------------------------------------------- Table of Contents Use of Non-GAAP Financial Measures To evaluate our business, we consider and use Non-GAAP net income (loss) and Adjusted EBITDA as a supplemental measure of operating performance. These measures include the same adjustments that management takes into account when it reviews and assesses operating performance on a period-to-period basis. We consider Non-GAAP net income (loss) to be an important indicator of overall business performance because it allows us to illustrate the impact of the effects of share-based compensation, litigation expenses, amortization of intangibles, acquisition related expenses, and discontinued operations. We define EBITDA as GAAP net income (loss) before interest income, interest expense, other income and expense, provision for income taxes, depreciation and amortization and discontinued operations. We believe that EBITDA provides a useful metric to investors to compare us with other companies within our industry and across industries. We define Adjusted EBITDA as EBITDA adjusted for operational expenses that we do not consider reflective of our ongoing operations. We use Adjusted EBITDA as a supplemental measure to review and assess operating performance. We also believe use of Adjusted EBITDA facilitates investors' use of operating performance comparisons from period to period. In addition, it should be noted that our performance-based executive officer bonus structure is tied closely to our performance as measured in part by certain non-GAAP financial measures. In our May 9, 2013 earnings press release, as furnished on Form 8-K, we included Non-GAAP net income (loss), EBITDA and Adjusted EBITDA. The terms Non-GAAP net income (loss), EBITDA, and Adjusted EBITDA are not defined under United States GAAP, and are not measures of operating income, operating performance, or liquidity presented in accordance with United States GAAP. Our Non-GAAP net income (loss), EBITDA, and Adjusted EBITDA have limitations as analytical tools, and when assessing our operating performance, Non-GAAP net income (loss), EBITDA, and Adjusted EBITDA should not be considered in isolation, or as a substitute for net income (loss) or other consolidated income statement data prepared in accordance with United States GAAP. Some of these limitations include, but are not limited to: • EBITDA and Adjusted EBITDA do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; • they do not reflect changes in, or cash requirements for, our working capital needs; • they do not reflect the cash requirements necessary for litigation costs; • they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt that we may incur; • they do not reflect income taxes or the cash requirements for any tax payments; • although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will be replaced sometime in the future, and EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements; • while share-based compensation is a component of operating expense, the impact on our financial statements compared to other companies can vary significantly due to such factors as the assumed life of the options and the assumed volatility of our common stock; and • other companies may calculate EBITDA and Adjusted EBITDA differently than we do, limiting their usefulness as comparative measures. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP net income (loss) and Adjusted EBITDA only as supplemental support for management's analysis of business performance. Non-GAAP net income (loss), EBITDA, and Adjusted EBITDA are calculated as follows for the periods presented. Reconciliation of Non-GAAP Financial Measures In accordance with the requirements of Regulation G issued by the SEC, we are presenting the most directly comparable GAAP financial measures and reconciling the non-GAAP financial metrics to the comparable GAAP measures. Reconciliation of GAAP Net Income (Loss) to Non-GAAP Net Income (Loss) (In thousands) (Unaudited) Three Months Ended March 31, March 31, 2013 2012 GAAP net loss $ (8,136 ) $ (10,006 ) Share-based compensation 3,350 3,951 Litigation defense expenses 42 49 Acquisition related expenses (24 ) (488 ) Amortization of intangible assets 732 695 Loss from discontinued operations - 309 Non-GAAP net loss $ (4,036 ) $ (5,490 ) 29 -------------------------------------------------------------------------------- Table of Contents Reconciliation of GAAP Net Income (Loss) to EBITDA to Adjusted EBITDA (In thousands) (Unaudited) Three Months Ended March 31, March 31, 2013 2012 GAAP net loss $ (8,136 ) $ (10,006 ) Depreciation and amortization 8,130 8,227 Interest expense 27 50 Interest and other income (expense) (638 ) (20 ) Income tax expense 80 137 Loss from discontinued operations - 309 EBITDA $ (537 ) $ (1,303 ) Share-based compensation 3,350 3,951 Litigation defense expenses 42 49 Acquisition related expenses (24 ) (488 ) Adjusted EBITDA $ 2,831 $ 2,209 |