[May 10, 2013] DEMAND MEDIA INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Forward Looking Statements The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our 2012 Annual Report on Form 10-K. This Quarterly Report on Form 10-Q contains forward-looking statements. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy and plans and our objectives for future operations, are forward-looking statements. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect" and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our estimates of our financial results and our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the section entitled "Risk Factors" in Part II Item 1A of this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results or to changes in our expectations. You should read this Quarterly Report on Form 10-Q and the documents that we reference in this Quarterly Report on Form 10-Q and have filed with the Securities and Exchange Commission (the "SEC") with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect. As used herein, "Demand Media," "the Company," "our," "we," or "us" and similar terms include Demand Media, Inc. and its subsidiaries, unless the context indicates otherwise. "Demand Media" and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. Overview We are a diversified Internet media and domain services company. We have developed a leading Internet-based model for the professional creation and distribution of high-quality, commercially valuable, long-lived content at scale, and we operate the world's largest wholesale registrar and the world's second largest registrar overall. Our business is comprised of two service offerings: Content & Media and Registrar. Our Content & Media offering is engaged in creating media content, primarily consisting of text articles and videos, and delivering such content along with our social media and monetization tools to our owned and operated websites and mobile applications, and to our network of customer websites and their mobile applications. Our Content & Media service offering also includes a portfolio of websites primarily containing advertising listings, which we refer to as undeveloped websites. Our Registrar service is the world's largest wholesale registrar of Internet domain names and the world's second largest registrar overall, based on the number of names under management, and provides domain name registration and related value-added services. We are also a leading participant in ICANN's significant expansion of the number of generic Top Level Domain ("gTLDs"), which is expected to result in the delegation on new gTLDs commencing in 2013. 25 -------------------------------------------------------------------------------- Our principal operations and decision-making functions are located in the United States. We report our financial results as one operating segment, with two distinct service offerings. Our operating results are regularly reviewed by our chief operating decision maker on a consolidated basis, principally to make decisions about how we allocate our resources and to measure our consolidated operating performance. Together, our service offerings provide us with proprietary data that facilitate the creation of commercially valuable, long-lived content, which we combine with broad distribution and targeted monetization capabilities. We currently generate the vast majority of our Content & Media revenue through the sale of advertising, and to a lesser extent through subscriptions to our social media applications and licensing and sales of select content and service offerings. Substantially all of our Registrar revenue is derived from domain name registration and related value-added service subscriptions. Our chief operating decision maker regularly reviews revenue for each of our Content & Media and Registrar service offerings in order to gain more depth and understanding of the key business metrics driving our business. Accordingly, we report Content & Media and Registrar revenue separately. In February 2013, we announced that our board of directors authorized a plan to explore separating the Company into two independent, publicly-traded companies: a pure-play Internet-based content and media company and a pure-play domain services company (hereinafter referred to as the "Proposed Business Separation"). We anticipate that the Proposed Business Separation will be structured as a tax-free pro rata distribution to stockholders of new publicly traded shares in the new domain services company. Consummation of the Proposed Business Separation is subject to final approval by our board of directors. Consummation of the Proposed Business Separation also is subject to satisfaction of several conditions, including confirmation of the transaction's tax-free treatment, receipt of listing approval, and the filing and effectiveness of a registration statement on Form 10 with the SEC. We have not yet finalized all of the details of the Proposed Business Separation and there is no assurance that the Proposed Business Separation as described herein will occur. For the three months ended March 31, 2012 and 2013, we reported revenue of $86.2 million and $100.6 million, respectively. For the three months ended March 31, 2012 and 2013, our Content & Media offering accounted for 63% and 65% of our total revenue, respectively, and our Registrar service accounted for 37% and 35% of our total revenue, respectively. Key Business Metrics We regularly review a number of business metrics, including the following key metrics, to evaluate our business, measure the performance of our business model, identify trends impacting our business, determine resource allocations, formulate financial projections and make strategic business decisions. Measures which we believe are the primary indicators of our performance are as follows: Content & Media Metrics • page views: We define page views as the total number of web pages viewed across (1) our owned and operated websites and/or (2) our network of customer websites, to the extent that the viewed web pages of our customers host the Company's monetization, social media and/or content services. Page views are primarily tracked through internal systems, such as our Omniture web analytics tool, contain estimates for our customer websites using our social media tools and may use data compiled from certain customer websites. We periodically review and refine our methodology for monitoring, gathering, and counting page views in an ongoing effort to improve the accuracy of our measure. •RPM: We define RPM as Content & Media revenue per one thousand page views. Registrar Metrics •domain: We define a domain as an individual domain name registered by a third-party customer on our platform for which we have begun to recognize revenue. This metric does not include any of the company's owned and operated websites. • average revenue per domain: We calculate average revenue per domain by dividing Registrar revenues for a period by the average number of domains registered in that period. The average number of domains is the simple average of the number of domains at the beginning and end of the period. Average revenue per domain for partial year periods is annualized. The following table sets forth additional performance highlights of key business metrics for the periods presented: 26 -------------------------------------------------------------------------------- Three months ended March 31, 2012 2013 % Change Content & Media Metrics (1) Owned & operated Page views (in millions) 3,142 3,780 20 % RPM $ 12.52 $ 13.15 5 % Network of customer websites Page views (in millions) 4,722 4,867 3 % RPM $ 3.10 $ 3.20 3 % RPM ex-TAC (1) $ 2.38 $ 2.09 (12 )% Registrar Metrics (2) End of Period # of Domains (in millions) 13.3 14.0 5 % Average Revenue per Domain $ 9.94 $ 10.22 3 % ___________________________________ (1) Traffic acquisition costs (TAC) represents revenue-sharing payments made to our network customers from advertising revenue generated from such customers' websites. (2) For a discussion of these period to period changes in the number of page views, RPM, end of period domains and average revenue per domain and how they impacted our financial results, see "Results of Operations" below. Opportunities, Challenges and Risks To date, we have derived the majority of our revenue through the sale of advertising in connection with our Content & Media service offering and through domain name registration subscriptions in our Registrar service offering. Our advertising revenue is primarily generated by advertising networks, which include both performance based Internet advertising, such as cost-per-click where an advertiser pays only when a user clicks on its advertisement, and display Internet advertising where an advertiser pays when the advertising is displayed. Historically and for the three months ended March 31, 2013, the majority of our advertising revenue was generated by our relationship with Google. We deliver online advertisements provided by Google on our owned and operated websites as well as on certain of our customer websites where we share a portion of the advertising revenue. For the three months ended March 31, 2013, approximately 40% of our total consolidated revenue was derived from our advertising arrangements with Google. Google maintains the direct relationships with the advertisers and provides us with cost-per-click and display advertising services. Growth in Content & Media revenue is principally dependent upon growth in page views and RPMs. Our recent growth in page views has been primarily due to an increase in the number of visitors to our library of content published in 2011 and earlier, the increase in the amount of our content distributed to our network of content partners, and traffic growth from mobile devices. We believe that there are opportunities to grow our page views by creating and publishing more content in a greater variety of formats on our owned and operated sites as well as expanding our network of customer websites. Our RPMs are subject to changes in the online advertising marketplace, which could include lower rates received for certain ad units. Currently, our Content & Media revenue is primarily advertising-based; however, we believe there is an opportunity to diversify our revenue by expanding our paid content services, including offering paid subscriptions to access certain of our media content. For example, we acquired Creativebug, an online destination for arts and crafts instructional content in March 2013 to accelerate our paid content opportunity. Google, the largest provider of search engine referrals to the majority of the Company's websites, regularly deploys changes to its search engine algorithms. Since 2011, the Company has experienced fluctuations in the total number of Google search referrals to its owned and operated websites and network of customer websites. Some of the more recent changes in 2013 have resulted in a significant reduction in search engine referral traffic to eHow and certain of our other owned and operated websites. These changes, as well as any potential future changes, may result in material fluctuations in our financial performance. During 2011 and 2012, and in response to changes in search engine algorithms in 2011, the Company performed an evaluation of its existing content library to identify potential improvements in its content creation and distribution platform. As a result of this evaluation, the Company elected to remove certain content assets from service, resulting in $5.9 of accelerated amortization expense in the fourth quarter of 2011 and $1.8 of accelerated amortization expense in the first quarter of 2012. 27 -------------------------------------------------------------------------------- We intend to evolve and continuously improve our content creation and distribution platform. During 2011 and 2012, we made certain improvements to this platform including establishing more stringent criteria for the admission of content creators, increasing our investment in video, long-form content and images, publishing content directed at international markets and in languages other than English, adding content production algorithms targeted toward ensuring that each additional unit of content published is unique in relation to existing content units, and expanding the distribution of our content to our network of customer websites. As we made these improvements to our content creation and distribution platform, we reduced the level of our overall investment in media content in 2012 when compared to 2011. Based on our assessment of the results of these improvements, we increased our investment in media content over the course of 2012. We expect this trend to continue and anticipate increased media content expenditures in 2013 compared to 2012, including additional investment in short-form articles on our owned and operated sites such as eHow.com, growth in content published on our network of customer websites and creation of new content formats, including paid content, designed to further diversify our content offering. There can be no assurance that these or any future changes that may be implemented by the Company, by search engines to their algorithms and search methodologies, or by consumers in their web usage habits will not adversely impact the carrying value, estimated useful life or intended use of our long-lived assets. The Company will continue to monitor these changes as well as any future changes and emerging trends in search engine algorithms and methodologies, including the resulting impact that these changes may have on future operating results, the economic performance of the Company's long-lived assets and in its assessment as to whether significant changes in circumstances might provide an indication of potential impairment of the carrying value of its long-lived assets, including its media content and goodwill arising from acquisitions. The growth in our Registrar revenue is dependent upon our ability to attract and retain customers to our Registrar platform through competitive pricing on domain registrations and value added services. Beginning in the first quarter of 2010 and extending through the third quarter of 2011, we added several customers with large volumes of domains to our Registrar platform. This resulted in fluctuations in our average revenue per domain over these periods, from which we only recognized revenue on a portion of these domain names while deferring revenue recognition on the remainder. As the mix of large, higher volume customers increases, we also expect that the associated service costs as a percentage of revenue will increase when compared to our historical results. The Internet Corporation for Assigned Names and Numbers, or ICANN, has approved a framework for the significant expansion of the number of gTLDs, which is expected to result in the delegation of new gTLDs commencing in 2013. We believe that such expansion, once completed, could result in an increase in the number of domains registered on our platform commencing in the latter half of 2013. In addition, we believe that the New gTLD Program could also provide us with new revenue opportunities commencing in the latter half of 2013, which include operating the back-end infrastructure for new gTLD registries and/or owning one or more gTLDs in our own right. During 2012, the Company paid $18.2 million for certain gTLD applications under the New gTLD Program. Payments for gTLD applications represent amounts paid directly to ICANN and or third parties in the pursuit of the Company's ownership of certain gTLD operator rights. While there can be no assurance that the Company will be awarded any gTLDs, the Company capitalizes payments made for gTLD applications that are determined to embody a probable economic benefit, which are included in other long-term assets at December 31, 2012 and March 31, 2013. During the remainder of 2013 and as part of the New gTLD Program, the Company may receive partial cash refunds for certain gTLD applications, and to the extent the Company elects to sell or dispose of certain gTLD applications throughout the process, it may also incur gains or losses on amounts invested. Gains on the sale of the Company's interest in gTLDs will be recognized when realized, while losses will be recognized when deemed probable. Upon the delegation of operator rights for each gTLD by ICANN, which the Company expects to commence in 2013, gTLD application fees will be reclassified as finite lived intangible assets and amortized on a straight-line basis over their estimated useful life. Other costs incurred by the Company as part of its gTLD initiative and not directly attributable to the acquisition of gTLD operator rights are expensed as incurred. We expect to incur between $5 and $10 million of formation expenses related to the New gTLD Program in 2013, and the total amount of our investment at the completion of the New gTLD Program could be substantially higher or lower than the amounts invested to date. Revenue is not expected to commence until the latter half of 2013 at the earliest. Our service costs, the largest component of our operating expenses, can vary from period to period, particularly as a percentage of revenue, based upon the mix of the underlying Content & Media and Registrar services revenues we generate. In the near term, we expect that the period-over-period growth in our Content & Media revenue will exceed the growth in our Registrar revenue, which would typically provide for higher operating margins. However, we also expect that our service costs will increase in 2013 compared to 2012 in line with revenue growth and also due to the impact of our acquisitions of 28 -------------------------------------------------------------------------------- Name.com and Creativebug. We believe that these factors, together with costs associated with our preparation for new gTLDs becoming available for registration later in 2013, will constrain our operating margin growth in the short-term as we increase our investment in new business initiatives to support future growth. Our content studio identifies and creates online text articles and videos through a community of freelance creative professionals and is core to our business strategy and long-term growth initiatives. Historically, we have made substantial investments in our platform to support our expanding community of freelance creative professionals and the growth of our content production and distribution and expect to continue to make such investments. As we develop new content formats, we may not be able to attract and retain qualified creative professionals to produce such new content at scale, which may adversely impact our ability to execute against emerging business opportunities or retain existing content creators. For the three months ended March 31, 2013, more than 90% of our revenue has been derived from websites and customers located in the United States. While our content is primarily targeted towards English-speaking users in the United States today, we believe that there is an opportunity in the longer term for us to create content targeted to users outside of the United States and thereby increase our revenue generated from countries outside of the United States. We plan to further expand our operations internationally to address this opportunity by launching new websites and expanding our existing web properties eHow en Español and eHow Brasil. As we expand our business internationally, we may incur additional expenses associated with this growth initiative. Basis of Presentation Revenue Our revenue is derived from our Content & Media and Registrar service offerings. Content & Media Revenue We currently generate substantially all of our Content & Media revenue through the sale of advertising, and to a lesser extent through subscriptions to our social media applications and select content and service offerings. Articles and videos, each of which we refer to as a content unit, generate revenue both directly and indirectly. Direct revenue is that directly attributable to a content unit, such as advertisements, including sponsored advertising links, display advertisements and in-text advertisements, on the same webpage on which the content is displayed. Indirect revenue is also derived primarily by our content library, but is not directly attributable to a specific content unit. Indirect revenue includes advertising revenue generated on our owned and operated websites' home pages (e.g., home page of eHow), on topic category webpages (e.g., home and garden category page), on user generated article pages that feature content that was not acquired through our proprietary content acquisition process, and subscription revenue. Our revenue generating advertising arrangements, for both our owned and operated websites and our network of customer websites, include cost-per-click performance-based advertising; display advertisements where revenue is dependent upon the number of page views; and lead generating advertisements where revenue is dependent upon users registering for, or purchasing or demonstrating interest in, advertisers' products and services. We generate revenue from advertisements displayed alongside our content offered to consumers across a broad range of topics and categories on our owned and operated websites and on certain customer websites. Our advertising revenue also includes revenue derived from cost-per-click advertising links we place on undeveloped websites owned both by us, which we acquire and sell on a regular basis, and certain of our customers. To a lesser extent, we also generate revenue from our subscription-based offerings, which include our social media applications deployed on our network of customer websites and subscriptions to premium content or services offered on certain of our owned and operated websites. Where we enter into revenue sharing arrangements with our customers, such as those relating to our IndieClick network and our undeveloped customer websites, and when we are considered the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record these revenue-sharing payments to our customers as traffic acquisition costs, or TAC, which are included in service costs. In circumstances where we distribute our content on third-party websites and the customer acts as the primary obligor we recognize revenue on a net basis. Registrar Revenue Our Registrar revenue is principally comprised of registration fees charged to resellers and consumers in connection with new, renewed and transferred domain name registrations. In addition, our Registrar also generates revenue from the sale of other value-added services that are designed to help our customers easily build, enhance and protect their domains, including security services, e-mail accounts and web-hosting. Finally, we generate revenue from fees related to auction services we provide to facilitate the selling of third-party owned domains. Our Registrar revenue varies based upon the number of domains 29 -------------------------------------------------------------------------------- registered, the rates we charge our customers and our ability to sell value-added services. We market our Registrar wholesale services under our eNom brand, and our retail registration services under Name.com and the eNomCentral brand, among others. Operating Expenses Operating expenses consist of service costs, sales and marketing, product development, general and administrative, and amortization of intangible assets. Included in our operating expenses are stock based compensation and depreciation expenses associated with our capital expenditures. Service Costs Service costs consist of: fees paid to registries and ICANN associated with domain registrations; advertising revenue recognized by us and shared with others as a result of our revenue-sharing arrangements, such as TAC and content creator revenue-sharing arrangements; Internet connection and co-location charges and other platform operating expenses including depreciation of the systems and hardware used to build and operate our Content & Media platform and Registrar; personnel costs related to in-house editorial, customer service and information technology; and certain content production costs such as our premium multi-channel video deal with YouTube in 2012 and costs associated with our paid content initiatives, such as instruction content created in connection with our acquisition of Creativebug in March 2013. We anticipate that content production costs will be a lower proportion of total service costs in 2013 than in 2012 as we completed the production of our content under the multi-channel video initiative with YouTube. Our service costs are dependent on a number of factors, including the number of page views generated across our platform and the volume of domain registrations and value-added services supported by our Registrar. In the near term, we expect that the decrease in the production of video for YouTube will be offset by increases in costs associated with our investment in new business initiatives in 2013 (including our preparation for new gTLDs) resulting in comparable service costs compared to historical results. Sales and Marketing Sales and marketing expenses consist primarily of sales and marketing personnel costs, sales support, public relations, advertising, marketing and general promotional expenditures. Fluctuations in our sales and marketing expenses are generally the result of our efforts to support the growth in our Content & Media service, including expenses required to support the expansion of our direct advertising sales force. We currently anticipate that our sales and marketing expenses will continue to increase in the near term as a percent of revenue as we continue to grow our sales and marketing organizations and invest in marketing activities to support the growth of our business. Product Development Product development expenses consist primarily of expenses incurred in our software engineering, product development and web design activities and related personnel costs. Fluctuations in our product development expenses are generally the result of hiring personnel to support and develop our platform, including the costs to further develop our content algorithms, our owned and operated websites and future product and service offerings of our Registrar. We currently anticipate that our product development expenses will increase as we continue to hire more product development personnel and further develop our products and offerings to support the growth of our business, but remain relatively flat as a percentage of revenue compared to 2012. General and Administrative General and administrative expenses consist primarily of personnel costs from our executive, legal, finance, human resources and information technology organizations and facilities related expenditures, as well as third party professional fees, insurance and bad debt expenses. Professional fees are largely comprised of outside legal, audit and information technology consulting. During the three months ended March 31, 2012 and 2013, our allowance for doubtful accounts and bad debt expense were not significant and we expect that this trend will continue in the near term. However, as we grow our revenue from direct advertising sales, which tend to have longer collection cycles, our allowance for doubtful accounts may increase, which may lead to increased bad debt expense. In 2013, we expect to incur higher personnel costs and professional fees related to our efforts to separate the Company into two distinct publicly traded companies. As we continue to expand our business, combined with higher general and administrative costs expected from the Proposed Business Separation in 2013, we anticipate general and administrative expenses will increase at a higher rate than our projected revenue growth in 2013 when compared to 2012. 30 -------------------------------------------------------------------------------- Amortization of Intangibles We capitalize certain costs allocated to the purchase price of certain identifiable intangible assets acquired in connection with business combinations, to acquire content that our models show embody probable economic benefit, and to acquire undeveloped websites, including initial registration costs. We amortize these costs on a straight-line basis over the related expected useful lives of these assets, which have a weighted average useful life of approximately 5.3 years on a combined basis as of March 31, 2013. We estimate our capitalized content to have a weighted average useful life of 5.1 years as of March 31, 2013. The Company determines the appropriate useful life of intangible assets by performing an analysis of expected cash flows based on its historical experience of intangible assets of similar quality and value. We expect amortization expense to fluctuate in the near term as we intend to increase our investment in content intangible assets as compared to the prior year, and because of the increase in identifiable intangible assets acquired in the Name.com and Creativebug acquisitions in December 2012 and March 2013, respectively. Amortization as a percentage of revenue will depend upon a variety of factors, such as the amounts and mix of our investments in content and identifiable intangible assets acquired in business combinations. Stock-based Compensation Included in our operating expenses are expenses associated with stock-based compensation, which are allocated and included in service costs, sales and marketing, product development and general and administrative expenses. Stock-based compensation expense is largely comprised of costs associated with stock options and restricted stock units granted to employees, restricted stock issued to employees and expenses relating to our Employee Stock Purchase Plan. We record the fair value of these equity-based awards and expense at their cost ratably over related vesting periods. In addition, stock-based compensation expense includes the cost of warrants to purchase common and preferred stock issued to certain non-employees. As of March 31, 2013, we had approximately $52.4 million of unrecognized employee related stock-based compensation, net of estimated forfeitures, that we expect to recognize over a weighted average period of approximately 2.5 years. In addition we also had approximately $1.4 million of unrecognized compensation expense related to our Employee Stock Purchase Plan that we expect to recognize on a straight-line basis through the fourth quarter of 2013. Stock-based compensation expense is expected to increase in 2013 compared to 2012 as a result of our existing unrecognized stock-based compensation and as we issue additional stock-based awards to continue to attract and retain employees and non-employee directors. Interest Expense Interest expense principally consists of interest on outstanding debt and amortization of debt issuance costs associated with our revolving credit facility. In the event that we increase, modify and or draw down on our revolving credit facility in the near term, interest expense would increase when compared to 2012. As of March 31, 2013 no principal balance was outstanding under the revolving credit facility. Interest Income Interest income consists of interest earned on cash balances and short-term investments. We typically invest our available cash balances in money market funds and short-term United States Treasury obligations. Other Income (Expense), Net Other income (expense), net consists primarily of transaction gains and losses on foreign currency-denominated assets and liabilities and changes in the value of certain long term investments and, prior to our initial public offering, changes in the fair value of our preferred stock warrant liability. We expect our transaction gains and losses will vary depending upon movements in underlying currency exchange rates, and could become more significant when we expand internationally. Provision for Income Taxes Since our inception, we have been subject to income taxes principally in the United States, and certain other countries where we have legal presence, including the United Kingdom, the Netherlands, Canada, Sweden, Ireland and Argentina. We anticipate that as we expand our operations outside the United States, we will become subject to taxation based on the foreign statutory rates and our effective tax rate could fluctuate accordingly. 31 -------------------------------------------------------------------------------- Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. We currently believe that based on the available information, it is more likely than not that our deferred tax assets will not be realized, and accordingly we have taken a full valuation allowance against all of our United States federal and certain state and foreign deferred tax assets. As of December 31, 2012, we had approximately $66 million of federal and $13 million of state operating loss carry-forwards available to offset future taxable income which expire in varying amounts beginning in 2020 for federal and 2013 for state purposes if unused. Federal and state laws impose substantial restrictions on the utilization of net operating loss and tax credit carry-forwards in the event of an "ownership change," as defined in Section 382 of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. Currently, we do not expect the utilization of our net operating loss and tax credit carry-forwards in the near term to be materially affected as no significant limitations are expected to be placed on these carry-forwards as a result of our previous ownership changes. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with our revenue recognition, accounts receivable and allowance for doubtful accounts, capitalization and useful lives associated with our intangible assets, including our internal software and website development and content costs, income taxes, stock-based compensation and the recoverability of our goodwill and long-lived assets have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates and have discussed those in our 2012 Annual Report on Form 10-K. There have been no material changes to our critical accounting policies and estimates since the date of our 2012 Annual Report on Form 10-K. 32 -------------------------------------------------------------------------------- Results of Operations The following tables set forth our results of operations for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of future results. Three months ended March 31, 2012 2013 (In thousands) Revenue $ 86,234 $ 100,620Operating expenses(1)(2): Service costs (exclusive of amortization of intangible assets) 41,262 48,177 Sales and marketing 10,393 14,083 Product development 10,124 11,160 General and administrative 15,395 16,375 Amortization of intangible assets 11,956 9,559 Total operating expenses 89,130 99,354 Income (loss) from operations (2,896 ) 1,266 Other income (expense) Interest income 15 7 Interest expense (137 ) (153 ) Other income (expense), net (19 ) (78 ) Total other expense (141 ) (224 ) Income (loss) before income taxes (3,037 ) 1,042 Income tax (expense)/benefit 1,195 (373 ) Net income (loss) (1,842 ) 669 Cumulative preferred stock dividends - - Net income (loss) attributable to common shareholders $ (1,842 ) $ 669 (1) Depreciation expense included in the above line items: Service costs $ 3,650 $ 3,982 Sales and marketing 134 107 Product development 282 236 General and administrative 898 1,020 Total depreciation expense $ 4,964 $ 5,345 (2) Stock-based compensation included in the above line items: Service costs $ 708 $ 611 Sales and marketing 1,536 1,923 Product development 1,688 1,165 General and administrative 3,459 3,564 Total stock-based compensation $ 7,391 $ 7,263 33-------------------------------------------------------------------------------- As a percentage of revenue: Three Months ended March 31, 2012 2013 Revenue 100.0 % 100.0 % Operating expenses: - -Service costs (exclusive of amortization of intangible assets) 47.8 % 47.9 % Sales and marketing 12.1 % 14.0 % Product development 11.7 % 11.1 % General and administrative 17.9 % 16.3 % Amortization of intangible assets 13.9 % 9.5 % Total operating expenses 103.4 % 98.7 % Income (loss) from operations (3.4 )% 1.3 % Other income (expense) - Interest income - % - % Interest expense (0.2 )% (0.2 )% Other income (expense), net - % (0.1 )% Total other expense (0.2 )% (0.2 )% Income (loss) before income taxes (3.5 )% 1.0 % Income tax (expense)/benefit 1.4 % (0.4 )% Net income (loss) (2.1 )% 0.7 % Revenue Revenue by service line were as follows: Three months ended March 31, 2012 2013 % Change (In thousands) Content & Media: Owned and operated websites $ 39,348 $ 49,703 26 % Network of customer websites 14,615 15,588 7 % Total Content & Media 53,963 65,291 21 % Registrar 32,271 35,329 9 % Total revenue $ 86,234 $ 100,620 17 % Content & Media Revenue from Owned and Operated Websites Content & Media revenue from our owned and operated websites increased by $10.4 million, or 26%, to $49.7 million for the three months ended March 31, 2013, as compared to $39.3 million for the same period in 2012. The increase was primarily due to an increase in page views and an increase in RPMs. Page views increased by 20%, from 3,142 million page views in the three months ended March 31, 2012 to 3,780 million page views in the three months ended March 31, 2013 primarily due to stronger traffic growth on eHow.com and Livestrong.com. RPMs increased by 5%, from $12.52 in the three months ended March 31, 2012 to $13.15 in the three months ended March 31, 2013 primarily due to growth on certain of our owned and operated websites and increasing monetization yield from mobile traffic. Content & Media Revenue from Network of Customer Websites 34 -------------------------------------------------------------------------------- Content & Media revenue from our network of customer websites for the three months ended March 31, 2013 increased by $1.0 million, or 7%, to $15.6 million, as compared to $14.6 million in the same period in 2012. The increase was primarily due to an increase in page views and RPMs, offset by lower revenue associated with less content delivered year-over-year as we satisfied our final content delivery requirements under the YouTube Channels agreement. Page views increased by 145 million or 3%, from 4,722 million page views in the three months ended March 31, 2012, to 4,867 million pages viewed in the three months ended March 31, 2013. The increase in page views was due primarily to growth in page views from our IndieClick network, offset by a decrease in page views associated with our Pluck customer base. RPMs increased 3% from $3.10 in the three months ended March 31, 2012 to $3.20 in the three months ended March 31, 2013. The increase in RPMs was primarily due to higher revenue growth from our content partners and network of customers with undeveloped websites, partially offset by growth in IndieClick page views, which typically average lower RPMs, and lower YouTube channels revenue. Registrar Revenue Registrar revenue for the three months ended March 31, 2013 increased $3.1 million, or 9%, to $35.3 million compared to $32.3 million for the same period in 2012. The increase was largely due to an increased number of new domain registrations and domain renewal registrations in 2013 compared to 2012 and an increase in our average revenue per domain. The number of domain registrations increased 0.7 million, or 5%, to 14.0 million during the three months ended March 31, 2013 as compared to 13.3 million in the same period in 2012 primarily due to the addition of large volume customers and the December 2012 acquisition of Name.com. Our average revenue per domain increased slightly by $0.28, or 3%, to $10.22 during the three months ended March 31, 2013 from $9.94 in the same period in 2012. Cost and Expenses Operating costs and expenses were as follows: Three months ended March 31, 2012 2013 % Change (In thousands) Service costs (exclusive of amortization of intangible assets) $ 41,262 $ 48,177 17 % Sales and marketing 10,393 14,083 36 % Product development 10,124 11,160 10 % General and administrative 15,395 16,375 6 % Amortization of intangible assets 11,956 9,559 (20 )% Service Costs Service costs for the three months ended March 31, 2013 increased by approximately $6.9 million, or 17%, to $48.2 million compared to $41.3 million in the same period in 2012. The increase was primarily due to a $3.2 million increase in domain registry fees and registrar costs associated with our growth in domain registrations and related revenue over the same period and the acquisition of Name.com in December 2012, a $2.1 million increase in TAC primarily due to revenue growth from customer-owned undeveloped websites over the same period, a $0.6 million increase in personnel related costs including stock-based compensation, a $0.3 million increase in depreciation expense and a $0.4 million increase in information technology expense to support growth in our business. These factors were partially offset by a $0.8 million decrease in content related expenses associated with our YouTube premium channels agreement. As a percentage of revenues, service costs (exclusive of amortization of intangible assets) increased 10 basis points to 47.9% in the three months ended March 31, 2013 compared to 47.8% during the same period in 2012. Sales and Marketing Sales and marketing expenses increased 36%, or $3.7 million, to $14.1 million for the three months ended March 31, 2013 from $10.4 million for the same period in 2012. The increase in expense was primarily driven by increased personnel related costs, including stock-based compensation expense, of approximately $1.1 million due to the Name.com acquisition, growth in our advertising sales teams, and an increase of approximately $2.7 million in marketing activities to support the growth of our 35 -------------------------------------------------------------------------------- business. As a percentage of revenue, sales and marketing expense increased 190 basis points to 14.0% during the three months ended March 31, 2013 compared to 12.1% during the same period in 2012. Product Development Product development expenses increased by $1.0 million, or 10%, to $11.2 million during the three months ended March 31, 2013 compared to $10.1 million in the same period in 2012. The increase was largely due to approximately $0.8 million increase in personnel and related costs including stock-based compensation expense, net of internal costs capitalized as internal software development. As a percentage of revenue, product development expenses decreased 60 basis points to 11.1% during the three months ended March 31, 2013 compared to 11.7% during the same period in 2012. General and Administrative General and administrative expenses increased by $1.0 million, or 6%, to $16.4 million during the three months ended March 31, 2013 compared to $15.4 million in the same period in 2012. The increase was primarily due to a $0.9 million increase in rent expense and $0.3 million increase in personnel related costs. The increase in rent expense was largely due to the acquisition of Name.com in December 2012 and incremental rent expense incurred during the period as a result of our upcoming headquarter relocation in the second quarter of 2013. Partially offsetting these expenses was a $0.9 million decrease in professional fees primarily due to decreased audit-related fees over the same period. As a percentage of revenue, general and administrative costs decreased 160 basis points to 16.3% during the three months ended March 31, 2013 compared to 17.9% during the same period in 2012. Amortization of Intangibles Amortization expense for the three months ended March 31, 2013 decreased by $2.4 million, or 20%, to $9.6 million compared to $12.0 million in the same period in 2012. The reduction is primarily due to a decrease in the amortization of content assets as well as other intangible assets primarily acquired via acquisitions prior to 2010 that are now fully amortized, offset by additional amortization expense from intangible assets acquired from acquisitions in 2011 and Name.com in 2012. Additionally, we accelerated $1.8 million of amortization expense during the three months ended March 31, 2012 as compared to $0.1 million in 2013 as a result of removing certain media content assets from service in these periods. As a percentage of revenue, amortization of intangible assets decreased 440 basis points to 9.5% during the three months ended March 31, 2013 compared to 13.9% during the same period in 2012 as the result of the increase in revenue. Interest Income Interest income for the three and three months ended March 31, 2013 did not change significantly compared to the same period in 2012. Interest Expense Interest expense for the three and nine months ended March 31, 2013 did not change significantly compared to the same period in 2012. Other Income (Expense), Net Other income (expense), net for the three months ended March 31, 2013 did not change significantly compared to the same period in 2012. Income Tax Benefit (Expense) During the three months ended March 31, 2013, we recorded an income tax expense of $0.4 million compared to a benefit of $1.2 million during the same period in 2012, representing an increase of $1.6 million. The increase was primarily due to a benefit from the change in California apportionment methodology during the quarter ended March 31, 2012. Non-GAAP Financial Measures To provide investors and others with additional information regarding our financial results, we have disclosed in the table below the following non-GAAP financial measures: adjusted earnings before interest, taxes, depreciation and amortization expense, or Adjusted EBITDA, and revenue less traffic acquisition costs, or Revenue ex-TAC. We have provided a 36 -------------------------------------------------------------------------------- reconciliation of our non-GAAP financial measures to the most directly comparable GAAP financial measures. Our non-GAAP Adjusted EBITDA financial measure differs from GAAP net income in that it excludes certain expenses such as depreciation, amortization, stock-based compensation, as well as the financial impact of acquisition and realignment costs, the formation expenses directly related to our generic Top Level Domain ("gTLD") initiative and any gains or losses on certain asset sales or dispositions. Acquisition and realignment costs include such items, when applicable, as (a) non-cash GAAP purchase accounting adjustments for certain deferred revenue and costs, (b) legal, accounting and other professional fees directly attributable to acquisition activity, (c) employee severance payments attributable to acquisition or corporate realignment activities and (d) expenditures related to the Proposed Business Separation. Our non-GAAP Revenue ex-TAC financial measure differs from GAAP revenue as it reflects our consolidated revenues net of our traffic acquisition costs. Adjusted EBITDA and Revenue ex-TAC are frequently used by securities analysts, investors and others as a common financial measure of our operating performance. These non-GAAP financial measures are the primary measures used by our management and board of directors to understand and evaluate our financial performance and operating trends, including period to period comparisons, to prepare and approve our annual budget and to develop short and long term operational plans. Additionally, Adjusted EBITDA is the primary measure used by the compensation committee of our board of directors to establish the target for and ultimately fund our annual employee bonus pool for all bonus eligible employees. We also frequently use Adjusted EBITDA in our discussions with investors, commercial bankers and other users of our financial statements. Management believes these non-GAAP financial measures reflect our ongoing business in a manner that allows for meaningful period to period comparisons and analysis of trends. In particular, the exclusion of certain expenses in calculating Adjusted EBITDA can provide a useful measure for period to period comparisons of our business' underlying recurring revenue and operating costs which is focused more closely on the current costs necessary to utilize previously acquired long-lived assets. In addition, we believe that it can be useful to exclude certain non-cash charges because the amount of such expenses is the result of long-term investment decisions in previous periods rather than day-to-day operating decisions. For example, due to the long-lived nature of our media content, revenue generated from our content assets in a given period bears little relationship to the amount of our investment in content in that same period. Accordingly, we believe that content acquisition costs represent a discretionary long-term capital investment decision undertaken by management at a point in time. This investment decision is clearly distinguishable from other ongoing business activities, and its discretionary nature and long term impact differentiate it from specific period transactions, decisions regarding day-to-day operations, and activities that would have immediate performance consequences if materially changed, deferred or terminated. We believe that Revenue ex-TAC is a meaningful measure of operating performance because it is frequently used for internal managerial purposes and helps facilitate a more complete period to period understanding of factors and trends affecting our underlying revenue performance. Accordingly, we believe that these non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our consolidated revenue and operating results in the same manner as our management and in comparing financial results across accounting periods and to those of our peer companies. The following table presents a reconciliation of Revenue ex-TAC and Adjusted EBITDA for each of the periods presented: 37 -------------------------------------------------------------------------------- Three months ended March 31, 2012 2013 (In thousands) Non-GAAP Financial Measures: Content & Media revenue $ 53,963 $ 65,291 Registrar revenue 32,271 35,329 Less: traffic acquisition costs (TAC)(1) (3,379 ) (5,436 ) Total revenue ex-TAC $ 82,855 $ 95,184 Net income (loss) $ (1,842 ) $ 669 Add: Income tax expense/(benefit) (1,195 ) 373 Interest and other expense, net 141 224 Depreciation and amortization(2) 16,920 14,904 Stock-based compensation(3) 7,391 7,263 Acquisition and realignment costs(4) 61 376 gTLD expense(5) 429 1,618 Adjusted EBITDA $ 21,905 $ 25,427 ___________________________________ (1) Represents revenue-sharing payments made to our network customers from advertising revenue generated from such customers' websites. (2) Represents depreciation expense of our long-lived tangible assets and amortization expense of our finite-lived intangible assets, including amortization expense related to our investment in media content assets, included in our GAAP results of operations. Amortization expense for the three months ended March 31, 2012 and 2013 includes $1.8 million and $0.1 million, respectively, of accelerated non-cash amortization expense associated with the removal of certain content intangible assets from service in that period. (3) Represents the fair value of stock-based awards and certain warrants to purchase our stock included in our GAAP results of operations. (4) Acquisition and realignment costs include such items, when applicable, as (a) non-cash GAAP purchase accounting adjustments for certain deferred revenue and costs, (b) legal, accounting and other professional fees directly attributable to acquisition activity, (c) employee severance payments attributable to acquisition or corporate realignment activities and (d) expenditures related to the Proposed Business Separation. (5) Comprises formation expenses directly related to our gTLDs initiative that is not expected to generate associated revenue until the latter half of 2013 at the earliest. The use of non-GAAP financial measures has certain limitations because they do not reflect all items of income and expense that affect our operations. We compensate for these limitations by reconciling the non-GAAP financial measures to the most comparable GAAP financial measures. These non-GAAP financial measures should be considered in addition to, not as a substitute for, measures prepared in accordance with GAAP. Further, these non-GAAP measures may differ from the non-GAAP information used by other companies, including peer companies, and therefore comparability may be limited. We encourage investors and others to review our financial information in its entirety and not rely on a single financial measure. Liquidity and Capital Resources As of March 31, 2013, our principal sources of liquidity were our cash and cash equivalents in the amount of $109.4 million, which primarily are invested in money market funds, and our $105 million revolving credit facility with a syndicate of commercial banks. We completed our initial public offering on January 31, 2011 and received proceeds, net of underwriting discounts but before deducting offering expenses, of $81.8 million from the issuance of 5.2 million shares of common stock. Historically, we have principally financed our operations from the issuance of stock, net cash provided by our operating activities and borrowings under our revolving credit facility. Our cash flows from operating activities are significantly affected by our cash-based investments in operations, including working capital, and corporate infrastructure to support our ability to 38 -------------------------------------------------------------------------------- generate revenue and conduct operations through cost of services, product development, sales and marketing and general and administrative activities. Cash used in investing activities has historically been, and is expected to be, impacted significantly by our upfront investments in content and also reflects our ongoing investments in our platform, company infrastructure and equipment for both service offerings, the net sales and purchases of our marketable securities and more recently our investments in gTLD applications. We intend to evolve and continuously improve our content creation and distribution platform and to create new content formats to enhance our content product offerings. In 2012 such changes included increasing our investment in video, long-form content and images and publishing content directed at international markets and in languages other than English, as well as increasing and expanding distribution of our content to our network of customer websites. As we made improvements and assessed the impact of such improvements to our content creation and distribution platform, we reduced the level of our overall investment in media content in 2012 when compared to 2010 and 2011. However, based on our assessment of the results to date, we expect to increase our investment in media content during 2013 compared to 2012. In connection with our gTLD initiative under the New gTLD Program, we incurred formation expenses of $4.3 million through March 31, 2013 and expect to incur up to $5 to $10 million of additional formation expenses in 2013. We also made $18.2 million of capital investment in gTLD applications as of March 31, 2013. The net amount of investment incurred in our pursuit of gTLD operator rights in 2013 could be substantially higher or lower as the New gTLD Program progresses throughout the remainder of the year. Since our inception through March 31, 2013, we have also used significant cash to make strategic acquisitions to further grow our business, including the recent acquisitions of Name.com in December 2012 and Creativebug in March 2013 and those detailed in our 2012 Annual Report on Form 10-K. We may make further acquisitions in the future. We announced a $25 million stock repurchase plan on August 19, 2011, which was further increased on February 8, 2012 to $50 million. Under the plan, the Company was authorized to repurchase up to $50 million of its common stock from time to time in open market purchases or in negotiated transactions. During the three months ended March 31, 2013, we repurchased 0.6 million shares at an average price of $8.65 per share for an aggregate amount of $4.8 million and approximately $19.2 million remains available under the repurchase plan at March 31, 2013. The timing and actual number of shares repurchased will depend on various factors including price, corporate and regulatory requirements, debt covenant requirements, alternative investment opportunities and other market conditions. We entered into a credit agreement (the "Credit Agreement") with a syndicate of commercial banks in August, 2011. The Credit Agreement provides for a $105 million, five year revolving credit facility, with the right (subject to certain conditions) to increase such facility by up to $75 million in the aggregate. The syndicate of commercial banks under the Credit Agreement have no obligation to fund any increase in the size of the facility. The Credit Agreement contains customary events of default and affirmative and negative covenants and restrictions, including certain financial maintenance covenants such as a maximum total net leverage ratio and a minimum fixed charge ratio. As of March 31, 2013, no principal balance was outstanding and approximately $95.6 million was available for borrowing under the Credit Agreement, after deducting the face amount of outstanding standby letters of credit of approximately $9.4 million, and we were in compliance with all covenants. In the future, we may utilize commercial financings, bonds, debentures, lines of credit and term loans with a syndicate of commercial banks or other bank syndicates for general corporate purposes, including acquisitions and investing in our intangible assets, platform and technologies. We expect that our existing cash and cash equivalents, our revolving credit facility and our cash flows from operating activities will be sufficient to fund our operations for at least the next 24 months. However, we may need to raise additional funds through the issuance of equity, equity-related or debt securities or through additional credit facilities to fund our growing operations, invest in new business opportunities and make potential acquisitions. We currently have an effective shelf registration statement on file with the SEC which we may use to offer and sell debt or equity securities with an aggregate offering price not to exceed $100 million. The following table sets forth our major sources and (uses) of cash for each period as set forth below: 39 -------------------------------------------------------------------------------- Three months ended March 31, 2012 2013 (In thousands) Net cash provided by operating activities $ 18,478 $ 26,815 Net cash used in investing activities (7,267 ) (15,770 ) Net cash used in financing activities (1,671 ) (4,564 ) Cash Flow from Operating Activities Three months ended March 31, 2013 Net cash inflows from our operating activities of $26.8 million primarily resulted from improved operating performance. Our net income during the period was $0.7 million, which included non-cash charges of $22.4 million such as depreciation, amortization, stock-based compensation and deferred taxes. The remainder of our sources of net cash flow from operating activities was from changes in our working capital, with positive contribution from increases in deferred revenue and decreases in accounts receivable of $9.8 million, offset by changes in deferred registrations costs and accrued expenses of $6.1 million. The increases in our deferred revenue and deferred registry costs were primarily due to growth in our Registrar service during the period, while the decrease in our accounts receivable was primarily due to timing of collections. The increase in accrued expenses reflects increases in amounts due to certain vendors and our employees resulting from growth in our business. Three months ended March 31, 2012 Net cash inflows from our operating activities of $18.5 million primarily resulted from improved operating performance. Our net loss during the period was $(1.8) million, which included non-cash charges of $22.9 million such as depreciation, amortization, stock-based compensation and deferred taxes. The remainder of our sources of net cash flow from operating activities was from changes in our working capital, including accounts receivable, deposits with registries and deferred revenue of $8.6 million, offset by changes in prepaid expenses and other assets, deferred registrations costs and accounts payable of $11.1 million. The increases in our deferred revenue and deferred registry costs were primarily due to growth in our Registrar service during the period. The increase in accounts payable is reflective of significant amounts due to certain vendors at the close of 2011. Cash Flow from Investing Activities Three months ended March 31, 2012 and 2013 Net cash used in investing activities was $15.8 million and $7.3 million during the three months ended March 31, 2013 and 2012, respectively. Cash used in investing activities during the three months ended March 31, 2013 and 2012 included investments in our intangible assets of $3.9 million and $2.6 million, respectively and investments in our property and equipment of $5.8 million and $4.3 million respectively, which included internally developed software. Net cash outflows from business acquisitions was $6.1 million and $0.2 million during the three months ended March 31, 2013 and 2012, respectively. Cash Flow from Financing Activities Three months ended March 31, 2012 and 2013 Net cash used in financing activities was $4.6 million and $1.7 million during the three months ended March 31, 2013 and 2012, respectively. Cash used in financing activities during the three months ended March 31, 2013 and 2012 was primarily driven by the repurchase of common stock of $4.8 million and $3.0 million, respectively, and payments of withholding tax on net exercise of certain employee stock-based awards of $1.4 million and $0.8 million, respectively. This was offset by proceeds from exercise of stock options and contributions to our ESPP of $1.7 million and $2.1 million during the three months ended March 31, 2013 and 2012, respectively. 40 -------------------------------------------------------------------------------- From time to time, we expect to receive cash from the exercise of employee stock options in our common stock. Proceeds from the exercise of employee stock options will vary from period to period based upon, among other factors, fluctuations in the market value of our common stock relative to the exercise price of such stock options. Off Balance Sheet Arrangements As of March 31, 2013, we did not have any off balance sheet arrangements. Capital Expenditures For the three months ended March 31, 2012 and 2013, we used $4.3 million and $5.8 million in cash to fund capital expenditures to create internally developed software and purchase property and equipment. We currently anticipate making further capital expenditures of between $20 million and $25 million during the remainder of the year ending December 31, 2013. [ Back To TMCnet.com's Homepage ]