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CREXENDO, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This section and other parts of this Form 10-Q contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future performance and our Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part II, Item 1A, "Risk Factors," which are incorporated herein by reference. The following discussion should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2013 (the "2013 Form 10-K") filed with the SEC and the Condensed Consolidated Financial Statements and notes thereto included in the 2013 Form 10-K and elsewhere in this Form 10-Q. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law. OVERVIEW We are a hosted services company that provides website hosting, hosted telecom services, e-commerce software, website development software, and broadband internet services for businesses and entrepreneurs. Our services are designed to make enterprise-class hosting services available to small, medium-sized and enterprise-sized businesses at affordable monthly rates. The Company has two operating segments, which consist of Hosted Telecom Services and Web Services. Hosted Telecom Services segment - Our hosted telecom services transmit calls using IP or cloud technology, which converts voice signals into digital data packets for transmission over the Internet or cloud. Each of our calling plans provides a number of basic features typically offered by traditional telephone service providers, plus a wide range of enhanced features that we believe offer an attractive value proposition to our customers. This platform enables a user, via a single "identity" or telephone number, to access and utilize services and features regardless of how the user is connected to the Internet or cloud, whether it's from a desktop device or a mobile device. We generate subscription fees from our hosted telecom and broadband Internet services. Our hosted telecom contracts typically have a thirty-six to sixty month term. We generate product revenue and equipment financing revenue from the sale and lease of our hosted telecom equipment. Revenues from the sale of equipment, including those from sales-type leases, are recognized at the time of sale or at the inception of the lease, as appropriate. Web Services segment -We generate website hosting revenue and professional services revenue primarily from search engine optimization services, link building, paid search management services, conversion rate optimization services, and website design and development. These services are typically billed on a fixed price basis or on a monthly recurring basis with an initial term of six to twelve months. During the quarter ended September 30, 2013, the Company made a strategic decision to limit our provision of web services to our enterprise sized customers. OUR SERVICES AND PRODUCTS Our goal is to provide a broad range of Cloud-based products and services that nearly eliminate the cost of a businesses' technology infrastructure and enable businesses of any size to more efficiently run their business. By providing a variety of comprehensive and scalable solutions, we are able to provide these solutions on a monthly basis to businesses and entrepreneurs without the need for expensive capital investments, regardless of where their business is in its lifecycle. Our products and services can be categorized in the following offerings: 21 --------------------------------------------------------------------------------Hosted Website Services - Our website hosting services allows businesses and entrepreneurs to host their websites in our data center for a monthly fee. Hosted Telecom Services - Our hosted telecom service offering includes hardware and software and unified communication solutions for businesses using IP or cloud technology over any high-speed internet connection. These services are rendered through a variety of devices and user interfaces such as a Crexendo branded desktop phones, mobile and desktop applications. Some examples of mobile devices are Android cell phones, iPhones, iPads or Android tablets. These services enable our customers to seamlessly communicate with others through phone calls that originate/terminate on our network or PSTN networks. Our hosted telecom services are powered by our proprietary implementation of standard Internet, Web and IP or cloud technologies. Our services also use our complex infrastructure that we build and manage based on industry standard best practices to achieve greater efficiencies and customer satisfaction. Our infrastructure comprises of computing, storage, network technologies, 3rd party products and vendor relationships. We also develop end user portals for account management, license management, billing and customer support and adopt other cloud technologies through our partnerships. Crexendo's hosted telecom service offers a wide variety of essential and advanced features for small and medium-size businesses. Many of these features included in the service offering are: ? Business Productivity Features such as dial-by extension and name, transfer, conference, call recording, Unlimited calling to anywhere in the US and Canada, International calling, Toll free (Inbound and Outbound) ? Individual Productivity Features such as Caller ID, Call Waiting, Last Call Return, Call Recording, Music-On-Hold, Voicemail, Unified Messaging, Hot-Desking ? Group Productivity Features such as Call Park, Call Pickup, Interactive Voice Response (IVR), Individual and Universal Paging, Corporate Directory, Multi-Party Conferencing, Group Mailboxes ? Call Center Features such as Automated Call Distribution (ACD), Call Monitor, Whisper and Barge, Automatic Call Recording ? Advanced Unified Communication Features such as Find-Me-Follow-Me, Sequential Ring and Simultaneous Ring ? Mobile Features such extension dialing, transfer and conference and seamless hand-off from Wifi to/from 3G and 4G, as well as other data services. These features are also available on CrexMo, an intelligent mobile application for iPhones and Android smartphones, as well as iPads and Android tablets. ? Traditional PBX Features such as Busy Lamp Fields, System Hold. 16-48 Port density Analog Devices ? Expanded Desktop Device Selection such as Entry Level Phone, Executive Desktop, DECT Phone for roaming users ? Advanced Faxing solution such as Cloud Fax (cFax) allowing customers to send and receive Faxes from their Email Clients, Mobile Phones and Desktops without having to use a Fax Machine simply by attaching a file ? Web based online portal to administer, manage and provision the system. Many of these services are available and included in our basic offering to our customers for a monthly recurring fee and do not require a capital expense. Some of the advanced features such as Automatic Call Recording and Call Center Features require additional monthly fees. Crexendo continues to invest and develop its technology and SaaS offerings to make them more competitive and profitable. Search Engine Optimization (SEO) - There are two general aspects to Search Engine Optimization ("SEO"). First, the tactical level, that includes conditioning a website and/or its pages to be relevant and search-engine friendly. Second, we help businesses strategically select keywords and keyword phrases. The popularity of a site plays a role in what keyword phrases a business can compete on versus what keyword phrases might be "out of their league". We focus on the strategic selection of keywords and prioritize keywords that have healthy search volumes and high 'win' capability. Our experience coupled with our software allow us to strategically select the best choices for keyword phrases to target which provide the highest probability of getting high search engine positions and draws maximum traffic to the website. Our SEO packages include a keyword interview, strategic keyword research, baseline ranking report, search engine optimization plan, and comparison ranking report. 22 -------------------------------------------------------------------------------- Link Building - Link building is a critical component of off-page SEO. To be effective, a link building campaign must be done manually. Search engines can detect links obtained via automated submission. Also, links need to come from many different types of sites, not just one or two. Link building is closely related to search engine optimization, as such; we carefully synchronize all our link building efforts and anchor text with our search engine optimization efforts. An effective link building effort is labor intensive, with no real shortcuts. We use a broad based approach for link building that follows search engine webmaster guidelines. We use strategies that include, but aren't limited to: Web 2.0 sites, social media and social bookmarking sites, vertical portals, local directories, live directories, and others. Paid Search Management - We offer paid search management services, such as management of Google® AdWords™, Yahoo and Microsoft Advertising adCenter™ accounts for our customers. Modern paid search networks are incredibly sophisticated and require a tremendous amount of experience and expertise to avoid the many potential pitfalls of paid search. We assist customers by taking a conservative approach to paid search management. By using a combination of proprietary automation tools, split test dedicated landing pages, as well as the practiced eye of an expert monitoring our customer accounts on a daily basis, we are able to consistently raise conversion rates and lower the cost of pay-per-click (PPC) acquisition. Website Design and Development - Using our proprietary software and processes we design and develop websites with "conversion" in mind. The term conversion means different things to different websites. To a lead-generation website, it means getting prospects to submit their contact information so the sales team can contact them. For an e-commerce website, conversion means getting an online customer to complete an order. Our website design packages range from a semi-custom template based design package to a completely custom design package. We incorporate analytics into every website we build. Proper analytics allow identification of weak spots in the conversion process. Once weak spots are identified, the site can be adjusted to smooth out the process and help turn more prospects into customers. Once the site is complete, we provide tutorials and tools to allow customers to make changes to their sites as often as necessary without having to pay additional programming fees. Alternatively, customers can elect to have us manage the changes to their websites for an additional fee. TECHNOLOGY We believe our proprietary implementation of standard Web, IP, Cloud, Mobile and Internet technologies represent a key component of our business model. We believe these technologies and how we deliver them to our customers distinguish our services and products from the services and products offered by our competitors. Our technology infrastructure and virtual network operation center, all of which is built and managed on industry standard computing, storage, data and platforms offers us greater efficiencies. The synergies between Web and Telecommunication protocols such as TCP/IP, HTTP, XML, SIP and innovations in computing, load balancing, redundancy and high availability of Web and Telecommunications technologies offers us a unique advantage in delivering these services to our customers seamlessly from our data center. Our Hosted Telecom technology is continuously being enhanced with additional features and software functionality. Our current functionality includes: ? High-end desktop telephony devices such as Gigabit, PoE, 6 Line Color Phone with 10 programmable buttons and lower end Monochrome 2 Line wall mountable device ? Basic Business Telephony Features such as those offered in a traditional private branch exchange ("PBX") systems like extension dialing, Direct Inward Dialing (DID), Hold/Resume, Music-On-Hold, Call Transfer (Attended and Unattended), Conferencing, Local, Long Distance, Toll-Free and International Dialing, Voicemail, Auto-Attendant and traditional faxing 23--------------------------------------------------------------------------------? Advanced telephony features such as Call Park, Call Pickup, Paging (through the phones), Overhead paging, Call Recording ? Call Center Functionality such as Agent Log In/Log Out, Whisper, Barge and Call center reporting ? Unified Communications features like Simultaneous Ring, Sequential Ring, Status based Routing (Find-Me-Follow-Me), 10-party instant conference, and Mobile application (CrexMo) ? Crexendo Mobile Application (CrexMo), which allows users to place and receive extension calls using Crexendo's network, transfer and conference other users right from their mobile device as if they were in the office. It also provided users instant access to visual voicemail and call logs ? End User Portal and Unified Messaging with Voicemail, Call Recording and eFax inbox. Our web software platform is continuously being enhanced and is an innovative website-building environment. Features and functions of our software include: ? during website development, our customers can experience the look and feel of their websites as if they were their own customers. They can shop, navigate, order products, track orders, and more. If they want to change or add more elements, they can edit, rearrange, add, and delete the elements all within a dynamic, point-and-click environment; ? designs that are customized based on the customers' choices and arrangements. Customers can modify the look and feel of the design to complement their services or products. In addition, design modification and arrangement are executed within a streamlined, point-and-click environment; ? blogs, online journals, message boards, and forums that are easily integrated into the content of the website. As administrators, the customers have full control in terms of filtering content, allowing images, and other blog, message board, and forum permissions; ? customizable forms that address customer-specific needs. By using customized forms, our customers can set up secure, encrypted forms with improved ease to collect sensitive information from their customers. This is especially useful for service-based businesses, as these forms can be used for job, loan, applications, questionnaires, bids, quotes, lead generation, etc.; ? advanced out of the box eCommerce features include: shopping cart, ordering rules setup for shipping, sales tax, discount codes, UPS integration, inventory control system, gift certificate and gift card purchasing and redemption, integration with Amazon® Checkout and/or Google® Checkout, Google® Base integration, eBay® auctions integration, shopping cart supporting multiple currencies and price sets, automatic sitemap generation used by search engines, and advanced website product search using filters to quickly narrow down the product offering based on product attributes. We continue to invest and develop on our Web platform to make it more easy-to-use, enable larger mobile and 3rd party integration features thus enabling our web customers to drive more traffic to their web-sites. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in our accounting policies described in Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2013 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. Our senior management has reviewed the development and selection of our critical accounting policies and estimates and their disclosure in this Form 10-Q with the Audit Committee of our Board of Directors. 24--------------------------------------------------------------------------------RESULTS OF OPERATIONS The following discussion of financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes thereto and other financial information included elsewhere in this Form 10-Q. Results of Consolidated Operations (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Revenue $ 1,808 $ 2,737 $ 3,880 $ 5,759 Loss before income taxes (1,481 ) (1,096 ) (3,079 ) (1,731 ) Income tax benefit (provision) (13 ) 26 (47 ) 263 Net loss (1,494 ) (1,070 ) (3,126 ) (1,468 ) Basic net (loss) per share $ (0.13 ) $ (0.10 ) $ (0.28 ) $ (0.14 ) Diluted net (loss) per share $ (0.13 ) $ (0.10 ) $ (0.28 ) $ (0.14 ) Three months ended June 30, 2014 compared to three months ended June 30, 2013 Revenue Total revenue decreased 34% or $929,000, to $1,808,000 for the three months ended June 30, 2014 as compared to $2,737,000 for the three months ended June 30, 2013. Hosted Telecom Services segment revenue increased 96% or $472,000, to $963,000 for the three months ended June 30, 2014 as compared to $491,000 for the three months ended June 30, 2013. Web Services segment revenue decreased 62% or $1,401,000, to $845,000 for the three months ended June 30, 2014 as compared to $2,246,000 for the three months ended June 30, 2013. Loss Before Income Taxes Loss before income tax increased $385,000, to $1,481,000 for the three months ended June 30, 2014 as compared to loss before income tax of $1,096,000 for the three months ended June 30, 2013. Revenue decreased 34% or $929,000, to $1,808,000 for the three months ended June 30, 2014 as compared to $2,737,000 for the three months ending June 30, 2013. Total operating expenses decreased 15% or $582,000, to $3,371,000 for the three months ended June 30, 2014 as compared to $3,953,000 for the three months ended June 30, 2013. Income Tax Provision Our effective tax rate for the three months ended June 30, 2014 was (0.9)%, which resulted in a provision for income taxes of $13,000. Our effective tax rate for the three months ended June 30, 2013 was 2.4%, which resulted in a benefit for income taxes of $26,000. 25 --------------------------------------------------------------------------------Six months ended June 30, 2014 compared to six months ended June 30, 2013 Revenue Total revenue decreased 33% or $1,879,000, to $3,880,000 for the six months ended June 30, 2014 as compared to $5,759,000 for the six months ended June 30, 2013. Hosted Telecom Services segment revenue increased 119% or $1,042,000, to $1,918,000 for the six months ended June 30, 2014 as compared to $876,000 for the six months ended June 30, 2013. Web Services segment revenue decreased 60% or $2,291,000, to $1,962,000 for the six months ended June 30, 2014 as compared to $4,883,000 for the six months ended June 30, 2013. Loss Before Income Taxes Loss before income tax increased $1,348,000, to $3,079,000 for the six months ended June 30, 2014 as compared to loss before income tax of $1,731,000 for the six months ended June 30, 2013. Revenue decreased 33% or $1,879,000, to $3,880,000 for the six months ended June 30, 2014 as compared to $5,759,000 for the six months ending June 30, 2013. Total operating expenses decreased 9% or $704,000, to $7,118,000 for the six months ended June 30, 2014 as compared to $7,822,000 for the six months ended June 30, 2013. Income Tax Provision Our effective tax rate for the six months ended June 30, 2014 was (1.5)%, which resulted in a provision for income taxes of $47,000. Our effective tax rate for the six months ended June 30, 2013 was 16%, which resulted in a benefit for income taxes of $263,000. Segment Operating Results The Company has two operating segments, which consist of Hosted Telecom Services and Web Services. Effective April 1, 2014, the Company changed its reporting segments to reflect changes in how the Chief Operating Decision Maker (CODM) internally measures performance and allocates resources. Segment operating results for the three and six months ended June 30, 2013 have been modified to conform to current segment operating results presentations. The information below is organized in accordance with our two reportable segments. Segment operating income (loss) is equal to segment net revenue less segment cost of revenue, sales and marketing, and general and administrative expenses. Operating Results of our Hosted Telecom Services segment (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Hosted Telecom Services Revenue $ 963 $ 491 $ 1,918 $ 876 Operating expenses: Cost of revenue 708 498 1,371 946 Research and development 258 248 506 539 Selling and marketing 488 490 1,106 1,012 General and administrative 885 506 1,822 864 Operating loss (1,376 ) (1,251 ) (2,887 ) (2,485 ) Other Income 21 - 41 3 Loss before taxes $ (1,355 ) $ (1,251 ) $ (2,846 ) $ (2,482 ) 26--------------------------------------------------------------------------------Three months ended June 30, 2014 compared to three months ended June 30, 2013 Revenue Hosted Telecom Services segment revenue increased 96% or $472,000, to $963,000 for the three months ended June 30, 2014 as compared to $491,000 for the three months ended June 30, 2013. Interest income associated with the sales-type leases increased 203% or $73,000, to $109,000 for the three months ended June 30, 2014 as compared to $36,000 for the three months ended June 30, 2013. Revenue from recurring and one-time services increased 107% or $349,000 to $675,000 for the three months ended June 30, 2014 as compared to $326,000 for the three months ended June 30, 2013. A substantial portion of Hosted Telecom Services segment revenue is generated through thirty-six to sixty month service contracts. As such, we believe growth in Hosted Telecom Services segment will initially be seen through increases in our backlog. Backlog represents contracts signed with no service or payment provided at June 30, 2014 and 2013. During the three months ended June 30, 2014, the Company added $588,000 in backlog in connection with the OSV acquisition (Note 9). Below is a table which displays the Hosted Telecom Services segment revenue backlog as of March 31, 2013 and 2014, and June 30, 2013 and 2014, which we expect to recognize as revenue within the next thirty-six to sixty months (in thousands): Hosted Telecom Services backlog as of March 31, 2014 $ 7,152 Hosted Telecom Services backlog as of June 30, 2014 $ 8,402 Hosted Telecom Services backlog as of March 31, 2013 $ 3,451 Hosted Telecom Services backlog as of June 30, 2013 $ 4,253 Cost of Revenue Cost of revenue consists primarily of product cost and customer support department salaries of our hosted telecom services and bandwidth. Cost of revenue increased 42% or $210,000, to $708,000 for the three months ended June 30, 2014 as compared to $498,000 for the three months ended June 30, 2013. The increase in cost of revenue was primarily due to an increase in product cost of $49,000 and customer support costs of $67,000, as we continue to increase personnel to fulfill our increasing hosted telecom services orders, and an increase in bandwidth costs of $31,000 and other cost of revenue of $51,000. Research and Development Research and development expenses consist primarily of salaries and benefits which are attributable to the development of our new hosted telecom products. Research and development expenses increased 4% or $10,000, to $258,000 for the three months ended June 30, 2014 as compared to $248,000 for the three months ended June 30, 2013. Selling and Marketing Selling and marketing expenses consist primarily of salaries and benefits, as well as advertising expenses. Selling and marketing expenses decreased 0.4% or $2,000, to $488,000 for the three months ended June 30, 2014 as compared to $490,000 for the three months ended June 30, 2013. General and Administrative General and administrative expenses consist primarily of payroll and related expenses for executives, administrative personnel, legal, rent, accounting and other professional services, and other general corporate expenses. General and administrative expenses increased 75% or $379,000, to $885,000 for the three months ended June 30, 2014 as compared to $506,000 for the three months ended June 30, 2013. The increase in general and administrative expenses for the three months ended June 30, 2014 primarily consisted of additional salaries and benefits of $119,000, additional allocation of stock option expense of $65,000, increase in rent expense of $39,000 corporate accounting service of $11,000, depreciation expense of $18,000 and software and maintenance expenses of $39,000, other expenses of $63,000, offset by a decrease of $4,000 in legal fees and permits. 27--------------------------------------------------------------------------------Six months ended June 30, 2014 compared to six months ended June 30, 2013 Revenue Hosted Telecom Services segment revenue increased 119% or $1,042,000, to $1,918,000 for the six months ended June 30, 2014 as compared to $876,000 for the six months ended June 30, 2013. A substantial portion of Hosted Telecom Services segment revenue is generated through thirty-six to sixty month service contracts. As such, we believe growth in Hosted Telecom Services segment will initially be seen through increases in our backlog. Backlog represents contracts signed with no service or payment provided at June 30, 2014 and 2013. During the six months ended June 30, 2014, the Company added $588,000 in backlog in connection with the OSV acquisition (Note 9). Below is a table which displays the Hosted Telecom Services segment revenue backlog as of January 1, 2013 and 2014, and June 30, 2013 and 2014, which we expect to recognize as revenue within the next thirty-six to sixty months (in thousands): Hosted Telecom Services backlog as of January 1, 2014 $ 7,019 Hosted Telecom Services backlog as of June 30, 2014 $ 8,402 Hosted Telecom Services backlog as of January 1, 2013 $ 2,374 Hosted Telecom Services backlog as of June 30, 2013 $ 4,253 Cost of Revenue Cost of revenue consists primarily of product cost and customer support department salaries of our hosted telecom services and bandwidth. Cost of revenue increased 45% or $425,000, to $1,371,000 for the six months ended June 30, 2014 as compared to $946,000 for the six months ended June 30, 2013. The increase in cost of revenue was primarily due to an increase in product cost of $126,000 and customer support costs of $159,000, as we continue to increase personnel to fulfill our increasing hosted telecom services orders, and an increase in bandwidth costs of $50,000, installation charges of $30,000 and other cost of revenue of $98,000. Research and Development Research and development expenses consist primarily of salaries and benefits which are attributable to the development of our new hosted telecom products. Research and development expenses decreased 6% or $33,000, to $506,000 for the six months ended June 30, 2014 as compared to $539,000 for the six months ended June 30, 2013. Selling and Marketing Selling and marketing expenses consist primarily of salaries and benefits, as well as advertising expenses. Selling and marketing expenses increased 9% or $94,000, to $1,106,000 for the six months ended June 30, 2014 as compared to $1,012,000 for the six months ended June 30, 2013. The increase in selling and marketing expenses was primarily due to the increase in the allocation of direct sales representative salaries and benefits expense of $30,000 as a result of increased revenue, and commissions for referral partners of $54,000 related to Network services segment sales. 28 --------------------------------------------------------------------------------General and Administrative General and administrative expenses consist primarily of payroll and related expenses for executives, administrative personnel, legal, rent, accounting and other professional services, and other general corporate expenses. General and administrative expenses increased 111% or $958,000, to $1,822,000 for the six months ended June 30, 2014 as compared to $864,000 for the six months ended June 30, 2013. The increase in general and administrative expenses for the six months ended June 30, 2014 primarily consisted of additional salaries and benefits of $257,000, additional allocation of stock option expense of $93,000, corporate accounting services of $62,000, software and maintenance expenses of $91,000, a $200,000 decrease in rent expense due to a net reversal of rent expense of $120,000 during the six months ended June 30, 2013, depreciation of $65,000, and other expenses of $117,000. Operating Results of Web Services segment (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Web Services Revenue $ 845 $ 2,246 $ 1,962 $ 4,883 Operating Expenses: Cost of revenue 176 472 443 1,066 Research and development 177 166 343 356 Selling and marketing 16 227 51 613 General and administrative 663 1,346 1,476 2,426 Operating (loss) income (187 ) 35 (351 ) 422 Other income 61 120 118 329 (Loss) income before taxes $ (126 ) $ 155 $ (233 ) $ 751 Three months ended June 30, 2014 compared to three months ended June 30, 2013 Revenue Web Services segment revenue decreased 62% or $1,401,000, to $845,000 for the three months ended June 30, 2014 as compared to $2,246,000 for the three months ended June 30, 2013. The decrease in revenue is primarily related to the decrease in cash collected on EPTAs of $870,000, our shift in focus to only providing web services to enterprise-sized customers resulting in a decrease of $388,000, and a decrease in hosting revenue of $90,000. We expect web services revenue to decrease as we complete existing contractual obligations. Revenue from Web Services segment is generated primarily through on-page and off-page Search Engine Optimization ("SEO") services, search engine management services, conversion rate optimization services, and website design and development services. A substantial portion of Web Services segment's revenue is generated through three to twelve-month service contracts. Below is a table which displays the Web Services segment revenue backlog as of March 31, 2014 and 2013, and June 30, 2014 and 2013, which is expected to be recognized as revenue within the next twelve months (in thousands): Web Services backlog as of March 31, 2014 $ 208 Web Services backlog as of June 30, 2014 $ 117 Web Services backlog as of March 31, 2013 $ 1,329 Web Services backlog as of June 30, 2013 $ 1,162 29 -------------------------------------------------------------------------------- Revenue related to cash collected under EPTA agreements decreased 81% or $666,000, to $160,000 for the three months ended June 30, 2014 as compared to $826,000 for the three months ended June 30, 2013. Our typical EPTA agreement has a term of two to three years. As such, while we no longer plan to offer EPTAs to our customers as a result of the suspension of our direct mail seminar sales, we will continue to recognize revenue from those EPTA contracts executed prior to July 2011 as cash is collected from those contracts. EPTAs were originally recognized in our balance sheet, net of an allowance for doubtful accounts, through our deferred revenue balance. The remaining deferred revenue balance is expected to be recognized as revenue, however, at a decreasing rate over the next year to eighteen months. The following table summarizes the activity within deferred revenue for the three months ended June 30, 2014 and 2013 (in thousands): EPTA deferred revenue as of March 31, 2014 $ 374 Cash collected on principal of EPTA contracts (166 ) Adjustments of EPTA deferred revenue 76 EPTA deferred revenue as of June 30, 2014 $ 284 EPTA deferred revenue as of March 31, 2013 $ 1,780 Cash collected on principal of EPTA contracts (826 ) Adjustments of EPTA deferred revenue 61 EPTA deferred revenue as of June 30, 2013 $ 1,015 Revenue related to cash collected on previously written off bad debt decreased 44% or $54,000, to $68,000 for the three months ended June 30, 2014 as compared to $122,000 for the three months ended June 30, 2013. Commissions from third parties and other revenue decreased 59% or $54,000, to $38,000 for the three months ended June 30, 2014 as compared to $92,000 for the three months ended June 30, 2013. The decrease in commissions was primarily due to the suspension our direct mail seminar sales channel. As a result of this decision, we no longer send leads to third parties, and we do not expect this revenue source to be significant in the future. Cost of Revenue Cost of revenue consists primarily of salaries and related expenses related to fulfillment of our web management services and customer service. Cost of revenue decreased 63% or $296,000, to $176,000 for the three months ended June 30, 2014 as compared to $472,000 for the three months ended June 30, 2013. The decrease is primarily related to the reduction in employee salaries and benefits associated with the fulfillment of service of website management services of $230,000 and customer service cost for website hosting of $49,000. Research and Development Research and development expenses consist primarily of salaries and benefits which are attributable to the development of our website development software products. Research and development expenses increased 7% or $11,000, to $177,000 for the three months ended June 30, 2014 as compared to $166,000 for the three months ended June 30, 2013. The increase was primarily due to salaries and expenses related to the continued development of our Web Builder. Selling and Marketing Selling and marketing expenses consist primarily of salaries and benefits, as well as advertising expenses. Selling and marketing expense decreased 93% or $211,000, to $16,000 for the three months ended June 30, 2014 as compared to $227,000 for the three months ended June 30, 2013. This decrease was primarily attributable to the decrease in allocated salaries and benefits based on reduced bookings. Additionally, our direct sales representatives have been reduced from 16 at June 30, 2013 to 9 at June 30, 2014. General and Administrative General and administrative expenses consist of salaries and related expenses for executives, administrative personnel, legal, rent, accounting and other professional services, and other general corporate expenses. General and administrative expenses decreased 51% or $683,000, to $663,000 for the three months ended June 30, 2014 as compared to $1,346,000 for the three months ended June 30, 2013. The decrease in general and administrative expenses is primarily due to less of an allocation of corporate general and administrative expenses due to the 62% reduction in revenue for the three months ended June 30, 2014 compared to the three months ended June 30, 2013, and a company-wide reduction in general and administrative expenses as we continue to cut unnecessary expenses. 30 --------------------------------------------------------------------------------Other Income Other income primarily relates to interest earned on EPTAs, which generally carry an 18% simple interest rate. Other income decreased 49% or $59,000, to $61,000 for the three months ended June 30, 2014 as compared to $120,000 for the three months ended June 30, 2013. The decrease primarily relates to the decrease in the outstanding EPTA balance to $284,000 as of June 30, 2014 compared to $1,015,000 at June 30, 2013. Six months ended June 30, 2014 compared to six months ended June 30, 2013 Revenue Web Services segment revenue decreased 60% or $2,921,000, to $1,962,000 for the six months ended June 30, 2014 as compared to $4,883,000 for the six months ended June 30, 2013. The decrease in revenue is primarily related to the decrease in cash collected on EPTAs of $1,928,000, our shift in focus to only providing web services to enterprise-sized customers resulting in a decrease of $668,000 and a decrease in hosting revenue of $224,000. We expect web services revenue to decrease as we complete existing contractual obligations. Revenue from Web Services segment is generated primarily through on-page and off-page Search Engine Optimization ("SEO") services, search engine management services, conversion rate optimization services, and website design and development services. A substantial portion of Web Services segment's revenue is generated through three to twelve-month service contracts. Below is a table which displays the Web Services segment revenue backlog as of January 1, 2014 and 2013, and June 30, 2014 and 2013, which is expected to be recognized as revenue within the next twelve months (in thousands): Web Services backlog as of January 1, 2014 $ 553 Web Services backlog as of June 30, 2014 $ 117 Web Services backlog as of January 1, 2013 $ 1,135 Web Services backlog as of June 30, 2013 $ 1,162 Revenue related to cash collected under EPTA agreements decreased 76% or $1,577,000, to $496,000 for the six months ended June 30, 2014 as compared to $2,073,000 for the six months ended June 30, 2013. Our typical EPTA agreement has a term of two to three years. As such, while we no longer plan to offer EPTAs to our customers as a result of the suspension of our direct mail seminar sales, we will continue to recognize revenue from those EPTA contracts executed prior to July 2011 as cash is collected from those contracts. EPTAs were originally recognized in our balance sheet, net of an allowance for doubtful accounts, through our deferred revenue balance. The remaining deferred revenue balance is expected to be recognized as revenue, however, at a decreasing rate over the next year to eighteen months. The following table summarizes the activity within deferred revenue for the six months ended June 30, 2014 and 2013 (in thousands): EPTA deferred revenue as of January 1, 2014 $ 545 Cash collected on principal of EPTA contracts (486 ) Adjustments of EPTA deferred revenue 225 EPTA deferred revenue as of June 30, 2014 $ 284 EPTA deferred revenue as of January 1, 2013 $ 3,173 Cash collected on principal of EPTA contracts (2,073 ) Adjustments of EPTA deferred revenue (85 ) EPTA deferred revenue as of June 30, 2013 $ 1,015 31-------------------------------------------------------------------------------- Revenue related to cash collected on previously written off bad debt decreased 32% or $85,000, to $177,000 for the six months ended June 30, 2014 as compared to $262,000 for the six months ended June 30, 2013. Commissions from third parties and other revenue decreased 62% or $100,000, to $62,000 for the six months ended June 30, 2014 as compared to $162,000 for the six months ended June 30, 2013. The decrease in commissions was primarily due to the suspension our direct mail seminar sales channel. As a result of this decision, we no longer send leads to third parties, and as such, we do not expect this revenue source to be significant in the future. Cost of Revenue Cost of revenue consists primarily of salaries and related expenses related to fulfillment of our web management services and customer service. Cost of revenue decreased 58% or $623,000, to $443,000 for the six months ended June 30, 2014 as compared to $1,066,000 for the six months ended June 30, 2013. The decrease is primarily related to the reduction in employee salaries and benefits associated with the fulfillment of service of the web management services of $419,000 and customer service costs for website hosting of $166,000. Research and Development Research and development expenses consist primarily of salaries and benefits which are attributable to the development of our Web Services products. Research and development expenses decreased 4% or $13,000, to $343,000 for the six months ended June 30, 2014 as compared to $356,000 for the six months ended June 30, 2013. Selling and Marketing Selling and marketing expenses consist primarily of salaries and benefits, as well as advertising expenses. Selling and marketing expense decreased 92% or $562,000, to $51,000 for the six months ended June 30, 2014 as compared to $613,000 for the six months ended June 30, 2013. This decrease was primarily attributable to the decrease in allocated salaries and benefits based on reduced bookings. Additionally, our direct sales representatives have been reduced from 16 at June 30, 2013 to 9 at June 30, 2014. General and Administrative General and administrative expenses consist of salaries and related expenses for executives, administrative personnel, legal, rent, accounting and other professional services, and other general corporate expenses. General and administrative expenses decreased 39% or $950,000, to $1,476,000 for the six months ended June 30, 2014 as compared to $2,426,000 for the six months ended June 30, 2013. The decrease in general and administrative expenses is primarily due to less of an allocation of corporate general and administrative expenses due to the 60% reduction in revenue for the six months ended June 30, 2014 compared to the six months ended June 30, 2013, and a company-wide reduction in general and administrative expenses as we continue to cut unnecessary expenses. Other Income Other income primarily relates to interest earned on EPTAs, which generally carry an 18% simple interest rate. Other income decreased 64% or $211,000, to $118,000 for the six months ended June 30, 2014 as compared to $329,000 for the six months ended June 30, 2013. The decrease primarily relates to the decrease in the outstanding EPTA balance to $284,000 as of June 30, 2014 compared to $1,015,000 at June 30, 2013. Liquidity and Capital Resources The Company has transformed into a start-up company with the inherent risks and uncertainties of funding operations until profitability is achieved. We currently plan to fund our operations during the next twelve months using our cash and cash equivalents of $2,677,000 and the collection of remaining accounts receivable from our former seminar sales of our website development software. However, in the event that any factors impacting future cash flows fall below management's expectations, the Company would be required to obtain additional debt or equity financing such as that available from its CEO to sustain operations. The Company received a commitment from the CEO, and major shareholder, in July 2014 that he would provide the necessary level of financial support to enable the Company to pay its debts as they become due through November 15, 2015. Accordingly the Company believes it will have sufficient funds to sustain its operations during the next twelve months as a result of the sources of funding detailed above. 32 --------------------------------------------------------------------------------Working Capital Working capital decreased 10% or $283,000, to $2,566,000 for the six months ended June 30, 2014 as compared to $2,849,000 for the year ended December 31, 2013. Working capital, excluding deferred revenue, decreased 17% or $706,000, to $3,342,000 as of June 30, 2014 as compared to $4,048,000 as of December 31, 2013. Deferred revenue balances represent historical contract sales for which we cannot immediately recognize revenue. We currently anticipate that the costs and expenses we will incur as these deferred revenue amounts are recognized as revenue will be insignificant. Consequently, we do not consider deferred revenue to be a factor that impacts our future cash requirements. The decrease in working capital excluding deferred revenue is primarily attributable to the decrease in revenue from our Web Services segment EPTA accounts receivable collections, resulting in the use of our cash and cash equivalents to fund operating activities. Cash and Cash Equivalents Cash and cash equivalents decreased 13% or $399,000, to $2,677,000 at June 30, 2014 as compared to $3,076,000 as of December 31, 2013. During the six months ended June 30, 2014, we used $2,212,000 in cash for operating activities, investing activities provided $1,808,000, and financing activities provided $5,000. Trade Receivables Current and long-term trade receivables, net of allowance for doubtful accounts, decreased 38% or $461,000, to $745,000 at June 30, 2014 as compared to $1,206,000 at December 31, 2013. Long-term trade receivables, net of allowance for doubtful accounts, decreased 19% or $22,000, to $94,000 at June 30, 2014 as compared to $116,000 at December 31, 2013. We offer our customers a contract with payment terms between 24 and 36 months, as one of several payment options. The payments that become due more than 12 months after the end of the fiscal period are classified as long-term trade receivables. The decrease in our accounts receivable balance at June 30, 2014 is primarily related to cash collections of EPTA agreements of $496,000 for the six month period ended June 30, 2014. Accounts Payable Accounts payable decreased 87% or $174,000, to $27,000 at June 30, 2014 as compared to $201,000 at December 31, 2013. Our accounts payable as of June 30, 2014 were generally within our vendors' terms of payment. Capital Total stockholders' equity decreased 23% or $1,555,000, to $5,146,000 at June 30, 2014 as compared to $6,701,000 at December 31, 2013. The significant changes in stockholders' equity during the six months ended June 30, 2014 included an increase of additional paid-in capital of $429,000 for options granted, $42,000 in proceeds from stock option exercises, $134,000 for issuance of common stock related to the acquisition of One Stop Voice (Note 9), and $966,000 for issuance of common stock related to the prepayment of rent on the corporate headquarters (Note 10). In addition, we had a net loss of $3,126,000 for the six month period ending June 30, 2014. Off Balance Sheet Arrangements As of June 30, 2014, we are not involved in any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. 33 --------------------------------------------------------------------------------Impact of Recent Accounting Pronouncements Recently Issued Accounting Pronouncements - In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09 that introduces a new five-step revenue recognition model in which an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU also requires disclosures sufficient to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This standard is effective for fiscal years beginning after December 15, 2016, including interim periods within that reporting period. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements. Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition With the exception of historical facts, the statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect our current expectations and beliefs regarding our future results of operations, performance and achievements. These statements are subject to risks and uncertainties and are based upon assumptions and beliefs that may or may not materialize. These forward-looking statements include, but are not limited to, statements concerning: ? our belief that our target market will increasingly look to Internet solutions providers who leverage industry and customer practices, increase predictability of success of their Internet initiatives and decrease implementation risks by providing low-cost, scalable solutions with minimal lead time; ? our belief that we can compete successfully by relying on our infrastructure and marketing strategies as well as techniques, systems and procedures, and by adding additional products and services in the future; ? our belief that we can continue our success by periodic review and revision of our methods of doing business and by continuing our expansion into domestic and international markets; ? our belief that a key component of our success comes from a number of new, recently developed proprietary technologies and that these technologies and advances distinguish our services and products from our competitors and further help to substantially reduce our operating costs and expenses; ? our contention that we do not offer our customers a "business opportunity" or a "franchise" as those terms are defined in applicable statutes of the states in which we operate; ? our belief that there is a large, fragmented and under-served population of small businesses and entrepreneurs searching for professional services firms that offer business-to-consumer e-commerce solutions coupled with support and continuing education; ? our expectation that our offering of products and services will evolve as some products are replaced by new and enhanced products intended to help our customers achieve success with their Internet-related businesses; and ? our expectation that the costs and expenses we incur will be insignificant as deferred revenue amounts are recognized as product and other revenues when cash is collected. We caution readers that our operating results are subject to various risks and uncertainties that could cause our actual results and outcomes to differ materially from those discussed or anticipated, including changes in economic conditions and internet technologies, interest rate fluctuations, and the factors set forth in the section entitled, "Risk Factors," under Part I, Item 1A of the 2013 Form 10-K. We also advise readers not to place any undue reliance on the forward-looking statements contained in this Form 10-Q, which reflect our beliefs and expectations only as of the date of this Report. We assume no obligation to update or revise these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, other than as required by law. 34-------------------------------------------------------------------------------- |