UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

Commission File Number: 000-24643

 

DIGITAL RIVER, INC.

(Exact name of registrant as specified in its charter)

 

 

9625 WEST 76TH STREET
EDEN PRAIRIE, MINNESOTA 55344
(Address of principal executive offices)

 

(952) 253-1234
(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

Name of each Exchange on which registered:

Common Stock $0.01 par value Nasdaq Global Select Market

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

Indicate by checkmark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicated by checkmark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Exchange Act Rule 12b-2)

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

As of June 30, 2006, there were 39,767,881 shares of Digital River, Inc. common stock, issued and outstanding. As of such date, based on the closing sales price as quoted by The NASDAQ Stock Market, 38,772,546 shares of common stock, having an aggregate market value of approximately $1,566,023,000 were held by non-affiliates. For purposes of the above statement only, all directors and executive officers of the registrant are assumed to be affiliates.

 

The number of shares of common stock outstanding at February 1, 2007 was 40,460,874 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain sections of the Registrant’s definitive Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K to the extent stated herein.

 

 

TABLE OF CONTENTS

 

 

The Business section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations. “Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Risk Factors” under Part I, Item 1A of this Form 10-K. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

 

Explanatory Note

 

In this Form 10-K, we are restating our consolidated balance sheet as of December 31, 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years ended December 31, 2005 and December 31, 2004, and each of the quarters in 2005.

 

This Form 10-K also reflects the restatement of “Selected Consolidated Financial Data” in Item 6 for the years ended December 31, 2005, 2004, 2003, and 2002, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 for the years ended December 31, 2005, and December 31, 2004.

 

Previously filed annual reports on Form 10-K and quarterly reports on Form 10-Q affected by the restatements have not been amended and should not be relied upon.

 

On February 6, 2007, we announced the substantial completion of an internal investigation into our historical stock option granting practices. Since that date, we have completed one additional witness interview, which did not alter the results of the investigation. The investigation uncovered irregularities related to the issuance of certain stock option grants made between 1998 and 2005. A Special Committee of the Board oversaw the investigation. The Special Committee authorized the General Counsel and Chief Financial Officer (who joined Digital River in January 2006 and February 2005, respectively) to conduct the investigation, with the assistance of outside counsel and forensic experts.

 

In particular, as a result of the internal investigation, the Special Committee concluded, and the Audit Committee and Board of Directors agree, that we used incorrect measurement dates for financial accounting purposes for certain stock option grants in prior periods. Therefore, we have recorded additional non-cash stock-based compensation expense and related tax effect with regard to certain past stock option grants, and we are restating previously filed financial statements in this Form 10-K. These adjustments, after-tax, amounted to $9.4 million, spread out over the nine year period from 1998 through 2006. The full year adjustment to 2006 was recorded in the fourth quarter of 2006 due to its insignificance.

 

The Special Committee investigation examined each stock option grant from August 1998 through December 2006 (the “relevant period”), a total of 69 distinct grant dates. These grants include all of the options granted since our initial public offering in August 1998. In all cases, the investigation considered the particular facts and circumstances surrounding each grant date, including all available documentation, relevant email archives, and interviews with present and former directors, officers, employees, and advisors.

 

Based on the totality of the evidence and the applicable law, the Special Committee found that no officer or director engaged in any wrongdoing for personal enrichment. The Special Committee also concluded that no director or member of the committee charged with awarding stock options to employees (the Stock Option Committee) knowingly failed to comply with the relevant accounting principles.

 

The Special Committee’s analysis determined that eighteen grant dates, representing three million shares, were not the proper measurement dates for the related options. Specifically, the Special Committee’s investigation identified certain non-officer employee grants for which the Stock Option Committee, with the

involvement of our finance staff, selected grant dates in order to obtain favorable exercise prices. This did not occur with respect to any grants to directors or members of the Stock Option Committee, and thus did not result in any financial benefit to those individuals. Additionally, the Special Committee determined that on certain occasions, the Stock Option Committee unknowingly exceeded its authority in granting stock options to Section 16 officers, which options should have been granted by the Board of Directors. In each of these instances, the Board ratified the grants at a subsequent meeting. The Special Committee also discovered a small number of instances where option grant dates preceded employee hire dates; such instances are attributable to either administrative error or a practice of pricing options for certain employees as of the employment offer date. Finally, the Special Committee identified six occasions where we did not properly expense option grants to consultants.

 

More generally, the internal investigation revealed weaknesses in our internal controls and record-keeping related to stock options during the relevant period. In particular, we lacked appropriate systems to ensure adequate communication between our accounting and human resources departments pertaining to the option grant process. Thus, the accounting personnel did not consistently receive accurate information necessary to determine appropriate measurement dates. Moreover, we failed to prepare adequate minutes of meetings of the Compensation Committee and Stock Option Committee.

 

Beginning in January 2003, we strengthened our internal controls and made significant improvements to our stock option granting practices. The Special Committee did not identify any measurement date issues associated with stock option grants since January 2003, with the exception of three dates, each of which apparently resulted from errors in internal processes rather than any intentional backdating.

 

During the relevant period, we granted 1,306 employees, consultants, officers and directors options to acquire approximately 16.8 million shares of our common stock. These option grants, awarded on 69 distinct grant dates, consisted of one or more of the following types of grants: (i) grants to directors; (ii) grants to Section 16 officers; (iii) follow-on grants to employees; (iv) grants to new hires; (v) grants to employees receiving promotions; and (vi) grants to consultants.

 

Grants to Directors.  During the relevant period, we appropriately awarded grants to directors during Board of Directors or Compensation Committee meetings. The Special Committee discovered no problems associated with director grants, with the exception of one grant to one director on February 13, 2003. Due to a clerical error, the original paperwork for the February 13, 2003 Board of Director grants was misdated, which was corrected in 2003 with the exception of one former director who had already exercised his option. We subsequently corrected this error for all but one director. We should have recorded a charge related to the grant price and recorded an additional charge for a subsequent vesting acceleration. These charges make up less than $10,000 of the total $9.4 million after-tax restatement.

 

Grants to Section 16 Officers.  During the relevant period, the Stock Option Committee awarded 540,000 stock options to nine Section 16 officers on four different specified grant dates. After a review of the corporate record, the Special Committee determined that the Stock Option Committee was not vested with the authority to award stock options to Section 16 officers. Outside counsel conducted interviews with the Stock Option Committee members and certain Compensation Committee members and determined that the committee members believed the Stock Option Committee possessed the authority to make the grants. This is corroborated by subsequent Board ratification of the grants. However, because the requisite authority did not exist, the measurement dates for these grants have been adjusted to the Board ratification date, and the charges under APB 25 make up $1.0 million of the total $9.4 million after-tax restatement.

 

Grants to Employees and Consultants (inclusive of follow-on, new hire, and promotion grants).  During the relevant period, stock option grants to non-Section 16 employees and consultants were generally awarded by the Stock Option Committee. Stock Option Committee documentation with respect to such grants is in many instances inadequate, particularly from 1998 through 2002. Based on interviews and a review of all available documentation, including relevant email archives, the Special Committee determined that employee and consultant grants on sixteen grant dates may not have been measured on the correct date. Consistent with accounting literature and recent guidance from the Securities and Exchange Commission (“SEC”), we employed one of three methods to assign the correct measurement date: (i) the date of a relevant email, if the

content of the email indicates action by the Stock Option Committee; (ii) beginning in 2003, the last trading day of the month of the grant in accordance with our policy adopted in early 2003; or (iii) the date a grant was ratified by the Board of Directors if no other relevant documentation existed.

 

Based on the findings of the Special Committee, after accounting for forfeitures, we calculated stock-based compensation expense (under APB 25 for 1998 through 2005 and under SFAS 123(R) for 2006) of approximately $11.9 million over the respective awards’ vesting terms for the periods from 1998 through 2006. We recorded $85,000, after-tax, of stock-based compensation in the 2006 financial statements related to the foregoing options. Due to its insignificance, the full year amount was recorded in the fourth quarter of 2006. In addition, the Company included unrecorded charges related to option grants to consultants not expensed in the relevant periods under EITF 96-18 ($427,862) and charges of ($70,008) related to option grants to employees prior to their dates of hire.

 

The incremental impact from recognizing stock-based compensation expense resulting from the investigation of past stock option grants is as follows (dollars in thousands):

 

 

CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

 

Certain statements set forth or incorporated by reference in this Form 10-K, as well as in our Annual Report to Stockholders for the year ended December 31, 2006, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “believes,” “anticipates,” “expects,” “intends,” “estimates,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements, or industry results, expressed or implied by such forward-looking statements. Such factors are set forth under “Risk Factors” under Item 1A in this Form 10-K. We expressly disclaim any obligation to update or publicly release any revision to these forward-looking statements after the date of this Form 10-K.

 

Overview

 

We provide outsourced e-commerce solutions globally to a wide variety of companies primarily in the software and high-tech products markets. We were incorporated in 1994 and began building and operating online stores for our clients in 1996. We offer our clients a broad range of services that enable them to quickly and cost effectively establish an online sales channel capability and to subsequently manage and grow online sales on a global basis. Our offerings help our clients mitigate risk and grow their online revenues. Our services include design, development and hosting of online stores, store merchandising and optimization, order management, fraud prevention screening, export controls and management, tax compliance and management, digital product delivery via download, physical product fulfillment, multi-lingual customer service, online marketing including e-mail marketing, management of paid search programs, website optimization, web analytics, and reporting.

 

Our products and services allow our clients to focus on promoting and marketing their brands while leveraging the investments we have made in technology and infrastructure that facilitate the purchase of products from their online stores. When shoppers visit the store on one of our clients’ websites, they are seamlessly transferred to our e-commerce platform. Once on our platform, shoppers can browse for products and make purchases online. After a purchase is made, we either deliver the product digitally via download over the Internet or transmit instructions to a third party for physical fulfillment. We also process the buyer’s payment, including collection and remittance of applicable taxes, and can provide customer service in multiple languages to handle order-related questions. We believe we are an example of an emerging trend known as “Software as a Service” (SaaS). We have invested substantial resources to develop our e-commerce software platform and we provide access and use of it to our clients as a service as opposed to selling the software to be operated on their own in-house computer hardware.

 

In addition to the services we provide that facilitate the completion of an online transaction, we also offer services designed to increase traffic to our clients’ online stores and to improve the sales effectiveness of those stores. Our services include paid search advertising, search engine optimization, affiliate marketing, store optimization, and e-mail optimization. All of our services are designed to help our clients acquire customers more effectively, sell to those customers more often and more efficiently, and increase the lifetime value of each customer.

 

Our clients include many of the largest software and high-tech products companies and major retailers of these products, including Allume Systems, Inc., Autodesk, Inc., CompUSA, Inc. Computer Associates, Canon Inc., Hewlett Packard Company, Lexmark, Inc., Microsoft Corporation, OfficeMax Incorporated., Nuance Communications Inc, Symantec Corporation, and Trend Micro, Inc.

 

General information about us can be found at www.digitalriver.com under the “Company/Investor Relations” link. 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 them with the Securities and Exchange Commission.

 

Industry Background

 

Growth of the Internet and E-Commerce.  E-Commerce sales continue to grow at a rapid rate. The U.S. Commerce Department reported that e-commerce sales in the fourth quarter of 2006 rose 24.6% compared to the fourth quarter of 2005, continuing a series of strong quarterly growth reports. We believe there are a number of factors that are contributing to the growth of e-commerce: (i) adoption of the Internet continues to increase globally; (ii) broadband technology is increasingly being used to deliver Internet service enabling the delivery of richer content as well as larger files to a wider array of users; (iii) Internet users are increasingly comfortable with the process of buying products online; (iv) the functionality of online stores continues to improve, a greater range of payment options are available, and special offers and shipping discounts are making online shopping more attractive; (v) businesses are placing more emphasis on their online stores as they can reach a larger audience at a comparatively lower cost than the methods used to drive traffic to traditional bricks-and-mortar retail stores; and (vi) concerns about conflicts between online and traditional sales channels are continuing to subside. As a result of these growth drivers, online businesses have begun to build large, global customer bases that can be reached cost-effectively, potentially resulting in higher sales and profitability.

 

Growing Interest in Direct Sales of Products to Consumers.  Increasingly, companies are selling their products directly to consumers via online sales channels. This is due to increased competition for shelf space in the traditional retail channels as well as recognition that direct sales can be more profitable as well as provides information about the consumer purchasing a product that is not easily obtained when a product is sold through traditional channels. Many companies have begun to use classic direct marketing techniques and approaches to selling their products in order to develop a long term relationship with consumers that can result in a higher lifetime value for each customer acquired.

 

Opportunities for Outsourced E-Commerce.  We believe there are advantages to outsourced e-commerce that will continue to make it an attractive alternative to building and maintaining this capability in-house. These advantages include: (i) eliminating the substantial up-front and ongoing costs of computer hardware, network infrastructure, specialized application software and training and support costs; (ii) reducing the time it takes to get online stores live and productive; (iii) shifting the ongoing technology, financial, regulatory and compliance risks to a proven service provider; (iv) leveraging the direct marketing expertise of an e-commerce service provider to accelerate growth of an online business; and (v) allowing businesses to focus on their specific core competencies.

 

We believe the market for outsourced e-commerce will continue to grow rapidly. The Internet is inherently global. Once an online store is established, it is immediately accessible to Internet users around the world. Web pages must be presented and customer service inquires handled in diverse languages, and a variety of currencies and payment options must be accepted. The appropriate taxes must be collected and paid, payment fraud risk mitigated, fulfillment provided, and assurances made that products are not shipped to banned locations. These and other requirements of a global e-commerce system make it an expensive and potentially risky undertaking for any business. These factors also make a comprehensive outsourced offering, such as that provided by Digital River, an attractive alternative.

 

Shift from Physical to Electronic Delivery of Software.  Consumers have grown increasingly comfortable with the electronic delivery of digital products, such as software, music, and video. This shift from physical to electronic delivery is being driven by benefits to both buyers and sellers of these products. For buyers, downloaded products are immediately available for use and a wider variety of products are available than can be found in most retail stores. For sellers, electronic delivery eliminates inventory-stocking requirements, shipping, handling, storage and inventory-carrying costs as well as the risk of product obsolescence.

 

The Digital River Solution

 

Our solution combines a robust e-commerce technology platform and a suite of services to help businesses worldwide grow their online revenues and avoid the costs and risks of running a global e-commerce operation in-house. We offer a comprehensive e-commerce solution that operates seamlessly as part of a client’s website. We provide services that facilitate e-commerce transactions and services that help drive traffic to our clients’ online stores and demand for their products. Our services include design, development and hosting of online stores, store merchandising, order management, fraud prevention, export controls, tax compliance and management, digital product delivery via download, physical product fulfillment, multi-lingual customer service, online marketing services including e-mail marketing, management of paid search programs, web analytics and, reporting. We also provide our clients with increased product visibility and sales opportunities through our large network of online channel partners, including retailers and affiliates. We generate a substantial majority of our revenue on a revenue-share basis, meaning that we are paid a percentage of the selling price of each product sold at a clients’ online store that is being managed by Digital River

 

Benefits to Clients

 

Reduced Total Cost of Ownership and Risk

 

Utilizing the Digital River solution, businesses can dramatically reduce or eliminate upfront and ongoing hardware, software, maintenance and support costs associated with developing, customizing, deploying, maintaining and upgrading an in-house e-commerce solution. They can have a global e-commerce presence without assuming the costs and risks of developing it themselves and take immediate advantage of the investments we continually make in our e-commerce systems and associated services. In addition, we help mitigate the risks of doing e-commerce globally, including risks associated with payment fraud, tax compliance, regulatory compliance and export and denied parties compliance. Our ongoing investments in the latest technologies and e-commerce functionality help ensure that our clients maintain pace with industry advances.

 

Revenue Growth

 

We can assist our clients in growing their businesses by (i) facilitating the acquisition of new customers, improving the retention of existing customers, and increasing the lifetime value of each customer; (ii) extending their businesses into international markets; and (iii) expanding the visibility and sales of their products through new online sales channels. We have developed substantial expertise in online marketing and merchandising which we apply to help our clients increase traffic to their online stores, and improve order close ratios, average order sizes and repeat purchases, all of which result in higher revenues for our clients’ businesses and a greater revenue share for Digital River.

 

We provide the technology and services required to establish, grow and support international sales, both for U.S-based clients seeking to reach customers overseas, and non-U.S.-based clients looking to access the U.S. and other markets. Our technology platform enables transactions to be completed in numerous currencies using a variety of payment options. In addition, we provide localized online content and offer customer service in a variety of languages, extending our clients’ reach beyond their home markets.

 

Through our large online marketplace, which we call Digital River oneNetwork^tm (described in more detail in the section titled “Strategy”), we provide our clients access to new online sales channels which can help grow their online businesses. Clients 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. Our channel partners benefit because we eliminate the need for each of them to manage hundreds of relationships with product developers while increasing the depth and breadth of products they can sell, all without requiring the management of physical product inventory.

 

Deployment Speed

 

Businesses can reduce the time required to develop an e-commerce presence by utilizing our outsourced business model. Typically, a new client can have an online store live in a matter of days or weeks compared with months or longer if they decide to build, test and deploy the e-commerce capability in-house. Once they are operational on our platform, most clients can utilize our remote control toolset to make real-time changes to their online store, allowing them to address issues and take advantage of opportunities without technical assistance.

 

Focus on Core Competency

 

By utilizing our outsourced e-commerce services, businesses can focus on developing, marketing and selling their products rather than devoting time and resources to building and maintaining an e-commerce infrastructure. Management can focus on what they know best while ensuring they have access to the latest technologies, tools and expertise for running a successful e-commerce operation.

 

Benefits to Buyers

 

Our solution emphasizes convenience as it enables products to be purchased online at any time from anywhere in the world via a connection to the Internet. In the case of software and digital products, buyers can immediately download their purchase and begin using it in a matter of minutes. Sophisticated search technology allows shoppers to browse our entire catalog to find the products they are looking for quickly and easily. Our extended download service, which guarantees replacement of products accidentally destroyed through computer error or malfunction, and our 24/7 customer service provided on behalf of our clients, offer shoppers additional assurance that their e-commerce experience will be a positive one. Our CD2Go service gives buyers the ability to obtain, for a fee, a copy on CD of the product they have purchased and downloaded, providing additional assurances to buyers.

 

Strategy

 

Our objective is to be the global leader in outsourced e-commerce services for software and digital products developers, high-tech product manufacturers and related online retailers. Our strategy for achieving this objective includes the following key components:

 

Attract New Clients and Expand Relationships with Existing Clients.  We have focused our efforts on securing new clients and expanding our relationships with existing clients primarily in the software, digital products, high-tech products, and consumer electronics markets. Our clients include software publishers, other digital content providers, high-tech product manufacturers, and online channel partners such as retailers. In 2006, we entered into more than 230 new contracts with new and existing clients.

 

We believe we can attract new clients and gain additional business with existing clients by expanding the range of services we offer. This includes services to enhance the e-commerce transaction as well as additional online marketing services. We believe that by expanding the size and breadth of the catalog of products we offer, we will attract additional online retailers and affiliates seeking to offer their customers a wide range of quality products. As of February 1, 2007, we were providing e-commerce services for more than 44,000 software and digital products publishers, high-tech products manufacturers, online retailers and affiliates.

 

We believe we have amassed the largest catalog of digital software titles available anywhere online, and we offer these titles to online retailers and affiliates. We generate revenue when web traffic is directed to a site for which we provide e-commerce services and a purchase transaction occurs. We will continue to expand the content available in our catalog, which we believe will make that catalog increasingly attractive to online retailers, affiliates and other online channel partners. We believe the Digital River oneNetwork is a unique marketplace and provides opportunities to grow our revenues and strengthen our relationships with clients and partners.

 

Expand International Sales.  We believe there is a substantial opportunity to grow our business by enabling our clients to expand their sales through international online stores. Internet adoption and broadband deployment continue to increase rapidly in the European and Asia Pacific regions. We have seen significant growth in sales for clients that have created international online stores and we intend to continue to enhance our technology platform, payment options and localized service offerings to increase sales in international markets.

 

Provide Clients with Strategic Marketing Services.  We proactively develop and deliver new products and services, called strategic marketing services that are designed to help our clients improve customer acquisition and retention and maximize the lifetime value of customers. These services currently include paid search advertising, search engine optimization, affiliate marketing, store optimization, and e-mail marketing and optimization. In general, we manage these programs for our clients and have achieved significant increases in client revenue, return-on-investment or both, compared to what clients experienced when running these programs and supporting technologies in-house. We intend to continue to develop and/or acquire new value-added strategic marketing services and technologies to create additional sources of revenue for our clients and for Digital River.

 

Maintain Technology Leadership.  We believe our technology platform and infrastructure afford us a competitive advantage in the market for outsourced e-commerce solutions. We intend to continue to invest in and enhance our platform to improve scalability, reliability, security and performance as well as reduce costs. By leveraging our fixed cost structure, we can improve our ability to provide low-cost, high-value services while continuing to deploy the latest technologies. Additionally, we plan to continue investing to enable our clients to further penetrate international markets, enhance their relationships with their customers, better manage the return-on-investment across all their online marketing activities, and successfully adopt new selling models such as subscriptions, “software-as-a-service,” “try-before-you-buy” and volume licensing.

 

Continue to Seek Strategic Acquisitions.  Historically, we have been an active acquirer of businesses, and we expect to continue actively pursuing acquisitions that further our business strategy. Some of the strategic factors we consider when evaluating an acquisition opportunity include: expanding our base of clients, improving the breadth and depth of our product offering, improving the catalog of content, extending our strategic marketing and other services offerings, expanding our geographic reach and diversifying our revenue stream into complementary or adjacent market segments.

 

Expand the Digital River oneNetwork Marketplace.  We have developed a global marketplace we call Digital River oneNetwork which enables our clients to efficiently offer their products to a broad range of online retailers and affiliates. Affiliates are entities (individuals, organizations, companies, etc.) that generate online traffic to specific websites. On those websites, there are links, advertisements and other offers to sell various products and services. If a visitor clicks one of the links or advertisements and subsequently makes a purchase, the affiliate receives a commission in the form of a fixed fee or a percentage of the selling price of the product(s) purchased. Affiliates are an increasingly important source of website traffic as they can target specific types of Internet users.

 

Services

 

We provide a broad range of services to our clients, including design, development and hosting of online stores,, merchandising, order management, fraud prevention screening, denied parties screening, export controls, tax compliance and management, digital and physical product fulfillment, multi-lingual customer service, online marketing services including email marketing and paid search program management, and analytics and reporting. Most of these offerings can be managed through client-facing, remote control self-service tools that are easily used by business users without specialized training. Since clients utilize our centralized system and processes, we can consistently offer best practices across our entire client base.

 

Store Design, Development and Hosting.  We offer our clients website design services utilizing our experience and expertise to create efficient and effective online stores. Our e-commerce solutions can be deployed quickly and implemented in a variety of ways from fully-functioning shopping carts through

completely merchandised online stores. The online stores we operate for our clients match their branding and website design to provide a seamless experience for shoppers. When a shopper navigates from a client’s website (operated by them) to its store (operated by us), the transition is seamless and the customer is unaware they are then being served by our technology platform. We manage the order process through payment processing, fraud screening, and fulfillment (either digital or physical) and notify the buyer via e-mail once the transaction is completed. Transaction information is captured and stored in our database systems, an increasingly valuable source of information used to create highly targeted merchandising programs, e-mail marketing campaigns, product offers and test marketing programs.

 

For many of our clients, the solution we provide is critical to their businesses and therefore we operate data centers that perform and scale for continuous e-commerce operation in a high-demand environment. We operate multiple data centers globally, which feature fully redundant high-speed connections to the Internet, server capacity to handle unpredictable spikes in traffic and transactions, 24/7 security and monitoring, back-up electric generators and dedicated power supplies.

 

Store Merchandising.  Our technology platforms support a wide range of merchandising activities. This enables our clients to effectively execute promotions, up-sell, and cross-sell activities and to feature specific products and services during any phase of the shopping process. From the home page of our clients’ online stores through the checkout and “thank you” pages, our solution allows clients to deliver targeted offers designed to increase order close ratios and average order sizes.

 

Order Management and Fraud Screening.  We manage all phases of a shopper’s order on our clients’ e-commerce stores. We process payment transactions for orders placed through our technology platform and support a wide variety of payment types, including credit cards, wire transfers, purchase orders, money orders, direct debit cards and many other payment types popular both in the United States and around the world. As part of the payment process, we ensure that the correct taxes are displayed, collected, remitted and reported.

 

The fraud screening component of our platform uses both rules-based and heuristic scoring methods which use observations of known fraudulent activities to make a determination regarding the validity of the order, buyer and payment information. As the order is entered, hundreds of data reviews can be processed in real time. We also provide denied-parties screening and export controls, which are designed to ensure persons and/or organizations appearing on government denied-parties lists are blocked from making purchases through our system. Once a transaction is approved and the digital product has been delivered via download or the physical product(s) has been shipped, we submit the transaction for payment.

 

Digital and Physical Fulfillment Services.  We provide both digital and physical fulfillment services to our clients. Digital delivery eliminates or reduces many of the costs associated with the distribution of physical products, including packaging, shipping, warehousing, handling, and inventory-carrying and management costs. We offer our clients a broad array of electronic delivery capabilities that enable delivery of digital products directly to customers’ computers via the Internet. Delivery is completed when a copy of the purchased digital product is made from a master stored on our technology platform and then securely downloaded to the purchaser. Optionally, buyers can, for an additional fee, request that a CD be created and shipped as a backup for their order. Our digital distribution model reduces costs, resulting in potentially higher margins for our software and digital products publishing clients. In addition, our model helps to address the shrinking supply of shelf space in retail stores, which limits the number of software titles available for sale.

 

In addition to electronic fulfillment via download, we offer physical distribution services to our clients as well. We have contracted with third-party fulfillment agents that maintain inventories of physical products for shipment to buyers. These products are held by the fulfillment agent on consignment from our clients. We provide notification of product shipment to the buyer as well as shipment tracking, order status, and inventory information. We also provide a service called “Physical on Demand” (POD), which utilizes robotic systems to create a client-branded product CD and packaging materials after a POD order has been placed. This eliminates the requirement for inventory to be stored in a warehouse as physical product is created only when needed. We believe physical fulfillment services are important to providing a complete e-commerce solution to our clients, particularly in the high-tech products market where digital fulfillment is not possible.

 

Customer Service.  At our client’s option and for an additional fee, we provide telephone, online chat and e-mail customer support for products sold through our platforms. We provide assistance to buyers regarding ordering and delivery questions on a 24/7 basis and in more than ten different languages. We continue to invest in technology and infrastructure to provide fast and efficient responses to customer inquiries as well as provide online self-help options. We provide extended download services for digital products for an additional fee, which enables buyers to download the products they have purchased more than once in the event of a computer failure or other unexpected problem.

 

Advanced Reporting and Analytics.  We capture and store detailed information about visitor traffic to and sales in the online stores we manage for our clients and this information is stored in our database systems where it is available for analysis and reporting. We provide clients access to a large collection of standard and customizable reports as well as our web analytics technology. This enables our clients to track and analyze sales, products, transactions, customer behavior and the results of marketing campaigns so they can optimize their marketing efforts to increase traffic, order close ratios and average order values.

 

Strategic Marketing Services.  We offer a wide range of strategic marketing services designed to increase customer acquisition, improve customer retention and enhance the lifetime value of each customer to our clients. Through a combination of web analytics, analytics-based statistical testing, optimization and proven direct marketing practices, our team of strategic marketing experts develops, delivers and manages programs such as paid search advertising, search engine optimization, affiliate marketing, store optimization and e-mail optimization on behalf of our clients. We generally charge an incremental percentage of the selling price of merchandise for sales driven by our strategic marketing services activities. We believe our ability to capture and analyze integrated traffic and e-commerce sales data enhances the value of our strategic marketing services as we can precisely determine the effectiveness of specific marketing activities, website changes, and other actions taken by our clients.

 

Clients

 

We serve two distinct groups of clients: (1) software, product developers and high tech product manufacturers; and (2) online channel partners including retailers and affiliates. We believe that the breadth of our catalog of products is a competitive advantage in selling e-commerce services to online channel partners as they can access a huge volume of products to sell without negotiating contract terms with every product provider. At the same time, we believe the breadth of our channel partner group is attractive to product developers and manufacturers as it gives them access to broad distribution through a single source.

 

Sales and Marketing

 

We sell products and services primarily to consumers through the Internet. We sell and market our services for clients through a direct sales force located in offices in the United States, Europe and Asia Pacific. These offices include staff dedicated to pre-sales, sales and sales support activities. Our client sales organization sells to executives within software companies, product manufacturers, and online channel partners who are looking to create or expand their e-commerce businesses. During the sales process, our sales staff delivers demonstrations, presentations, collateral material, return-on-investment analyses, proposals and contracts.

 

We also design, implement and manage marketing and merchandising programs to help our clients drive traffic to their online stores and increase order close ratios, average order values and repeat purchases at those stores. Our strategic e-marketing team delivers a range of marketing and merchandising programs such as paid search advertising, search engine optimization, affiliate marketing, site and store optimization, e-mail marketing and optimization and site merchandising, which includes promotions, cross-sells and up-sells. This team combines their marketing domain expertise with our suite of technology, including reporting, analytics, optimization and e-mail to drive increased sales for our clients.

 

We market our products and services directly to clients and prospective clients. We focus our efforts on generating awareness of our brand and capabilities, establishing our position as a global leader in e-commerce outsourcing, generating leads in our target markets, and providing sales tools for our direct sales force. We

conduct a variety of highly integrated marketing programs to achieve these objectives in an efficient and effective manner. We currently market our products and services to clients and prospects via direct marketing, print and electronic advertising, trade shows and events, public relations, media events and speaking engagements.

 

Technology

 

We deliver our outsourced e-commerce solutions on several platforms, each of which has been architected to solve our clients multi-faceted e-commerce needs. The following is a brief description of the technology standards utilized by the family of Digital River commerce platforms:

 

Architecture.  Our platforms are highly scalable and designed to handle tens of thousands of individual e-commerce stores and millions of products available for sale within those stores. These platforms consist of Digital River developed proprietary software applications running on multiple pods of Sun Microsystems and Dell servers that serve dynamic web pages using Oracle, SQL server and MySQL databases, and .net Microsoft IIS and Oracle 9iAS application servers. We use Akamai, Limelight and Mirror Image’s worldwide caching technology to enable our platform engines to serve web pages with consistent load times around the world. Our platforms are designed to support growth by adding servers, CPUs, memory and bandwidth without substantial changes to the software applications. We believe this level of scalability is a competitive advantage. The application software is written in modular layers, enabling us to quickly respond to industry changes, payment processing changes, changes to international requirements for taxes and export screening, banking procedures, encryption technologies, and new and emerging web technologies, including AJAX, Web Services, DHTML, and web Caches.

 

The platforms include search capabilities that allow shoppers to search for items across millions of products and thousands of categories based on specific product characteristics or specifications while maintaining page response times acceptable to the user. We use sophisticated database indexing combined with a dynamic cache system to provide flexibility and speed. The platforms have been designed to index, retrieve and manipulate all transaction data that flows through the system, including detailed commerce transactions and end-user interaction data. This enables us to create proprietary market profiles of each shopper and groups of shoppers that can then be used to create merchandising campaigns that are better targeted and more successful. We also use our platforms internally for fraud detection and prevention, management of physical shipping, return authorizations, backorder processing, and transaction auditing and reporting.

 

E-Commerce System Maintenance.  Our platforms have a centralized maintenance management system that we use to build and manage our clients’ e-commerce systems. Changes that affect all of our clients’ e-commerce sites or groups of e-commerce sites can be made centrally, dramatically reducing maintenance time and complexity. Most of our clients’ e-commerce sites include a central store and many have additional web pages where highly targeted traffic is routed. Clients also may choose to link specific locations on their e-commerce stores to detailed product or category information within their stores to more effectively address a shopper’s specific areas of interest.

 

Security.  We have security systems in place to control access to our internal systems and commerce data. Log-ins and passwords are required for all systems with additional levels of log-in, password and IP security in place to control access on an individual basis. Access only is granted to commerce areas for which an individual is responsible. Multiple levels of firewalls prevent unauthorized access from the outside or access to confidential data from the inside. Our security system does not allow direct access to any client or customer data. We license certain encryption and authentication technology from third parties to provide secure transmission of confidential information such as credit card data. The security system is designed not to interfere with the end-user’s experience on our clients’ e-commerce sites.

 

Data Center Operations.  Continuous data center operations are crucial to our success. We currently maintain major data center operations in six facilities; in California and Minnesota, USA; and in Germany and Ireland. All major data center locations are currently processing transactions and serving downloads.

 

All data centers currently utilize multiple levels of redundant systems, including load balancers managing traffic volumes across web and application server farms, database servers, and enterprise disk storage arrays. For the majority of these systems, we have automatic failover procedures in place such that when a fault is detected, a process automatically takes that portion of the system offline and processing continues on the remaining redundant portions of the system, or in an alternate datacenter. In the event of an electrical power failure, we have redundant power generators and uninterruptible power supplies that protect our facilities. Fire suppression systems are present in each data center.

 

Our network software constantly monitors our clients’ e-commerce sites and internal system functions, and notifies systems engineers if any unexpected conditions arise. We lease multiple lines from diverse Internet service providers and maintain a policy of adding additional capacity if more than 40 percent of our capacity is consistently utilized. Accordingly, if one line fails, the other lines are able to assume the traffic load of the failed line. We also utilize content distribution networks operated by our vendors to serve appropriate types of traffic; currently, the majority of our image traffic and a substantial portion of our download traffic is served via the Akamai, Limelight and Mirror Image networks.

 

Product Research and Development

 

Our primary product research and development strategy is to continually enhance the technology and feature set of our commerce platforms and related technologies. To this end, we continually have numerous development projects in process, including ongoing enhancement of our commerce platforms, improvements in our remote control capabilities, enhanced international support, advanced product distribution capabilities, and new marketing technologies. Product research and development expenses were $32.3 million, $20.7 million, and $14.3 million, in 2006, 2005, and 2004 respectively.

 

We believe that the functionality and capabilities of our commerce platforms are a competitive advantage and that we must continue to invest in them to maintain our competitive position. The Internet and e-commerce, in particular, are subject to rapid technological change, changes in user and client requirements and expectations, new technologies and evolving industry standards. To remain successful, we must continually adapt to these and other changes. We rely on internally developed, acquired and licensed technologies to maintain the technological sufficiency of our commerce platforms.

 

Competition

 

The market for e-commerce solutions is highly competitive. We compete with e-commerce solutions that our customers develop themselves or contract with third parties to develop. We also compete with other outsourced e-commerce providers. The competition we encounter includes:

 

 

 

We believe that the principal competitive factors in our market are the breadth of consumer products and services offered, the number of clients and online channel partnerships, brand recognition, system reliability and scalability, price, customer service, ease of use, speed to market, convenience, and quality of delivery. Some of the companies described above are clients or potential clients, but they may choose to compete with us by adopting a similar business model.

 

Intellectual Property

 

We believe the protection of our trademarks, copyrights, trade secrets and other intellectual property is critical to our success. We rely on patent, copyright and trademark enforcement, contractual restrictions, and service mark and trade secret laws to protect our proprietary rights. We have entered into confidentiality and invention assignment agreements with our employees and contractors, and nondisclosure agreements with certain parties with whom we conduct business in order to limit access to and disclosure of our proprietary information. We also seek to protect our proprietary position by filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to our business. We currently have fourteen U.S patents issued with eight to seventeen years remaining prior to expiration. We also have over forty U.S. and foreign patent applications pending. We pursue the registration of our trademarks and service marks in the U.S. and internationally. We have a number of registered trademarks in the U.S., European Union and other countries.

 

Employees

 

As of January 28, 2007, we employed 1,086 people. We also employ independent contractors and other temporary employees. None of our employees are represented by a labor union, and we consider our employee relations to be good. Competition for qualified personnel in our industry is intense. We believe that our future success will continue to depend, in part, on our continued ability to attract, hire and retain qualified personnel.

 

Executive Officers

 

The following table sets forth information regarding our executive officers at February 1, 2007:

 

 

Mr. Ronning founded Digital River in February 1994 and has been our Chief Executive Officer and a director since that time. From February 2001 through February 2004, Mr. Ronning also was a member of the Office of the President. From February 1994 to July 1998, Mr. Ronning served as President of Digital River. From May 1995 to December 1999, Mr. Ronning served as Chairman of the Board of Directors of Tech Squared, Inc., a direct catalog marketer of software and hardware products. From May 1995 to July 1998, Mr. Ronning served as Chief Executive Officer, Chief Financial Officer and Secretary of Tech Squared. From May 1995 to August 1996, Mr. Ronning also served as President of Tech Squared. Mr. Ronning founded MacUSA, Inc., formerly a wholly-owned subsidiary of Tech Squared, and served as a director of MacUSA, Inc. from April 1990 to December 1999. From April 1990 to July 1998, Mr. Ronning also served as the Chief Executive Officer of MacUSA, Inc.

 

Mr. Donnelly joined Digital River in February 2005 as Vice President of Finance and Treasurer and was named Chief Financial Officer and Secretary in July 2005. From March 1997 to May 2004, he held various positions, including President, Chief Operating Officer and Chief Financial Officer with Net Perceptions, Inc., a developer of software systems used to improve the effectiveness of various customer interaction systems. From March 1995 to March 1997, Mr. Donnelly served as a financial and management consultant in the capacity of chief financial officer or corporate controller for various public and private companies and

partnerships. Prior to 1995, Mr. Donnelly served as an investment analyst for Marshall Financial Group, a merchant banking company, Chief Financial Officer of Medical Documentation Systems, Inc., a medical software company, and Controller of Staats International, Inc., a defense subcontractor.

 

The risks described below are not the only ones facing our company. Additional risks not presently known to us or that we currently deem immaterial also may impair our business operations. Our business, financial condition or results of operations could be materially adversely affected by any of these risks and the value of our common stock could decline due to any of these risks. This annual report also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us described below and elsewhere in this report.

 

A loss of any client that accounts for a large portion of our revenue would cause our revenue to decline.

 

Sales of products for one software publisher client, Symantec Corporation, accounted for approximately 30.2% of our revenue in 2006. In addition, revenues derived from proprietary Digital River services sold to Symantec end-users and sales of Symantec products through our oneNetwork retail and affiliate channel together accounted for approximately 16.6% of total Digital River revenue. In addition, a limited number of other software and physical goods clients contribute a large portion of our annual revenue. Contracts with our clients are generally one or two years in length. If any one of these key contracts is not renewed or otherwise terminates, or if revenues from these clients decline for any other reason (such as competitive developments), our revenue would decline and our ability to sustain profitability would be impaired. If our contract with Symantec is not renewed or otherwise terminated, or if revenues from Symantec and Symantec-related services decline for any other reason, our revenue and our ability to sustain profitability could be materially adversely impaired. It is important to our ongoing success that we maintain our key client relationships and, at the same time, develop new client relationships.

 

We have a limited profitable operating history.

 

Our limited profitable operating history, which we first achieved in the quarter ended September 30, 2002, makes it difficult to evaluate our ability to sustain profitability in the future. The success of our business model depends upon our success in generating sufficient transaction and service fees from the use of our e-commerce solutions by existing and future clients. Accordingly, we must maintain our existing relationships and develop new relationships with software publishers, online retailers and physical goods clients. To achieve this goal, we intend to continue to expend significant financial and management resources on the development of additional services, sales and marketing, improved technology and expanded operations. If we are unable to maintain existing, and develop new, client relationships, we will not generate a profitable return on our investments and we will be unable to gain meaningful market share to justify those investments. Further, we may be unable to sustain profitability if our revenues decrease or increase at a slower rate than expected, or if operating expenses exceed our expectations and cannot be adjusted to compensate for lower than expected revenues.

 

Failure to properly manage and sustain our expansion efforts could strain our management and other resources.

 

Through acquisitions and organic growth, we are rapidly and significantly expanding our operations, both domestically and internationally. We will continue to expand further to pursue growth of our service offerings and customer base. This expansion increases the complexity of our business and places a significant strain on our management, operations, technical performance, financial resources, and internal financial control and reporting functions, and there can be no assurance that we will be able to manage it effectively. Our personnel, systems, procedures and controls may not be adequate to effectively manage our future operations, especially as we employ personnel in multiple domestic and international locations. We may not be able to hire, train, retain and manage the personnel required to address our growth. Failure to effectively manage our growth

opportunities could damage our reputation, limit our future growth, negatively affect our operating results and harm our business.

 

We intend to continue to expand our international operations and these efforts may not be successful in generating additional revenue.

 

We sell products and services to end-users outside the United States and we intend to continue expanding our international presence. In 2006, our sales to international consumers represented approximately 41% of our total sales. Expansion into international markets, particularly the European and Asia-Pacific regions, requires significant resources that we may fail to recover by generating additional revenue. Conducting business outside of the United States is subject to risks, including:

 

 

These risks have grown with the acquisitions of element 5 AG (now Digital River GmbH) and SWReg, which have substantial operations outside the U.S. and with our expansion into the Asia-Pacific region.

 

We may be unable to successfully and cost-effectively market, sell and distribute our services in foreign markets. This may be more difficult or take longer than anticipated especially due to international challenges, such as language barriers, currency exchange issues and the fact that the Internet infrastructure in foreign countries may be less advanced than the U.S. Internet infrastructure. If we are unable to successfully expand our international operations, or manage this expansion, our operating results and financial condition could be harmed.

 

Our operating results are subject to fluctuations in demand for products and services offered by us or our clients.

 

Our quarterly and annual operating results are subject to fluctuations in demand for the products or services offered by us or our clients, such as anti-virus software and anti-spyware software. In particular, sales of anti-virus software represented a significant portion of our revenues in recent years and in 2006, and continue to be very important to our business. Demand for anti-virus software is subject to the unpredictable introduction of significant computer viruses. On May 31, 2006, Microsoft Corporation introduced products to protect businesses and consumers from computer viruses and other security risks. To the extent that Microsoft or others successfully introduce products or services not sold through our platform that are competitive with products and services sold by current Digital River clients (including anti-virus products and services), our revenues could be materially adversely affected.

 

New obligations to collect or pay transaction taxes could substantially increase the cost to us of doing business.

 

Currently, we collect sales, use, value added tax (VAT) or other similar transaction taxes with respect to electronic software download and physical delivery of products in tax jurisdictions where we believe we have taxable presences. The application of transaction taxes to interstate and international sales over the Internet is complex and evolving. We already are required to collect and remit VAT in the European Union, for example. Local, state or international jurisdictions may seek to impose transaction tax collection obligations on

companies like ours that engage in e-commerce, and they may seek to impose taxes retroactively on past transactions that we believed were exempt from transaction tax liability. A successful assertion by one or more tax jurisdictions that we should collect or were obligated to collect transaction taxes on the products we sell could harm our results of operations.

 

We could be liable for fraudulent, improper or illegal uses of our platforms.

 

In recent years revenues from our “remote control” platforms have grown as a percentage of our overall business, and we plan to continue to emphasize our self service e-commerce solutions. These platforms typically have an automated structure that allows customers to use our e-commerce services without significant participation from Digital River personnel. Despite our efforts to detect and contractually prohibit the sale of inappropriate and illegal goods and services, the remote control nature of these platforms makes it more likely that transactions involving the sale of unlawful goods or services or the violation of the proprietary rights of others may occur before we become aware of them. Furthermore, unscrupulous individuals may offer illegal products for sale via such platforms under innocuous names, further frustrating attempts to prevent inappropriate use of our services. Failure to detect inappropriate or illegal uses of our platforms by third parties could expose us to a number of risks, including fines, increased fees or termination of services by payment processors or credit card associations, risks of lawsuits, and civil and criminal penalties.

 

Loss of our credit card acceptance privileges would seriously hamper our ability to process the sale of merchandise.

 

The payment by end-users for the purchase of digital goods that we process is typically made by credit card or similar payment method. As a result, we must rely on banks or payment processors to process transactions, and must pay a fee for this service. From time to time, credit card associations may increase the interchange fees that they charge for each transaction using one of their cards. Any such increased fees will increase our operating costs and reduce our profit margins. We also are required by our processors to comply with credit card association operating rules, and we have agreed to reimburse our processors for any fines they are assessed by credit card associations as a result of processing payments for us. The credit card associations and their member banks set and interpret the credit card rules. Visa, MasterCard, American Express, or Discover could adopt new operating rules or re-interpret existing rules that we or our processors might find difficult to follow. We have had payment processing agreements with certain of our payment processors terminated due to violations of their rules, and although we have been able to successfully migrate to new processors, such migrations require significant attention from our personnel, and often result in higher fees and customer dissatisfaction. Any disputes or problems associated with our payment processors could impair our ability to give customers the option of using credit cards to fund their payments. If we were unable to accept credit cards, our business would be seriously damaged. We also could be subject to fines or increased fees from MasterCard and Visa if we fail to detect that merchants are engaging in activities that are illegal or activities that are considered “high risk,” primarily the sale of certain types of digital content. We may be required to expend significant capital and other resources to monitor these activities.

 

Our failure to attract and retain software and digital products publishers, manufacturers, online retailers and online channel partners as clients would cause our revenue and operating profits to decline.

 

We generate revenue by providing outsourced services to a wide variety of companies, primarily in the software and high-tech products markets. If we cannot develop and maintain satisfactory relationships with software and digital products publishers, manufacturers, online retailers and online channel partners on acceptable commercial terms, we will likely experience a decline in revenue and operating profit. We also depend on our software and digital publisher clients creating and supporting software and digital products that end-users will purchase. If we are unable to obtain sufficient quantities of software and digital products for any reason, or if the quality of service provided by these software and digital products publishers falls below a satisfactory level, we could also experience a decline in revenue, operating profit and end-user satisfaction, and our reputation could be harmed. Our contracts with our software and digital products publisher clients are generally one to two years in duration, with an automatic renewal provision for additional one-year periods,

unless we are provided with a written notice at least 90 days before the end of the contract. As is common in our industry, we have no material long-term or exclusive contracts or arrangements with any software or digital products publishers that guarantee the availability of software or digital products. Software and digital products publishers that currently supply software or digital products to us may not continue to do so and we may be unable to establish new relationships with software or digital product publishers to supplement or replace existing relationships.

 

The matters relating to the investigation by the Special Committee of the Board of Directors and the restatement of our consolidated financial statements may result in additional litigation and governmental enforcement actions.

 

On February 6, 2007, we announced that an internal review had discovered irregularities related to the issuance of certain stock option grants primarily made between 1998 and 2002. As described in the Explanatory Note immediately preceding Part I, Item 1, and in Note 2, “Restatement of Consolidated Financial Statements,” in Notes to Consolidated Financial Statements in this Form 10-K, as a result of the internal review, the Special Committee concluded, and the Audit Committee and Board of Directors agree, that we used incorrect measurement dates for financial accounting purposes for certain stock option grants in prior periods. Therefore, we have recorded additional non-cash stock-based compensation expense and related tax effect with regard to certain past stock option grants, and we are restating previously filed financial statements in this Form 10-K. The full year adjustment to 2006 was recorded in the fourth quarter of 2006 due to its insignificance.

 

Activities related to our internal review of historical stock option practices have required us to incur substantial expenses for legal, accounting, tax and other professional services, have diverted management’s attention from our business, and could in the future harm our business, financial condition, results of operations and cash flows.

 

While we believe we have made appropriate judgments in determining the correct measurement dates for our stock option grants, the SEC may disagree with the manner in which we have accounted for and reported, or not reported, the financial impact. Accordingly, there is a risk we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.

 

Our past stock option granting practices and the restatement of prior financial statements have exposed us to greater risks associated with litigation, regulatory proceedings and government enforcement actions. As described in Part II, Item 1, “Legal Proceedings”, several derivative complaints had been filed in federal court against our directors and certain of our executive officers pertaining to allegations relating to stock option grants. On December 18, 2006, the SEC initiated an informal inquiry into our historical stock option practices. We have provided the results of our internal review together with supporting documentation to the SEC. We intend to continue to fully cooperate with the SEC’s inquiry. No assurance can be given regarding the outcomes from litigation, regulatory proceedings or government enforcement actions relating to our past stock option practices. The resolution of these matters will be time consuming, expensive, and may distract management from the conduct of our business. Furthermore, if we are subject to adverse findings in litigation, regulatory proceedings or government enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could harm our business, financial condition, results of operations and cash flows.

 

Implementing our acquisition strategy could result in dilution and operating difficulties leading to a decline in revenue and operating profit.

 

We have acquired, and intend to continue engaging in strategic acquisitions of businesses, technologies, services and products. Since December 2005, we have acquired three businesses, Commerce5, Inc. (now DR globalTech, Inc.), Direct Response Technologies, Inc. (now DR Marketing Solutions, Inc.) and MindVision, Inc. The process of integrating an acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired business also may disrupt our ongoing business, distract management and make it difficult to maintain

standards, controls and procedures. Moreover, the anticipated benefits of any acquisition may not be realized. If a significant number of clients of the acquired businesses cease doing business with us, we would experience lost revenue and operating profit, and any synergies from the acquisition may be lost. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities, amortization of intangible assets or impairment of goodwill.

 

We may need to raise additional capital to achieve our business objectives, which could result in dilution to existing investors or increase our debt obligations.

 

We require substantial working capital to fund our business. In January 2005, we filed a registration statement to increase our available shelf registration amount from approximately $55 million to $255 million. Of this amount, approximately $173 million was utilized to issue common stock in March 2006, leaving approximately $82 million available for future use. In addition, we filed an acquisition shelf for up to approximately 1.5 million shares. In February 2006, we filed a shelf registration that would allow us to sell an undetermined amount of equity or debt securities in accordance with the recently approved rules applying to “well-known seasoned issuers.” If additional funds are raised through the issuance of equity securities, the percentage ownership of our stockholders will be reduced and these equity securities may have rights, preferences or privileges senior to those of our common stock. In June 2004, we issued 1.25% convertible notes which require us to make interest payments and will require us to pay principal when the notes become due in 2024 or in the event of acceleration under certain circumstances, unless the notes are converted into our common stock prior to that. We may not have sufficient capital to service this or any future debt securities that we may issue, and the conversion of the notes into our common stock may result in further dilution to our stockholders. Our capital requirements depend on several factors, including the rate of market acceptance of our products, the ability to expand our client base, the growth of sales and marketing, and opportunities for acquisitions of other businesses. We have had significant operating losses and negative cash flow from operations since inception. Additional financing may not be available when needed, on terms favorable to us or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to develop or enhance our services, take advantage of future opportunities or respond to competitive pressures, which would harm our operating results and adversely affect our ability to sustain profitability.

 

Our operating results have fluctuated in the past and are likely to continue to do so, which could cause the price of our common stock to be volatile.

 

Our quarterly and annual operating results have fluctuated significantly in the past and are likely to continue to do so in the future due to a variety of factors, some of which are outside our control. As a result, we believe that quarter-to-quarter and year-to-year comparisons of our revenue and operating results are not necessarily meaningful, and that these comparisons may not be accurate indicators of future performance. If our annual or quarterly operating results fail to meet the guidance we provide to securities analysts and investors or otherwise fail to meet their expectations, the trading price of our common stock will likely decline. Some of the factors that have or may contribute to fluctuations in our quarterly and annual operating results include:

 

 

 

In addition, revenue generated by our software and digital commerce services is likely to fluctuate on a seasonal basis that is typical for the software publishing market in general. We believe that our first and fourth quarters are generally seasonally stronger than our second and third quarters due to the timing of new product introductions, which generally do not occur in the summer months, the holiday selling period, and the post-holiday retail season.

 

Our operating expenses are based on our expectations of future revenue. These expenses are relatively fixed in the short-term. If our revenue for a quarter falls below our expectations and we are unable to quickly reduce spending in response, our operating results for that quarter would be harmed. In addition, the operating results of companies in the electronic commerce industry have, in the past, experienced significant quarter-to-quarter fluctuations that may adversely affect our stock price.

 

Security breaches could hinder our ability to securely transmit confidential information.

 

A significant barrier to e-commerce and communications is the secure transmission of confidential information over public networks. Any compromise or elimination of our security could be costly to remedy, damage our reputation and expose us to liability, and dissuade existing and new clients from using our services. We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary for secure transmission of confidential information, such as end-user credit card numbers. A party who circumvents our security measures could misappropriate proprietary information or interrupt our operations.

 

We may be required to expend significant capital and other resources to protect against security breaches or address problems caused by breaches. Concerns over the security of the Internet and other online transactions and the privacy of users could deter people from using the Internet to conduct transactions that involve transmitting confidential information, thereby inhibiting the growth of our business. To the extent that our activities or those of third-party contractors involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could damage our reputation and expose us to a risk of loss, fines or litigation and possible liability. Our security measures may not prevent security breaches, and failure to prevent security breaches could lead to a loss of existing clients and also deter potential clients away from our services.

 

Claims of infringement of other parties’ intellectual property rights could require us to expend significant resources, enter into unfavorable licenses or require us to change our business plans.

 

From time-to-time we are named as a defendant in lawsuits claiming that we have, in some way, violated the intellectual property rights of others. We have been notified of several potential patent disputes, and expect that we will increasingly be subject to patent infringement claims as our services expand in scope and complexity. Any assertions or prosecutions of claims like these could require us to expend significant financial and managerial resources. The defense of any claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause product enhancement delays or require that we develop non-infringing technology or enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us or at all. In the event of a successful claim of infringement against us and our failure or inability to develop non-infringing technology or license the infringed or similar technology on a timely basis, we may be unable to pursue our current business plan. We expect that we will increasingly be subject to patent infringement claims as our services expand in scope and complexity, and our results of operation and financial condition could be materially adversely affected.

 

Claims against us related to the software products that we deliver electronically and the tangible goods that we deliver physically could require us to expend significant resources.

 

We may become more vulnerable to third party claims as laws such as the Digital Millennium Copyright Act, the Lanham Act and the Communications Decency Act are interpreted by the courts. Claims may be made against us for negligence, copyright or trademark infringement, products liability or other theories based on the nature and content of software products or tangible goods that we deliver electronically and physically. Because we did not create these products, we are generally not in a position to know the quality or nature of the content of these products. Although we carry general liability insurance and require that our customers indemnify us against end-user claims, our insurance and indemnification measures may not cover potential claims of this type, may not adequately cover all costs incurred in defense of potential claims, or may not reimburse us for all liability that may be imposed. Any costs or imposition of liability that are not covered by insurance or indemnification measures could be expensive and time-consuming to address, distract management and delay product deliveries, even if we are ultimately successful in the defense of these claims.

 

The growth of the market for our services depends on the development and maintenance of the Internet infrastructure.

 

Our business is based on highly reliable Internet delivery of services. The success of our business therefore depends on the development and maintenance of a sound Internet infrastructure. This includes maintenance of a reliable network backbone with the necessary speed, data capacity and security, as well as timely development of complementary products, such as routers, for providing reliable Internet access and services. Our ability to increase the speed and scope of our services is limited by, and depends upon, the speed and reliability of both the Internet and our clients’ internal networks. Consequently, as Internet usage increases, the growth of the market for our services depends upon improvements made to the Internet as well as to individual clients’ networking infrastructures to alleviate overloading and congestion. In addition, any delays in the adoption of new standards and protocols required to govern increased levels of Internet activity or increased governmental regulation may have a detrimental effect on the Internet infrastructure.

 

Because the e-commerce industry is highly competitive and has low barriers to entry, we may be unable to compete effectively.

 

The market for e-commerce solutions is extremely competitive and we may find ourselves unable to compete effectively. Because there are relatively low barriers to entry in the e-commerce market, we expect continued intense competition as current competitors expand their product offerings and new competitors enter the market. In addition, our clients may become competitors in the future. Increased competition is likely to result in price reductions, reduced margins, longer sales cycles and a decrease or loss of our market share, any of which could negatively impact our revenue and earnings. We face competition from the following sources:

 

 

 

We believe that the principal competitive factors for a participant in our market are the breadth of products and services offered, the number of clients and online channel partnerships a participant has, brand recognition, system reliability and scalability, price, customer service, ease of use, speed to market, convenience and quality of delivery. The online channel partners and the other companies described above may compete directly with us by adopting a similar business model. Moreover, while some of these companies also are clients or potential clients of ours, they may compete with our e-commerce outsourcing solution to the extent that they develop e-commerce systems or acquire such systems from other software vendors or service providers.

 

Many of our competitors have, and new potential competitors may have, more experience developing Internet-based software and e-commerce solutions, larger technical staffs, larger customer bases, more established distribution channels and customer relationships, greater brand recognition and greater financial, marketing and other resources than we have. In addition, competitors may be able to develop services that are superior to our services, achieve greater customer acceptance or have significantly improved functionality as compared to our existing and future products and services. Our competitors may be able to respond more quickly to technological developments and changes in customers’ needs. Our inability to compete successfully against current and future competitors could cause our revenue and earnings to decline.

 

Changes in government regulation could limit our Internet activities or result in additional costs of doing business over the Internet.

 

We are subject to the same international, federal, state and local laws as other companies conducting business over the Internet. Today, there are relatively few laws specifically directed towards conducting business over the Internet. The adoption or modification of laws related to the Internet could harm our business, operating results and financial condition by increasing our costs and administrative burdens. Due to the increasing popularity and use of the Internet, many laws and regulations relating to the Internet are being debated at the international, federal and state levels. These laws and regulations could cover issues such as:

 

 

Applicability to the Internet of existing laws governing issues, such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy also could harm our operating results and substantially increase the cost to us of doing business. For example, numerous state legislatures have proposed that tax rules for Internet retailing and catalog sales correspond to enacted tax rules for sales from physical stores. Any requirement that we collect sales tax for each online purchase and remit the tax to the appropriate state authority would be a significant administrative burden to us, and would likely depress online sales. This and any other change in laws applicable to the Internet also might require significant management resources to respond appropriately. The vast majority of these laws was adopted prior to the

advent of the Internet, and do not contemplate or address the unique issues raised thereby. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act, are only beginning to be interpreted by the courts, and their applicability and reach are therefore uncertain.

 

Failure to develop our technology to accommodate increased traffic could reduce demand for our services and impair the growth of our business.

 

We periodically enhance and expand our technology and transaction-processing systems, network infrastructure and other technologies to accommodate increases in the volume of traffic on our technology platforms. Any inability to add software and hardware or to develop and upgrade existing technology, transaction-processing systems or network infrastructure to manage increased traffic on this platform may cause unanticipated systems disruptions, slower response times and degradation in client services, including impaired quality and speed of order fulfillment. Failure to manage increased traffic could harm our reputation and significantly reduce demand for our services, which would impair the growth of our business. We may be unable to improve and increase the capacity of our network infrastructure sufficiently or anticipate and react to expected increases in the use of the platform to handle increased volume. Further, additional network capacity may not be available from third-party suppliers when we need it. Our network and our suppliers’ networks may be unable to maintain an acceptable data transmission capability, especially if demands on the platform increase.

 

To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our e-commerce platforms and the underlying network infrastructure. If we incur significant costs without adequate results, or are unable to adapt rapidly to technological changes, we may fail to achieve our business plan. The Internet and the e-commerce industry are characterized by rapid technological changes, changes in user and client requirements and preferences, frequent new product and service introductions embodying new technologies and the emergence of new industry standards and practices that could render our technology and systems obsolete. To be successful, we must adapt to rapid technological changes by licensing and internally developing leading technologies to enhance our existing services, developing new products, services and technologies that address the increasingly sophisticated and varied needs of our clients, and responding to technological advances and emerging industry standards and practices on a cost-effective and timely basis. The development of our proprietary technologies involves significant technical and business risks. We may fail to use new technologies effectively or fail to adapt our proprietary technology and systems to client requirements or emerging industry standards.

 

System failures could reduce the attractiveness of our service offerings.

 

We provide commerce, marketing and delivery services to our clients and end-users through our proprietary technology transaction processing and client management systems. These systems also maintain an electronic inventory of products and gather consumer marketing information. The satisfactory performance, reliability and availability of the technology and the underlying network infrastructure are critical to our operations, level of client service, reputation and ability to attract and retain clients. We have experienced periodic interruptions, affecting all or a portion of our systems, which we believe will continue to occur from time-to-time. Any systems damage or interruption that impairs our ability to accept and fill client orders could result in an immediate loss of revenue to us, and could cause some clients to purchase services offered by our competitors. In addition, frequent systems failures could harm our reputation.

 

Although we maintain system redundancies in multiple physical locations, our systems and operations are vulnerable to damage or interruption from:

 

 

We may not carry sufficient business interruption insurance to fully compensate us for losses that may occur.

 

We may become liable to clients who are dissatisfied with our services.

 

We design, develop, implement and manage e-commerce solutions that are crucial to the operation of our clients’ businesses. Defects in the solutions we develop could result in delayed or lost revenue, adverse end-user reaction, and/or negative publicity, which could require expensive corrections. As a result, clients who experience these adverse consequences either directly or indirectly by using our services could bring claims against us for substantial damages. Any claims asserted could exceed the level of any insurance coverage that may be available to us. The successful assertion of one or more large claims that are uninsured, that exceed insurance coverage or that result in changes to insurance policies, including future premium increases that could adversely affect our operating results or financial condition.

 

We depend on key personnel.

 

Our future success significantly depends on the continued services and performance of our senior management. Our performance also depends on our ability to retain and motivate our key technical employees who are skilled in maintaining our proprietary technology platforms. The loss of the services of any of our executive officers or key employees could harm our business if we are unable to effectively replace that officer or employee, or if that person should decide to join a competitor or otherwise directly or indirectly compete with us. Further, we may need to incur additional operating expenses and divert other management time in order to search for a replacement.

 

Our future success depends on our ability to continue to identify, attract, hire, train, retain and motivate highly skilled personnel. Competition for these personnel is intense, particularly in the Internet industry. We may be unable to successfully attract, assimilate or retain sufficiently qualified personnel. In making employment decisions, particularly in the Internet and high-technology industries, job candidates often consider the value of stock option grants they are to receive in connection with their employment. Fluctuations in our stock price may make it more difficult to retain and motivate employees. Consequently, potential employees may perceive our equity incentives as less attractive and current employees whose equity incentives are no longer attractively priced may choose not to remain with our organization. In that case, our ability to attract employees will be adversely affected. As a result, our ability to use stock options as equity incentives will be adversely affected, which will make it more difficult to compete for and attract qualified personnel. Finally, should our stock price substantially decline, the retention value of stock options may weaken and employees who hold such options may choose not to remain with our organization.

 

Protecting our intellectual property is critical to our success.

 

We regard the protection of our trademarks, copyrights, trade secrets and other intellectual property as critical to our success. We rely on a combination of patent, copyright, trademark, service mark and trade secret laws and contractual restrictions to protect our proprietary rights. We have entered into confidentiality and invention assignment agreements with our employees and contractors, and nondisclosure agreements with parties with whom we conduct business, in order to limit access to and disclosure of our proprietary information. These contractual arrangements and the other steps taken by us to protect our intellectual property may not prevent misappropriation of our technology or deter independent third-party development of similar technologies. We also seek to protect our proprietary position by filing U.S. patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. Proprietary rights relating to our technologies will be protected from unauthorized use by third parties only to the extent they are covered by valid and enforceable patents or are effectively maintained as trade secrets. We pursue the registration of our trademarks and service marks in the U.S. and internationally. Effective trademark, service mark, copyright and trade secret protection may not be available in every country in which our services are made available online.

 

The steps we have taken to protect our proprietary rights may be inadequate and third parties may infringe or misappropriate our trade secrets, trademarks and similar proprietary rights. Any significant failure on our part to protect our intellectual property could make it easier for our competitors to offer similar services and thereby adversely affect our market opportunities. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of management and technical resources.

 

Our clients’ sales cycles are lengthy, which may cause us to incur substantial expenses and expend management time without generating corresponding consumer revenue, which would impair our cash flow.

 

We market our services directly to software publishers, online retailers and other prospective customers outside of the software industry. These relationships are typically complex and take time to finalize. Due to operating procedures in many organizations, a significant amount of time may pass between selection of our products and services by key decision-makers and the signing of a contract. The period between the initial client sales call and the signing of a contract with significant sales potential is difficult to predict and typically ranges from six to twelve months. If at the end of a sales effort a prospective client does not purchase our products or services, we may have incurred substantial expenses and expended management time that cannot be recovered and that will not generate corresponding revenue. As a result, our cash flow and our ability to fund expenditures incurred during the sales cycle may be impaired.

 

The listing of our network addresses on anti-SPAM lists could harm our ability to service our clients and deliver goods over the Internet.

 

Certain privacy and anti-email proponents have engaged in a practice of gathering, and publicly listing, network addresses that they believe have been involved in sending unwanted, unsolicited emails commonly known as SPAM. In response to user complaints about SPAM, Internet service providers have from time-to-time blocked such network addresses from sending emails to their users. If our network addresses mistakenly end up on these SPAM lists, our ability to provide services for our clients and consummate the sales of digital and physical goods over the Internet could be harmed.

 

We are subject to regulations relating to consumer privacy.

 

We collect and maintain end-user data for our clients, which subjects us to increasing international, federal and state regulations related to online privacy and the use of personal user information. Congress has enacted anti-SPAM legislation with which we must comply when providing email campaigns for our clients. Legislation and regulations are pending in various domestic and international governmental bodies that address online privacy protections. Several governments have proposed, and some have enacted, legislation that would limit the use of personal user information or require online services to establish privacy policies. In addition, the U.S. Federal Trade Commission, or FTC, has urged Congress to adopt legislation regarding the collection and use of personal identifying information obtained from individuals when accessing websites. In the past, the emphasis has been on information obtained from minors. Focus has now shifted to include online privacy protection for minors and adults.

 

Even in the absence of laws requiring companies to establish these procedures, the FTC has settled several proceedings resulting in consent decrees in which Internet companies have been required to establish programs regarding the manner in which personal information is collected from users and provided to third parties. We could become a party to a similar enforcement proceeding. These regulatory and enforcement efforts could limit our collection of and/or ability to share with our clients demographic and personal information from end-users, which could adversely affect our ability to comprehensively serve our clients.

 

The European Union has adopted a privacy directive that regulates the collection and use of information that identifies an individual person. These regulations may inhibit or prohibit the collection and sharing of personal information in ways that could harm our clients or us. The globalization of Internet commerce may

be harmed by these and similar regulations because the European Union privacy directive prohibits transmission of personal information outside the European Union. The United States and the European Union have negotiated an agreement providing a “safe harbor” for those companies who agree to comply with the principles set forth by the U.S. Department of Commerce and agreed to by the European Union. Failure to comply with these principles may result in fines, private lawsuits and enforcement actions. These enforcement actions can include interruption or shutdown of operations relating to the collection and sharing of information pertaining to citizens of the European Union.

 

Compliance with future laws imposed on e-commerce may substantially increase our costs of doing business or otherwise adversely affect our ability to offer our services.

 

Because our services are accessible worldwide, and we facilitate sales of products to end-users worldwide, international jurisdictions may claim that we are required to comply with their laws. Laws regulating Internet companies outside of the United States may be less favorable than those in the United States, giving greater rights to consumers, content owners and users. Compliance may be more costly or may require us to change our business practices or restrict our service offerings relative to those provided in the United States. Any failure to comply with foreign laws could subject us to penalties ranging from fines to bans on our ability to offer our services.

 

As our services are available over the Internet in multiple states and foreign countries, these jurisdictions may claim that we are required to qualify to do business as a foreign corporation in each state or foreign country. We and/or our subsidiaries are qualified to do business only in certain states. Failure to qualify as a foreign corporation in a required jurisdiction could subject us to taxes and penalties and could result in our inability to enforce contracts in these jurisdictions.

 

In addition, we are subject to United States laws governing the conduct of business with other countries, such as export control laws, which prohibit or restrict the export of goods, services and technology to designated countries, denied persons or denied entities from the United States. Violation of these laws could result in fines or other actions by regulatory agencies and result in increased costs of doing business and reduced profits. In addition, any significant changes in these laws, particularly an expansion in export control laws, will increase our costs of compliance and may further restrict our overseas client base.

 

We are exposed to foreign currency exchange risk.

 

Sales outside the United States accounted for approximately 41% of our total sales in 2006. The results of operations of, and certain of our intercompany balances associated with, our internationally focused websites are exposed to foreign exchange rate fluctuations. Upon translation, net sales and other operating results from our international operations may differ materially from expectations, and we may record significant gains or losses on the remeasurement of intercompany balances. If the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions will result in increased net revenues and operating expenses. Similarly, our net revenues and operating expenses will decrease if the U.S. dollar strengthens against foreign currencies. As we have expanded our international operations, our exposure to exchange rate fluctuations has become more pronounced. We may enter into short-term currency forward contracts to offset the foreign exchange gains and losses generated by the re-measurement of certain assets and liabilities recorded in non-functional currencies. The use of such hedging activities may not offset more than a portion of the adverse financial impact resulting from unfavorable movements in foreign exchange rates. See Item 7A of Part II, for information demonstrating the effect on our consolidated statements of operations from changes in exchange rates versus the U.S. dollar.

 

Changes in our tax rates could affect our future results.

 

Our future effective tax rates could be favorably or unfavorably affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws or their interpretation. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our

provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse effect on our results of operations and financial condition.

 

Developments in accounting standards may cause us to increase our recorded expenses, which in turn would jeopardize our ability to demonstrate sustained profitability.

 

In January 2002, we adopted Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). The statement generally establishes that goodwill and intangible assets with indefinite lives are not amortized, but are to be tested on an annual basis for impairment and, if impaired, are recorded as an impairment charge in income from operations. As of December 31, 2006, we had goodwill with an indefinite life of $243.8 million from our acquisitions. If our goodwill is determined for any reason to be impaired, the subsequent accounting of the impaired portion as an expense would lower our earnings and jeopardize our ability to demonstrate sustained profitability. On January 1, 2006, we adopted SFAS 123(R) which requires the measurement and recognition of compensation expense for all stock-based compensation based on estimated fair values. Our operating results for 2006 contain, and our operating results for future periods will contain, a charge for stock-based compensation related to stock options, restricted stock grants and employee stock purchases. As a result of our adoption of SFAS 123(R), our earnings for 2006 were lower than they would have been had we not been required to adopt SFAS 123(R). This will continue to be the case for future periods.

 

Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.

 

Keeping abreast of, and in compliance with, changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and the NASDAQ Stock Market rules, have required an increased amount of management attention and external resources. We intend to invest all reasonably necessary resources to comply with evolving corporate governance and public disclosure standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue generating activities to compliance activities.

 

Internet-related stock prices are especially volatile and this volatility may depress our stock price or cause it to fluctuate significantly.

 

The stock market and the trading prices of Internet-related companies in particular, have been notably volatile. This volatility is likely to continue in the short-term and is not necessarily related to the operating performance of affected companies. This broad market and industry volatility could significantly reduce the price of our common stock at any time, without regard to our operating performance. Factors that could cause our stock price in particular to fluctuate include, but are not limited to:

 

 

 

In addition, our stock price may be impacted by the short sales and actions of other parties who may disseminate misleading information about us in an effort to profit from fluctuations in our stock price.

 

Provisions of our charter documents, other agreements and Delaware law may inhibit potential acquisition bids for us.

 

Certain provisions of our amended and restated certificate of incorporation, bylaws, other agreements and Delaware law could make it more difficult for a third party to acquire us, even if a change in control would be beneficial to our stockholders.

 

 

None.

 

 

The following table summarizes the various facilities that we lease for our business operations:

 

 

 

 

We believe our properties are suitable and adequate for our present needs, and we periodically evaluate whether additional facilities are necessary.

 

 

DDR Holdings, LLC has brought a claim against us and several other defendants regarding US Patents No. 6,629,135 and 6,993,572, which are owned by DDR Holdings. These patents claim e-commerce outsourcing systems and methods relating to the provision of outsourced e-commerce support pages having a common look and feel with a host’s website. The case was filed in the U.S. District Court for the Eastern District of Texas on January 31, 2006. The complaint seeks injunctive relief, declaratory relief, damages and attorneys’ fees. We have denied infringement of any valid claim of the patents-in-suit, and have asserted counter-claims which seek a judicial declaration that the patents are invalid and not infringed. We intend to vigorously defend ourselves in this matter. On September 22, 2006, DDR Holdings filed an application for reexamination of its patents based upon the prior art produced by us and the other defendants in the case. As part of that application, DDR Holdings asserted that this prior art raised a substantial question as to the patentability of the inventions claimed in the patents. DDR Holdings has also moved to stay its litigation pending a decision on the reexamination application. We intend to vigorously defend ourselves in this matter.

 

NetRatings, Inc. has brought a claim against us regarding US Patents Nos. 5,675,510, 6,115,680, 6,108,637, 6,138,155 and 6,763,386, which are owned by NetRatings. These patents claim web analytic and reporting

systems. The case was filed in the U.S. District Court for the District of Minnesota on October 5, 2006. The complaint seeks injunctive relief, declaratory relief, damages and attorney’s fees. We have answered this complaint and are in the early stages of discovery. We intend to vigorously defend ourselves in this matter.

 

Voice Signal Technologies, Inc. (“VST”) has brought a claim against us and several other defendants regarding US Patent No. 5,855,000, which is owned by VST. This patent claim is on the use of general purpose dictation for personal computers and mobile devices. The case was filed in the U.S. District Court for the Western District of Pennsylvania on November 8, 2006. This complaint relates to our resale of a product from one of our software publisher clients. Under the terms of the contract that we have with this client, the client will defend and indemnify us for intellectual property claims. In accordance with the terms of that contract, this client is assuming the defense of this matter.

 

On October 31, 2006, a party identifying itself as a shareholder of the Company filed a derivative shareholder suit against us and certain of our current and former officers and directors in the U.S. District Court for the District of Minnesota. The action made general allegations regarding our purported stock option practices and on that basis asserted claims for violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, Sections 14(a) and 20(a) of the Exchange Act, breach of the fiduciary duties of loyalty and good faith, an accounting, unjust enrichment and rescission. On November 17, 2006, we filed a motion to dismiss the action in its entirety. On December 22, 2006, rather than opposing this motion to dismiss, plaintiff filed a motion for voluntary dismissal of the case. On January 3, 2007, the Court entered an order granting plaintiff’s motion for voluntary dismissal without prejudice. On February 6, 2007, this shareholder filed a complaint in the Court of Chancery of the State of Delaware. The complaint seeks an order pursuant to Section 220 of the Delaware General Corporation Law permitting plaintiff to inspect and make copies and extracts of certain of our books and records. We intend to vigorously defend ourselves in this matter.

 

On November 21, 2006, a separate plaintiff filed a derivative shareholder suit against us and certain of our current and former officers and directors in the U.S. District Court for the District of Minnesota substantially similar to the complaint filed against us on October 31, 2006. On January 11, 2007, plaintiff filed a motion for voluntary dismissal of the case. On January 17, 2007, the Court entered an order granting plaintiff’s motion for voluntary dismissal without prejudice.

 

In December 2006, we announced that we had received an informal inquiry from the SEC relating to our stock option grant practices. We have cooperated with the SEC regarding this matter and intend to continue to do so.

 

We are subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the final outcome of these matters is currently not determinable, we believe there is no litigation pending against us that is likely to have, individually or in the aggregate, a material adverse effect on our consolidated financial position, results of operation or cash flows. Because of the uncertainty inherent in litigation, it is possible that unfavorable resolutions of these lawsuits, proceedings and claims could exceed the amount we have currently reserved for these matters.

 

Third parties have from time-to-time claimed, and others may claim in the future, that we have infringed their intellectual property rights. We have been notified of several potential patent disputes, and expect that we will increasingly be subject to patent infringement claims as our services expand in scope and complexity. We have in the past been forced to litigate such claims. We also may become more vulnerable to third-party claims as laws, such as the Digital Millennium Copyright Act, the Lanham Act and the Communications Decency Act are interpreted by the courts and as we expand geographically into jurisdictions where the underlying laws with respect to the potential liability of online intermediaries like ourselves are either unclear or less favorable. These claims, whether meritorious or not, could be time-consuming and costly to resolve, cause service upgrade delays, require expensive changes in our methods of doing business, or could require us to enter into costly royalty or licensing agreements.

 

None.

 

Price Range of Common Stock

 

Our common stock is traded on The NASDAQ Stock Market under the symbol “DRIV.” The following table sets forth, for the periods indicated, the high and low sale price per share of our common stock on that market. These over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, markdown or commission, and may not necessarily represent actual transactions.

 

 

Holders

 

As of February 1, 2007, there were approximately 390 holders of record of our common stock. On February 1, 2007, the last sale price reported on The NASDAQ Stock Market for our common stock was $50.14 per share.

 

Dividend Policy

 

We have never declared or paid any cash dividends on our capital stock. We intend to retain any future earnings to support operations and to finance the growth and development of our business and do not anticipate paying cash dividends for the foreseeable future.

 

Issuer Purchases of Equity Securities

 

In April 2005, our Board of Directors authorized a new share repurchase program of up to $50.0 million of our outstanding shares of common stock. This new program superseded and replaced the $5.0 million share repurchase program adopted in 2001. Under the new program, the shares may be repurchased in the open market or in privately negotiated transactions. Repurchases are at our discretion based on ongoing assessments of the capital needs of the business, the market price of our common stock and general market conditions. No time limit was set for the completion of the repurchase program.

 

There were no common stock repurchases in the fourth quarter of 2006.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The information required in the table of Securities Authorized for Issuance under Equity Compensation Plans is incorporated by reference to our Proxy Statement in connection with our 2007 Annual Meeting to be filed in accordance with Regulation 14A under the Securities Exchange Act of 1934, as amended.

 

Securities Performance Measurement Comparison¹

 

The SEC requires a comparison on an indexed basis of cumulative total stockholder return for the Company, a relevant broad equity market index and a published industry line-of-business index. The following graph shows a total stockholder return of an investment of $100 in cash on December 31, 2001 for (i) the Company’s Common Stock; (ii) the CRSP Total Return Index for the Nasdaq Stock Market (U.S. companies) (the “Nasdaq Composite Index”); and (iii) the RDG Technology Composite Index. The RDG Technology Composite Index is composed of approximately 500 technology companies in the semiconductor, electronics, medical and related technology industries. Historic stock price performance is not necessarily indicative of future stock price performance. All values assume reinvestment of the full amount of all dividends.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Digital River, Inc., The NASDAQ Composite Index
And The RDG Technology Composite Index

 

 

 

Fiscal year ending December 31.

 

 

¹ This Section is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any filing of the Company under the Securities Act or the Exchange Act whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

 

The consolidated financial information below has been restated as set forth in this Form 10-K. The data as of and for the years ended December 31, 2005, 2004, 2003 and 2002 have been restated as set forth in this Form 10-K, but such restated data have not been audited and are derived from the Company’s books and records. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis-Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below. The information presented in the following tables has been adjusted to reflect the restatement of our financial results, which is more fully described in Management’s Discussion and Analysis-Restatement of Consolidated Financial Statements and in Note 2 to Consolidated Financial Statements of this Form 10-K.

 

We have not amended any other previously-filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by this restatement. The financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this Annual Report on Form 10-K, and the financial statements and related financial information contained in previously-filed reports should no longer be relied upon.

 

 

 

 

 

 

 

 

 

 

 

The discussion in this Annual 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 elsewhere in this Annual 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.

 

The following information has been adjusted to reflect the restatement of our financial results, which is more fully described in the “Explanatory Note” immediately preceding Part I Item 1 and in Note 2, “Restatement of Consolidated Financial Statements” in Notes to Consolidated Financial Statements of this Form 10-K.

 

Overview

 

We provide outsourced e-commerce solutions globally to a wide variety of companies primarily in the software and high-tech products markets. We offer our clients a broad range of services that enable them to effectively build, manage, and grow online sales on a global basis. We focus on helping our clients mitigate risk and grow their revenues. Our services include online store design, development, and hosting, store merchandising and optimization, order management, fraud prevention screening, export controls and management, tax management, digital product delivery via download, physical product fulfillment, multi-lingual customer service, e-mail marketing, website optimization, web analytics and reporting.

 

Acquisitions and Comparability of Results

 

We acquired SWReg in March 2005, Commerce5, Inc. (now DR globalTech, Inc.) in December 2005, Direct Response Technologies, Inc. (now DR Marketing Solutions, Inc.) in January 2006 and MindVision, Inc. in June 2006. The results of these acquisitions must be factored into any comparison of our 2006 results to the results for 2005 or 2004. See Note 5 of our consolidated financial statements for the year ended December 31, 2006, for pro forma financial information as if these entities had been acquired on January 1, 2005.

 

Critical Accounting Policies

 

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting policies that we believe are the most critical in fully understanding and evaluating our reported financial results are the following:

 

Revenue Recognition.  We recognize revenue from services rendered once all the following criteria for revenue recognition have been met: (1) pervasive evidence of an agreement exists; (2) the services have been rendered; (3) the fee is fixed and determinable and not subject to refund or adjustment; and (4) collection of the amounts due is reasonably assured.

 

We evaluate the criteria outlined in Emerging Issues Task Force, (“EITF”) Issues No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as net revenue. We act as the merchant of record on most of the transactions processed and have contractual relationships with our

clients, which obligate us to pay to the client a specified percentage of each sale. We derive our revenue primarily from transaction fees based on a percentage of the products sale price and fees from services rendered associated with the e-commerce and other services provided to our clients and end customers. Our revenue is recorded as net as generally our clients are subject to inventory risks and control customers’ product choices. Clients do not have the right to take possession of the software applications used in the delivery of services.

 

We also provide customers with various proprietary software backup services. We recognize revenue for these backup services upon delivery or based upon historical usage within the contract period of the digital backup services when this information is available. Digital backup services are recognized straight-line over the life of the backup service when historical usage information is unavailable. Shipping revenues are recorded net of any associated costs.

 

We also, to a lesser extent, provide fee-based client services, which include website design, custom development and integration, analytical marketing and email marketing services. If we receive payments for fee-based services in advance of delivery, these amounts are deferred and recognized over the service period.

 

Provisions for doubtful accounts and transaction losses and authorized credits are made at the time of revenue recognition based upon our historical experience. The provision for doubtful accounts and transaction losses are recorded as charges to operating expense, while the provision for authorized credits is recognized as a reduction of net revenues.

 

Allowance for Doubtful Accounts.  We must make estimates and assumptions that can affect the amount of assets and liabilities and the amounts of revenues and expenses we report in any financial reporting period. We use estimates in determining our allowance for doubtful accounts, which are based on our historical experience and current trends. We must estimate the collectability of our billed accounts receivable. We analyze accounts receivable and consider our historical bad debt experience, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. We must make significant judgments and estimates in connection with the allowance in any accounting period. There may be material differences in our operating results for any period if we change our estimates or if the estimates are not accurate. Credit Card Chargeback Reserve. We use estimates based on historical experience and current trends to determine accrued chargeback expenses. Significant management judgments are used and estimates made in connection with the accrued expenses in any accounting period. There may be material differences in our operating results for any period if we change our estimates or if the estimates are not accurate.

 

Goodwill, Intangibles and Other Long-Lived Assets.  We depreciate property, plant and equipment; amortize certain intangibles and certain other long-lived assets with definite lives over their useful lives. Useful lives are based on our estimates of the period of time over which the assets will generate revenue or benefit our business. We review assets with definite lives for impairment whenever events or changes in circumstances indicate that the value we are carrying on our financial statements for an asset may not be recoverable. Our evaluation considers non-financial data such as changes in the operating environment and business strategy, competitive information, market trends and operating performance. If there are indications that impairment may be necessary, we use an undiscounted cash flow analysis to determine the impairment amount, if any. Assets with indefinite lives are reviewed for impairment annually (or more frequently if there are indications that an impairment may be necessary) utilizing the two-step approach prescribed in Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” There have been no impairments of goodwill and other intangible assets for the years 2006, 2005 and 2004.

 

Income Taxes and Deferred Taxes.  Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We record deferred tax assets for favorable tax attributes, including tax loss carryforwards. We currently have significant U.S. tax loss carryforwards resulting from the tax deduction for exercise of stock options and acquired operating tax loss carryforwards, and a lesser

amount of acquired foreign operating tax loss carryforwards. The benefit of the loss carryforwards from exercise of stock options was recognized as additional paid in capital when the deferred tax asset valuation allowance was reversed in the fourth quarter of 2005. The benefit of the acquired tax loss carryforwards has been reserved by a valuation allowance pursuant to United States generally accepted accounting principles. These valuation reserves of the deferred tax asset will be reversed if and when it is more likely than not that the deferred tax asset will be realized. We evaluate the need for a valuation allowance of the deferred tax asset on a quarterly basis. If the benefit of these acquired tax loss carryforwards is recognized, we will not recognize the benefit in the statement of income. Rather, the benefit will be recognized as a reduction to goodwill.

 

We may face challenges from domestic and foreign tax authorities regarding the amount of tax due. These challenges may include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various tax filing positions, we record reserves for probable exposures. Based on our evaluation of our tax position, we believe the amounts related to these tax exposures are appropriately accrued. To the extent we were to favorably resolve matters for which accruals have been established or be required to pay amounts in excess of the aforementioned reserves, our effective tax rate in a given financial statement period may be impacted.

 

No provision has been made for federal income taxes on approximately $25.8 million of our foreign subsidiaries undistributed earnings since we plan to indefinitely reinvest all such earnings. If these earnings were distributed to the U.S. in the form of dividends or otherwise, we would be subject to U.S. income taxes on such earnings. The amount of U.S. income taxes would be subject to adjustment for foreign tax credits and for the impact of the step-up in the basis of assets resulting from a Section 338 election made at the time of acquisition. If these earnings were to be distributed, the income tax liability would be approximately $4.9 million.

 

Stock-Based Compensation Expense.  On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payments made to employees and directors including stock options, restricted stock grants and employee stock purchases made through our Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” for periods beginning in 2006.

 

Prior to the adoption of SFAS 123(R), we had elected to apply the disclosure-only provision of SFAS No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148. Accordingly, we accounted for stock-based compensation using the intrinsic value method prescribed in APB 25 and related interpretations. Compensation expense for stock options was measured as the excess, if any, of the fair value of our common stock at the date of grant over the stock option exercise price.

 

We have adopted SFAS 123(R) using the modified prospective transition method under which prior periods are not revised. Stock-based compensation expense recognized during the period is based on the value of the portion of share-based awards that are ultimately expected to vest during the period. Stock-based compensation expense recognized in our Consolidated Statement of Operations for 2006 includes compensation expense for share-based awards granted prior to, but not yet vested, as of December 31, 2005 as well as compensation expense for the share-based payment awards granted subsequent to December 31, 2005. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The fair value of restricted stock is determined based on the number of shares granted and the closing price of our common stock on the date of grant. Compensation expense for all share-based payment awards are recognized using the straight-line amortization method over the vesting period. Stock-based compensation expense of $13.9 million was charged to operating expenses during 2006. The related tax benefit of $4.9 million resulted in a net after-tax stock-based compensation expense of $9.0 million for 2006.

 

As stock-based compensation expense recognized in our Consolidated Statement of Operations for 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R)

requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Our pro forma information required under SFAS 123, for periods prior to 2006, accounted for forfeitures as they occurred. In March 2005 the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides supplemental implementation guidance for SFAS 123(R). We have applied the provision of SAB 107 in our adoption of SFAS 123(R).

 

SFAS 123(R) also requires the benefits of tax deductions in excess of recognized stock-based compensation expense be reported as a financing cash flow, rather than an operating cash flow as required prior to adoption of SFAS 123(R) in our Consolidated Statement of Cash Flows. On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Share-based Payment Awards.” We have elected not to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R).

 

As a result of adopting Statement 123(R) on January 1, 2006, our income before income taxes and net income for the twelve months ended December 31, 2006 were $13.9 million and $9.0 million lower, respectively, than if we had continued to account for share-based compensation under APB25. Basic and diluted earnings per share for the twelve months ended December 31, 2006 were $0.23 and $0.20 lower, respectively, than if we had continued to account for share-based compensation under APB 25.

 

See Note 6 in the Consolidated Financial Statements in this Form 10-K for further information regarding the impact of our adoption of SFAS 123(R) and the assumptions we use to calculate the fair value of share-based compensation.

 

Results of Operations

 

The following table presents certain items from our consolidated statements of operations as a percentage of total revenue for the years indicated.

 

 

 

 

Revenue.  Our revenue increased to $307.6 million in 2006 from $220.4 million in 2005 and $154.1 million in 2004. The revenue increases were primarily attributable to higher online sales activity across our client base, growth in the number of software publishers and online retailer clients we served, increased sales from

international sites, expanded strategic marketing activities with a larger number of clients, and acquisitions. Sales of security software products for PCs represent the largest contributor to our revenues. Acquisitions made during each of 2006, 2005 and 2004 generated approximately 3.5%, 2.0% and 16.1% of our total revenue for those years, respectively. International sales represented approximately 41%, 39% and 31% of revenue in the years ended December 31, 2006, 2005 and 2004, respectively. That growth is attributable to a larger number of international stores being operated for our clients as well as the European outsourced e-commerce providers we acquired in 2004 and 2005. Sales of products for one software publisher client, Symantec Corporation, accounted for approximately 30.2% of our revenue in 2006, 29.7% in 2005 and 27.2% in 2004. In addition, revenues derived from proprietary Digital River services sold to Symantec end-users and dealer network sales of Symantec products amounted to approximately 16.6% of our total revenue in 2006, 14.4% in 2005 and 10.8% in 2004.

 

Direct Cost of Services.  Our direct cost of services line item primarily includes the personnel costs and costs related to product fulfillment, physical on demand, our proprietary back-up CD production and client-specific related costs. Direct cost of service expense was $7.7 million, $5.1 million, and $5.2 million, in 2006, 2005 and 2004, respectively. The increase in 2006 compared with 2005 resulted primarily from (i) personnel added to serve new clients, and to handle increased transaction volumes, (ii) recent acquisitions and (iii) stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). The cost remained flat in 2005 compared with 2004 as we were able to leverage our installed infrastructure to support the higher level of revenue.

 

We currently believe that direct costs of services will increase in absolute dollars in 2007 compared to 2006 as we continue to expand our worldwide fulfillment capacity in order to meet anticipated shipment volumes from sales.

 

Network and Infrastructure.  Our network and infrastructure expense line item primarily includes the personnel costs and related expenses to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expense was $29.3 million in 2006, up from $19.8 million and $15.2 million in 2005 and 2004, respectively. The increase in 2006 from 2005, and in 2005 from 2004, resulted primarily from personnel added to support our revenue growth as well as those gained through acquisition of other businesses, and costs related to operating new international data centers. Expenses in 2006 were also higher due to stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R).

 

We currently believe that network and infrastructure expenses will increase in absolute dollars in 2007 compared to 2006 as we continue to expand our worldwide customer service capacity, and as we expand the number of operating global data centers, expected increased network usage, which will drive higher Internet connection charges.

 

Sales and Marketing.  Our sales and marketing expense line item primarily includes personnel costs and related expenses, advertising, promotional and product marketing expenses, credit card transaction and other payment processing fees, credit card chargebacks and bad debt expense. Sales and marketing expense increased to $113.5 million in 2006, from $69.4 million and $52.1 million in 2005 and 2004, respectively. As a percentage of revenue, sales and marketing expense increased to 36.9% in 2006 from 31.5% in 2005. The increase in 2006 from 2005 resulted primarily from credit card fees directly associated with the increase in revenue and additional sales, the addition of new international payment methods, personnel and related expenses to support our global growth initiatives, costs from recent acquisitions, and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). During 2006, we continued to expand our presence in global markets, the consumer electronics market, our strategic marketing services programs, and our oneNetwork affiliate program. We also expanded our relationships with two of our major partners, Symantec and Microsoft. The increase in 2005 from 2004 resulted primarily from increases in credit card transaction fees. During 2005, sales and marketing expense decreased as a percentage of revenue to 31.5% from 33.8% in 2004, primarily due to our revenue growing faster than these expenses.

 

We currently believe that sales and marketing expenses will increase in absolute dollars in 2007 compared to 2006, as we continue to grow and expand our reach to clients, and continue to offer increased levels of strategic marketing services.

 

Product Research and Development.  Our product research and development expense line item includes the costs of personnel and related expenses associated with developing and enhancing our technology platforms and related systems. Product research and development expense was $32.3 million in 2006, compared to $20.7 million and $14.3 million in 2005 and 2004, respectively. The increase in 2006 from 2005 resulted primarily from increases in personnel related expenses to support our growth initiatives, costs from recent acquisitions, development related to our expanded relationship with Microsoft and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAF 123(R). During 2006, we continued to advance our remote-control technology, as well as the international and e-marketing capabilities. We capitalized $0.1 million of software development costs related to those efforts during 2006. The increase in 2005 from 2004 resulted primarily from increases in personnel related expenses. We capitalized approximately $0.4 million of software development costs during 2005. As a percentage of revenue, product research and development expense increased to 10.5% in 2006 from 9.4% in 2005 and 9.3% in 2004.

 

We currently believe that product research and development expenses will increase in absolute dollars in 2007 compared to 2006, as a result of continued investments in product development required to remain competitive.

 

General and Administrative.  Our general and administrative expense line item primarily includes the costs of executive, accounting, and administrative personnel and related expenses, insurance expense, and professional fees for legal, tax and audit services. General and administrative expense increased to $34.2 million in 2006 from $21.5 million in 2005 and $17.0 million in 2004. The increase in 2006 from 2005 resulted primarily from the addition of personnel and facilities to support our global expansion, such as our offices in Ireland and Luxembourg, as well as those gained through acquisition of other businesses, from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R), and costs incurred for activities related to our internal review of historical stock option practices. The increase in 2005 from 2004 resulted primarily from the addition of personnel and facilities to support our growth as well as those gained through acquisitions of other businesses. As a percentage of revenue, general and administrative expense increased to 11.1% in 2006 from 9.7% in 2005. As a percentage of revenue, general and administrative expense declined to 9.7% in 2005 from 11.0% in 2004 due to our ability to spread administrative costs over the higher revenue base.

 

We currently believe that general and administrative expenses will increase in absolute dollars in 2007 compared to 2006, as we continue to invest in our infrastructure to support our continued organic growth. We may also incur additional expenses to resolve matters related to our historical stock option practices.

 

Depreciation and Amortization.  Our depreciation and amortization expense line item includes the depreciation of computer equipment and office furniture and the amortization of purchased and internally developed software, leasehold improvements made to our leased facilities, and debt financing costs. Computer equipment, software and furniture are depreciated under the straight-line method using three to seven years lives, and leasehold improvements are amortized over the shorter of the life of the asset or the remaining length of the lease. Depreciation and amortization expense increased to $11.0 million in 2006 from $8.8 million in 2005 and $8.2 million in 2004. The increased expenses in 2006 and 2005 resulted primarily from increases in our assets, as gross capitalized property and equipment increased to $56.4 million on December 31, 2006, from $52.0 million and $41.1million on December 31, 2005 and 2004, respectively. We currently believe that depreciation and amortization expenses will increase in absolute dollars in 2007 compared to 2006 as we continue to expand our worldwide customer support capacity and expand the number of operating global data centers.

 

Amortization of Acquisition Related Intangibles.  Our amortization of acquisition-related intangibles line item consists of the amortization of intangible assets recorded from our 14 acquisitions in the past four years. Amortization of acquisition related intangibles increased to $12.1 million in 2006 from $8.7 million in 2005

and $8.3 million in 2004. The increase in 2006 from 2005 and 2004 reflects the increased amortization of 2006 acquisitions partially offset by full amortization of certain past acquisitions. We complete our annual goodwill impairment test using a two-step approach in the fourth quarter of each year. Our assessment has indicated that there is no impairment of goodwill for the years ended December 31, 2006, 2005 and 2004. We have purchased, and expect to continue purchasing, assets or businesses, which may include the purchase of intangible assets.

 

Income from Operations.  Our income from operations in 2006 was $67.6 million, up from $66.4 million in 2005 and $33.9 million in 2004. As a percentage of revenue, income from operations was 22.0% in 2006, 30.1% in 2005 and 22.0% in 2004. Income from operations decreased during 2006 from 2005 as a percentage of revenue as expenses grew faster than revenues primarily due to higher spending on global growth initiatives and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). The increase in income from operations in 2005 from 2004 resulted primarily from growth in revenue while our cost of revenue and operating expenses grew at a slower rate.

 

Other Income, Net.  Our other income, net line item is the total of interest income on our cash, cash equivalents, and short-term investments, interest expense on our debt and foreign currency transaction gains and losses. Interest income was $22.8 million, $9.7 million and $3.2 million in 2006, 2005 and 2004, respectively. The increases in interest income were primarily due to higher cash balances. Interest expense was $2.5 million in 2006 compared with $2.5 million in 2005 and $1.5 million in 2004. Our gain from foreign currency remeasurement was $1.5 million in 2006 compared to a loss of $2.2 million in 2005. Gains or losses were immaterial in 2004.

 

Income Taxes.  In 2006, our tax expense was $28.7 million, made up of approximately $39.4 million of current tax expense and $10.8 million of deferred tax benefit. In 2005, our tax expense was $14.9 million, made up of approximately $26.1 million of current tax expense and $11.2 million of deferred tax benefit. In 2004, our tax expense was $1.1 million, made up of international current tax expense.

 

In 2006, we recorded tax expense at a rate that reflects the estimated impact of current year changes in foreign operations. We have established new locations in Shannon, Ireland and Luxembourg. We transferred existing non-U.S. operations to these locations and expanded these operations in order to more effectively manage current international activity and facilitate further international growth. We commenced business operations in these locations on April 1, 2006. These operating changes generally reduce our effective tax rate compared to prior years.

 

As of December 31, 2006, we had net U.S. tax loss carryforwards of approximately $61.6 million and foreign tax loss carryforwards of $1.3 million. The U.S. amount consists of $30.0 million of deductions resulting from exercise of stock options and $31.6 million of acquired net operating losses. The U.S. tax loss carryforwards expire in the years 2020 through 2025.

 

In prior years, there was uncertainty of future realization of the deferred tax assets resulting from temporary differences and from tax loss carryforwards from operations and stock option deductions, therefore a valuation allowance equal to the deferred tax assets was recorded. At December 31, 2005, we evaluated our deferred tax assets related to tax loss carryforwards from stock option deductions and other items and concluded it was more likely than not that the deferred tax assets would be realized, and accordingly the valuation allowance was reversed.

 

In accordance with SFAS 123(R), which we adopted January 1, 2006, tax savings from expected future deductions based on the expense attributable to our stock option plans are reflected in the U.S. tax provisions for 2006 and 2005. They were not reflected in the provision for 2004.

 

We also have evaluated our deferred tax assets related to acquired operating losses and we believe a full valuation allowance for these assets is required as it is not more likely than not that the deferred tax assets will be realized. This valuation allowance is due to anticipated limitations on acquired losses, including limitations under Section 382 of the Internal Revenue Code. Any future release of this valuation allowance will reduce goodwill.

 

Comprehensive Income.  Comprehensive income includes revenues, expenses, gains and losses that are excluded from net earnings under GAAP. Items of comprehensive income are unrealized gains and losses on short term investments and foreign currency translation adjustments which are added to net income to compute comprehensive income. Comprehensive income is net of income tax benefits or expense.

 

In 2006, comprehensive income included $13.5 million recorded for unrealized foreign exchange gains on the revaluation of investments in foreign subsidiaries; and $0.6 million net of $0.2 million tax expense for unrealized investment gains. In 2005, comprehensive income included $1.3 million recorded for unrealized foreign exchange losses on the revaluation of investments in foreign subsidiaries; and $0.8 million net of $0.5 million tax benefit for unrealized investment losses. In 2004, comprehensive income included $0.1 million recorded for unrealized foreign exchange losses on the revaluation of investments in foreign subsidiaries, and $0.3 million for unrealized investment losses. There was no tax benefit for comprehensive income in 2004 as we had no tax expense.

 

Quarterly Results of Operations

 

The following discussion of results of operations that originally appeared in our Forms 10-Q filed for 2006 have been adjusted to reflect the restatement of our quarterly financial results for 2005, which is more fully described in the “Explanatory Note” immediately preceding Part I Item 1 and in Note 2, “Restatement of Consolidated Financial Statements” in Notes to Consolidated Financial Statements of this Form 10-K.

 

Quarterly Period Ended September 30, 2006

 

The following table sets forth certain items from our condensed consolidated statements of operations as a percentage of total revenue for the periods indicated.

 

 

 

 

REVENUE.  Our revenue increased to $75.3 million for the three months ended September 30, 2006 from $53.2 million for the same period in the prior year, an increase of $22.2 million, or 41.7%. For the nine months ended September 30, 2006, revenue totaled $224.6 million, an increase of $65.8 million, or 41.4%,

from revenue of $158.9 million in the same period of the prior year. The increase was primarily attributable to higher online sales activity across our client base, increased sales from international sites, expanded strategic marketing activities with a larger number of clients, and acquisitions made during 2005 and 2006.

 

International sales were approximately 39% and 39% of total sales in the three month period ended September 30, 2006 and 2005, respectively, and approximately 40% and 38% of total sales for the nine month period ended September 30, 2006 and 2005, respectively. The year-to-date growth is attributable to a larger number of international stores being operated for our clients as well as the European outsourced e-commerce providers we acquired in 2004 and 2005.

 

DIRECT COST OF SERVICES.  Our direct cost of services line item primarily includes the personnel costs and costs related to product fulfillment, physical on demand, our proprietary back-up CD production and client-specific dedicated costs. Direct cost of service expense was $1.9 million for the three months ended September 30, 2006, up from $1.1 million for the same period in the prior year. For the nine months ended September 30, 2006, direct cost of service expense was $5.7 million, up from $3.6 million for the same period of the prior year. The increase resulted primarily from (i) personnel added to serve new clients, and to handle increased transaction volumes, (ii) recent acquisitions and (iii) stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that direct cost of services will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide fulfillment capacity in order to meet anticipated shipment volumes from sales, and expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

NETWORK AND INFRASTRUCTURE.  Our network and infrastructure expense line item primarily includes the personnel costs and related expenses to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expense was $7.8 million for the three months ended September 30, 2006, up from $5.0 million for the same period in the prior year. For the nine months ended September 30, 2006, network and infrastructure expense was $21.5 million, up from $14.2 million for the same period in the prior year. The increases resulted primarily from personnel added to support our revenue growth as well as those gained through acquisition of other businesses, costs related to operating new international data centers and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that network and infrastructure expenses will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide customer service capacity, as we expand the number of operating global data centers, expected increased network usage, which will drive higher Internet connection charges, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of the adoption of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

SALES AND MARKETING.  Our sales and marketing expense line item primarily includes personnel costs and related expenses, advertising, promotional and product marketing expenses, credit card transaction and other payment processing fees, credit card chargebacks and bad debt expense. Sales and marketing expense increased to $28.5 million for the three months ended September 30, 2006 from $16.7 million for the same period in the prior year, an increase of $11.7 million, or 70.0%. Sales and marketing expense increased to $83.0 million for the nine months ended September 30, 2006 from $48.9 million for the same period in the prior year, an increase of $34.1 million, or 69.7%. The increases primarily resulted from credit card fees directly associated with the increase in revenue and additional sales, the addition of new international payment methods, personnel and related expenses to support our global growth initiatives, costs from recent acquisitions, and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, sales and marketing expense was 37.8% and 37.0% in the three months and nine months ended September 30, 2006, compared to 31.4% and 30.7% for the same periods in the prior year. During the first nine months of 2006, we continued to expand our presence in global markets, the consumer electronics market, our strategic marketing services programs, and our oneNetwork affiliate program. We also expanded our relationships with two of our major partners,

Symantec and Microsoft. We currently believe that sales and marketing expenses will increase in absolute dollars in 2006 compared to 2005, as we continue to grow and expand our reach to clients, as we continue to offer increased levels of strategic marketing services, as we incur costs for acquisitions completed in 2005 and 2006, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

PRODUCT RESEARCH AND DEVELOPMENT.  Our product research and development expense line item includes the costs of personnel and related expenses associated with developing and enhancing our technology platforms and related systems. Product research and development expense increased to $8.3 million and $23.4 million, respectively, for the three and nine months ended September 30, 2006 from $5.2 million and $14.9 million for the same periods in the prior year, an increase of $3.1 million, or 59.0%, and $8.5 million, or 57.2%, respectively. The increases were primarily driven by increases in personnel-related expenses to support our growth initiatives, costs from recent acquisitions, development related to our expanded relationship with Microsoft and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). During the first nine months of 2006, we continued to advance our remote-control technology, as well as the international and e-marketing capabilities. We capitalized approximately $0.0 million and $0.4 million of software development costs related to these efforts in the nine months ended September 30, 2006 and 2005, respectively. We did not capitalize any material costs related to software development during the nine months ended September 30, 2006 and do not expect to capitalize any such costs for the balance of 2006. As a percentage of revenue, product research and development expense was 11.1% and 10.4% in the three and nine months ended September 30, 2006, compared to 9.9% and 9.4% for the same periods in the prior year. We currently believe that product research and development expenses will increase in absolute dollars in 2006 compared to 2005, as a result of (i) continued investments in product development required to remain competitive, (ii) costs from acquisitions completed in 2005 and 2006, and (iii) recording expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

GENERAL AND ADMINISTRATIVE.  Our general and administrative expense line item primarily includes the costs of executive, accounting, and administrative personnel and related expenses, insurance expense, and professional fees for legal, tax and audit services. General and administrative expenses increased to $8.1 million and $24.6 million, respectively, for the three and nine months ended September 30, 2006 from $5.3 million and $16.2 million for the same periods in the prior year, an increase of $2.8 million, or 52.1%, and $8.3 million, or 51.4%, respectively. The increase resulted primarily from the addition of personnel and facilities to support our global expansion, such as our offices in Ireland and Luxembourg, as well as those gained through acquisition of other businesses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, general and administrative expense was 10.7% and 10.9% for the three and nine months ended September 30, 2006, compared to 10.0% and 10.2% for the same periods in the prior year. We currently believe that general and administrative expenses will increase in absolute dollars in 2006 compared to 2005, as we (i) continue to invest in our infrastructure to support our continued organic growth, (ii) incur costs from acquisitions completed in 2005 and 2006 and (iii) record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES.  Our amortization of acquisition-related intangibles line item consists of amortization of intangible assets recorded from 13 of our acquisitions during the past four years. Amortization of acquisition-related intangible assets was $3.3 million and $9.2 million, respectively, for the three and nine months ended September 30, 2006 compared to $2.1 million and $6.6 million for the same periods in the prior year. The increase was due to additional amortizable assets acquired throughout 2005 and the first half of 2006. We have purchased, and expect to continue purchasing, assets or businesses, which may include the purchase of intangible assets.

 

OTHER INCOME, NET.  Our other income, net line item is the total of interest income on our cash, cash equivalents and short-term investments, interest expense on our debt and foreign currency transaction gains and losses. Interest income was $6.4 million and $15.6 million, respectively, for the three and nine months ended September 30, 2006 compared to $2.7 million and $6.8 million for the same periods in the prior year. Interest expense was $0.6 million and $1.9 million, respectively, for the three and nine months ended September 30, 2006 compared to $0.6 million and $1.8 million for the same periods in the prior year. Gains from foreign currency remeasurement were $0.0 million and $1.4 million, respectively, for the three and nine months ended September 30, 2006 compared to losses of $0.6 million and $1.4 million for the same periods in the prior year. Gains and losses from the sale of investments were immaterial for the three and nine months ended September 30, 2006 and 2005.

 

INCOME TAXES.  For the three months ended September 30, 2006 and 2005, our tax expense was $5.6 million and $4.7 million, respectively. For the three months ended September 30, 2006, our tax expense consisted of approximately $5.1 million of U.S. tax expense and $0.5 million of foreign tax expense. For the nine months ended September 30, 2006 and 2005, our tax expense was $20.3 million and $12.8 million, respectively. For the nine months ended September 30, 2006, our tax expense consisted of approximately $18.5 million of U.S. tax expense and $1.8 million of foreign tax expense.

 

During the three months ended September 30, 2006, we recorded tax expense at a rate that reflected the estimated impact of current year changes in foreign operations. We established new locations in Shannon, Ireland and Luxembourg. We transferred existing non-U.S. operations to these locations and expanded these operations in order to more effectively manage current international activity and facilitate further international growth. We commenced business operations in these locations on April 1, 2006. These operating changes generally reduce our effective tax rate compared to prior years.

 

During the quarter, we recorded, as a discrete item, the tax benefit of research and development tax credits as a result of a study completed during the quarter. The net effect of this benefit reduced our tax expense in the third quarter by approximately $1.2 million. The research and development credit related to federal and state tax credits generated prior to 2006. Current year federal tax credits are dependent upon federal legislation to extend this benefit.

 

As of September 30, 2006, we had net U.S. tax loss carryforwards of approximately $66 million and foreign tax loss carryforwards of $3 million. The U.S. amount consisted of approximately $24 million of deductions resulting from exercise of stock options and $42 million of acquired net operating losses. The tax loss carryforwards from exercise of stock options expire in the years 2020 through 2024. The acquired net operating losses expire in the years 2020 through 2025 and are subject to other deductibility restrictions discussed below.

 

In prior years, there was uncertainty of future realization of the deferred tax assets resulting from temporary differences and from tax loss carryforwards from operations and stock option deductions, therefore a valuation allowance equal to the deferred tax assets was recorded. At December 31, 2005, we evaluated our deferred tax assets related to tax loss carryforwards from stock option deductions and other items and concluded that it was more likely than not that the deferred tax assets would be realized, and accordingly the valuation allowance was reversed.

 

We also have evaluated our deferred tax assets related to acquired operating losses and we believe a full valuation allowance for these assets is required under GAAP. This valuation allowance is due to anticipated limitations, including limitations under Section 382 of the Internal Revenue Code, on acquired losses. Any future release of this valuation allowance will reduce goodwill.

 

Quarterly Period Ended June 30, 2006

 

The following table sets forth certain items from our condensed consolidated statements of operations as a percentage of total revenue for the periods indicated.

 

 

 

 

REVENUE.  Our revenue increased to $71.3 million for the three months ended June 30, 2006 from $51.1 million for the same period in the prior year, an increase of $20.1 million, or 39.4%. For the six months ended June 30, 2006, revenue totaled $149.3 million, an increase of $43.6 million, or 41.3%, from revenue of $105.7 million in the same period of the prior year. The increase was primarily attributable to higher online sales activity across our client base, increased sales from international sites, expanded strategic marketing activities with a larger number of clients, and acquisitions made during 2005 and 2006.

 

International sales were approximately 42% and 39% of total sales in the three month period ended June 30, 2006 and 2005, respectively, and approximately 41% and 38% of total sales for the six month period ended June 30, 2006 and 2005, respectively. That growth is attributable to a larger number of international stores being operated for our clients as well as the European outsourced e-commerce providers we acquired in 2004 and 2005.

 

DIRECT COST OF SERVICES.  Our direct cost of services line item primarily includes the personnel costs and costs related to product fulfillment, physical on demand, our proprietary back-up CD production and client-specific dedicated costs. Direct cost of service expense was $1.9 million for the three months ended June 30, 2006, up from $1.2 million for the same period in the prior year. For the six months ended June 30, 2006, direct cost of service expense was $3.8 million, up from $2.5 million for the same period of the prior year. The increase resulted primarily from (i) personnel added to serve new clients, and to handle increased transaction volumes, (ii) recent acquisitions and (iii) stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that direct cost of services will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide fulfillment capacity in order to meet anticipated shipment volumes from sales, and expense related

to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

NETWORK AND INFRASTRUCTURE.  Our network and infrastructure expense line item primarily includes the personnel costs and related expenses to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expense was $6.3 million for the three months ended June 30, 2006, up from $4.7 million for the same period in the prior year. For the six months ended June 30, 2006, network and infrastructure expense was $13.7 million, up from $9.2 million for the same period in the prior year. The increase resulted primarily from personnel added to support our revenue growth as well as those gained through acquisition of other businesses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that network and infrastructure expenses will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide customer service capacity, as we expand the number of operating global data centers, expected increased network usage, which will drive higher Internet connection charges, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of the adoption of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

SALES AND MARKETING.  Our sales and marketing expense line item primarily includes personnel costs and related expenses, advertising, promotional and product marketing expenses, credit card transaction and other payment processing fees, credit card chargebacks and bad debt expense. Sales and marketing expense increased to $27.6 million for the three months ended June 30, 2006 from $15.8 million for the same period in the prior year, an increase of $11.9 million, or 75.3%. Sales and marketing expense increased to $54.6 million for the six months ended June 30, 2006 from $32.2 million for the same period in the prior year, an increase of $22.4 million, or 69.5%. The increase primarily resulted from credit card fees directly associated with the increase in revenue and additional sales, the addition of new, international payment methods, personnel and related expenses to support our growth initiatives, costs from recent acquisitions, and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, sales and marketing expense was 38.7% and 36.5% in the three months and six months ended June 30, 2006, compared to 30.8% and 30.5% for the same periods in the prior year. During the first half of 2006, we continued to expand our presence in global markets, our strategic marketing services programs, and our oneNetwork affiliate program. We currently believe that sales and marketing expenses will increase in absolute dollars in 2006 compared to 2005, as we continue to grow and expand our reach to clients, as we continue to offer increased levels of strategic marketing services, as we incur costs for acquisitions completed in 2005 and 2006, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

PRODUCT RESEARCH AND DEVELOPMENT.  Our product research and development expense line item includes the costs of personnel and related expenses associated with developing and enhancing our technology platforms and related systems. Product research and development expense increased to $7.5 million and $15.1 million, respectively, for the three and six months ended June 30, 2006 from $5.2 million and $9.7 million for the same periods in the prior year, an increase of $2.3 million, or 45.1%, and $5.4 million, or 56.2%, respectively. The increase was primarily driven by increases in personnel-related expenses to support our growth initiatives, costs from recent acquisitions and stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). During the first half of 2006, we continued to advance our remote-control technology, as well as the international and e-marketing capabilities. We capitalized approximately $0.0 million and $0.4 million of software development costs related to these efforts in the six months ended June 30, 2006 and 2005, respectively. We did not capitalize any material costs related to software development during the six months ended June 30, 2006 and do not expect to capitalize any such costs for the balance of 2006. As a percentage of revenue, product research and development expense was 10.5% and 10.1% in the three and six months ended June 30, 2006, compared to 10.1% and 9.1% for the same periods in the prior year. We currently believe that product research and

development expenses will increase in absolute dollars in 2006 compared to 2005, as a result of (i) continued investments in product development required to remain competitive, (ii) costs from acquisitions completed in 2005 and 2006, and (iii) recording expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

GENERAL AND ADMINISTRATIVE.  Our general and administrative expense line item primarily includes the costs of executive, accounting, and administrative personnel and related expenses, insurance expense, and professional fees for legal, tax and audit services. General and administrative expenses increased to $8.2 million and $16.5 million, respectively, for the three and six months ended June 30, 2006 from $5.3 million and $10.9 million for the same periods in the prior year, an increase of $2.9 million, or 55.5%, and $5.6 million, or 51.1%, respectively. The increase resulted primarily from the addition of personnel and facilities to support our global expansion, such as our offices in Ireland and Luxembourg, as well as those gained through acquisition of other businesses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, general and administrative expense was 11.6% and 11.1% for the three and six months ended June 30, 2006, compared to 10.4% and 10.3% for the same periods in the prior year. We currently believe that general and administrative expenses will increase in absolute dollars in 2006 compared to 2005, as we (i) continue to invest in our infrastructure to support our continued organic growth, (ii) incur costs from acquisitions completed in 2005 and 2006 and (iii) record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES.  Our amortization of acquisition-related intangibles line item consists of amortization of intangible assets recorded from 13 of our acquisitions during the past four years. Amortization of acquisition-related intangible assets was $3.0 million and $5.9 million, respectively, for the three and six months ended June 30, 2006 compared to $2.1 million and $4.5 million for the same periods in the prior year. The increase was due to additional amortizable assets acquired throughout 2005 and the first half of 2006. We have purchased, and expect to continue purchasing, assets or businesses, which may include the purchase of intangible assets.

 

OTHER INCOME, NET.  Our other income, net line item is the total of interest income on our cash, cash equivalents and short-term investments, interest expense on our debt and foreign currency transaction gains and losses. Interest income was $5.8 million and $9.2 million, respectively, for the three and six months ended June 30, 2006 compared to $2.3 million and $4.1 million for the same periods in the prior year. Interest expense was $0.6 million and $1.2 million, respectively, for the three and six months ended June 30, 2006 compared to $0.6 million and $1.2 million for the same periods in the prior year. Gains from foreign currency remeasurement were $1.2 million and $1.3 million, respectively, for the three and six months ended June 30, 2006 compared to losses of $0.7 million and $0.8 million for the same periods in the prior year. Gains and losses from the sale of investments were immaterial for the three and six months ended June 30, 2006 and 2005.

 

INCOME TAXES.  For the three months ended June 30, 2006, our tax expense was $7.3 million, made up of approximately $9.6 million of current tax expense and $2.3 million of deferred tax benefit. For the three months ended June 30, 2005, our tax expense was $5.2 million, made up of $4.3 million related to domestic and $0.9 million to foreign operations.

 

During the three month period ended June 30, 2006, we recorded tax expense at a rate that reflects the estimated impact of recent changes in foreign operations. We established new locations in Shannon, Ireland and Luxembourg. We transferred existing non-U.S. operations to these locations and expanded these operations in order to more effectively manage current international activity and facilitate further international growth. We commenced business operations in these locations on April 1, 2006. We have also established in the past 18 months, or are in the process of establishing, operations in Taipei, Taiwan, Tokyo, Japan, Seoul, Korea and Rio de Janeiro, Brazil. These operating changes may reduce our effective tax rate from prior quarters.

 

As of June 30, 2006, we had net U.S. tax loss carryforwards of approximately $82.4 million, and foreign tax loss carryforwards of $4.8 million. The U.S. amount consists of $40.4 million of deductions resulting from exercise of stock options and $42.0 million of acquired net operating losses. The tax loss carryforwards from exercise of stock options expire in the years 2020 through 2024. The acquired net operating losses expire in the years 2020 through 2025 and are subject to other deductibility restrictions discussed below.

 

In prior years, there was uncertainty of future realization of the deferred tax assets resulting from temporary differences and from tax loss carryforwards from operations and stock option deductions, therefore a valuation allowance equal to the deferred tax assets was recorded. At December 31, 2005, we evaluated our deferred tax assets related to tax loss carryforwards from stock option deductions and other items and concluded that the valuation allowance should be reversed. We met the requirements under GAAP as we believe it is more likely than not that we will realize the benefit of these deferred tax assets. This conclusion was based primarily on our earnings history over the last three years as well as our expected future taxable income. The impact on U.S. taxable income of future stock option deductions should not reduce taxable income to a level that would jeopardize this conclusion or unreasonably extend the period in which we may recognize the tax benefit associated with these deferred tax assets.

 

We also have evaluated our deferred tax assets related to acquired operating losses and we believe a full valuation allowance for these assets is required under GAAP. This valuation allowance is due to anticipated limitations, including limitations under Section 382 of the Internal Revenue Code, on acquired losses. Any future release of this valuation allowance will reduce goodwill.

 

Quarterly Period Ended March 31, 2006

 

The following table sets forth certain items from our condensed consolidated statements of operations as a percentage of total revenue for the periods indicated.

 

 

 

 

REVENUE.  Our revenue increased to $78.0 million for the three months ended March 31, 2006 from $54.5 million for the same period in the prior year, an increase of $23.5 million, or 43.1%. The increase was primarily attributable to higher online sales activity across our client base, increased sales from international sites, expanded strategic marketing activities with a larger number of clients, and acquisitions made during 2005. Sales of security software products for PCs represent the largest contributor to our revenues.

 

International sales represented approximately 40% and 36% of total revenue in the three month period ended March 31, 2006 and 2005, respectively. That growth is attributable to a larger number of international stores being operated for our clients as well as the European outsourced e-commerce providers we acquired in 2004 and 2005.

 

DIRECT COST OF SERVICES.  Our direct cost of services line item primarily includes the personnel costs and costs related to product fulfillment, physical on demand and our proprietary back-up CD production. Direct cost of service expense was $1.9 million for the three months ended March 31, 2006, up from $1.3 million for the same period in the prior year. The increase resulted primarily from (i) personnel added to serve new clients, and to handle increased transaction volumes, and (ii) stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that direct cost of services will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide fulfillment capacity in order to meet anticipated shipment volumes from sales, and expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

NETWORK AND INFRASTRUCTURE.  Our network and infrastructure expense line item primarily includes the personnel costs and related expenses to operate and maintain our technology platforms, customer service, data communication and data center operations. Network and infrastructure expense was $7.4 million for the three months ended March 31, 2006, up from $4.5 million for the same period in the prior year. The increase resulted primarily from personnel added to support our revenue growth as well as those gained through acquisition of other businesses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). We currently believe that network and infrastructure expenses will increase in absolute dollars in 2006 compared to 2005 as we continue to expand our worldwide customer service capacity, as we expand the number of operating global data centers, expected increased network usage, which will drive higher Internet connection charges, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of the adoption of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

SALES AND MARKETING.  Our sales and marketing expense line item primarily includes personnel costs and related expenses, advertising and promotional expenses, credit card transaction and other payment processing fees, credit card chargebacks and bad debt expense. Sales and marketing expense increased to $26.9 million for the three months ended March 31, 2006 from $16.4 million for the same period in the prior year, an increase of $10.5 million, or 63.9%. The increase primarily resulted from credit card fees directly associated with the increase in revenue and additional sales, marketing personnel and related expenses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, sales and marketing expense was 34.5% in the three months ended March 31, 2006, compared to 30.2% for the same period in the prior year. During the first quarter of 2006, we expanded the depth and breadth of our strategic marketing programs that we manage on behalf of our clients. These core programs include search engine optimization, affiliate and email marketing and site optimization. We also increased our marketing efforts to expand our oneNetwork affiliate program. We currently believe that sales and marketing expenses will increase in absolute dollars in 2006 compared to 2005, as we continue to grow and expand our reach to clients, as we continue to offer increased levels of strategic marketing services, as we incur a full year of costs in 2006 related to acquisitions completed in 2005, and as we record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

PRODUCT RESEARCH AND DEVELOPMENT.  Our product research and development expense line item includes the costs of personnel and related expenses associated with developing and enhancing our technology platforms and related systems. Product research and development expense increased to $7.6 million for the three months ended March 31, 2006 from $4.5 million for the same period in the prior year, an increase of $3.1 million, or 69.0%. The increase was primarily driven by increases in personnel-related expenses, outside consulting fees and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). During the first quarter of 2006, we continued to advance our remote-control technology, as well as the international and e-marketing capabilities. We capitalized approximately $0.4 million of software development costs related to these efforts in the three months ended March 31, 2005. We did not capitalize any costs related to software development during the three months ended March 31, 2006 and do not expect to capitalize any such costs for the balance of 2006. As a percentage of revenue, product research and development expense was 9.7% in the three months ended March 31, 2006, compared to 8.2% for the same period in the prior year. We currently believe that product research and development expenses will increase in absolute dollars in 2006 compared to 2005, as a result of (i) continued investments in product development required to remain competitive, (ii) incurring a full year of costs in 2006 related to acquisitions completed in 2005, and (iii) recording expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

GENERAL AND ADMINISTRATIVE.  Our general and administrative expense line item primarily includes the costs of executive, accounting, and administrative personnel and related expenses, insurance expense, professional fees, including legal and accounting, and shareholder and compliance expenses. General and administrative expenses increased to $8.3 million for the three months ended March 31, 2006 from $5.6 million for the same period in the prior year, an increase of $2.6 million, or 46.8%. The increase resulted primarily from the addition of personnel and facilities to support our growth as well as those gained through acquisition of other businesses, and from stock-based compensation expense related to employee stock options and employee stock purchases recognized under SFAS 123(R). As a percentage of revenue, general and administrative expense was 10.6% for the three months ended March 31, 2006, compared to 10.3% for the same period in the prior year. We currently believe that general and administrative expenses will increase in absolute dollars in 2006 compared to 2005, as we (i) continue to invest in our infrastructure to support our continued organic growth, (ii) incur a full year of costs in 2006 related to acquisitions completed in 2005 and (iii) record expense related to stock-based compensation. See Note 6 — “Stock-Based Compensation,” in the consolidated financial statements for a discussion of the impact of SFAS 123(R), “Share Based Payment,” which we adopted on January 1, 2006.

 

AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES.  Our amortization of acquisition-related intangibles line item consists of amortization of intangible assets recorded from our 15 acquisitions in the last four years. Amortization of acquisition-related intangibles assets was $2.8 million for the three months ended March 31, 2006 compared to $2.4 million for the same period in the prior year. The increase was due to additional amortizable assets acquired throughout 2005 and the first quarter of 2006. We have purchased, and expect to continue purchasing, assets or businesses, which may include the purchase of intangible assets.

 

OTHER INCOME, NET.  Our other income, net line item is the total of interest income on our cash, cash equivalents and short-term investments, interest expense on our debt and foreign currency transaction gains and losses. Interest income was $3.4 million and $1.8 million for the three months ended March 31, 2006 and 2005, respectively. Interest expense was $0.6 million and $0.6 million for the three months ended March 31, 2006 and 2005, respectively. Gains and losses from foreign currency remeasurement were $0.1 million for the three months ended March 31, 2006 and immaterial for the same period in the prior year. Gains and losses from the sale of investments were immaterial for the three months ended March 31, 2006 and 2005.

 

INCOME TAXES.  For the three months ended March 31, 2006, our tax expense was $7.4 million, made up of approximately $8.9 million of current tax expense and $1.5 million of deferred tax benefit. For the three months ended March 31, 2005, our tax expense was $2.9 million, made up of $1.7 million related to domestic and $1.2 million to foreign operations.

 

During the three month period ending March 31, 2006, we recorded tax expense at a rate that reflected the estimated impact of recent changes in foreign operations. These operating changes generally reduce our effective tax rate compared to prior quarters. However, the estimated tax rate in the first quarter of 2005 reflected the favorable impact of utilizing U.S. tax loss carryforwards arising from operations including a $2.0 million tax benefit related to stock-based compensation expense (see “Explanatory Note” immediately preceding Part I Item 1 and in Note 2, “Restatement of Consolidated Financial Statements” in Notes to Consolidated Financial Statements of this Form 10-K). The utilization of these U.S. tax loss carryforwards had a favorable impact on our tax rate due to the fact that we released the valuation allowance associated with these tax loss carryforwards at the time of utilization.

 

As of March 31, 2006, we had net U.S. tax loss carryforwards of approximately $97.0 million, and foreign tax loss carryforwards of $6.0 million. The U.S. amount consists of $55.0 million of deductions resulting from exercise of stock options and $42.0 million of acquired net operating losses. These tax loss carryforwards expire in the years 2020 through 2024. The acquired net operating losses expire in the years 2020 through 2025 and are subject to other deductibility restrictions discussed below.

 

In prior years, there was uncertainty of future realization of the deferred tax assets resulting from temporary differences and from tax loss carryforwards from operations and stock option deductions, therefore a valuation allowance equal to the deferred tax assets was recorded. At December 31, 2005, we have evaluated our deferred tax assets related to tax loss carryforwards from stock option deductions and other items and concluded that the valuation allowance should be reversed. We met the requirements under GAAP as we believe it is more likely than not that we will realize the benefit of these deferred tax assets. This conclusion was based primarily on our earnings history over the last three years as well as our expected future taxable income. The impact on U.S. taxable income of future stock option deductions should not reduce taxable income to a level that would jeopardize this conclusion or unreasonably extend the period in which we may recognize the tax benefit associated with these deferred tax assets. We also have evaluated our deferred tax assets related to acquired operating losses and we believe a full valuation allowance for these assets is required under GAAP. This valuation allowance is due to anticipated limitations, including limitations under Section 382 of the Internal Revenue Code, on acquired losses. Any future release of this valuation allowance will reduce goodwill.

 

Liquidity and Capital Resources

 

As of December 31, 2006, we had $390.2 million of cash and cash equivalents, $235.7 million of short-term investments, and working capital of $497.9 million. The major components of our working capital are cash and cash equivalents, short-term investments and short-term receivables net of client and merchant payables. Our primary source of internal liquidity is our operating activities. Net cash provided by operating activities in 2006, 2005 and 2004 was $117.5 million, $119.8 million and $85.1 million, respectively. Net cash provided by operating activities in 2006 and 2005 was primarily the result of net income adjusted for non-cash expenses, and increases in accrued liabilities, accounts payable and income tax payable partially offset by an increase in accounts receivable. Net cash provided by operating activities in 2004 was primarily the result of net income adjusted for non-cash expenses, and increases in accrued liabilities and accounts payable partially offset by an increase in accounts receivable. Due to our adoption of SFAS 123(R), as of January 1, 2006, the impact of the excess tax benefits of stock-based compensation, defined as the benefits of a tax deduction for share-based payment expenses that exceeds the recognized compensation expenses, is now reported under financing activities with a corresponding deduction from operating activities in our Consolidated Statements of Cash Flows.

 

Net cash used in investing activities was $68.0 million in 2006 and was the result of net purchases of investments of $14.3 million, cash paid for acquisitions, net of cash received, of $37.8 million, and purchases of capital equipment of $15.9 million. Net cash used in investing activities was $125.4 million in 2005 and was the result of net purchases of investments of $62.9 million, cash paid for acquisitions, net of cash received, of $54.2 million, and purchases of capital equipment of $8.3 million. Net cash used in investing activities in 2004 was $241.4 million and was the result of net purchases of investments of $105.6 million

cash paid for acquisitions, net of cash received, of $126.5 million and purchases of capital equipment of $6.6 million and capitalized internal-use software of $2.7 million.

 

In January 2006, we acquired Direct Response Technologies, Inc. (now DR Marketing Solutions, Inc.) for approximately $15.0 million in cash, and in June 2006, we acquired MindVision for approximately $21.2 million in cash payments to stockholders plus the assumption of certain liabilities. In December 2005, we acquired all of the capital stock of Commerce5, Inc., an outsourced e-commerce provider to high-tech and consumer electronics manufacturers for $45.1 million in cash. In March 2005, we acquired SWReg, an operating business of Atlantic Coast plc, a private limited UK company, for $8.8 million in cash. In November 2004, we acquired all of the outstanding stock of BlueHornet Networks, Inc. Under the terms of the agreement we issued 160,185 shares of common stock to BlueHornet shareholders and assumed debt obligations of BlueHornet totaling approximately $0.7 million. In June 2004, we acquired substantially all of the assets and assumed certain liabilities of Fireclick, Inc. Under the terms of the agreement, we paid $7.5 million in cash. In April 2004, we acquired element 5 AG (now Digital River GmbH), a privately held company based in Germany. Under the terms of the acquisition, we paid $120 million in cash to acquire all of the outstanding shares of capital stock of element 5.

 

Net cash provided by financing activities in 2006, 2005 and 2004 was $204.6 million, $12.3 million and $209.0 million, respectively. Our external financing has been provided primarily by the sale of our stock and convertible notes in private and public offerings, and, to a lesser extent, by sales to employees under our employee stock purchase plan and by exercise of stock options. In March 2006, we sold 4.0 million shares of our common stock. The offering provided net proceeds of $172.8 million, and was made pursuant to a shelf registration statement previously filed with the Securities and Exchange Commission. During 2006, proceeds from the exercise of stock options provided cash of $21.1 million, and proceeds of $9.0 million were provided by the excess tax benefit from stock-based compensation. During 2005, proceeds from the exercise of stock options provided cash of $23.2 million, and we repurchased $13.1 million of common stock, which reduced our net cash provided by financing activities. In June 2004, we sold and issued $175 million in aggregate principal amount of 1.25% convertible senior notes due January 1, 2024, in a private, unregistered offering. The notes were subsequently registered for resale. The notes were sold at 100% of their principal amount. The initial purchasers exercised in full their option to purchase up to an additional $20 million in aggregate principal amount of the notes, closing on July 6, 2004. Cash provided from the issuance of convertible senior notes in 2004 totaled $188.4 million, net of financing expense. Proceeds from the exercise of stock options provided cash of $19.7 million in 2004.

 

Liquidity and Capital Resource Requirements

 

We believe that existing sources of liquidity and the results of our operations will provide adequate cash to fund our ongoing operations for the foreseeable future, although we may seek to raise additional capital during that period. In January 2005, we filed a registration statement to increase our available shelf registration amount from approximately $55 million to approximately $255 million. In addition, we filed an acquisition shelf for up to approximately 1.5 million shares. In February 2006, we filed a shelf registration that would allow us to sell an undetermined amount of equity or debt securities in accordance with the recently approved rules applying to “well known seasoned issuers.” These filings were made to provide future flexibility for acquisition and financing purposes. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders. There can be no assurances that financing will be available in amounts or on terms acceptable to us, if at all.

 

Contractual Obligations

 

At December 31, 2006, our principal commitments consisted of interest and principal on our convertible senior notes and long-term obligations outstanding under operating leases. Although we have no material commitments for capital expenditures, we anticipate continued capital expenditures consistent with our anticipated growth in operations, infrastructure and personnel. We expect that our operating expenses will continue to grow as our overall business grows and that they will be a material use of our cash resources.

 

 

With respect to our convertible senior notes, we are required to pay interest on the notes on January 1 and July 1 of each year. The notes bear interest at a rate of 1.25% and, if specified conditions are met, are convertible into our common stock at a conversion price of $44.063 per share. The notes may be surrendered for conversion under certain circumstances, including the satisfaction of a market price condition, such that the price of our common stock reaches a specified threshold; the satisfaction of a trading price condition, such that the trading price of the notes falls below a specified level; the redemption of the notes by us; the occurrence of specified corporate transactions, as defined in the related indenture; and the occurrence of a fundamental change, as defined in the related indenture. The initial conversion price is equivalent to a conversion rate of approximately 22.6948 shares per $1,000 of principal amount of the notes. We will adjust the conversion price if certain events occur, as specified in the related indenture, such as the issuance of our common stock as a dividend or distribution or the occurrence of a stock subdivision or combination. If a fundamental change, such as a change in our control, as defined in the related indenture, occurs on or before January 1, 2009, we also may be required to purchase the notes for cash and pay an additional make-whole premium payable in our common stock, or in the same form of consideration into which all, or substantially, all of the shares of our common stock have been converted or exchanged in connection with the fundamental change, upon the repurchase or conversion of the notes in connection with the fundamental change. Holders of the notes have the right to require us to repurchase their notes prior to maturity on January 1, 2009, 2014 and 2019. We have the right to redeem the notes, under certain circumstances, on or after July 1, 2007, and prior to January 1, 2009, and we may redeem the notes at any time on or after January 1, 2009.

 

2007 Outlook

 

We believe the outlook for our business remains positive for 2007. Total online sales continue to increase globally and buyers appear increasingly comfortable shopping and purchasing online. In our core market, trends continue to favor the transition from packaged, physical delivery of software products to electronic download. In addition, our strategic marketing programs have been well received by our clients to date and we believe we can expand adoption of these services by additional clients as well as add new services. We anticipate making additional investments to support existing client growth, new client additions, development of other complementary vertical markets, international expansion and improvements in our technology platform.

 

New Accounting Standards

 

In September 2006, the FASB issued statement No. 157, “Fair Value Measurements”, (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, with earlier application encouraged. Any amounts recognized upon adoption as a cumulative effect adjustment will be recorded to the opening balance of retained earnings in the year of adoption. The Company has not yet determined the impact of this Statement on its financial condition and results of operations.

 

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). To reduce diversity in practice among registrants, SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. The accounting requirements of SAB 108 were effective for us on January 1, 2006, and did not have a material impact on our consolidated financial position, results of operations or cash flows.

 

In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting and disclosure for uncertainty in tax positions. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007, as required. The cumulative effect of adopting FIN 48 will be recorded in retained earnings and other accounts as applicable. We do not believe that FIN 48 will have a material impact on our consolidated financial statements.

 

In November 2005, the FASB issued Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (“FSP 115-1”). FSP 115-1 provides accounting guidance for determining and measuring other-than-temporary impairments of debt and equity securities, and confirms the disclosure requirements for investments in unrealized loss positions as outlined in EITF issue 03-01, “The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments.” The accounting requirements of FSP 115-1 were effective for us on January 1, 2006, and did not have a material impact on our consolidated financial position, results of operations or cash flows.

 

Off Balance Sheet Arrangements

 

None

 

Interest Rate Risk

 

Our portfolio of cash equivalents and short-term investments is maintained in a variety of securities, including government obligations and money market funds. Investments are classified as available-for-sale securities and carried at their market value with cumulative unrealized gains or losses recorded as a component of “accumulated other comprehensive income/(loss)” within stockholders’ equity. At December 31, 2006 and 2005, all securities held had maturities or reset dates of less than three years. A sharp rise in interest rates could have an adverse impact on the market value of certain securities in our portfolio. We do not currently hedge our interest rate exposure and do not enter into financial instruments for trading or speculative purposes or utilize derivative financial instruments. A hypothetical and immediate one percent (1%) increase in interest rates would decrease the fair value in our investment portfolio held at December 31, 2006 and 2005, by $1.38 million and by $1.77 million, respectively. A hypothetical and immediate one percent (1%) decrease in interest rates would increase the fair value in our investment portfolio held at December 31, 2006 and 2005, by $1.38 million and by $1.77 million, respectively. The approximate gains or losses in earnings are estimates, and actual results could vary due to the assumptions used. At December 31, 2006 and 2005, we had $195.0 million of 1.25% fixed rate contingent convertible debt outstanding. We presently believe there is minimal risk that market interest rates will drop significantly below 1.25%.

 

Foreign Currency Risk

 

Our business has historically been transacted primarily in the U.S. dollar and, as such, has not been subject to material foreign currency exchange rate risk. However, the growth in our international operations has increased our exposure to foreign currency fluctuations as well as other risks typical of international operations, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures and other regulations and restrictions. Accordingly, our future results could be materially adversely impacted by changes in these or other factors.

 

Foreign exchange rate fluctuations may adversely impact our consolidated results of operations as exchange rate fluctuations on transactions denominated in currencies other than our functional currencies result in gains and losses that are reflected in our consolidated statement of income. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency-denominated transactions will result in increased net revenues and operating expenses. Conversely, our net revenues and operating expenses will decrease when the U.S. dollar strengthens against foreign currencies. The following schedule summarizes revenue, costs and expenses and income from operations that would have resulted had exchange rates in the current period been the same as those in effect in the comparable prior-year period for operating results.

 

The effect on our consolidated statements of operations from changes in exchange rates versus the U.S. Dollar is as follows (in thousands):