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GLOBAL EAGLE ENTERTAINMENT INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Note Regarding Forward-Looking Statements We make forward-looking statements in this Annual Report on Form 10-K and the documents incorporated by reference herein within the meaning of the Securities Litigation Reform Act of 1995. These forward-looking statements relate to expectations or forecasts for future events, including without limitation our earnings, revenues, expenses or other future financial or business performance or strategies, or the impact of legal or regulatory matters on our business, results of operations or financial condition. These statements may be preceded by, followed by or include the words "may," "might," "will," "will likely result," "should," "estimate," "plan," "project," "forecast," "intend," "expect," "anticipate," "believe," "seek," "continue," "target" or similar expressions. These forward-looking statements are based on information available to us as of the date of this Annual Report on Form 10-K and on our current expectations, forecasts and assumptions, and involve substantial risks and uncertainties. Actual results may vary materially from those expressed or implied by the forward looking statements herein due to a variety of factors, including: our ability to integrate our recently acquired businesses, the ability of the combined business to grow, including through acquisitions which we are able to successfully integrate, and the ability of our executive officers to manage growth profitably; the ability of our customer Southwest Airlines to maintain a sponsor for its "TV Flies Free" offering and our ability to replicate this model through other sponsorship alliances; the outcome of any legal proceedings pending or that may be instituted against us, Row 44, AIA, PMG or IFES; changes in laws or regulations that apply to us or our industry; our ability to recognize and timely implement future technologies in the satellite connectivity space, including Ka-band system development and deployment; our ability to deliver end-to-end network performance sufficient to meet increasing airline customer and passenger demand; our ability to obtain and maintain international authorizations to operate our service over the airspace of foreign jurisdictions our customers utilize; our ability to expand our service offerings and deliver on our service roadmap; our ability to timely and cost-effectively identify and license television and media content that passengers will purchase; general economic and technological circumstances in the satellite transponder market, including access to transponder space in capacity limited regions and successful launch of replacement transponder capacity where applicable; our ability to obtain and maintain licenses for content used on legacy installed in-flight entertainment systems; the loss of, or failure to realize benefits from, agreements with our airline partners; the loss of relationships with original equipment manufacturers or dealers; unfavorable economic conditions in the airline industry and economy as a whole; our ability to expand our domestic or international operations, including our ability to grow our business with current and potential future airline partners or successfully partner with satellite service providers, including Hughes Network Systems; our reliance on third-party satellite service providers and equipment and other suppliers, including single source providers and suppliers; the effects of service interruptions or delays, technology failures, material defects or errors in our software, damage to our equipment or geopolitical restrictions; the limited operating history of our connectivity and in-flight television and media products; costs associated with defending pending or future intellectual property infringement actions and other litigation or claims; increases in our projected capital expenditures due to, among other things, unexpected costs incurred in connection with the roll out of our technology roadmap or our international plan of expansion; fluctuation in our operating results; the demand for in-flight broadband Internet access services and market acceptance for our products and services; and other risks and uncertainties set forth herein. We do not undertake any obligation to update forward-looking statements as a result of as a result of new information, future events or developments or otherwise. The following discussion and analysis of our business and results of operations for the twelve months ended December 31, 2013, and our financial conditions at that date, should be read in conjunction with the financial statements and the notes thereto included in Item 15. Exhibits and Financial Statement Schedules. As used herein, "Global Eagle Entertainment," "GEE," "the Company," "our," "we," or "us" and similar terms include Global Eagle Entertainment Inc. and its subsidiaries, unless the context indicates otherwise. Overview of the Company We are a leading full service provider of connectivity and content to the worldwide airline industry. Our principal operations and decision-making functions are located in North America and Europe. We manage and report our businesses in two operating segments: Connectivity and Content. Our operating results are regularly reviewed by our chief operating decision makers by our Connectivity and Content operating segments, principally to make decisions about how we allocate our resources and to measure our segment and consolidated operating performance. We currently generate a majority of our revenue through the licensing of content and the sale of network equipment to airlines, and to a lesser extent through our Wi-Fi and Content services to the airline industry. Our chief operating decision makers regularly review revenue and contribution 36-------------------------------------------------------------------------------- Table of Contents profit on a segment basis, and results of operating expenses and pre-tax income or loss for each of our operating segments in order to gain more depth and understanding of the key business metrics driving our business. Accordingly, we report these segments separately. For the years ended December 31, 2013, 2012 and 2011, we reported revenue of $259.7 million, $69.2 million and $33.6 million, respectively. For the years ended December 31, 2013, 2012 and 2011, our Content operating segment accounted for 70%, 0% and 0% of our total revenue, respectively, and our Connectivity operating segment accounted for 30%, 100% and 100%, respectively. For the years ended December 31, 2013, 2012, and 2011, one airline customer, Southwest Airlines, accounted for 22%, 85% and 62% of our consolidated revenues, respectively. 2013 Transactions On January 31, 2013, we completed a business combination transaction (the "Business Combination") in which we acquired all of the outstanding capital stock of Row 44 and 86% of the shares of AIA. We currently own approximately 94% of the shares of AIA, and expect to acquire the remaining 6% of the shares of AIA in the first half of 2014. We expect to pay between $15.0 million to $20.0 million to acquire these remaining outstanding shares. On July 9, 2013, we acquired PMG for approximately $10.6 million in a cash, 431,734 shares of common stock and assumption of $3.3 million of debt, subject to an earnout as more fully described in Note 3. Business Combinations, to our consolidated financial statements included in Item 15. Exhibits and Financial Statement Schedules. PMG is a premier provider of digital media production and post-production services. PMG's operations, which include AMP International, Ambient, Criterion Pictures and Sea Movies, provide video production, post-production and digital content delivery services spanning television shows, feature films, commercials, home video and live news broadcasts, as well as multi-language media for use in in-flight and cruise line entertainment systems. PMG serves Hollywood studios and distributors, advertising agencies, major corporations, federal and local government entities, airlines and cruise lines worldwide. On October 18, 2013, we acquired the U.K.-based parent of IFES for approximately $36 million in cash. IFES is a leading provider of in-flight entertainment services to airlines and cruise lines worldwide. IFES supplies a full range of services to enable its clients to provide a first class entertainment experience to passengers, including movies, television programs, audio, games, 3D maps, safety and destination films, portable entertainment systems, onboard publications and audio- and video-on-demand technical support and management. We financed the acquisition of IFES through the issuance of a convertible note which we subsequently repaid and the issuance of common stock as more fully described below. Basis of Presentation This analysis is presented on a consolidated basis. In addition, a brief description is provided of significant transactions and events that have an impact on the comparability of the results being analyzed. Due to our specific situation, the presented financial information for the year ended December 31, 2013 is only partially comparable to the financial information for the years ended December 31, 2012 and 2011. Since Row 44 was deemed the accounting acquirer in the Business Combination consummated on January 31, 2013, the presented financial information for the years ended December 31, 2012 and 2011 reflects the financial information and activities of Row 44 only. The presented financial information for the year ended December 31, 2013 includes the financial information and activities of Row 44 for the period January 1, 2013 to December 31, 2013 (365 days) as well as the financial information and activities of GEE and AIA for the period January 31, 2013 to December 31, 2013 (335 days), PMG for the period July 10, 2013 to December 31, 2013 (174 days) and IFES for the period October 18, 2013 to December 31, 2013 (74 days). This lack of comparability needs to be taken into account when reading the discussion and analysis of our results of operations and cash flows. Furthermore, the presented financial information for the year ended December 31, 2013 also contains other one-time costs that are directly associated with the Business Combination such as professional fees to support the Company's new and complex legal, tax, statutory and reporting requirements following the Business Combination. Opportunities, Challenges and Risks For the year ended December 31, 2013, we derived the majority of our revenue through the licensing of content in connection with our Content offerings, and secondarily from equipment and Wi-Fi Internet service from our Connectivity operating segment. Historically and for the year ended December 31, 2013, the vast majority of our equipment and Wi-Fi Internet service revenues were generated by two airlines, Southwest Airlines and Norwegian Airlines. For the years ended December 31, 2013, 2012 and 2011, these airlines accounted for substantially all of our Connectivity revenue. 37-------------------------------------------------------------------------------- Table of Contents We believe our operating results and performance are driven by various factors that affect the commercial airline industry, including general macroeconomic trends affecting the travel industry, trends affecting our target user base, regulatory changes, competition and the rate of passenger adoption of our services, as well as factors that affect Wi-Fi Internet service providers in general. Growth in our Content and Connectivity operating segments is principally dependent upon the number of airlines that implement our services, our ability to negotiate favorable economic terms with our customers and partners, and the number of passengers who use our services. Growth in our margins is dependent on our ability to manage the costs associated with implementing and operating our services, including the costs of licensing and distributing content, equipment and satellite service. Our ability to attract and retain new and existing customers will be highly dependent on our abilities to implement our services on a timely basis and continually improve our network and operations as technology changes and as we experience increased network capacity constraints as we continue to grow. As technology continues to evolve, we believe that there are opportunities to expand our services by adding more content in a greater variety of formats. Currently, our Content and Connectivity operating segments are separate platforms; however, we believe there is an opportunity to diversify our revenue long-term by cross leveraging these services, including offering a greater variety of premium paid content across our Connectivity platform. For example, we acquired AIA (we currently own 94%), and more recently PMG and IFES, to accelerate our paid premium content opportunity. In addition, we expect to realize significant cost savings as we integrate the operations of Row 44, AIA, PMG, and IFES during the second half of 2014. Conversely, the evolution of technology presents an inherent risk to our Content and Connectivity operating segments. Today, our Connectivity platform utilizes leading satellite Ku-band systems and equipment; however, and with the introduction and evolution of more competitive technologies such as GSM and Ka-band satellite solutions, our current technology may become obsolete, too expensive and or outdated. As a result, we may lose customers to our competitors who offer more technologically evolved and or less costly connectivity systems in the future. In addition, the future growth in our Content operating segment relies heavily on our airline customers continuing to utilize onboard in-flight entertainment ("IFE") systems for their passengers to watch media content. With the emergence and increased use of hand-held personal devices by airline passengers, our airline customers may decide to decrease the media content onboard IFE systems, and or discontinue the use of IFE systems indefinitely. This would adversely impact the future growth of our Content operating segment. As of December 31, 2013, we owned approximately 94% of AIA. Shares of AIA's capital stock not owned by us are listed in the Regulated Market ("General Standard") of the Frankfurt Stock Exchange. During the third quarter of 2013, we commenced the process to acquire the remaining non-controlling AIA shareholder interests. In February 2014, AIA's shareholders approved a resolution to transfer all non-controlling AIA shareholder interests to us in exchange for specified cash compensation to be paid in the first half of 2014. We expect to pay between $15.0 million to $20 million to acquire these non-controlling AIA shareholder interests. In addition, following the acquisition of these remaining outstanding shares, we expect to incur significant professional fees and personnel costs to integrate the operations of AIA during the second half of 2014. We are significantly dependent on certain key suppliers. The Connectivity operating segment purchases its satellite bandwidth from a single supplier, TECOM, which also provides us with certain equipment and servers required to deliver the satellite stream, rack space at the supplier's data centers to house the equipment and servers and network operations service support. We also purchase radomes, satellite antenna systems and rings from single suppliers. Any interruption in supply from these significant vendors could have a material impact on our ability to provide connectivity services to airline customers. Our consolidated cost of sales, 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 equipment and service revenues we generate. In the near term, we expect that the period-over-period growth in our Connectivity revenue will exceed the growth in our Content revenue, which typically provides for lower operating margins. However, we do expect that our costs of sales as a percentage of our revenue will continue to improve through the first half of 2014 compared to same period in 2013 largely due to the expected growth of our Connectivity services revenue. In July 2013, our customer Southwest Airlines announced "TV Flies Free" under which Southwest passengers using Internet-ready personal devices have free access to live television and up to 75 on-demand shows on the airline's more than 400 Wi-Fi-enabled aircraft powered by us. TV Flies Free initially is being sponsored by DISH Network Corporation, through 2014, with a possible extension through 2015. A significant amount of the revenue we generate from the TV Flies Free program is indirectly provided by the program's sponsor. Should sponsorship revenue not be available to Southwest Airlines from DISH or another third party, Southwest Airlines is under no contractual obligation to offer free access to live television and on-demand shows to its passengers. As a result, there can be no assurance that we will continue to receive the same level of revenues from Southwest Airlines, and Connectivity service revenue in future periods may fluctuate accordingly. In connection with our Business Combination in the first quarter of 2013, we assumed approximately $22.0 million of accrued expense obligations and incurred an incremental $12.0 million in one-time fees associated with the transaction. We 38-------------------------------------------------------------------------------- Table of Contents incurred approximately $3.5 million of additional operating expenses in the fourth quarter of 2013 related to the addition of personnel, professional fees and systems to build our infrastructure to support our public company compliance and certain corporate alignment initiatives in the latter half of 2013. We believe that factors such as these will continue to constrain our operating margin growth in the short-term as we increase our investment in new business initiatives, such as our recent acquisitions of PMG and IFES, to support future growth. For the year ended December 31, 2013, a substantial amount of our Connectivity revenue was derived from airlines located in the United States. While our Connectivity revenue is primarily generated through airlines based in the United States today, we believe that there is an opportunity in the longer term for us to significantly expand our Connectivity operating segment's service offerings to airlines based in countries outside of the United States. More recently, we began installing our Connectivity services on two airlines based in Russia. In 2013, we announced a partnership with China Telecom Communications Co., LTD to jointly work to expand our Connectivity services within the People's Republic of China. We plan to further expand our Connectivity operations internationally to address this opportunity. As we expand our business internationally, we may incur additional expenses associated with this growth initiative. Key Components of Consolidated Statements of Operations The following briefly describes certain key components of revenue and expenses as presented in our consolidated statements of operations. Revenue Our revenue is derived from our Connectivity and Content operating segments. Connectivity Segment We currently generate our Connectivity revenue through the sale of equipment and through our Wi-Fi Internet and related service offerings. Our equipment revenue is based on the sale and corresponding support of Row 44's connectivity equipment to its commercial airline customers. Our service revenue is based on the fees paid by airlines and/or airline passengers for the delivery of in-flight services, such as Internet access and live television, and to a lesser extent from revenue sharing arrangements with commercial airlines for Internet based services used by their passengers, such as shopping. Where we enter into revenue sharing arrangements with our customers, and we act as the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record the revenue-sharing payments to our customers in costs of sales. In determining whether to report revenue gross for the amount of fees received from our customers, we assess whether we maintain the principal relationship, bear credit risk and have latitude in establishing prices with the airlines. Included in our Connectivity service revenue are periodic service level credits, which vary from airline to airline and are based on the contracted service levels we provide over any given period. Content Segment A significant amount of our Content revenue is generated from licensing of acquired and third party media content, video and music programming, applications, and video games to the airline industry, and secondarily from services ranging from selection, purchase, production, customer support and technical adjustment of content in connection with the integration and servicing of in-flight entertainment programs. Our Content licensing revenue is based upon individual licensing agreements with the airlines to deliver and air content over specified terms. Content services revenue, such as technical services, the encoding of video products, development of graphical interfaces or the provision of materials, is priced on specific services contracted for and recognized as services are performed. Operating Expenses Operating expenses consist of cost of sales, 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. Cost of Sales 39-------------------------------------------------------------------------------- Table of Contents Connectivity Segment Cost of Sales Connectivity segment cost of sales consists of the costs of our equipment and services. Equipment. Equipment costs of sales are substantially comprised of the costs paid to procure our equipment for services. Equipment costs are principally comprised of the costs we pay to third parties to facilitate our equipment orders, and are originally classified as inventory on our balance sheet upon receipt of goods. Upon sale, equipment costs of sales are recorded when title and risk of loss pass to the customer, which is aligned with our equipment revenue recognition. As we near the completion of equipping the Southwest airline fleet for our services, we expect that equipment costs of sales will continue to decline in the near term as compared to 2012. Services. Service costs of sales principally consist of the costs of satellite service and support, revenue recognized by us and shared with others as a result of our 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 platform; and personnel costs related to our network operations, customer service and information technology. As we continue to build out our Connectivity services platform and expand our satellite coverage globally, we anticipate that our service costs will increase when compared to historical periods. Our services cost of sales are dependent on a number of factors, including the amount of satellite coverage and bandwidth required to operate our services and the number of partners we share our corresponding revenue with. Content Segment Cost of Sales Content segment cost of sales principally consists of licensing fees paid to acquire content rights for the airline industry, and to a lesser extent service and personnel costs to support our Content business. 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 businesses, including expenses required to support the expansion of our direct 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 businesses. Product Development Product development expenses consist primarily of expenses incurred in our software engineering, product development and web portal 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 Connectivity segment platform and network operations. 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 2013. 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, accounting audit and information technology consulting. For the years ended December 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. During the first quarter of 2013, we incurred approximately $12.0 million in one-time professional fees associated with the Business Combination. For the second half of 2013, we experienced increased personnel costs and professional fees related to merger and acquisition activities, including the acquisitions of PMG and IFES in July and October 2013, respectively, our efforts to support public company compliance and efforts to create synergies between our businesses. As we continue to expand our business, we anticipate general and administrative expenses will increase at a higher rate than our projected revenue growth in the near term when compared to historical periods. Amortization of Intangibles 40-------------------------------------------------------------------------------- Table of Contents 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 increase identifiable intangible assets acquired in the PMG and IFES acquisitions in the second half of 2013. Amortization as a percentage of revenue will depend upon a variety of factors, such as the amounts and mix of our 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 costs of sales, sales and marketing, product development and general and administrative expenses as necessary. Stock-based compensation expense is largely comprised of costs associated with stock options granted to employees and certain non-employees. 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 December 31, 2013, we had approximately $19.7 million of unrecognized employee related stock-based compensation, net of estimated forfeitures, which we expect to recognize over a weighted average period of approximately 3.03 years. Stock-based compensation expense is expected to increase throughout 2014 as compared to 2013 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. Other Income (Expense) Other income (expense) principally consists of changes in the fair value of our derivative financial instruments, interest on outstanding debt associated with our foreign notes payable and interest income on interest earned on cash balances and short-term investments and certain unrealized transaction gains and losses on foreign currency denominated assets and liabilities. We typically invest our available cash balances in money market funds and short-term United States Treasury obligations. We expect our transaction gains and losses will vary depending upon movements in underlying currency exchange rates, and could become more significant with the acquisitions of AIA and IFES in 2013. Provision for Income Taxes Since our inception, we have been subject to income taxes principally in the United States, and more recently with the acquisition of AIA in January 2013, PMG in July 2013, and IFES in October 2013, in other countries where we have a legal presence, including Germany, the United Kingdom, the Netherlands, Canada, China, India, Hong Kong and the United Arab Emirates. We anticipate that as we continue to 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. 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 some of our deferred tax assets will not be realized, and accordingly we have recorded a valuation allowance against certain of our federal, state and foreign deferred tax assets. As of December 31, 2013 and 2012, we had approximately $102.2 million and $81.0 million of federal and $58.9 million and $54.2 million, respectively, of state operating loss carry-forwards available to offset future taxable income which expire in varying amounts beginning in 2026 for federal and 2014 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 expect the utilization of our net operating loss and tax credit carry-forwards in the near term to be affected by certain limitations placed on these carry-forwards as a result of our previous ownership changes with PAR Capital. 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 41-------------------------------------------------------------------------------- Table of Contents 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, derivative financial instruments, 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. Revenue Recognition We recognize revenue when four basic criteria are met: persuasive evidence of a sales arrangement exists; performance of services has occurred; the sales price is fixed or determinable; and collectability is reasonably assured. We consider persuasive evidence of a sales arrangement to be the receipt of a signed contract. Collectability is assessed based on a number of factors, including transaction history and the credit worthiness of a customer. If it is determined that collection is not reasonably assured, revenue is not recognized until collection becomes reasonably assured, which is generally upon receipt of cash. We record cash received in advance of revenue recognition as deferred revenue. We have determined, among other criteria, that we are the primary obligor in the fulfillment of our Connectivity and Content services. As a result, we report revenue on a gross basis in our consolidated statements of operations for both segments. Connectivity Equipment Revenue Connectivity equipment revenue is generated as title and risk of our equipment sales pass to our customers, which is generally upon shipment or arrival at destination depending on the contractual arrangement with the customer. In determining whether an arrangement exists, we ensure that a binding arrangement is in place, such as a standard purchase order or a fully executed customer-specific agreement. In cases where a customer has the contractual ability to accept or return equipment within a specific time frame, we will provide for return reserves when and if necessary, based upon historical experience. Connectivity Service Revenue Our Connectivity service revenue includes in-flight Wi-Fi Internet services, live television, on-demand content, shopping and travel-related information. Service revenue is recognized after it has been rendered and the customer can use the service, which is in the form of (i) enplanement for boarded passengers, (ii) usage by passengers, depending upon the specific contract, and (iii) other revenue such as advertising sponsorship. Content Licensing Revenue Content licensing revenue is principally generated through the sale or license of media content, video and music programming, applications, and video games to airlines, and to a lesser extent, through various services such as encoding and editing of media content. Revenue from the sale or license of content is recognized when the content has been delivered and the contractual performance obligations have been fulfilled, generally at the time a customer's license period begins. Content Services Revenue Content services revenue, such as technical services or the provision of materials, is billed and recognized as services are performed. Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable primarily consist of amounts due from airlines or third parties who we provide services to, including our Connectivity and Content related services, advertising services through our platform and sales of our equipment. Accounts receivable from these providers are recorded when we earn the underlying revenue, and are generally due within 30 to 45 days from the month-end in which the invoice is generated. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables from our customers based on our best estimate of the amount of probable losses from existing accounts receivable. We determine the allowance based on analysis of historical bad debts, advertiser concentrations, advertiser credit-worthiness and current 42-------------------------------------------------------------------------------- Table of Contents economic trends. In addition, past due balances over 90 days and specific other balances are reviewed individually for collectability on at least a quarterly basis. Goodwill Goodwill represents the excess of the cost of an acquired entity over the fair value of the acquired net assets. Beginning in 2013, and in conjunction with the acquisitions of AIA in January 2013, PMG in July 2013, and IFES in October 2013, we perform our annual impairment test of goodwill on October 1st of our fiscal year or when events or circumstances change that would indicate that goodwill might be impaired, including, but not limited to, a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key personnel, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends or significant under-performance relative to expected historical or projected future results of operations. Goodwill is tested for impairment at the reporting unit level, which is one level below or the same as an operating segment. In accordance with amended FASB guidance for goodwill impairment testing, we performed a qualitative assessment for our reporting units which management estimates each have fair values that significantly exceed their respective carrying values. For each reporting unit, we weighed the relative impact of factors that are specific to the reporting unit as well as industry and macroeconomic factors. The reporting unit specific factors that we considered included financial performance and changes to the reporting units' carrying amounts. For each reporting unit, we considered assumptions about sales, operating margins, and growth rates which are based on our forecasts, business plans, economic projections, anticipated future cash flows and marketplace data. We also assessed the impact of macroeconomic factors on the discount rates and growth rates used for the most recent impairment tests, and determine if they would significantly affect the fair value of our reporting units. As of December 31, 2013, the Company concluded that for each of its reporting units, it is more likely than not that the fair value of each reporting unit exceeds its carrying amount and that it was therefore unnecessary to perform any additional impairment tests as of such date. Useful Lives Associated with our Intangible Assets, including Internal Software and Website Development Costs We have capitalized certain identifiable intangible assets acquired in connection with business combinations and we use valuation techniques to value these intangibles assets, with the primary technique being a discounted cash flow analysis. A discounted cash flow analysis requires us to make various judgmental assumptions and estimates including projected revenues, operating costs, growth rates, useful lives and discount rates. Beginning in the first half of 2013, we also began capitalizing our internally developed software and platform development costs during their development phase. We amortize our intangible assets acquired through business combinations on a straight-line basis over the period in which the underlying economic benefits are expected to be realized. Internally developed software and website development costs are depreciated on a straight-line basis over their estimated useful life, which is generally no greater than three years. 43-------------------------------------------------------------------------------- Table of Contents Recoverability of Long-lived Assets We evaluate the recoverability of our intangible assets, and other long-lived assets with finite useful lives for impairment when events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. These trigger events or changes in circumstances include, but are not limited to a significant decrease in the market price of a long-lived asset, a significant adverse change in the extent or manner in which a long-lived asset is being used, significant adverse changes in legal factors, including changes that could result from our inability to renew or replace material agreements with certain of our partners such as Southwest on favorable terms, significant adverse changes in the business climate including changes which may result from adverse shifts in technology in our industry and the impact of competition, a significant adverse deterioration in the amount of revenue or cash flows we expect to generate from an asset group, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or development of a long-lived asset, current or future operating or cash flow losses that demonstrate continuing losses associated with the use of our long-lived asset, or a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. We perform impairment testing at the asset group level that represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. In making this determination, we consider the specific operating characteristics of the relevant long-lived assets, including (i) the nature of the direct and any indirect revenues generated by the assets; (ii) the interdependency of the revenues generated by the assets; and (iii) the nature and extent of any shared costs necessary to operate the assets in their intended use. An impairment test would be performed when the estimated undiscounted future cash flows expected to result from the use of the asset group is less than its carrying amount. Impairment is measured by assessing the usefulness of an asset by comparing its carrying value to its fair value. If an asset is considered impaired, the impairment loss is measured as the amount by which the carrying value of the asset group exceeds its estimated fair value. Fair value is determined based upon estimated discounted future cash flows. The key estimates applied when preparing cash flow projections relate to revenue, operating margins, economic lives of assets, overheads, taxation and discount rates. To date, we have not recognized any such impairment loss associated with our long-lived assets. Income Taxes We account for our income taxes using the liability and asset method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or in our tax returns. In estimating future tax consequences, generally all expected future events other than enactments or changes in the tax law or rates are considered. Deferred income taxes are recognized for differences between financial reporting and tax bases of assets and liabilities at the enacted statutory tax rates in effect for the years in which the temporary differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate the realizability of our deferred tax assets and valuation allowances are provided when necessary to reduce deferred tax assets to the amounts expected to be realized. We operate in various tax jurisdictions and are subject to audit by various tax authorities. We provide tax contingencies whenever it is deemed probable that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon their technical merits, and relevant tax law and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax contingencies. We recognize a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. We recognize interest and penalties accrued related to unrecognized tax benefits in our income tax (benefit) provision in our statements of operations. We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed in subsequent years. Adjustments based on filed returns are recorded when identified. The amount of income taxes we pay is subject to ongoing audits by federal, state and foreign tax authorities. Our estimate of the potential outcome of any uncertain tax issue is subject to management's assessment of relevant risks, facts, and circumstances existing at that time. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. 44-------------------------------------------------------------------------------- Table of Contents Derivative Financial Instruments Derivative financial instruments include certain warrants to purchase shares of our stock that are accounted for on a fair value basis. Embedded derivative instruments subject to bifurcation are also accounted for on a fair value basis. The period to period change in fair value of derivatives is recorded through earnings. Cash flows from embedded derivatives subject to bifurcation are reported consistently with the host contracts within the statements of cash flows. Cash flows from other derivatives are reported in cash flows from investing activities within the statements of cash flows. The Company sometimes uses derivative financial instruments such as interest rate swaps to hedge interest rate risks. These derivatives are recognized at fair value on the transaction date and subsequently remeasured at fair value. Derivatives are measured as financial assets when their fair value is positive and as financial liabilities when their fair value is negative. Gains or losses on changes in the fair value of derivatives are recognized immediately in the statement of operations as a component of other income (expense). Stock-based Compensation We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on the grant date fair values of the awards. For stock option awards to employees with service and/or performance based vesting conditions, the fair value is estimated using the Black-Scholes option pricing model. The value of an award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statements of operations. We elected to treat share-based payment awards, other than performance awards, with graded vesting schedules and time-based service conditions as a single award and recognize stock-based compensation expense on a straight-line basis (net of estimated forfeitures) over the requisite service period. Stock-based compensation expenses are classified in the statement of operations based on the department to which the related employee reports. Our stock-based awards are comprised principally of stock options. We account for stock options issued to non-employees in accordance with the guidance for equity-based payments to non-employees. Stock option awards to non-employees are accounted for at fair value using the Black-Scholes option pricing model. Our management believes that the fair value of stock options is more reliably measured than the fair value of the services received. The fair value of the unvested portion of the options granted to non-employees is re-measured each period. The resulting increase in value, if any, is recognized as expense during the period the related services are rendered. The Black-Scholes option pricing model requires management to make assumptions and to apply judgment in determining the fair value of our awards. The most significant assumptions and judgments include estimating the fair value of our underlying stock, the expected volatility and the expected term of the award. In addition, the recognition of stock-based compensation expense is impacted by estimated forfeiture rates. Because the accounting acquirer's common stock was not publicly traded prior to February 1, 2013, we estimated the expected volatility of our awards from the historical volatility of selected public companies within the technology and media industries with comparable characteristics to us, including similarity in size, lines of business, market capitalization, revenue and financial leverage. From our inception through December 31, 2013, the weighted average expected life of options was calculated using the simplified method as prescribed under guidance by the SEC. This decision was based on the lack of relevant historical data due to our limited experience and the lack of an active market for our common stock. The risk free interest rate is based on the implied yield currently available on U.S. Treasury issues with terms approximately equal to the expected life of the option. The expected dividend rate is zero based on the fact that we currently have no history or expectation of paying cash dividends on our common stock. The forfeiture rate is established based on the historical average period of time that options were outstanding and adjusted for expected changes in future exercise patterns. 45-------------------------------------------------------------------------------- Table of Contents 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 (in thousands): Year ended December 31, 2013 2012 2011 Revenue $ 259,722 $ 69,210 $ 33,637 Operating expenses: Cost of sales 197,938 76,897 35,947 Sales and marketing expenses 10,330 3,935 3,129 Product development 9,068 2,646 3,392 General and administrative 70,629 14,534 9,552 Amortization of intangible assets 17,281 34 25 Total operating expenses 305,246 98,046 52,045 Loss from operations (45,524 ) (28,836 ) (18,408 ) Other income (expense): Interest income (expense), net (2,417 ) (10,368 ) (233 ) Change in value of derivative financial instruments (63,961 ) (3,576 ) - Other income (expense) (1,000 ) (23 ) (60 ) Total other income (expense) (67,378 ) (13,967 ) (293 ) Loss before income taxes (112,902 ) (42,803 ) (18,701 ) Income tax expense (1,839 ) - - Net loss (114,741 ) (42,803 ) (18,701 ) Net income attributable to non-controlling interests (290 ) - - Net loss attributable to common stockholders $ (115,031 ) $ (42,803 ) $ (18,701 ) Net loss attributable to common stock per share - basic and diluted $ (2.17 ) $ (2.24 ) $ (1.35 ) Weighted average number of common shares outstanding - basic and diluted 53,061 19,148 13,883 The following table provides the depreciation expense included in the above line items (in thousands): Year ended December 31, 2013 2012 2011 Cost of sales $ 1,113 $ - $ - Sales and marketing - - - Product development 71 - - General and administrative 2,719 1,225 834 Total depreciation expense $ 3,903 $ 1,225 $ 834 46-------------------------------------------------------------------------------- Table of Contents The following table provides the stock-based compensation expense included in the above line items (in thousands): Year ended December 31, Stock-based compensation expense: 2013 2012 2011 Cost of sales $ - $ 2 $ 7 Sales and marketing expenses - 2 9 Product development - 3 43 General and administrative 4,536 1,634 34 Total stock-based compensation expense $ 4,536 $ 1,641 $ 93 The following table provides our results of operations, as a percentage of revenue, for the periods presented: Year ended December 31, 2013 2012 2011 Revenue 100 % 100 % 100 % Operating expenses: Cost of sales 76 % 111 % 107 % Sales and marketing expenses 4 % 6 % 9 % Product development 3 % 4 % 10 % General and administrative 27 % 21 % 28 % Amortization of intangible assets 7 % - % - % Total operating expenses 118 % 142 % 155 % Loss from operations (18 )% (42 )% (55 )% Other income (expense), net (26 )% (20 )% (1 )% Loss before income taxes (43 )% (62 )% (56 )% Income tax expense (1 )% - % - % Net loss (44 )% (62 )% (56 )% Preferred stock dividends, accretion on preferred stock & non-controlling interests - % (13 )% (16 )% Net loss attributable to common stockholders (44 )% (62 )% (56 )% 47-------------------------------------------------------------------------------- Table of Contents Operating Segments The following tables set forth our contribution profit for each operating segment in the periods presented (in thousands): Year ended December 31, 2013 2012 2011 Content Connectivity Consolidated Content Connectivity Content Connectivity Revenue: Licensing $ 153,966 - $ 153,966 $ - $ - $ - $ - Service 27,912 51,350 79,262 11,365 - 3,182 Equipment 7 26,487 26,494 - 57,845 - 30,455 Total Revenue 181,885 77,837 259,722 - 69,210 - 33,637 Operating Expenses: Cost of Sales 134,207 63,731 197,938 - 76,897 - 35,947 Contribution Profit 47,678 14,106 61,784 - (7,687 ) - (2,310 ) Other Operating Expenses 107,308 - 21,149 - 16,098 Loss from Operations $ (45,524 ) - $ (28,836 ) - $ (18,408 ) Revenue Connectivity operating segment revenue was as follows (in thousands): Year ended December 31, % Change 2013 2012 2011 2012 to 2013 2011 to 2012 Service revenue $ 51,350 $ 11,365 $ 3,182 352 % 257 % Equipment revenue 26,487 57,845 30,455 (54 )% 90 % Total Revenue Connectivity Segment $ 77,837 $ 69,210 $ 33,637 12 % 106 % Connectivity Service Revenue 2013 compared to 2012. Connectivity service revenue increased $40.0 million, or 352%, to $51.4 million for the year ended December 31, 2013, as compared to $11.4 million for the year ended December 31, 2012. The increase was principally due to the growth in users of our Wi-Fi Internet services on Southwest Airlines, which was driven by a higher number of Southwest planes offering our Connectivity services in 2013 as compared to 2012, coupled with the commencement of the TV Flies Free service on Southwest Airlines in July 2013. 2012 compared to 2011. Connectivity service revenue increased $8.1 million or 257% to $11.4 million for the year ended December 31, 2012, as compared to $3.2 million for the year ended December 31, 2011. The increase was principally due to the growth in users of our Wi-Fi Internet services on Southwest Airlines, which was driven by a higher number of Southwest planes offering our Connectivity services in 2012 as compared to 2011. Connectivity Equipment Revenue 2013 compared to 2012. Connectivity equipment revenue decreased by $31.4 million, or 54%, to $26.5 million for the year ended December 31, 2013, as compared to $57.8 million for the year ended December 31, 2012. The decrease was primarily due to the timing of equipment installations on the Southwest Airlines fleet, which was substantially complete prior 2013. 2012 compared to 2011. Connectivity equipment revenue increased $27.4 million, or 90%, to $57.8 million for the year ended December 31, 2012, as compared to $30.5 million for the year ended December 31, 2011. The increase was primarily due to increased equipment shipments for installations on the Southwest Airlines fleet in 2012 as compared to 2011. 48-------------------------------------------------------------------------------- Table of Contents Content operating segment revenue was as follows (in thousands): Year ended December 31, % Change 2013 2012 2011 2012 to 2013 2011 to 2012 Licensing revenue $ 153,966 $ - $ - - - Service revenue 27,912 - - N/A N/A Equipment revenue 7 - - N/A N/ATotal Revenue Content Segment $ 181,885 $ - $ - N/A N/A Content Licensing Revenue 2013 compared to 2012. Content licensing revenue increased to $154.0 million for the year ended December 31, 2013 compared to $0 for the year ended December 31, 2012. Content licensing revenue is generated from AIA, PMG and IFES, which we acquired on January 31, July 10, and October 18, 2013, respectively, and were not part of our operations in 2012. Content Service Revenue 2013 compared to 2012. Content service revenue increased to $27.9 million for the year ended December 31, 2013 compared to $0 for the year ended December 31, 2012. Content service revenue is generated from AIA, PMG and IFES, which we acquired on January 31, July 10, and October 18, 2013, respectively, and were not part of our operations in 2012. Cost of Sales Connectivity operating segment cost of sales was as follows (in thousands): Year Ended December 31, % Change 2013 2012 2011 2012 to 2013 2011 to 2012 Service cost of sales $ 42,590 $ 22,327 $ 8,089 91 % 176 % Equipment cost of sales 21,141 54,570 27,858 (61 )% 96 % Total Connectivity Cost of Sales $ 63,731 $ 76,897 $ 35,947 (17 )% 114 % 2013 compared to 2012. Connectivity cost of sales decreased $13.2 million, or 17%, to $63.7 million for the year ended December 31, 2013 compared to $76.9 million for the year ended December 31, 2012 due to a $33.4 million decrease in Connectivity equipment cost of sales, offset by a $20.3 million increase in Connectivity service cost of sales. The decrease in equipment cost of sales was principally due to a decline in equipment revenue over the same period as a result of the timing of equipment installations on the Southwest Airlines fleet, which was substantially complete prior to 2013. The increase in service cost of sales was principally due to higher satellite bandwidth costs to support the growth in our Connectivity service revenue during the same period. As a percentage of Connectivity equipment revenue, Connectivity equipment cost of sales was 79.8% during the year ended December 31, 2013 as compared to 94.3% for the year ended December 31, 2012, a decrease of 1,450 basis points. The period over period improvement in contribution margin was primarily due to a higher mix of equipment installations on the Southwest Airline fleet during 2012 as compared to 2013, which were sold at less favorable margins as compared to other airlines. As a percentage of Connectivity service revenue, Connectivity service cost of sales was 82.9% during the year ended December 31, 2013 as compared to 196.5% for the year ended December 31, 2012, an improvement of 11.355 basis points. The period to period improvement in contribution margin was largely due to higher service revenue from Southwest Airlines during the year ended December 31, 2013 versus the year ended December 31, 2012. When compared to 2012, the growth in Connectivity service revenue during 2013 exceeded the increase in certain fixed satellite bandwidth costs over the same period, coupled with the commencement of the TV Flies Free service on Southwest Airlines in 2013. The TV Flies Free service largely utilizes our existing bandwidth and satellite costs, and as a result is highly accretive to our operating results. 2012 compared to 2011. Connectivity cost of sales increased $41.0 million or 114% to $76.9 million for the year ended December 31, 2013 compared to $35.9 million for the year ended December 31, 2012. The increase was due to a $26.7 49-------------------------------------------------------------------------------- Table of Contents million increase in Connectivity equipment cost of sales, coupled with a $14.2 million increase in Connectivity service cost of sales. The increase in Connectivity equipment cost of sales was associated with the corresponding increase in equipment revenue as a result of the timing of equipment installations in 2012 on the Southwest Airlines fleet as compared to 2011. The Connectivity service cost of sales increase was principally a result of higher satellite bandwidth costs to support the growth in our Connectivity service revenue during the same period. As a percentage of Connectivity equipment revenue, Connectivity equipment cost of sales was 94.3% during 2012 as compared to 91.5% during 2011, an increase of 250 basis points. The period over period change in contribution margin was primarily due to higher mix of equipment installations on the Southwest Airline fleet in 2012, as compared to 2011, which were sold at less favorable margins as compared to other airlines. As a percentage of Connectivity service revenue, Connectivity service cost of sales was 196.5% during the year ended December 31, 2012 as compared to 254.2% during the year ended December 31, 2011, a decrease of 5,770 basis points. The period to period improvement was largely due to increased passenger service revenue from Southwest, which exceeded certain fixed satellite bandwidth costs during 2012 as compared to 2011. Content operating segment cost of sales was as follows (in thousands): Year Ended December 31, % Change 2013 2012 2011 2012 to 2013 2011 to 2012 Content Cost of Sales $ 134,207 - - N/A N/A 2013 compared to 2012. Content licensing cost of sales increased to $134.2 million for the year ended December 31, 2013, as compared to $0.0 million for the year ended December 31, 2012. The increase was a result of the acquisitions of AIA, PMG and IFES in 2013. Other Operating Expenses Other operating expenses were as follows (in thousands): Year Ended December 31, % Change 2013 2012 2011 2012 to 2013 2011 to 2012 Sales and marketing expenses $ 10,330 $ 3,935 $ 3,129 163 % 26 % Product development 9,068 2,646 3,392 243 % (22 )% General and administrative 70,631 14,534 9,552 386 % 52 % Amortization of intangible assets $ 17,281 $ 34 $ 25 50,726 % 36 % Sales and Marketing Expenses 2013 compared to 2012. Sales and marketing expenses increased $6.4 million, or 163%, to $10.3 million for the year ended December 31, 2013 as compared to $3.9 million for the year ended December 31, 2012. The increase was largely due to $5.1 million of sales and marketing expenses in the year ended December 31, 2013 associated with the acquisitions of AIA, PMG and IFES in 2013. The remaining increase of $1.2 million was largely due to increased consulting expenses to support the growth in our Connectivity business and the further development of our Wi-Fi Internet portal in 2013. 2012 compared to 2011.Sales and marketing expenses increased $0.8 million, or 26%, to $3.9 million for the year ended December 31, 2012 as compared to $3.1 million for the year ended December 31, 2011. The increase was largely due to increased sales travel in 2012 of $0.4 million to support increased sales efforts in territories such as Russia and Iceland, and $0.4 million in increased sales tradeshow expenses in 2012. Product Development 2013 compared to 2012. Product development expenses increased $6.4 million, or 243%, to $9.1 million for the year ended December 31, 2013 compared to $2.6 million for the year ended December 31, 2012. The increase was largely due to 50-------------------------------------------------------------------------------- Table of Contents $5.7 million of product development expenses in the year ended December 31, 2013 associated with the acquisitions of AIA, PMG, and IFES in 2013. The remaining $0.7 million increase was due to product development consulting associated with new development efforts and increased consulting expenses associated with the deployment of our W-Fi Internet portal in 2013, coupled with increased research and development on new technologies in the Connectivity business in 2013. Offsetting these increases were approximately $1.4 million of internally developed software projects capitalized during 2013 compared to $0 in 2012, offset by certain development expenses reimbursed by clients in 2012 of approximately $0.5 compared to $0 in 2013. 2012 compared to 2011. Product development expenses decreased $0.7 million, or 22%, to $2.6 million for the year ended December 31, 2012 compared to $3.4 million for the year ended December 31, 2012. The decrease was largely due to $0.5 million of development expenses reimbursed by clients in 2012 as compared to $0 in 2011. The remaining decrease of $0.2 million in product development consulting was largely due to increased consulting expenses in 2011 associated with the deployments of STCs on commercial airlines. General and Administrative 2013 compared to 2012. General and administrative costs increased $56.1 million, or 386%, to $70.6 million during the year ended December 31, 2013 compared to $14.5 million for the year ended December 31, 2012. The increase was due in part to $24.3 million of general and administrative expenses from AIA, PMG and IFES, which were acquired in 2013. The remaining increase of $31.8 million was principally due to a one-time backstop fee of $11.9 million paid to PAR Capital in the first quarter of 2013 in connection with Business Combination, an increase of approximately $10.0 million in professional fees principally to support the Business Combination and various public company initiatives in the period, $2.7 million in certain one-time expenses associated with the departures of two executives in the period, approximately $2.0 million increase in personnel-related expenses, and an increase of $5.3 million in stock-based compensation and depreciation expense. 2012 compared to 2011. General and administrative costs increased $4.9 million or 52% to $14.5 million during the year ended December 31, 2012 compared to $9.6 million for the year ended December 31, 2011. The increase was due to Row 44, which experienced increases of $2.4 million in hiring new personnel and related expenses in 2012 and $1.4 million in increased professional fees principally to support the then pending Business Combination and various company initiatives in 2012 as compared to 2011. The remaining increase of $1.1 million was largely due to increases in various corporate initiatives in 2012 as Row 44 began to invest in its infrastructure. Amortization of Intangible Assets 2013 compared to 2012. Amortization expense increased to $17.3 million during the year ended December 31, 2013 as compared to less than $0.1 million for the year ended December 31, 2012. The increase is due to the amortization of acquired intangible assets acquired via the 2013 acquisitions of AIA, PMG and IFES. There were no acquisitions during the year ended December 31, 2012 and 2011, and as a result the year to date amounts in 2012 and 2011 are not comparable to 2013. Total Other Income (Expense) 2013 compared to 2012. Total other income (expense) increased $53.4 million, or 382%, to $67.4 million during the year ended December 31, 2013 as compared to $14.0 million for the year ended December 31, 2012. The increase in the net expense of $60.3 million was principally due to the change in the fair value of the Company's public warrants in 2013, which did not exist until the Business Combination in January 2013, offset by a $7.9 million decrease in interest expense. Interest expense decreased $7.9 million principally due to a substantial reduction of Row 44's interest bearing debt in conjunction with the January 31, 2013 Business Combination, offset by an increase of $1.4 million in interest associated with upfront fees and accrued interest from the $19.0 million PAR note issued in the three months ended December 31, 2013. The remaining change of $1.0 million of other income (net) related to unrealized net losses and gains in foreign exchange rates during the year ended December 31, 2013, which did not exist until the Business Combination in January 2013. 2012 compared to 2011. Total other income (expense) increased $13.7 million, or 4,667%, to $14.0 million during the year ended December 31, 2012 as compared to $0.3 million for the year ended December 31, 2011. The increase was principally due to an increase in Row 44's interest bearing debt in conjunction with its financings in 2012 as compared to 2011. Income Tax Expense 51-------------------------------------------------------------------------------- Table of Contents 2013 compared to 2012. Income tax expense was $1.8 million for the year ended December 31, 2013 compared to $0 for the year ended December 31, 2012. The income tax expense increase was largely due to foreign withholding taxes and income earned in the U.S., Germany, Canada and other foreign jurisdictions. Due to uncertainties in realizing future taxable income in certain U.S. and foreign jurisdictions, the Company had a valuation allowance of $ 50.8 million and $39.1 million at December 31, 2013 and 2012, respectively. Selected Quarterly Financial Data (in thousands) The following unaudited quarterly consolidated statements of operations data for the years ended December 31, 2013 and 2012, have been prepared on a basis consistent with our audited consolidated annual financial statements, and include, in the opinion of management, all normal recurring adjustments necessary for the fair statement of the financial information contained in those statements. The period-to-period comparison of financial results is not necessarily indicative of future results and should be read in conjunction with our audited consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. Quarter ended, September 30 December 31, September December 31, March 31, 2012 June 30, 2012 2012 2012 March 31, 2013 June 30, 2013 30, 2013 2013 Revenue $ 18,507 $ 16,836 $ 19,305 $ 14,562 $ 42,513 $ 62,831 $ 74,518 $ 79,860 Operating expenses: Cost of sales 17,882 18,722 22,264 18,029 35,749 49,820 54,002 58,367 Sales and marketing expenses 1,215 777 1,055 888 2,287 2,399 3,758 1,871 Product development 649 850 758 389 1,337 2,327 2,282 3,122 General and administrative 2,897 3,030 3,176 5,431 24,059 12,745 17,056 16,784 Amortization of intangible assets 6 6 12 10 1,233 3,016 4,221 8,811 Total operating expenses 22,649 23,385 27,265 24,747 64,665 70,307 81,319 88,955 Loss from operations (4,142 ) (6,549 ) (7,960 ) (10,185 ) (22,152 ) (7,476 ) (6,801 ) (9,095 ) Other interest income (expense), net (3,386 ) (7,132 ) 18 131 (176 ) (282 ) (267 ) (1,691 ) Change in fair value of financial instruments - - 248 (3,824 ) (4,615 ) (4,725 ) 2,233 (56,854 ) Other income (expense), net 92 (92 ) (157 ) 135 (44 ) 13 601 (1,571 ) Loss before income taxes (7,436 ) (13,773 ) (7,851 ) (13,743 ) (26,987 ) (12,470 ) (4,234 ) (69,211 ) Income tax expense - - - - (34 ) (559 ) (1,161 ) (85 ) Net loss (7,436 ) (13,773 ) (7,851 ) (13,743 ) (27,021 ) (13,029 ) (5,395 ) (69,296 ) Non-controlling interests - - - - 39 (108 ) (158 ) (63 ) Net loss attributable to common stockholders $ (7,436 ) $ (13,773 ) $ (7,851 ) $ (13,743 ) $ (26,982 ) $ (13,137 ) $ (5,553 ) $ (69,359 ) Basic and Diluted $ (0.50 ) $ (0.86 ) $ (0.35 ) $ (0.59 ) $ (0.61 ) $ (0.24 ) $ (0.10 ) $ (1.19 ) Weighted average common shares basic and diluted 14,873 16,030 22,287 23,403 44,014 54,843 55,166 58,223 Certain prior year amounts have been reclassified to conform to the current period presentation. 52-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Current Financial Condition As of December 31, 2013, our principal sources of liquidity were our cash and cash equivalents in the amount of $258.8 million, which primarily are invested in cash and money market funds in banking institutions in the U.S. and in Europe, and our remaining availability on our unsecured four-year loan from UniCredit Bank AG, Munich, Germany. Excluded from our cash balance at December 31, 2013 is approximately $3.3 million of restricted cash that is attached to letters of credit agreements between our subsidiaries and certain airlines. The vast majority of our cash was from the Business Combination in January 2013 and follow-on offering in December 2013. Historically, Row 44, the accounting acquirer in the Business Combination, principally financed its operations from the issuance of stock, net cash provided by its operating activities and borrowings from shareholders in the form of convertible notes. 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 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 investments in business combinations, our platform, Company infrastructure and equipment for our business offerings, the net sales and purchases of our marketable securities and changes in our derivative financial instruments. We recently invested an aggregate $44.9 million of our cash from July 2013 to October 2013 to acquire PMG and IFES. In the near term, we also expect to continue using significant cash to make additional strategic acquisitions to further grow our business. In connection with the Business Combination, we incurred approximately $3.0 million of additional operating expenses related to the addition of personnel, professional fees and systems to build our infrastructure to support our public company compliance and certain corporate alignment initiatives through the end of 2013. In addition, our use of cash flows from operating activities exceeded our proceeds from operating activities throughout the remainder of 2013, primarily as a result of our efforts to grow our Connectivity business. In the future, our net use of our working capital could be substantially higher or lower depending on the number and timing of new customers that we add to our Connectivity and Content businesses. Subsequent to the Business Combination, we acquired a total of 22.6 million additional shares in AIA, which raised our ownership in AIA from approximately 86% in January 2013 to 94%. Total costs used to complete these share acquisitions was approximately $15.4 million. In addition, we expect to pay between $15.0 million to $20 million to acquire the remaining 6% non-controlling interests in AIA in the first half of 2014. Through September 30, 2013, we (i) sold our interest in Guestlogix for approximately $6.0 million in cash, (ii) purchased an 18% interest in Allegiant Systems for approximately $1.5 million, (iii) spent $0.8 million to retire certain publicly traded warrants, (iv) repurchased approximately 0.1 million shares of our common stock for approximately $1.1 million, and (v) acquired the assets of PMG in exchange for approximately $10.8 million in cash, shares of our common stock and the assumption of approximately $3.3 million in debt. During the three months ended December 31, 2013, we acquired IFES for approximately $36.2 million in cash. We financed the acquisition of IFES through the sale of approximately 2.45 million shares of our common stock to a current stockholder for gross proceeds of approximately $21 million, and the issuance to PAR of a $19 million convertible note. Lastly, in December 2013, we raised gross proceeds (before expenses) of $212.0 million through the issuance of approximately 13.3 million shares of our common stock in a registered follow-on offering. We used a portion of the proceeds of the follow-on offering to repay in full the convertible note we issued to PAR. During the year ended December 31, 2013, the former CEO of AIA, who is also a current Board member, entered into a consulting agreement and mutual general release, which was subsequently amended (as so amended, the "Consulting Agreement"). The Consulting Agreement provides that, among other things, the former executive is entitled to certain remuneration (the "Remuneration Payment"), in exchange for certain releases. In December 2013, the Company paid the executive $2.0 million in cash and 103,977 fully vested shares of common stock (subject to certain limitations) to satisfy the Remuneration Payment under the agreement. The executive also received a stock option grant of 25,000 in September 2013 for his service as a Board member, which vests monthly over two years beginning on the date of grant. During the year ended December 31, 2013, we recorded an expense of approximately $3.5 million associated with the Remuneration Payment obligation. 53-------------------------------------------------------------------------------- Table of Contents 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 and/or issue equity securities (publicly or privately) 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. Sources and Uses of Cash - year ended December 31, 2013 vs. year ended December 31, 2012 The following table presents a summary of our cash flow activity for the periods set forth below (in thousands): Year Ended December 31, 2013 2012 2011 Net cash provided by (used in) operating activities $ (54,145 ) $ (39,280 ) $ (3,995 ) Net cash provided by (used in) investing activities $ 129,840 $ (2,432 ) $ (587 ) Net cash provided by (used in) financing activities $ 181,011 $ 34,990 $ 9,903 Cash Flows Provided/Used by Operating Activities Year ended December 31, 2013 Net cash used from our operating activities of $54.1 million primarily resulted from our net loss during the period of $114.7 million, which included non-cash charges of $94.7 million largely comprised of changes in the fair value of our derivative financial instruments, depreciation and amortization, changes in our deferred income taxes, and stock based compensation. The remainder of our uses of net cash flow from operating activities of $34.1 million was from changes in our working capital, including accounts payable and accrued expenses, prepaid expenses, content and inventory investments, and accounts receivable of approximately $44.6 million. Offsetting these uses of cash from operating activities was a net cash inflow of $10.5 million from an increase in deferred revenue and timing of income taxes payable. The decrease in accounts payable and accrued expenses is reflective of significant amounts of accrued obligations paid as a result of our Business Combination in January 2013, including $11.9 million paid to PAR as a one-time back stop fee. The increase in prepaid expenses, inventory and content purchases were continued investments to support the growth in our Connectivity equipment installations and Content licensing acquisitions, and included an increase in restricted cash attached to certain agreements with our airline partners. The increase in accounts receivable is reflective of the growth in service revenue over the period. Year ended December 31, 2012 Net cash used in our operating activities of $39.2 million primarily resulted from our net loss during the period of $42.8 million, which included non-cash charges of $19.3 million largely comprised of interest on Row 44 convertible promissory notes, changes in the fair value of our derivative financial instruments, depreciation and stock-based compensation. The remainder of our uses of net cash flow from operating activities of $15.6 million was from changes in our working capital, including accounts payable and accrued expenses, accounts receivable, deferred revenue and prepaid expenses of $9.2 million. The increases in prepaid and accounts payable and accrued expenses and prepaid expenses is reflective of significant amounts paid to certain vendors such as Hughes at the close of December 31, 2012. The increase in accounts receivable and decrease in deferred revenue is reflective of the growth in equipment sales and installations of Southwest and Norwegian airlines relative to the timing of billings and cash collections during the year ended December 31, 2012. Year ended December 31, 2011 Net cash used in our operating activities of $4.0 million primarily resulted from our net loss during the period of $18.7 million, which included non-cash charges of $1.4 million largely comprised of depreciation, interest on Row 44 convertible promissory notes and stock-based compensation. Offsetting this were net sources of net cash flow from operating activities from changes in our working capital, including accounts payable and deferred revenue of $14.0 million. The increase in accounts payable and accrued expenses is reflective of the delay in significant amounts paid to certain vendors at the close of December 31, 2011. The increase in deferred revenue is reflective of the growth in equipment sales and installations of 54-------------------------------------------------------------------------------- Table of Contents Southwest and Norwegian airlines relative to the timing of billings and cash collections during the year ended December 31, 2011. Cash Flows Provided/Used by Investing Activities Year ended December 31, 2013 Net cash provided by investing activities of $129.9 million was largely from the Business Combination in January 2013, which resulted in net cash provided from the Row 44 merger of $159.3 million and AIA stock purchase of $22.1 million. In addition we sold our 8.5% interest in Guestlogix for total proceeds of approximately $6.3 million, and cash used in purchases of PMG (for approximately $10.6 million) and IFES (for approximately $34.3 million) during the year ended December 31, 2013. The remaining change in net cash used in investing activities of $11.5 million was largely due to investments in property and equipment of $11.4 million to expand our network operations in Russia and Europe and to support our new "TV Flies Free" product on Southwest Airlines and the build-out of our internal infrastructure, and a $1.5 million equity method investment in Allegiant Systems. Year ended December 31, 2012 Net cash used in investing activities of $2.4 million was largely due to investments in our property and equipment to build out our network operations center during the year ended December 31, 2012. Year ended December 31, 2011 Net cash used in investing activities of $0.1 million was largely due to investments in our property and equipment to build out our network operations center during the year ended December 31, 2011. Cash Flows Provided/Used by Financing Activities Year ended December 31, 2013 Net cash provided by financing activities of $181.0 million was primarily driven by the completion of our follow-on and registered offerings during the three months ended December 31, 2013, where we raised proceeds of $204.0 million, net of approximately $7.1 million in transaction costs. Offsetting this was use of net cash in financing activities of $22.5 million, which was largely due to our acquisition of AIA shares, where we purchased $15.4 million of non-controlling shares of AIA to increase our ownership to 94.07%, $5.6 million in payments of certain debt obligations and $2.0 million in repurchases of our common stock warrants and payments of withholding taxes associated with cashless exercises of stock based awards in conjunction with the Business Combination during the year ended December 31, 2013. Year ended December 31, 2012 Net cash provided by financing activities of $35.0 million was driven by Row 44, which raised proceeds of $35.0 million through the issuance of preferred stock, warrants and notes during the period. Year ended December 31, 2011 Net cash provided by financing activities of $9.9 million was driven by Row 44, which raised proceeds of $10.0 million through the issuance of preferred stock, warrants and notes during the period. Debt Instruments Long-term debt consists of the following at December 31, 2013 and 2012 (in thousands): December 31, 2013 December 31, 2012 Bank loans $ 10,801 $ 38 55-------------------------------------------------------------------------------- Table of Contents The following is a schedule, by year, of future minimum principal payments required under notes payable and bank debt as of December 31, 2013 (in thousands): Years Ending December 31, Amount 2014 $ 9,648 2015 250 2016 112 2017 101 2018 101 Thereafter 589 Total $ 10,801 Bank loan The Company's controlled subsidiary AIA has an unsecured four-year loan of $15.9 million from UniCredit Bank AG, Munich, Germany. The loan is subject to half-yearly repayments of $2.2 million, no prepayment penalties and variable interest based on the six-month Euribor plus 2.35%. In order to avoid exposure to the risk from rising interest rates associated with variable interest obligations, a portion of the variable interest payments was converted into fixed interest obligations by means of interest rate swaps over the term of the loan. Under the terms of the loan agreement, mandatory special loan repayments are agreed under certain conditions. The provision regarding mandatory special loan payments resulted in a special loan payment of $1.4 million during the year ended December 31, 2013. As of December 31, 2013, the carrying amount of the bank loan was approximately $3.5 million. Subordinated bank loan AIA holds a note payable of $2.6 million from mezzanine capital through a financing program from AG, Zug, Switzerland. This financing program matures in March 2014. The interest rate is 8.8% per year. A principal payment of 1% must be made each year and interest of 7.8% on the principal must be paid every quarter. The liability's carrying amount as of December 31, 2013 was $2.9 million. Contractual Obligations The following table summarizes our contractual obligations that require us to make future cash payments as of December 31, 2013. The future contractual requirements include payments required for our operating leases and contractual purchase agreements. 56-------------------------------------------------------------------------------- Table of Contents Less than 1 More than 5 Total year 1-3 years 3-5 years years Contractual Obligations (in thousands): Operating lease obligations $ 9,946 $ 4,042 $ 3,623 $ 763 $ 1,518 MSA with Hughes Network Systems (1) 179,784 37,800 62,428 43,644 35,912 Deferred revenue arrangements (2) 16,998 11,190 2,156 1,926 1,726 UniCredit Bank AG loan 3,488 3,488 - - - Interest on IniCredit Bank loan (3) 55 55 - - - AG Zug note payable 2,909 2,749 149 11 - Interest on AG note payable (3) 62 62 - - - Union Bank loan 3,203 3,203 - - - Interest on Union Bank loan (3) 89 89 - - - Barclay's loan (4) 1,046 51 148 156 691 Interest on Barclay's loan (3) 182 18 49 42 73 Barclay's term loan (4) 154 154 - - - Interest on Barclay's term loan (3) 3 3 - - - Deferred employment obligations (5) 1,754 1,659 95 - - Content and television license fees and guarantees (6) 56,464 20,986 25,051 9,677 750 Equipment purchase commitments (7) 34,970 32,760 2,210 - - Acquisition-related liabilities (8) 800 800 - - - Total $ 311,907 $ 119,109 $ 95,909 $ 56,219 $ 40,670 (1) Amounts represent future satellite cost commitments to Hughes Network Systems over the period January 1, 2014 through December 31, 2020. (2) Amounts represent obligations to provide service for which we have already received cash from our customers. (3) Interest payments were calculated based upon the interest rate in effect at December 31, 2013. See also Note 14. Notes Payable and Bank Debts. (4) Amounts pertain to a mortgage loan assumed for a building acquired in the IFES acquisition. (5) Amounts represent certain contractual employee obligations accrued as of December 31, 2013. The amounts presented above include $1.4 million earn-out liability for EIM, a subsidiary of AIA assumed in the Business Combination, and $0.3 million earn-out liability for PMG executives. (6) Amounts represent minimum guarantees and contractual obligations associated with licensing and providing our content and Internet protocol television services to our customers. (7) Equipment purchase commitments represent purchase commitments for Connectivity equipment inventory. The Company has purchase commitments with various providers of equipment for the Company's connectivity services. As of December 31, 2013, the Company have committed to purchase $35.0 million of future products, of which we expect to purchase approximately $32.8 million and $22.2 million in the year ended December 31, 2014, and 2015, respectively. (8) Acquisition-related liabilities represent $0.8 of purchase consideration held back in conjunction with the PMG acquisition in July 2013. Excluded from the table above is $29.8 million related to our deferred tax liabilities and uncertain tax positions due to the uncertainty of their timing. |