TMCnet News

DIGITAL RIVER INC /DE - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[October 31, 2014]

DIGITAL RIVER INC /DE - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) The discussion in this Quarterly Report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Additional factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled "Risk Factors," included in Item 1A of Part II of this Quarterly Report. When used in this document, the words "believes," "expects," "anticipates," "intends," "plans," and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. We have no obligation to update the matters set forth herein, whether as a result of new information, future events or otherwise.



Business Overview Digital River is a leading provider of global Commerce-as-a-Service (CaaS) solutions. We provide commerce, payments and marketing solutions to business-to-business (B2B) and business-to-consumer (B2C) digital product and cloud service companies as well as branded manufacturers across a variety of vertical markets through our multi-tenant technology, platform and service offerings. Our customers range in size from small to mid-sized companies to multi-national enterprises that serve a wide variety of markets, including, software, consumer electronics, computer games, publishing, travel, music, video games, electronic toys, housewares, medical equipment, power tools and direct-selling, among others.

We offer our customers a broad range of solutions to quickly and cost effectively establish, manage and grow commerce sales channels via Internet-connected devices. We have invested substantial resources to develop our solutions, services, infrastructure and platforms, and to mitigate the risks our customers may encounter when conducting global commerce.


Commerce Our Commerce-as-a-Service suite includes our commerce experience, tools and capabilities; Commerce Business Infrastructure (CBI), which we believe is a competitive differentiator; and marketing services. Our solutions allow our customers to focus on promoting and marketing their products and brands worldwide while leveraging our technology and global infrastructure investments to facilitate the purchase of products or services through e-commerce stores. We generate a significant proportion of our revenue based on the difference between the selling price and our wholesale purchase price, which can be expressed on a revenue-share basis, meaning that we earn as margin a percentage of the selling price of each product sold through our commerce solution. We believe this model aligns our interests with those of our clients. In addition, we also offer our customers transaction-based models and hybrid combinations of revenue share and transaction models.

· Commerce experience, tools and capabilities: With our commerce experience, tools and capabilities we create and manage world-class commerce sites and online experiences that include all of the classic components of a commerce operation, such as responsive and adaptive design, development and hosting of commerce stores, in-application and in-product commerce experiences, shopping carts, store merchandising and optimization, digital product or license key delivery via download, physical product fulfillment, subscription management, e-marketing services, international payment processing services, web store optimization, web analytics and reporting.

When shoppers decide to purchase a customer's product or service online, they are transferred to a commerce store and/or shopping cart operated by us using our multi-tenant commerce platform. Once on our system, shoppers can browse for products and make purchases using connected devices such as PCs, tablet computers, smartphones and other similar devices. After a purchase is made, we deliver the product or license key digitally via download over the Internet, enable access to the product via a time- or -usage- 17 -------------------------------------------------------------------------------- Table of Contents based subscription model or transmit instructions to a third party partner for physical fulfillment of the order.

· Commerce business infrastructure (CBI): Our CBI is the underpinning for our Commerce-as-a-Service suite and our payments solution. We believe it is unique and differentiated, enabling us to manage the complexity of global commerce on behalf of our customers. It includes our merchant-of-record and seller-of-record capabilities, our fraud screening and management capabilities, our order management, business intelligence analytics, customer support services and our integration services capabilities as well as our local business entities, which enable us to have on-the-ground experts, strong localization capabilities and local payment methods and banking relationships; and it enables us to manage legal compliance requirements and export controls and management.

We have invested substantial resources to develop our CBI as part of our multi-tenant SaaS commerce and marketing platform and business processes. We provide access and use of our platform to our clients as a service as opposed to selling the software to be operated on our customers' own in-house computer hardware.

Payments Our Payments solutions offer our customers a global payments footprint, including a full range of domestic and international payment solutions, 180 global payment methods, 170 international currencies and 50 connections to local banks from across the globe. The payments services we provide ourselves or through third parties include transaction processing, global payment methods, fraud management, cloud-based billing, mobile payments services, and other payment optimization services. Our online payments solutions are designed to help our customers maximize credit card and transaction authorization rates, reduce online shopping cart abandonment, ease entry into new geographies and protect transactions from fraud on a global basis. Our payments offerings can function as independent online payment solutions and as fully integrated components of Digital River's enterprise commerce solution.

Marketing In addition to the services we provide that facilitate the completion of an online transaction, we also offer services designed to help our clients acquire customers more effectively, sell to those customers more often and more efficiently, and increase the lifetime value and retention of each customer. The e-marketing services we provide are supported through several channels. Our performance marketing services include: · marketForce: Our marketForce™ digital marketing agency includes a global team of marketers that offer managed direct response e-marketing services. Digital River's e-marketing experts offer managed services that span email and affiliate marketing management, search engine marketing, site optimization, multi-variate testing, mass dynamic personalization and contextual advertising.

· oneNetworkDirect: Through our large oneNetworkDirect™ affiliate network, we provide our customers access to a new sales channel, which can help grow their online businesses. Customers can offer any part of their product catalogs to our network of online channel partners, including online retailers and affiliates. This increases the exposure these products receive and can result in higher sales volumes.

· BlueHornet Email Marketing: Our BlueHornetTM enterprise email marketing service provides traditional as well as social and mobile email marketing capabilities.

BlueHornet offers email marketing technology, a service model including account management by expert email marketers, and proactive inbox deliverability management.

We view our operations and manage our business as one reportable segment, providing solutions to companies that want to sell their products and services online.

18 -------------------------------------------------------------------------------- Table of Contents We were incorporated in Delaware in February 1994. Our headquarters are located at 10380 Bren Road West, Minnetonka, Minnesota and our telephone number is 952-253-1234.

General information about us can be found at www.digitalriver.com under the "Company/Investor Relations" link or follow the Company on Twitter at twitter.com/digitalriverinc. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments or exhibits to those reports, are available free of charge through our website as soon as reasonably practicable after we file such reports with the Securities and Exchange Current Period Results For the three months ended September 30, 2014, we recorded net income of $4.2 million, or $0.14 per diluted share, comprised of net income from continuing operations of $4.0 million, or $0.13 per diluted share and a $0.1 million gain from discontinued operations, $0.01 per diluted share. For the comparative period ended September 30, 2013, we recorded a net loss of $12.5 million, or loss of $0.40 per share, comprised of net loss from continuing operations of $7.6 million, or loss of $0.24 per share, and net loss from discontinued operations of $4.9 million, or loss of $0.16 per share. Revenue for the quarter ended September 30, 2014 was $88.8 million, compared to $87.3 million for the same period in the prior year. The 1.8% growth in revenue quarter over quarter was driven by the addition of new payments clients.

Total costs and expenses in continuing operations for the three months ended September 30, 2014 were $94.7 million compared to $93.8 million in the same period in the prior year, an increase of 1.0%.

As of September 30, 2014 and December 31, 2013, we had $385.8 million and $599.5 million in cash, cash equivalents and short-term investments, respectively.

Results of Operations The results of the operations of CustomCD, Inc. (CustomCD) and Digital River Education Services, Inc. (DRES), which were sold on September 30, 2013 and October 1, 2013, respectively, have been classified within Discontinued Operations in our Consolidated Statements of Operations for all periods presented.

19 -------------------------------------------------------------------------------- Table of Contents The following table sets forth certain items from our Consolidated Statements of Operations as a percentage of total revenue for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Revenue 100.0 % 100.0 % 100.0 % 100.0 % Costs and expenses (exclusive of depreciation and amortization expense shown separately below): Direct cost of services 20.6 18.5 19.4 19.1 Network and infrastructure 15.5 16.8 15.2 15.3 Sales and marketing 28.2 28.7 26.9 27.9 Product research and development 20.6 20.8 20.2 18.4 General and administrative 12.0 13.8 12.9 15.3 Goodwill impairment - - - 7.4 Depreciation and amortization 7.5 6.5 7.1 5.4 Amortization of acquisition-related intangibles 2.3 2.4 2.3 2.2 Total costs and expenses 106.7 107.5 104.0 111.0 Income (loss) from operations (6.7) (7.5) (4.0) (11.0) Interest income 0.5 0.6 0.6 0.6 Interest expense (1.0) (2.2) (1.2) (2.0) Other income (expense), net 2.3 (0.3) 0.7 5.8 Gain (loss) on extinguishment of debt - - (2.0) - Income (loss) from continuing operations before income taxes (4.9) (9.4) (5.9) (6.6) Income tax expense (benefit) (9.3) (0.7) (2.7) (0.2) Income (loss) from continuing operations 4.4 (8.7) (3.2) (6.4) Income (loss) from discontinued operations, net of tax 0.2 (5.6) 0.1 (2.2) Net income (loss) 4.6 % (14.3) % (3.1) % (8.6) % Revenue. Our revenue was $88.8 million and $87.3 million for the three months ended September 30, 2014 and 2013, respectively, an increase of $1.5 million or 1.8%. For the nine months ended September 30, 2014, revenue totaled $274.0 million, a decrease of $14.4 million or 5.0%, from revenue of $288.4 million for the same period in the prior year.

Our revenue is driven primarily by global commerce and payment services provided to a wide variety of companies in the software, consumer electronics, computer games and other markets.

Payments revenue for the three and nine months ended September 30, 2014, increased $1.8 million or 12.7%, and $4.6 million or 10.1%, respectively. The growth in both periods is mainly related to the addition of new clients.

Commerce revenue, including Microsoft, for the three months ended September 30, 2014 was consistent with the same period in the prior year, decreasing $0.3 million or 0.4%. For the nine months ended September 30, 2014, commerce revenue decreased $19.0 million or 7.8%, due primarily to client attrition, as well as one-time significant product launches that occurred in the first quarter of 2013.

International sales were approximately 46.4% and 47.6% of revenue from continuing operations in the three and nine month periods ended September 30, 2014, compared to 46.8% and 47.7% for the same periods in the prior year.

20 -------------------------------------------------------------------------------- Table of Contents Direct Cost of Services. Direct cost of services includes payment processing fees, chargeback expense, fraud detection and prevention, costs related to product fulfillment, delivery solutions and certain client-specific costs. Direct cost of services were $18.3 million for the three months ended September 30, 2014, compared to $16.2 million for the same period in the prior year. The increase was primarily related to higher payment processing costs.

For the nine months ended September 30, 2014, direct cost of services was $53.3 million compared to $55.3 million for the same period in the prior year. Higher costs in 2013 were primarily due to CD costs related to one time significant product launches in the first quarter of 2013.

Network and Infrastructure. Our network and infrastructure expenses primarily include costs to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expenses were $13.8 million and $14.6 million for the three months ended September 30, 2014 and 2013, respectively. For the nine months ended September 30, 2014 and 2013, network and infrastructure expenses were $41.7 million and $44.0 million, respectively. The decreases for both periods were primarily related to reductions in workforce, consulting, and overhead related expenses.

Sales and Marketing. Our sales and marketing expenses include personnel and related costs, advertising, promotional and product marketing expenses. Sales and marketing expenses were $25.1 million for the three months ended September 30, 2014, consistent with $25.0 million for the same period in the prior year.

For the nine months ended September 30, 2014 and 2013, sales and marketing expenses were $73.6 million and $80.4 million, respectively. The decrease year-over year was driven by reductions in workforce costs, including severance and stock compensation expense incurred in 2013 as part of planned cost reduction strategies, and lower marketing expense, including the utilization of third parties.

Product Research and Development. Our product research and development expenses include costs associated with design, development and enhancement of our technology platforms and related systems. Research and development costs are expensed as incurred, except certain internal-use software development costs that are eligible for capitalization and costs directly associated with preparing a client website launch that are eligible to be deferred and amortized over the life of the site's associated revenue streams. Product research and development expenses were $18.3 million and $18.1 million for the three months ended September 30, 2014 and 2013, respectively, and $55.2 million and $53.0 million for the nine months ended September 30, 2014 and 2013, respectively.

The increases for both periods were driven by employee and contractor expenses related to the continued investment in our platforms.

General and Administrative. Our general and administrative expenses primarily include executive, finance, human resources and other administrative workforce and other related expenses, fees for professional services, bank fees, litigation costs, insurance costs, acquisition and integration costs and non-income related taxes. General and administrative expenses were $10.7 million and $12.0 million for the three months ended September 30, 2014 and 2013, respectively. The decrease was primarily related to strategic consulting expenses incurred in 2013 associated with business transformation plans, as well as lower legal and professional services spending. For the nine months ended September 30, 2014 and 2013, general and administrative expenses were $35.3 million and $44.0 million, respectively. In addition to the quarter over quarter decreases, the nine months in 2013 included acquisition and integration costs associated with the acquisition of LML Payment Systems, Inc. and severance and stock compensation expense associated with an executive departure.

Goodwill Impairment. During the first quarter of 2013, we completed our fiscal year 2012 goodwill impairment analysis and recorded an additional non-cash pretax goodwill impairment charge of $21.2 million.

Depreciation and Amortization. Our depreciation and amortization expenses include the depreciation of computer equipment, office furniture and leasehold improvements and the amortization of purchased and internally developed software. Computer equipment, software and furniture are depreciated/amortized under the straight-line method using three to seven year lives and leasehold improvements are depreciated over the shorter of the life of the asset or the remaining length of the lease. Depreciation and amortization expense was $6.6 million and $5.7 million for the three months ended September 30, 2014 and 2013, respectively. Depreciation and amortization expense was $19.5 million and $15.7 million for the nine months ended September 30, 2014 and 2013, respectively. The increase in depreciation and amortization in both periods is primarily related to assets acquired for our new data center which were put into service during the third quarter of 2013.

21 -------------------------------------------------------------------------------- Table of Contents Amortization of Acquisition-Related Intangibles. Acquisition-related intangibles consists of the assets such as customer relationships, technology and trade names acquired in business combinations. Amortization of acquisition-related intangible assets was $2.0 million for the three months ended September 30, 2014, consistent with the $2.1 million recognized in the three months ended September 30, 2013. Amortization of acquisition-related intangible assets was $6.4 million for both of the nine months ended September 30, 2014 and 2013.

Interest Income. Our interest income represents the total of interest income on our cash, cash equivalents, short-term investments and certain long-term investments. Interest income was $0.5 million and $0.6 million for the three months ended September 30, 2014 and 2013, respectively. Interest income was $1.7 million and $1.9 million for the nine months ended September 30, 2014 and 2013, respectively. The small decrease in interest income in both periods is related to lower total cash and cash equivalent and investment balances due to senior convertible note and stock repurchases over the past year.

Interest Expense. Our interest expense includes the total of cash and non-cash interest expense attributable to our outstanding convertible debt. For the three months ended September 30, 2014 and 2013, interest expense was $0.9 million and $1.9 million, respectively, which included $0.2 million and $0.4 million of debt financing cost amortization, respectively. For the nine months ended September 30, 2014 and 2013, interest expense was $3.4 million and $5.9 million, respectively, which included $0.7 million and $1.3 million of debt financing cost amortization, respectively. The decrease in interest expense in both periods was due to the repurchase of our senior convertible notes during 2013 and the first quarter of 2014.

Other Income (Expense), Net. Other income (expense), net includes foreign currency transaction gains and losses, gains and losses on investments or asset disposals (excluding disposals of businesses included in discontinued operations), and dividend income. Other income (expense), net was $2.1 million of income compared to $0.3 million of expense for the three months ended September 30, 2014 and 2013, respectively. Other income (expense), net was $1.9 million of income compared to $16.7 million of income for the nine months ended September 30, 2014 and 2013, respectively. The other income, net that was recognized in the three and nine months ended September 30, 2014 was primarily related to additional gains recognized on the sale of a cost method investment that occurred in the first quarter of 2013. These gains were contingent on the release of an escrow amount that occurred in the third quarter of 2014. The other income, net that was recorded for the nine months ended September 30, 2013 was related to the initial gain on the sale of the same cost method investment.

Gain (Loss) on Extinguishment of Debt. During the first quarter of 2014, we repurchased $160.6 million of our 2.00% senior convertible notes in the open market for $164.5 million, excluding accrued interest. The loss on extinguishment of this debt, including the premium on repurchase and acceleration of the recognition of deferred financing fees was $5.5 million. In addition, we repurchased $8.7 million of our 1.25% senior convertible notes at par in the first quarter of 2014 and recorded a $0.1 million charge related to the acceleration of the recognition of deferred financing fees.

Income Tax Expense. For the three months ended September 30, 2014 and 2013, our tax benefit related to continuing operations was $8.3 million and $0.6 million, respectively. For the three months ended September 30, 2014 our tax benefit related to discontinued operations was $0.1 million compared to a tax expense of $2.7 million for the three months ended September 30, 2013. For the three months ended September 30, 2014, our tax benefit related to continuing operations consisted of $8.4 million U.S. tax benefit and $0.1 million of foreign tax expense. For the three months ended September 30, 2013, our tax benefit related to continuing operations consisted of $0.4 million of U.S. tax benefit and $0.2 million of foreign tax benefit. For the three months ended September 30, 2014 and 2013, the tax rate was a benefit of 194.0% and 7.8%, respectively.

For the nine months ended September 30, 2014 and 2013, our tax benefit related to continuing operations was $7.4 million and $0.4 million, respectively. For the nine months ended September 30, 2014, we had no tax expense related to discontinued operations compared to tax expense of $2.5 million for the nine months ended September 30, 2013. For the nine months ended September 30, 2014, our tax expense related to continuing operations consisted of $8.1 million of U.S. tax benefit and $0.8 million of foreign tax expense. For the nine months ended September 30, 2013, our tax expense related continuing operations consisted of $1.0 million of U.S. tax 22 -------------------------------------------------------------------------------- Table of Contents expense and $1.4 million of foreign tax benefit. For the nine months ended September 30, 2014 and 2013, the tax rate was 45.0% and 2.2%, respectively.

The tax benefit for both the three and nine month periods ended September 30, 2014 was driven by $9.1 million of previously unrecognized tax benefits, including $1.4 million of related interest, which was released in the third quarter of 2014 due to the expiration of a statute of limitations.

Discontinued Operations. The pre-tax gain related to the disposal of discontinued operations recorded in the three months ended September 30, 2014 was immaterial compared to a pre-tax loss related to the operation of the discontinued entities of $0.1 million and pre-tax loss of $2.1 million related to the disposal of those entities for the three months ended September 30, 2013.

Total net gain from discontinued operations was $0.1 million for the three months ended September 30, 2014, compared to a net loss of $4.9 million for the same period in the prior year. The pre-tax gain related to the disposal of discontinued operations recorded in the nine months ended September 30, 2014 was $0.3 million compared to a pre-tax loss of $3.7 million for the nine months ended September 30, 2013, which consists of $1.6 million of pre-tax loss on the operation of the discontinued entities and $2.1 million pre-tax loss on disposal. Total net gain from discontinued operations was $0.3 million for the nine months ended September 30, 2014, compared to a net loss of $6.2 million for the same period in the prior year.

Off Balance Sheet Arrangements None.

Liquidity and Capital Resources Nine Months Ended September 30, 2014 2013 Cash provided by (used in): Operating activities $ 8,199 $ (45,555) Investing activities (44,875) 5,799 Financing activities (204,667) (51,176) Effect of exchange rate changes on cash and cash equivalents (9,120) 6,143 Net increase (decrease) in cash and cash equivalents $ (250,463) $ (84,789) As of September 30, 2014, we had $233.4 million of cash and cash equivalents, approximately 63.2% was held by our international subsidiaries. Cash and cash equivalents are sufficient to fund our current and anticipated operations and we do not anticipate any local liquidity restrictions that would preclude us from funding our expansion or operating needs.

Operating Activities Net cash provided by operations for the nine months ended September 30, 2014, of $8.2 million was due to net add backs for non-cash operating expenses, offset by changes in working capital, a $27.5 million use of cash. Excluding the impact of working capital changes, our operating cash flow for the nine months ended September 30, 2014, was $35.7 million. Net cash used in operations for the nine months ended September 30, 2013, was $45.6 million, and was primarily the result of changes in working capital, a $71.9 million use of cash. Excluding the impact of working capital changes, our operating cash flow for the nine months ended September 30, 2013, was $26.4 million.

Investing Activities 23 -------------------------------------------------------------------------------- Table of Contents Net cash used in investing activities for the nine months ended September 30, 2014, was $44.9 million and was the result of net purchases of investments of $31.8 million and purchases of equipment and capitalized software of $13.6 million, offset by proceeds from sale of equipment of $0.5 million. Net cash provided by investing activities for the nine months ended September 30, 2013, was $5.8 million and was the result of net sales of investments of $77.3 million, offset by cash paid for acquisitions of $55.8 million and $15.7 million of purchases of equipment and capitalized software.

Financing Activities Net cash used in financing activities for the nine months ended September 30, 2014, was $204.7 million and was due to $173.3 million in repurchases of our senior convertible notes, $28.3 million in repurchases of our common stock and $4.1 million in repurchases of restricted stock to satisfy tax withholding obligations, offset by $1.0 million of sales of common stock under our employee stock purchase plan. Net cash used in financing activities for the nine months ended September 30, 2013, was $51.2 million and was due to $44.0 million in repurchases of common stock, $4.3 million in repurchases of restricted stock to satisfy tax withholding obligations and $5.4 million in repurchases of our senior convertible notes, offset by proceeds of $1.3 million related to the exercise of stock options and $1.2 million of sales of common stock under our employee stock purchase plan.

Effect of Exchange Rate Changes For the nine months ended September 30, 2014 changes in foreign currency rates resulted in a decrease in our cash and cash equivalents of $9.1 million. For the nine months ended September 30, 2013 changes in foreign currency rates resulted in an increase in our cash and cash equivalents of $6.1 million. The changes are due to foreign currency volatility on our international entity balance sheet exposures, primarily from the Euro.

Auction Rate Securities Information regarding auction rate securities is included in Note 4 to the Consolidated Financial Statements in Part I, Item 1.

Commitments and Guarantees At certain times, we enter into agreements where a letter of credit is required to ensure payment of future obligations by counterparties, such as our credit card processors and international taxing jurisdictions. Upon withdrawal, we are obligated to fund the executor bank on demand. We have not set aside specific funds to cover this potential obligation as we can generally recover these costs from our clients. If drawn upon, we expect to fund this commitment with cash and cash equivalents. There were $0.5 million and $0.6 million in undrawn letters of credit at September 30, 2014 and December 31, 2013, respectively.

Application of Critical Accounting Policies Critical Accounting Estimates and Policies A detailed description of our significant accounting policies can be found in our most recent Annual Report filed on Form 10-K for the fiscal year ended December 31, 2013. There were no material changes in significant accounting policies during the nine months ended September 30, 2014.

Recent Accounting Pronouncements Information regarding recently issued accounting standards is included in Note 1 to the Consolidated Financial Statements in Part I, Item 1.

[ Back To TMCnet.com's Homepage ]