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QUINSTREET, INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in the sections titled "Special Note Regarding Forward-Looking Statements" and "Risk Factors". Management Overview QuinStreet is a leader in performance marketing online. We have built a strong set of capabilities to engage Internet visitors with targeted media and to connect our marketing clients with their potential customers online. We focus on serving clients in large, information-intensive industry verticals where relevant, targeted media and offerings help visitors make informed choices, find the products that match their needs, and thus become qualified customer prospects for our clients. We deliver cost-effective marketing results to our clients most typically in the form of a qualified lead or inquiry, in the form of a qualified click, or call. Leads, clicks or calls can then convert into a customer or sale for clients at a rate that results in an acceptable marketing cost to them. We are typically paid by clients when we deliver qualified leads, clicks, calls or customers as defined by our agreements with them. References to the delivery of customers means the sale of completed customer transactions (e.g., bound insurance policies or customer appointments with clients). Because we bear the costs of media, our programs must deliver value to our clients and provide for a media yield, or generation of an acceptable margin on our media costs, that provides a sound financial outcome for us. To deliver leads, clicks, calls, and customers to our clients, generally we: • own or access targeted media; • run advertisements or other forms of marketing messages and programs in that media to create visitor responses in the form most typically of leads (visitor generated contact information and requests), clicks (to further qualification or matching steps, or to online client applications or offerings), or calls (to our owned and operated call centers or that of our clients or their agents); • match these leads, clicks, calls, or customers to client offerings or brands that we believe can meet visitor interests or needs, converting visitors into qualified leads, clicks, calls, or customers for our clients; and • optimize client matches and media yield such that we achieve desired results for clients and a sound financial outcome for us. Our primary financial objective has been and remains creating revenue growth from sustainable sources, at target levels of profitability. Our primary financial objective is not to maximize profits, but rather to achieve target levels of profitability while investing in various growth initiatives, as we continue to believe we are in the early stages of a large, long-term market. Our Direct Marketing Services ("DMS"), business accounted for substantially all of our net revenue in fiscal years 2014, 2013 and 2012. Our DMS business derives its net revenue from fees earned through the delivery of qualified leads, clicks, calls or customers and, to a lesser extent, display advertisements, or impressions. Through a vertical focus, targeted media presence and our technology platform, we are able to deliver targeted, measurable marketing results to our clients. Our two largest client verticals within our DMS business are education and financial services. Our education client vertical represented 43%, 44% and 42% of net revenue in fiscal years 2014, 2013 and 2012. Our financial services client vertical represented 39%, 40% and 42% of net revenue in fiscal years 2014, 2013 and 2012. Other DMS client verticals, consisting primarily of business-to-business technology, home services and medical, represented 18%, 16% and 16% of net revenue in fiscal years 2014, 2013 and 2012. 35-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements We generated substantially all of our revenue from sales to clients in the United States. Trends Affecting our Business Client Verticals To date, our education and financial services client verticals have generated the majority of our revenue. We expect that a majority of our revenue in fiscal year 2015 will also be generated from clients in these client verticals. Our education client vertical has been significantly affected by regulations and enforcement activity affecting for-profit educational institutions over the past several years. These activities have affected and are expected to continue to affect our clients' businesses and marketing practices, including an overall decrease in our clients' external marketing expenditures. The effect of these activities may continue to result in fluctuations in the volume and mix of our business with these clients. To offset the impact these activities have had on the for-profit educational clients, we have broadened our product set from our traditional lead business with the addition of clicks and calls to our product mix. We are also broadening our markets in education to include not-for-profit schools as well as expanding internationally in Brazil and India. Our financial services client vertical continued to be negatively affected due to the limited availability of high quality media at acceptable margins caused by changes in search engine algorithms, acquisition of media sources by competitors and increased competition for quality media. These effects may continue to impact our business in the near future. To offset this impact, we have broadened our product set with the launch of enhanced click, lead and policy products, where better monetization will provide greater access to high quality media sources. Acquisitions Acquisitions in Fiscal Year 2014 In December 2013, we acquired the operations of an online publishing business for $0.9 million in cash paid upon closing of the acquisition. Acquisitions in Fiscal Year 2013 We did not complete any acquisitions during fiscal year 2013. Acquisitions in Fiscal Year 2012 In February 2012, we acquired certain assets of Ziff Davis Enterprise from Enterprise Media Group, Inc., a New York-based online media and marketing company in the business-to-business technology market, in exchange for $17.3 million in cash, to broaden our registered user database and brand name in the business-to-business technology market. In August 2011, we acquired 100% of the outstanding equity interests of NarrowCast Group, LLC, or IT BusinessEdge, a Kentucky-based Internet media company in the business-to-business technology market, in exchange for $24.0 million in cash, to broaden our registered user database and media access in the business-to-business technology market. During fiscal year 2012, in addition to certain assets of Ziff Davis Enterprise and all of the equity interests of IT BusinessEdge, we acquired eleven other online publishing businesses. Development, Acquisition and Retention of Targeted Media One of the primary challenges of our business is acquiring or creating media that is high quality and targeted enough to attract prospects for our clients at costs that work for our business model. In order to grow our 36-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements business, we must be able to develop or acquire and retain quality targeted media on a cost-effective basis. Changes in search engine algorithms, and retain high quality targeted media and increased competition on available media has, during some periods, limited and may continue to limit our ability to generate revenue. Seasonality Our results are subject to significant fluctuation as a result of seasonality. In particular, our quarters ending December 31 (our second fiscal quarter) are typically characterized by seasonal weakness. In our second fiscal quarters, there is lower availability of lead supply from some forms of media during the holiday period on a cost effective basis and some of our clients have lower budgets. In our quarters ending March 31 (our third fiscal quarter), this trend generally reverses with better lead availability and often new budgets at the beginning of the year for our clients with fiscal years ending December 31. Regulations Our revenue has fluctuated as a result of recently adopted or amended regulations and the increased enforcement of existing regulations. Our business is affected directly because we operate websites and conduct telemarketing and email marketing, and indirectly as clients adjust their operations as a result of regulatory changes and enforcement activity that affect their industries. One example of a recent regulatory change that may affect our business is the Telephone Consumer Protection Act (the "TCPA"), which the Federal Communications Commission amended to, among other things, impose heightened consent and opt-out requirements that companies conducting telemarketing must follow. Certain provisions of the regulations became effective in July 2012, and additional regulations requiring prior express written consent for telemarketing calls to wireless numbers became effective in October 2013. Our efforts to comply with the TCPA has not had a material impact on traffic conversion rates. Our clients may make business decisions based on their own experiences with the TCPA regardless of our products, and the changes we implemented to comply with the new regulations. Those decisions may negatively affect our revenue or profitability. In addition, our education client vertical has been significantly affected by the adoption of regulations affecting for-profit educational institutions over the past several years, and a higher level of governmental scrutiny is expected to continue. Clients in our financial services vertical have increasingly been affected by laws and regulations as a result of the adoption of new regulations under The Dodd-Frank Wall Street Reform and Consumer Protection Act and the increased enforcement of new and pre-existing laws and regulations. The effect of these regulations, or any future regulations, may continue to result in fluctuations in the volume and mix of our business with these clients. Basis of Presentation General We operate in one reportable segment: DMS. The remainder of our business is classified as "all other". See Note 14, Segment Information, to our consolidated financial statements for further discussion and financial information regarding our reporting segment. Net Revenue Our DMS business generates revenue from fees earned through the delivery of qualified leads, clicks, calls, customers and, to a lesser extent, display advertisements, or impressions. We deliver targeted and measurable results through a vertical focus that we classify into the following client verticals: education, financial services and "other" (which includes business-to-business technology, home services and medical). All other revenue 37-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements generated is less than 1% of net revenue in fiscal years 2014, 2013 and 2012. We expect all other revenue to continue to represent an immaterial portion of our business. Cost of Revenue Cost of revenue consists primarily of media costs, personnel costs, amortization of intangible assets, depreciation expense and amortization of internal software development costs related to revenue-producing technologies. Media costs consist primarily of fees paid to third-party publishers that are directly related to a revenue-generating event and pay-per-click (PPC) ad purchases from Internet search companies. We pay these third-party publishers and Internet search companies on a revenue-share, a cost-per-lead (CPL) cost-per-click, (CPC), or cost-per-thousand-impressions (CPM) basis. Personnel costs include salaries, stock-based compensation expense, bonuses and employee benefit costs. Personnel costs are primarily related to individuals associated with maintaining our servers and websites, our editorial staff, client management, creative team, content, compliance group and media purchasing analysts. Costs associated with software incurred in the development phase or obtained for internal use are capitalized and amortized in cost of revenue over the software's estimated useful life. We anticipate that our cost of revenue will increase more than our revenue for the near term as we invest in opportunities we see in the financial services client vertical. Operating Expenses We classify our operating expenses into three categories: product development, sales and marketing, and general and administrative. Our operating expenses consist primarily of personnel costs and, to a lesser extent, professional services fees, rent and other costs. Personnel costs for each category of operating expenses generally include salaries, stock-based compensation expense, bonuses, commissions and employee benefit costs. Product Development. Product development expenses consist primarily of personnel costs and professional services fees associated with the development and maintenance of our technology platforms, development and launching of our websites, product-based quality assurance and testing. In the current period of business challenges, we are constraining expenses generally to the extent practicable. However, we expect product and development expenses to continue to increase in absolute dollars in the future as we believe that continuous investment in technology is critical to attaining our strategic objectives. Sales and Marketing. Sales and marketing expenses consist primarily of personnel costs, advertising, professional services fees, and travel costs. We expect sales and marketing expenses to continue to increase in absolute dollars as we increase advertising spend and hire additional personnel in sales and marketing to support our offerings. General and Administrative. General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, employee benefits and compliance, technical support and other administrative personnel, as well as accounting and legal professional services fees, and insurance. In the current period of business challenges, we are constraining expenses generally to the extent practicable. However, we expect general and administrative expenses to increase in absolute dollars in future periods as we continue to invest in corporate infrastructure. Interest and Other Income (Expense), Net Interest and other expense, net, consists primarily of interest expense, other income and expense, net and interest income. Interest expense is related to our credit facility, including the related interest rate swap and promissory notes issued in connection with our acquisitions, and includes imputed interest on non-interest bearing notes. Borrowings under our credit facility, the aggregate principal amount of outstanding promissory notes and related interest expense could increase if, among other things, we make additional acquisitions through debt financing. Interest income represents interest earned on our cash, cash equivalents and marketable securities, which may increase or decrease depending on market interest rates and the amounts invested. 38-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Other income (expense), net, includes foreign currency exchange gains and losses and other non-operating items. Income Tax (Provision for) Benefit from We are subject to tax in the United States as well as other tax jurisdictions or countries in which we conduct business. Earnings from our limited non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Results of Operations The following table sets forth our consolidated statement of operations for the periods indicated: Fiscal Year Ended 2014 2013 2012 (In thousands) Net revenue $ 282,549 100.0 % $305,101 100.0 % $ 370,468 100.0 % Cost of revenue (1) 241,907 85.6 251,591 82.5 283,466 76.5 Gross profit 40,642 14.4 53,510 17.5 87,002 23.5 Operating expenses: (1) Product development 19,548 6.9 19,048 6.2 21,051 5.7 Sales and marketing 16,385 5.8 14,705 4.8 14,074 3.8 General and administrative 17,046 6.0 16,226 5.3 23,375 6.3 Impairment of goodwill 95,641 33.8 92,350 30.3 - 0.0 Operating (loss) income (107,978 ) (38.1 ) (88,819 ) (29.1 ) 28,502 7.7 Interest income 115 0.0 115 0.0 134 0.0 Interest expense (3,825 ) (1.4 ) (5,200 ) (1.7 ) (4,462 ) (1.2 ) Other income (expense), net 1,493 0.5 (69 ) (0.0 ) (42 ) (0.0 ) (Loss) income before income taxes (110,195 ) (39.0 ) (93,973 ) (30.8 ) 24,132 6.5 (Provision for) benefit from taxes (36,209 ) (12.8 ) 26,601 8.7 (11,131 ) (3.0 ) Net (loss) income $ (146,404 ) (51.8 )% $ (67,372 ) (22.1 )% $ 13,001 3.5 % (1) Cost of revenue and operating expenses include stock-based compensation expense as follows: Cost of revenue $ 2,767 1.0 % $ 3,930 1.3 % $ 4,293 1.2 % Product development 2,429 0.9 2,765 0.9 2,570 0.7 Sales and marketing 2,937 1.0 3,264 1.1 3,096 0.8 General and administrative 2,296 0.8 2,057 0.7 3,037 0.8 Net Revenue Fiscal Year Ended June 30, 2014 - 2013 2013 - 2012 2014 2013 2012 % Change % Change (In thousands) Net revenue $ 282,549 $ 305,101 $ 370,468 (7 %) (18 %) Cost of revenue 241,907 251,591 283,466 (4 %) (11 %) Gross profit $ 40,642 $ 53,510 $ 87,002 (24 %) (38 %) Net revenue decreased $22.6 million, or 7%, in fiscal year 2014 compared to fiscal year 2013. Our education client vertical revenue decreased $15.0 million, or 11%, primarily as a result of our education clients' 39-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements lower budgets, largely due to uncertainty surrounding regulations and enforcement activity affecting for-profit educational institutions and their operational adjustment to this activity. Our financial services client vertical revenue decreased $8.2 million, or 7%, primarily due to our inability to cost effectively access sufficient high quality media during the first three quarters of the year, as well as due to a reduction in mortgage inquiry traffic caused by an increase in interest rates. Revenue from other client verticals increased $0.6 million, or 1%, primarily due to increased client demand in our business-to-business and home services client verticals partially offset by decreased client demand in our medical client vertical. Net revenue decreased $65.4 million, or 18%, in fiscal year 2013 compared to fiscal year 2012. Our financial services client vertical revenue decreased $35.4 million, or 23%, primarily due to reduced availability of quality publisher media as a result of search engine algorithm changes, acquisitions of media sources by competitors and increased competition for quality media. Our education client vertical revenue decreased $19.6 million, or 13%, primarily as a result of our education clients' lower budgets, largely due to uncertainty surrounding regulations affecting for-profit educational institutions and their operational adjustment to those regulation changes. Revenue from other client verticals decreased $10.3 million, or 17%, primarily due to decreased client demand in our home services and business-to-business technology client verticals. Cost of Revenue Cost of revenue decreased $9.7 million, or 4%, in fiscal year 2014 compared to fiscal year 2013, driven by decreased media costs of $6.7 million, decreased amortization of intangible assets and depreciation of $6.4 million, and decreased stock based compensation expense of $1.2 million, partially offset by increased personnel costs of $2.6 million and other increases of $2.0 million. The decreased media costs were primarily attributable to lower revenue levels offset by a lower mix of traffic from owned and operated websites. The decreased amortization of intangible assets was attributable to an amortization charge associated with certain licensed patents in fiscal year 2013, assets from historical acquisitions becoming fully amortized and a reduced number of acquisitions in recent periods. The increased personnel costs were attributable to an increase in average headcount. Gross margin was 14% in fiscal year 2014 compared to 18% in fiscal year 2013. Cost of revenue decreased $31.9 million, or 11%, in fiscal year 2013 compared to fiscal year 2012, driven by decreased media costs of $26.1 million due to lower lead and click volumes, decreased personnel costs of $4.9 million and other decreases of $1.7 million, partially offset by increased amortization of intangible assets and depreciation of $1.2 million. The decreased personnel costs were attributable to a reduction in average headcount. Gross margin was 18% in fiscal year 2013 compared to 23% in fiscal year 2012. Operating Expenses Fiscal Year Ended June 30, 2014 - 2013 2013 - 2012 2014 2013 2012 % Change % Change (In thousands) Product development $ 19,548 $ 19,048 $ 21,051 3 % (10 %) Sales and marketing 16,385 14,705 14,074 11 % 4 % General and administrative 17,046 16,226 23,375 5 % (31 %) Impairment of goodwill 95,641 92,350 - 4 % 100 % Operating expenses $ 148,620 $ 142,329 $ 58,500 4 % 143 % Product Development Expenses Product development expenses increased $0.5 million, or 3%, in fiscal year 2014 compared to fiscal year 2013, primarily due to increased personnel costs of $0.8 million due to an increase in average headcount, offset by a decrease in stock-based compensation expense of $0.3 million. 40-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Product development expenses decreased $2.0 million, or 10%, in fiscal year 2013 compared to fiscal year 2012, primarily due to decreased personnel costs of $1.5 million resulting from a reduction in average headcount and other decreases in various product development expenses. Sales and Marketing Expenses Sales and marketing expenses increased $1.7 million, or 11%, in fiscal year 2014 compared to fiscal year 2013, primarily due to increased advertising expenses for our current product offerings of $1.0 million and increased personnel costs of $0.6 million. Sales and marketing expenses increased $0.6 million, or 4%, in fiscal year 2013 compared to fiscal year 2012, primarily due to increased personnel costs of $0.8 million and increased stock-based compensation expense of $0.2 million, partially offset by decreased advertising cost of $0.2 million. General and Administrative Expenses General and administrative expenses increased $0.8 million, or 5%, in fiscal year 2014 compared to fiscal year 2013. This was primarily due to an additional business tax assessment of $0.8 million, an increase in software license fees and maintenance contracts of $0.4 million due to increased company-wide headcount, an increase in bad debt expense of $0.3 million and an increase in stock-based compensation expense of $0.2 million due to incremental stock grants offset by a decrease in personnel costs of $1.0 million. General and administrative expenses decreased $7.1 million, or 31%, in fiscal year 2013 compared to fiscal year 2012. This was due to a $2.5 million payment to the attorneys general of multiple states in connection with a settlement related to online marketing for education companies in the prior year and additional decreased legal costs of $1.9 million related primarily to litigation expense, decreased bad debt expense of $1.4 million resulting from the insolvency of an advertising agency of record of one of our clients in the prior year, and decreased stock-based compensation expense of $1.0 million related to the departure of one of our directors and reduction in average headcount. Impairment of Goodwill As discussed under "Critical Accounting Policies and Estimates" we recorded a goodwill impairment charge of $95.6 million for the year ended June 30, 2014 compared to $92.4 million for the year ended June 30, 2013. Interest and Other Expense, Net Fiscal Year Ended June 30, 2014 - 2013 2013 - 2012 2014 2013 2012 % Change % Change (In thousands) Interest income $ 115 $ 115 $ 134 0 % (14 %) Interest expense (3,825 ) (5,200 ) (4,462 ) (26 %) 17 % Other income (expense), net 1,493 (69 ) (42 ) 2264 % 64 % Interest and other expense, net $ (2,217 ) $ (5,154 ) $ (4,370 ) (57 %) 18 % Interest and other expense, net decreased by $2.9 million, or 57%, in fiscal year 2014 compared to fiscal year 2013, primarily due to increased other income (expense), net related to the gain of $0.9 million on the sale of our shares of preferred stock in DemandBase and the sale of certain domain names for a gain of $0.5 million and due to decreased interest expense related to accelerated amortization of approximately $0.7 million of unamortized deferred upfront costs incurred in connection with the amendment of our credit facility in fiscal year 2013 and decreased debt obligations. 41-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Interest and other (expense), net increased by $0.8 million, or 18%, in fiscal year 2013 compared to fiscal year 2012, primarily due to increased interest expense related to accelerated amortization of approximately $0.7 million of unamortized deferred upfront costs incurred in connection with the amendment of our credit facility during the third quarter of fiscal 2013. See Note 9, Debt, to our consolidated financial statements for more information about our credit facility. Benefit from (Provision for) Taxes Fiscal Year Ended June 30, 2014 2013 2012 (In thousands) (Provision for) benefit from taxes $ (36,209 ) $ 26,601 $ (11,131 ) Effective tax rate (32.8 )% 28.3 % 46.1 % The decrease in our effective tax rate for the fiscal year 2014 compared to fiscal year 2013 was primarily due to a one-time, non-cash charge to establish a valuation allowance for a specific portion of our deferred tax assets. The decrease in our effective tax rate for fiscal year 2013 compared to fiscal year 2012, was primarily due to a goodwill impairment charge of $92.4 million for fiscal year 2013. The goodwill impairment charge had an associated tax benefit of $28.7 million due to the impairment of goodwill that is deductible for tax purposes. As of June 30, 2014, we had net deferred tax assets of $1.9 million. Our net deferred tax assets consist primarily of historic taxable income available to carryback projected future losses. See Note 8, Income Taxes, to our consolidated financial statements for more information about our deferred tax assets. Selected Quarterly Financial Data The following table sets forth our unaudited quarterly consolidated statements of operations data for the eight quarters ended June 30, 2014. We have prepared the statements of operations for each of these quarters on the same basis as the audited consolidated financial statements included elsewhere in this report and, in the opinion of management, each statement of operations includes all adjustments, consisting solely of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this report. These quarterly operating results are not necessarily indicative of our operating results for any future period. Three Months Ended June 30, Mar 31, Dec 31, Sept 30, June 30, Mar 31, Dec 31, Sept 30, 2014 2014 2013 2013 2013 2013 2012 2012 (In thousands, except per share data) Net revenue $ 67,555 $ 71,888 $ 66,145 $ 76,961 $ 75,707 $ 79,017 $ 71,751 $ 78,626 Costs of revenue 60,553 61,646 56,116 63,592 60,826 63,863 61,712 65,190 Gross profit 7,002 10,242 10,029 13,369 14,881 15,154 10,039 13,436 Operating expenses: Product development 4,754 4,859 4,776 5,159 4,760 4,891 4,504 4,893 Sales and marketing 4,689 3,881 3,659 4,156 3,835 3,683 3,496 3,691 General and administrative 4,217 4,284 4,411 4,134 3,887 4,394 4,019 3,926 Impairment of goodwill 95,641 - - - - - 92,350 - Operating (loss) income (102,299 ) (2,782 ) (2,817 ) (80 ) 2,399 2,186 (94,330 ) 926 Interest income 31 30 27 27 31 28 28 28 42 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Three Months Ended June 30, Mar 31, Dec 31, Sept 30, June 30, Mar 31, Dec 31, Sept 30, 2014 2014 2013 2013 2013 2013 2012 2012 (In thousands, except per share data) Interest expense (912 ) (911 ) (976 ) (1,026 ) (1,024 ) (1,810 ) (1,354 ) (1,012 ) Other (expense) income, net 1,544 (3 ) (29 ) (19 ) (72 ) (39 ) (4 ) 46 (Loss) income before income taxes (101,636 ) (3,666 ) (3,795 ) (1,098 ) 1,334 365 (95,660 ) (12 ) Benefit from (provision for) taxes 2,873 993 (40,234 ) 159 (2,916 ) (2,527 ) 32,169 (125 ) Net loss $ (98,763 ) $ (2,673 ) $ (44,029 ) $ (939 ) $ (1,582 ) $ (2,162 ) $ (63,491 ) $ (137 ) Net loss per share: (1) Basic $ (2.25 ) $ (0.06 ) $ (1.01 ) $ (0.02 ) $ (1.57 ) $ (0.05 ) $ (1.48 ) $ (0.00 ) Diluted $ (2.25 ) $ (0.06 ) $ (1.01 ) $ (0.02 ) $ (1.57 ) $ (0.05 ) $ (1.48 ) $ (0.00 ) Other Financial Data: Adjusted EBITDA $ 1,802 $ 6,279 $ 6,477 $ 9,631 $ 12,261 $ 12,407 $ 11,228 $ 11,975 (1) Net loss per share for the four quarters of each fiscal year may not sum to the total for the fiscal year because of the different number of shares outstanding during each period. Adjusted EBITDA Our use of adjusted EBITDA. We include adjusted EBITDA in this report because (i) we seek to manage our business to a level of adjusted EBITDA as a percentage of net revenue, (ii) it is a key basis upon which our management assesses our operating performance, (iii) it is one of the primary metrics investors use in evaluating Internet marketing companies, (iv) it is a factor in the evaluation of the performance of our management in determining compensation, and (v) it is an element of certain financial covenants under our credit facility. We define adjusted EBITDA as net (loss) income less benefit from (provision for) taxes, depreciation expense, amortization expense, stock-based compensation expense, interest, other income (expense), net, impairment of goodwill, and other extraordinary or non-recurring expenses. We use adjusted EBITDA as a key performance measure because we believe it facilitates operating performance comparisons from period to period by excluding potential differences caused by variations in capital structures (affecting interest expense), tax positions (such as the impact on periods or companies of changes in effective tax rates or fluctuations in permanent differences or discrete quarterly items) and the non-cash impact of depreciation, amortization, stock-based compensation expense, and impairment of goodwill. Since adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we also use adjusted EBITDA for business planning purposes, to incentivize and compensate our management personnel and in evaluating acquisition opportunities. In addition, we believe adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of adjusted EBITDA has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are: • adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments; • although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements; 43 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements • adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • adjusted EBITDA does not consider the potentially dilutive impact of issuing stock-based compensation to our management team and employees; • adjusted EBITDA does not reflect the interest expense or the cash requirements necessary to service interest or principal payments on our indebtedness; • adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and • other companies, including companies in our industry, may calculate adjusted EBITDA measures differently, which reduces their usefulness as a comparative measure. Due to these limitations, adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. When evaluating our performance, adjusted EBITDA should be considered alongside other financial performance measures, including various cash flow metrics, net (loss) income and our other GAAP results. The following table presents a reconciliation of adjusted EBITDA to net (loss) income, the most comparable GAAP measure, for each of the periods indicated: Three Months Ended June 30, Mar 31, Dec 31, Sept 30, June 30, Mar 31, Dec 31, Sept 30, 2014 2014 2013 2013 2013 2013 2012 2012 (In thousands) Net loss $ (98,763 ) $ (2,673 ) $ (44,029 ) $ (939 ) $ (1,582 ) $ (2,162 ) $ (63,491 ) $ (137 ) Interest and other (expense) income, net (663 ) 884 978 1,018 1,065 1,821 1,330 938 (Benefit from) provision for taxes (2,873 ) (993 ) 40,234 (159 ) 2,916 2,527 (32,169 ) 125 Depreciation and amortization 6,142 6,611 6,668 6,676 6,659 7,208 10,179 8,279 Stock-based compensation expense 2,318 2,450 2,626 3,035 3,203 3,013 3,029 2,770 Impairment of goodwill 95,641 - - - - - 92,350 - Adjusted EBITDA $ 1,802 $ 6,279 $ 6,477 $ 9,631 $ 12,261 $ 12,407 $ 11,228 $ 11,975 . . Adjusted EBITDA as a percentage of net revenue 3 % 9 % 10 % 13 % 16 % 16 % 16 % 15 % Adjusted EBITDA quarterly trends. We seek to manage our business to a level of adjusted EBITDA as a percentage of net revenue. We do so on a fiscal year basis by varying our operations to balance revenue growth and costs throughout the fiscal year. We do not seek to manage our business to a level of adjusted EBITDA on a quarterly basis and we expect our adjusted EBITDA margins to vary from quarter to quarter. Liquidity and Capital Resources As of June 30, 2014, our principal sources of liquidity consisted of cash and cash equivalents of $84.2 million, short-term marketable securities of $38.6 million, cash we expect to generate from operations, and our $50.0 million revolving credit line, which is committed until November 2016, a portion of which is available to be drawn subject to compliance with applicable covenants. Our cash and cash equivalents are maintained in highly liquid investments with remaining maturities of 90 days or less at the time of purchase. We believe our cash equivalents are liquid and accessible. 44-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Our short-term and long-term liquidity requirements primarily arise from our working capital requirements, debt service on our $77.5 million term loan balance at June 30, 2014, and acquisitions from time to time. Our primary operating cash requirements include the payment of media costs, personnel costs, costs of information technology systems and office facilities. Our ability to fund these requirements will depend on our future cash flows, which are determined, in part, by future operating performance and are, therefore, subject to prevailing global macroeconomic conditions and financial, business and other factors, some of which are beyond our control, and also our ability to access our credit facility. Even though we may not need additional funds, we may still elect to obtain additional debt or equity securities or draw down on or increase our borrowing capacity under our current credit facility for other reasons. We believe that our existing cash, cash equivalents, short-term marketable securities, cash generated from operations and our available borrowings under the credit facility will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Fiscal Year Ended June 30, 2014 2013 2012 (In thousands) Cash flows from operating activities $ 18,377 $ 50,665 $ 46,375 Cash flows used in investing activities (10,731 ) (7,469 ) (66,554 ) Cash flows used in financing activities (13,539 ) (21,616 ) (43,447 ) Net Cash Provided by Operating Activities Cash flows from operating activities are primarily the result of our net (loss) income adjusted for depreciation and amortization, stock-based compensation expense, impairment of goodwill and changes in working capital components. Cash flows provided by operating activities were $18.4 million for fiscal year 2014 compared to $50.7 million for fiscal year 2013 and $46.4 million for fiscal year 2012. Cash flows provided by operating activities in fiscal year 2014 consisted of primarily non-cash adjustments of $130.4 million and changes in working capital of $34.4 million, partially offset by net loss of $146.4 million. The changes in working capital accounts was primarily due to a decrease in net deferred taxes of $45.1 million and an increase in accounts payable and accrued liabilities of $0.4 million partially offset by an increase in accounts receivable of $3.5 million, an increase in prepaid expenses and other current assets of $6.3 million, and a decrease in deferred revenue and other noncurrent liabilities of $1.3 million. The decrease in deferred taxes is due to a one-time charge to establish a valuation allowance. The increase in accounts receivable is due to timing of collections. The non-cash charges primarily consisted of impairment of goodwill of $95.6 million, depreciation and amortization of $26.1 million, and stock-based compensation expense net of tax benefits of $9.9 million, offset by other adjustments, net of $1.1 million. Cash flows provided by operating activities in fiscal year 2013 consisted of primarily non-cash adjustments of $136.6 million, partially offset by net loss of $67.4 million and an increase in working capital of $18.5 million. The non-cash adjustments consisted primarily of impairment of goodwill of $92.4 million, depreciation and amortization of $32.3 million and stock-based compensation expense net of tax benefits of $11.9 million. The contribution to working capital accounts was primarily due to an increase in deferred taxes of $30.8 million resulting from tax deductible goodwill write-off, a decrease in accounts receivable of $15.3 million, net decrease in accounts payable and accrued liabilities of $6.0 million, and a decrease in prepaid expenses and other assets of $3.2 million. The decrease in accounts receivable are primarily due to better collections. The net decrease in accounts payable and accrued and prepaid expenses and other assets are primarily due to timing of payments. 45-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Cash flows provided by operating activities in fiscal year 2012 consisted of primarily non-cash adjustments of $44.6 million and net income of $13.0 million, partially offset by contributions to working capital of $11.3 million. The non-cash adjustments primarily consisted of depreciation and amortization of $31.2 million and stock-based compensation expense net of tax benefits of $12.8 million. The contribution to working capital accounts was primarily due to a decrease in accounts payable and accrued liabilities of $7.8 million and a decrease in deferred taxes of $2.8 million, partially offset by an increase in prepaid expenses and other assets of $2.7 million, and an increase in accounts receivable of $2.0 million. The decrease in accounts payable and accrued liabilities is due to timing of payments and decreased cost of revenue associated with decreased revenue. The decrease in deferred taxes is due to larger temporary differences between the financial statement carrying amount and the tax basis of certain existing assets and liabilities. The increase in prepaid expenses and other assets is primarily due to timing of payments. The increase in accounts receivable is attributable to timing of receipts. Net Cash Used in Investing Activities Cash flows from investing activities include acquisitions of media websites and businesses; purchases, sales and maturities of marketable securities; capital expenditures; and capitalized internal development costs. Cash flows used by investing activities were $10.7 million for fiscal year 2014 compared to $7.5 million for fiscal year 2013 and $66.6 million for fiscal year 2012. Cash used in investing activities in fiscal year 2014 was primarily due to capital expenditures and internal software development costs of $7.9 million, licenses to intangible assets of $2.8 million and acquisition costs of $0.9 million offset by proceeds from sale of investment of $1.4 million and other investing activities of $0.5 million. Net investments in marketable securities totaled $1.0 million. Cash used in investing activities in fiscal year 2013 was primarily due to net investments in marketable securities of $1.1 million and licenses of intangible assets of $2.5 million. Capital expenditures and internal software development costs totaled $3.9 million in fiscal year 2013. Cash used in investing activities in fiscal year 2012 was primarily due to our acquisition of IT Business Edge for a cash payment of $24.0 million, acquisition of certain assets of Ziff Davis Enterprise of $17.3 million and the purchases of the operations of eleven other online publishing businesses for an aggregate of $14.6 million in cash payments, as well as net investments in marketable securities of $1.8 million. Capital expenditures and internal software development costs totaled $4.6 million in fiscal year 2012. Net Cash Used in Financing Activities Cash flows from financing activities include proceeds from exercise of stock options, withholding taxes related to restricted stock net of share settlement, excess tax benefits from stock-based compensation, and principal payments on bank debt and acquisition-related notes payable. Cash flows used by financing activities were $13.5 million for fiscal year 2014 compared to $21.6 million for fiscal year 2013 and $43.4 million for fiscal year 2012. Cash used in financing activities in fiscal year 2014 was primarily due to principal payments on acquisition-related notes payable and our term loan and related fees of $15.5 million and withholding taxes related to restricted stock net of share settlement of $1.9 million offset by proceeds received from exercises of stock options of $3.3 million and excess tax benefits from exercises of stock options of $0.5 million. Cash used in financing activities in fiscal year 2013 was primarily due to principal payments on acquisition-related notes payable and our term loan and related fees of $15.8 million and repurchases of our common stock 46-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements of $6.2 million under our stock repurchase program partially offset by proceeds received from exercises of stock options of $0.5 million. Cash used in financing activities in fiscal year 2012 was primarily due to repurchases of our common stock of $43.9 million under our stock repurchase program and principal payments on acquisition-related notes payable and our term loan and related fees of $9.9 million, partially offset by proceeds from bank debt of $5.9 million and exercises of stock options of $4.7 million. Off-Balance Sheet Arrangements During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Contractual Obligations Our contractual obligations relate primarily to borrowings under our credit facility, acquisition-related notes payable, and operating leases. The following table sets forth payments due under our contractual obligations as of June 30, 2014: Payment Due by Period Less than 1 More than Total Year 1-3 Years 3-5 Years 5 Years (In thousands) Second Loan Agreement $ 77,500 $ 17,500 $ 60,000 $ - $ - Operating Leases 14,409 3,541 6,707 4,161 - Promissory Notes 610 560 50 - - Total $ 92,519 $ 21,601 $ 66,757 $ 4,161 $ - The above table does not include approximately $3.1 million of long-term income tax liabilities for uncertainty in income taxes due to the fact that we are unable to reasonably estimate the timing of these potential future payments. Credit Facility In November 2011, we entered into the Second Amended and Restated Revolving Credit and Term Loan Agreement ("Second Loan Agreement") with Comerica Bank (the "Bank"), the administrative agent and lead arranger. The Second Loan Agreement consists of a $100.0 million five-year term loan, with annual principal amortization of 5%, 10%, 15%, 20% and 50%, and a $200.0 million five-year revolving credit line. On February 15, 2013, we entered into the First Amendment to Credit Agreement and Amendment to Guaranty ("First Amendment") with the Bank to, among other things: (1) amend the definition of EBITDA, effective as of December 31, 2012, to exclude extraordinary or non-recurring non-cash expenses or losses including, without limitation, goodwill impairments, and any extraordinary or non-recurring cash expenses in an aggregate amount not to exceed $5.0 million for the life of the Second Loan Agreement; and (2) reduce the $200.0 million five-year revolving credit line portion of the facility to $100.0 million, effective as of February 15, 2013. On July 17, 2014, we entered into the Second Amendment to Credit Agreement ("Second Amendment") with the Bank to, among other things, amend the financial covenants and reduce the revolving loan facility from $100.0 million to $50.0 million, each effective as of June 30, 2014. 47 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Borrowings under the Second Loan Agreement are secured by substantially all of our assets. Interest is payable at a rate computed using either Base rate or Eurodollar rate plus an applicable margin, at our option. Base rate is defined as an applicable margin plus the greatest of (a) the Prime Rate for such day, (b) the Federal Funds Effective Rate in effect on such day, plus 1% and (c) the Daily Adjusting LIBOR Rate plus 1%. Base rate borrowings bear interest at a Base rate plus an applicable margin which varies from (1) 0.625% to 1.375% for revolving loans and (2) 1.00% to 1.75% for term loans, depending on our funded debt to EBITDA ratio. Eurodollar rate borrowings bear interest at the Eurodollar rate plus an applicable margin which varies from (1) 1.625% to 2.375% for revolving loans and (2) 2.00% to 2.75% for term loans, depending on our funded debt to EBITDA ratio. Pursuant to the Second Amendment, for the period beginning on the effective date of the Second Amendment until the delivery of financial statements for the fiscal quarter ending December 31, 2015, (1) the applicable margin for Base rate borrowings is set at (a) 1.375% for revolving loans or (b) 1.75% for term loans, and (2) the applicable margin for Eurodollar rate borrowings is set at (a) 2.375% for revolving loans or (b) 2.75% for term loans. Thereafter, the applicable margin varies depending on our funded debt to EBITDA ratio, as described above. EBITDA is defined as net (loss) income less (provision for) benefit from taxes, depreciation expense, amortization expense, stock-based compensation expense, interest and other income (expense), acquisition costs for business combinations, extraordinary or non-recurring non-cash expenses or losses including, without limitation, goodwill impairments, and any extraordinary or non-recurring cash expenses in an aggregate amount not to exceed $5 million for the life of this Second Loan Agreement. The revolving loan facility requires an annual facility fee of 0.375% of the revolving credit line capacity. The Second Loan Agreement expires in November 2016. The Second Loan Agreement, as amended, restricts our ability to raise additional debt financing and pay dividends, and also requires us to comply with other nonfinancial covenants. In addition, we are required to maintain financial covenants as follows: 1. A minimum fixed charge coverage ratio as of the end of each fiscal quarter of not less than: (a) 1.00:1:00 for the period between September 30, 2015 and June 30, 2016; and (b) 1.15:1:00 for the period beginning July 1, 2016 and thereafter. The fixed charge coverage ratio is not tested until the fiscal quarter ending September 30, 2015. 2. Minimum EBITDA as of the end of each fiscal quarter of not less than: (a) $1 for the period between April 1, 2014 and June 30, 2015; (b) $3,400,000 for the period between July 1, 2015 and September 30, 2015; (c) $3,200,000 for the period between October 1, 2015 and December 31, 2015. EBITDA is not tested after the fiscal quarter ending December 31, 2015. 3. Minimum liquidity as of the end of each month of not less than $20,000,000. We were in compliance with the covenants of our Second Loan Agreement, as amended, as of June 30, 2014 and 2013. Upfront arrangement fees incurred in connection with the Second Amendment totaled $0.3 million and will be deferred and amortized over the remaining term of the arrangement. Upfront arrangement fees incurred in connection with the First Amendment totaled $0.2 million and were deferred and will be amortized over the remaining term of the arrangement. In connection with the reduction of the revolving credit line capacity, during the third quarter of fiscal year 2013 we accelerated amortization of approximately $0.7 million of unamortized deferred upfront costs. 48 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Interest Rate Swap In February 2012, we entered into an interest rate swap to reduce our exposure to the financial impact of changing interest rates under our term loan. We do not speculate using derivative instruments. The swap encompasses the principal balances outstanding as of January 1, 2014 and scheduled to be outstanding thereafter, such principal and notional amount totaling $85 million in January 2014 and amortizing to $35 million in November 2016. The effective date of the swap was April 9, 2012 with a maturity date of November 4, 2016. At June 30, 2014, we had approximately $77.5 million of notional amount outstanding in the swap agreement that exchanges a variable interest rate base (Eurodollar rate) for a fixed interest rate of 0.97% over the term of the agreement. This interest rate swap is designated as a cash flow hedge of the interest rate risk attributable to forecasted variable interest payments. The effective portion of the fair value gains or losses on this swap are included as a component of accumulated other comprehensive loss. At June 30, 2014, our interest rate swap qualified as a cash flow hedge. For this qualifying hedge, the effective portion of the change in fair value will be recognized through earnings when the underlying transaction being hedged affects earnings, thereby allowing the swap's gains and losses to offset interest expense from the term loan in the consolidated statements of operations. Any hedge ineffectiveness is recognized in earnings in the current period. Headquarters Lease We entered into a lease agreement in February 2010 for approximately 63,998 square feet of office space located at 950 Tower Lane, Foster City, California. The term of the lease began on November 1, 2010 and expires on October 31, 2018. The monthly base rent was abated for the first 12 calendar months under the lease, and remained at $0.1 million through the 24th calendar month of the term of the lease. After this 24 month period, monthly base rent increased to $0.2 million for the subsequent 12 months and now increases approximately 3% after each 12-month anniversary during the remaining term, including any extensions under our options to extend. We have two options to extend the term of the lease for one additional year for each option following the expiration date of the lease or renewal term, as applicable. Critical Accounting Policies and Estimates We have prepared our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP"). In doing so, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Actual results may differ significantly from these estimates. We believe that the critical accounting policies listed below involve our more significant judgments, estimates and assumptions and, therefore, could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understand and evaluate the consolidated financial statements contained in this report. See Note 2, Summary of Significant Accounting Principles, of our consolidated financial statements for further information on our critical and other significant accounting policies. 49-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Revenue Recognition More than 99% of total revenue is derived from the DMS business. DMS revenue is derived primarily from fees which are earned through the delivery of qualified leads, clicks, calls, customers and, to a lesser extent, display advertisements, or impressions. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is reasonably assured. Delivery is deemed to have occurred at the time a qualified lead or click is delivered to the client provided that no significant obligations remain. Under our revenue recognition policies, we allocate revenue in an arrangement using the estimated selling price ("ESP") of deliverables if vendor-specific objective evidence ("VSOE") of selling price based on historical stand-alone sales or third-party evidence ("TPE") of selling price does not exist. Due to the unique nature of some of our multiple deliverable revenue arrangements, we may not be able to establish selling prices based on historical stand-alone sales or third-party evidence, therefore we may use our best estimate to establish selling prices for these arrangements under the new standard. We establish best estimates within a range of selling prices considering multiple factors including, but not limited to, factors such as class of client, size of transaction, available media inventory, pricing strategies and market conditions. We believe the use of the best estimate of selling price allows revenue recognition in a manner consistent with the underlying economics of the transaction. From time to time, we may agree to credit a client for certain leads, clicks, calls or customers if they fail to meet the contractual or other guidelines of a particular client. We have established a sales reserve based on historical experience. To date, such credits have been within our expectations. For a portion of our revenue, we have agreements with providers of online media or third-party publishers used in the generation of qualified leads, clicks, calls or customers. We receive a fee from our clients and pay a fee to publishers either on a revenue-share, cost-per-lead, cost-per-click or cost-per-thousand-impressions basis. We are the primary obligor in the transaction. As a result, the fees paid by our clients are recognized as revenue and the fees paid to our publishers are included in cost of revenue. All other revenue is comprised of (i) set-up and professional services fees and (ii) usage fees. Set-up and professional service fees that do not provide stand-alone value to a client are recognized over the contractual term of the agreement or the expected client relationship period, whichever is longer, effective when the application reaches the "go-live" date. We define the "go-live" date as the date when the application enters into a production environment or all essential functionalities have been delivered. Usage fees are recognized on a monthly basis as earned. Deferred revenue is comprised of contractual billings in excess of recognized revenue and payments received in advance of revenue recognition. Stock-Based Compensation We measure and record the expense related to stock-based transactions based on the fair values of the awards as determined on the date of grant. For stock options, we selected and have historically used the Black-Scholes option pricing model to estimate the fair value. In applying the Black-Scholes option pricing model, our determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the stock options and the employees' actual and projected stock option exercise and pre-vesting employment termination behaviors. We estimate the expected volatility of our common stock based on our historical volatility over the stock option's expected term. We have no history or expectation of paying dividends on our common stock. The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected term of the stock options. The fair value of restricted stock units is determined based on the closing price of our common stock on the date of grant. 50-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements We recognize stock-based compensation expense over the requisite service period using the straight-line method, based on awards ultimately expected to vest. We estimate future forfeitures at the date of grant and revise the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Goodwill We conduct a test for the impairment of goodwill at the reporting unit level on at least an annual basis and whenever there are events or changes in circumstances that would more likely than not reduce the estimated fair value of a reporting unit below its carrying value. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows and determining appropriate discount rates, growth rates, an appropriate control premium and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit which could trigger impairment. We have two reporting units for purposes of allocating and testing goodwill, DMS and DSS. We performed our annual goodwill impairment test on April 30, 2014 in our quarter ending June 30, 2014. While we are permitted to conduct a qualitative assessment to determine whether it is necessary to perform a two-step quantitative goodwill impairment test, for our annual goodwill impairment test in the fourth quarter of fiscal 2014, we performed a quantitative test for both of our reporting units. In the first step of the annual impairment test, we compare the fair value of each reporting unit to its carrying value. We estimated the fair value of the DSS reporting unit using only the income approach as market comparables were not meaningful. We have concluded that the carrying value of the DSS reporting unit exceeded its estimated fair value therefore we performed Step 2 analysis, as required and recorded a goodwill impairment charge of $1.2 million for the entire goodwill of our DSS reporting unit. We estimated the fair value of our DMS reporting unit based on our market capitalization and determined that there were no instances of impairment in our DMS reporting unit. Our public market capitalization sustained a decline after June 30, 2014 primarily due to our operating results in the fourth quarter of fiscal year 2014, to a value below the net book carrying value of our equity. As a result, we determined that this triggered the necessity to conduct an interim goodwill impairment test as of June 30, 2014. We first tested the long-lived assets related to the DMS reporting unit as of June 30, 2014 and, based on the undiscounted cash flows, determined that these assets were not impaired. A two-step process was then required to test goodwill impairment. The first step is to determine if there is an indication of impairment by comparing the estimated fair value to its carrying value including goodwill. Goodwill is considered impaired if the carrying value exceeds the estimated fair value. Upon indication of impairment, a second step is performed to determine the amount of the impairment by comparing the implied fair value of the reporting unit's goodwill with its carrying value. We estimated the fair value of our DMS reporting unit using a weighting of fair values derived most significantly from the market approach which approximated our market capitalization and to a lesser extent the income approach. Under the market approach, we utilize publicly-traded comparable company information to determine revenue and earnings multiples that are used to value our reporting units adjusted for an estimated control premium. As the DMS reporting unit represents substantially the entire Company, the market approach has been reconciled to our market capitalization. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on management's estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit's ability to execute on the projected cash flows. 51-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements The second step of the goodwill impairment test required us to fair value all assets and liabilities of our DMS reporting unit to determine the implied fair value of goodwill. We compared the implied fair value of the reporting unit's goodwill to its carrying value. This test resulted in a non-cash goodwill impairment charge in aggregate of $95.6 million for the year ended June 30, 2014. The inputs used to measure the estimated fair value of goodwill are classified as a Level 3 fair value measurement due to the significance of unobservable inputs in income approach using company-specific information. Long-Lived Assets We evaluate long-lived assets, such as property and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We apply judgment when estimating the fair value of the assets based on the undiscounted future cash flows the assets are expected to generate and recognize an impairment loss if estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. We tested our long-lived assets related to the DMS reporting unit as of June 30, 2014 and based on the undiscounted cash flows, determined that these assets were not impaired. Income Taxes We account for income taxes using an asset and liability approach to record deferred taxes. Our deferred income tax assets represent temporary differences between the financial statement carrying amount and the tax basis of existing assets and liabilities that will result in deductible amounts in future years, including net operating loss carry forwards. A valuation allowance is recorded against our deferred tax assets which are not expected to be realized. Our judgment regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. Recent Accounting Pronouncements See Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements for information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements. |