Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in the sections titled "Special Note Regarding Forward-Looking Statements" and "Risk Factors".
Management Overview
QuinStreet is a leader in vertical marketing and media online. We have built a strong set of capabilities to engage Internet visitors with targeted media and to connect our marketing clients with their potential customers online. We focus on serving clients in large, information-intensive industry verticals where relevant, targeted media and offerings help visitors make informed choices, find the products that match their needs, and thus become qualified customer prospects for our clients. We deliver cost-effective marketing results to our clients most typically in the form of a qualified lead or click. These leads or clicks can then convert into a customer or sale for the client at a rate, that results in an acceptable marketing cost to them. We get paid by clients primarily when we deliver qualified leads or clicks as defined by our agreements with them. Because we bear the costs of media, our programs must deliver a value to our clients and provide for a media yield, or our ability to generate an acceptable margin on our media costs that provides a sound financial outcome, for us. Our general process is:
• We own or access targeted media;
• We run advertisements or other forms of marketing messages and programs in
that media to create visitor responses or clicks through to client
offerings;
• We match these responses or clicks to client offerings or brands that meet
visitor interests or needs, converting visitors into qualified leads or clicks; and
• We optimize client matches and media yield such that we achieve desired
results for clients and a sound financial outcome for us.
Our primary financial objective has been and remains creating revenue growth from sustainable sources, at target levels of profitability. Our primary financial objective is not to maximize profits, but rather to achieve target levels of profitability while investing in various growth initiatives, as we believe we are in the early stages of a large, long-term market. Our Direct Marketing Services, or DMS, business accounted for 99%, 99% and 98% of our net revenue in fiscal years 2010, 2009 and 2008, respectively. Our DMS business derives substantially all of its net revenue from fees earned through the delivery of qualified leads and clicks to our clients. Through a vertical focus, targeted media presence and our technology platform, we are able to deliver targeted, measurable marketing results to our clients. Our two largest client verticals are education and financial services. Our education client vertical represented 45%, 58% and 74% of net revenue in fiscal years 2010, 2009 and 2008, respectively. Our financial services client vertical represented 43%, 31% and 11% of net revenue in fiscal years 2010, 2009 and 2008, respectively. Other DMS client verticals, consisting primarily of home services, business-to-business, or B2B, and medical, represented 11%, 10% and 13% of net revenue in fiscal years 2010, 2009 and 2008, respectively. In addition, we derived 1%, 1% and 2% of our net revenue in fiscal years 2010, 2009 and 2008, respectively, from the provision of a hosted solution and related services for clients in the direct selling industry, also referred to as our Direct Selling Services, or DSS, business.
We generated substantially all of our revenue from sales to clients in the United States.
One of our largest clients retained an advertising agency and reduced its purchases of leads from us beginning November 2009. This client accounted for 19% and 23% of our net revenue in fiscal years 2009 and 2008,
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respectively. In fiscal year 2010, this client comprised less than 10% of our net revenue. We have been addressing this challenge by working with this client and the agency to understand their evolving needs and strategies and understand how we can best serve them going forward. In addition, we have been expanding our business with other clients in our education client vertical. We are also expanding our client base in education to replace visitor matches previously delivered to this client. Trends Affecting our Business Seasonality Our results are subject to significant fluctuation as a result of seasonality. In particular, our quarters ending December 31 (our second fiscal quarter) typically demonstrate seasonal weakness. In our second fiscal quarters, there is lower availability of lead supply from some forms of media during the holiday period on a cost effective basis and some of our clients often request fewer leads due to holiday staffing. For example, in the quarters ended December 31, 2009 and 2008 net revenue from our education clients declined 10% and 13%, respectively, from the previous quarter. In our quarters ending March 31 (our third fiscal quarter), this trend generally reverses with better lead availability and often new budgets at the beginning of the year for our clients with fiscal years ending December 31.
Acquisitions
Acquisitions in Fiscal Year 2010
In November 2009, we acquired the website business Internet.com, a division of WebMediaBrands, Inc., or Internet.com, a New York-based Internet media company, in exchange for $15.9 million in cash and the issuance of a $1.7 million non-interest-bearing promissory note payable, to broaden our media access and client base in the B2B market. In October 2009, we acquired the website business Insure.com from Life Quotes, Inc., or Insure.com, an Illinois-based online insurance quote service and brokerage business, in exchange for $15.0 million in cash and the issuance of a $1.0 million non-interest-bearing promissory note payable, for its capacity to generate online visitors in the financial services market. During fiscal year 2010, in addition to the acquisitions of Internet.com and Insure.com, we acquired an aggregate of 31 online publishing businesses.
Also, in July 2010, we acquired the website business Insurance.com from Insurance.com Group, Inc., or Insurance.com, an Ohio-based online insurance business, in exchange for $33.0 million in cash and the issuance of a $2.6 million non-interest-bearing promissory note payable, for its capacity to generate online visitors in the financial services market.
Acquisitions in Fiscal Year 2009
In August 2008, we acquired 100% of the outstanding shares of U.S. Citizens for Fair Credit Card Terms, Inc., or CardRatings, an Arkansas-based online marketing company, in exchange for $10.4 million in cash and the issuance of $5.0 million in non-interest-bearing, secured promissory notes payable, for its capacity to generate online visitors in the financial services market. During fiscal year 2009, in addition to the acquisition of CardRatings, we acquired an aggregate of 33 online publishing businesses.
Acquisitions in Fiscal Year 2008
In April 2008, we acquired 100% of the outstanding shares of Cyberspace Communication Corporation, or SureHits, an Oklahoma-based online marketing company, in exchange for $28.4 million in cash and $18.0 million in potential earn-out payments, in an effort to broaden our media access and client base in the financial services market. In each of fiscal year 2010 and 2009, we paid $4.5 million in earn-out payments upon the achievement of specified financial targets. In February 2008, we acquired 100% of the outstanding shares of ReliableRemodeler.com, Inc., or ReliableRemodeler, an Oregon-based company specializing in online home renovation and contractor referrals, in exchange for $17.5 million in cash and the issuance of $8.0 million in non-interest-bearing, unsecured promissory notes payable, in an effort to broaden our media access and client base in the home services market. In May 2008, we acquired the assets of Vendorseek, a New Jersey-based provider of online matching services for businesses that connect Internet visitors with vendors, in exchange for $10.7 million in cash 39
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and the issuance of $3.8 million in interest-bearing, unsecured promissory notes payable, to broaden our media access and client base in the B2B market. During fiscal year 2008, in addition to the acquisitions of Surehits, ReliableRemodeler and Vendorseek, we acquired an aggregate of 20 online publishing businesses. Our acquisition strategy may result in significant fluctuations in our available working capital from period to period and over the years. We may use cash, stock or promissory notes to acquire various businesses or technologies, and we cannot accurately predict the timing of those acquisitions or the impact on our cash flows and balance sheet. Large acquisitions or multiple acquisitions within a particular period may significantly affect our financial results for that period. We may utilize debt financing to make acquisitions, which could give rise to higher interest expense and more restrictive operating covenants. We may also utilize our stock as consideration, which could result in substantial dilution.
Client Verticals
To date, we have generated the majority of our revenue from clients in our education and financial services client verticals. We expect that a majority of our revenue in fiscal year 2011 will be generated from clients in our education and financial services client verticals. Marketing budgets for clients in our education client vertical are affected by a number of factors, including the availability of student financial aid, the regulation of for-profit financial institutions and economic conditions. Over the past year, some segments of the financial services industry, particularly mortgages, credit cards and deposits, have seen declines in marketing budgets given the difficult market conditions. In addition, the education and financial services industries are highly regulated. Changes in regulations or government actions may negatively affect our clients' businesses and marketing practices and therefore, adversely affect our financial results.
Development and Acquisition of Vertical Media
One of the primary challenges of our business is finding or creating media that is targeted enough to attract prospects economically for our clients and at costs that work for our business model. In order to continue to grow our business, we must be able to continue to find or develop quality vertical media on a cost-effective basis. Our inability to find or develop vertical media could impair our growth or adversely affect our financial performance.
Basis of Presentation
General
We operate in two segments: DMS and DSS. For further discussion or financial information about our reporting segments, see note 14 to our consolidated financial statements.
Net Revenue
DMS. We derive substantially all of our revenue from fees earned through the delivery of qualified leads or paid clicks. We deliver targeted and measurable results through a vertical focus that we classify into the following client verticals: education, financial services and "other" (which includes home services, B2B and medical). DSS. We derived approximately 1% of net revenue from our DSS business in fiscal year 2010. We expect DSS to continue to represent an immaterial portion of our business. Cost of Revenue Cost of revenue consists primarily of media costs, personnel costs, amortization of acquisition-related intangible assets, depreciation expense and amortization of internal software development costs on revenue-producing technologies. Media costs consist primarily of fees paid to website publishers that are directly related to a revenue-generating event and pay-per-click, or PPC, ad purchases from Internet search companies. We pay these Internet search companies and website publishers on a cost-per-lead, or CPL, cost-per-click, or CPC, cost-per-thousand-impressions, or CPM and revenue-share basis. Personnel costs include salaries, bonuses, stock-based compensation expense and employee benefit costs. Personnel costs are primarily related to individuals associated with maintaining our servers and websites, our editorial staff, client management, creative team, compliance group and media purchasing analysts. 40
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Costs associated with software incurred in the development phase or obtained for internal use are capitalized and amortized in cost of revenue over the software's estimated useful life.
We anticipate that our cost of revenue will increase in absolute dollars as we continue to increase our revenue base and product offerings
Operating Expenses
We classify our operating expenses into three categories: product development, sales and marketing, and general and administrative. Our operating expenses consist primarily of personnel costs and, to a lesser extent, professional services fees, rent and allocated costs. Personnel costs for each category of operating expenses generally include salaries, bonuses and commissions, stock-based compensation expense and employee benefit costs. Product Development. Product development expenses consist primarily of personnel costs and professional services fees associated with the development and maintenance of our technology platforms, development and launching of our websites, product-based quality assurance and testing. We believe that continued investment in technology is critical to attaining our strategic objectives and, as a result, we expect technology development and enhancement expenses to increase in absolute dollars in future periods. Sales and Marketing. Sales and marketing expenses consist primarily of personnel costs and, to a lesser extent, allocated overhead costs, professional services fees, travel advertising and marketing materials. We expect sales and marketing expenses to increase in absolute dollars as we hire additional personnel in sales and marketing to support our increasing revenue base and product offerings. General and Administrative. General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, corporate and business development, employee benefits and compliance, and other administrative personnel, as well as accounting and legal professional services fees and other corporate expenses. We expect general and administrative expenses to increase in absolute dollars in future periods as we continue to invest in corporate infrastructure and incur additional expenses associated with being a public company, including increased legal and accounting costs, higher insurance premiums, investor relations costs and compliance costs associated with Section 404 of the Sarbanes-Oxley Act of 2002.
Interest and Other Income (Expense), Net
Interest and other income (expense), net, consists of interest income, interest expense and other income and expense. Interest expense is related to our credit facility and promissory notes issued in connection with our acquisitions and includes imputed interest. The outstanding balance of our credit facility and acquisition-related promissory notes was $75.9 million and $19.5 million, respectively, as of June 30, 2010. Borrowings under our credit facility and related interest expense could increase as we continue to implement our acquisition strategy. Interest income represents interest received on our cash and cash equivalents, which may decrease depending on market interest rates and the amount of our invested cash and cash equivalents.
Other income (expense), net, includes gains or losses from the early extinguishment of debt when we settle acquisition related promissory notes before their maturity and exchange gains and losses.
Income Tax Expense
We are subject to tax in the United States as well as other tax jurisdictions or countries in which we conduct business. Earnings from our limited non-U.S. activities are subject to local country income tax and may be subject to current U.S. income tax. As of June 30, 2010, we did not have net operating loss carryforwards for federal income tax purposes and had approximately $2.5 million in California state net operating loss carryforwards that begin to expire in March 2011 and that we expect to utilize in an amended return. The California net operating loss carryforwards will not offset future taxable income, but may instead result in a refund of historical taxes paid. 41
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As of June 30, 2010, we had net deferred tax assets of $12.5 million. Our net deferred tax assets consist primarily of accruals, reserves and stock-based compensation expense not currently deductible for tax purposes. We assess the need for a valuation allowance on the deferred tax assets by evaluating both positive and negative evidence that may exist. Any adjustment to the deferred tax asset valuation allowance would be recorded in the income statement in the periods that the adjustment is determined to be required.
On July 1, 2007, we adopted the authoritative accounting guidance on uncertainties in income tax. The cumulative effect of adoption to the opening balance of retained earnings was $1.7 million.
Results of Operations
The following table sets forth our consolidated statement of operations for the periods indicated: Fiscal Year Ended June 30, 2010 2009 2008 (In thousands) Net revenue $ 334,835 100.0 % $ 260,527 100.0 % $ 192,030 100.0 % Cost of revenue(1) 240,730 71.9 181,593 69.7 130,869 68.2 Gross profit 94,105 28.1 78,934 30.3 61,161 31.8 Operating expenses:(1) Product development 19,726 5.9 14,887 5.7 14,051 7.3 Sales and marketing 16,698 5.0 16,154 6.2 12,409 6.5 General and administrative 18,464 5.5 13,172 5.1 13,371 7.0 Operating income 39,217 11.7 34,721 13.3 21,330 11.1 Interest income 97 0.0 245 0.1 1,482 0.8 Interest expense (3,977 ) (1.2 ) (3,544 ) (1.4 ) (1,214 ) (0.6 ) Other income (expense), net 1,523 0.5
(239 ) (0.1 ) 145 0.1
Income before income taxes 36,860 11.0 31,183 12.0 21,743 11.3 Provision for taxes (16,276 ) (4.9 ) (13,909 ) (5.3 ) (8,876 ) (4.6 ) Net income $ 20,584 6.1 % $ 17,274 6.6 % $ 12,867 6.7 % (1) Cost of revenue and operating expenses include stock-based compensation expense as follows: Cost of revenue $ 3,111 0.9 % $ 1,916 0.7 % $ 1,112 0.6 % Product development 2,176 0.6 669 0.3 443 0.2 Sales and marketing 3,463 1.0 1,761 0.7 581 0.3 General and administrative 4,621 1.4 1,827 0.7 1,086 0.6 Net Revenue Fiscal Year Ended June 30, 2010 - 2009 2009 - 2008 2010 2009 2008 % Change % Change (In thousands) Net revenue $ 334,835 $ 260,527 $ 192,030 29 % 36 % Cost of revenue 240,730 181,593 130,869 33 % 39 % Gross profit $ 94,105 $ 78,934 $ 61,161 19 % 29 % Net revenue increased $74.3 million, or 29%, in fiscal year 2010 compared to fiscal year 2009, attributable to an increase in revenue from our financial services client vertical and, to a lesser extent, our other client verticals. Financial services client vertical revenue increased $64.2 million, or 81%. The increase in financial services client vertical revenue was driven by lead and click volume increases at relatively steady prices. Our other client verticals' 42
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revenue increased $9.3 million, or 31%. The increase in our other client vertical revenue was primarily affected by growth in our B2B client vertical revenue resulting from our acquisition of Internet.com in November 2009 and, to a lesser extent, due to growth in our medical client vertical resulting from our acquisition of the website business of ElderCareLink in April 2009. Our education client vertical revenue remained relatively flat, increasing $863,000, or 1%. The slight increase was driven by growth from a majority of our education clients, almost entirely offset by revenue decline from a single client. Net revenue increased $68.5 million, or 36%, in fiscal year 2009 compared to fiscal year 2008, attributable primarily to growth in our financial services and education client verticals, offset in part by a decline in our DSS business. Financial services client vertical revenue increased $57.8 million, or 264%. Revenue growth in our financial services client vertical was driven by lead and click volume increases at relatively steady prices and the full effect of the acquisition of SureHits in the fourth quarter of fiscal year 2008. Our education client vertical revenue increased $9.1 million, or 6%, due to lead volume increases and price increases. Our other client verticals' revenue increased $2.0 million, or 8%, due primarily to the full effect of the acquisition of the assets of Vendorseek, within our B2B client vertical in the fourth quarter of fiscal year 2008. The revenue increase in our B2B client vertical was partially offset by a decline in our home services client vertical due to both a challenging economic environment and lack of available consumer credit.
Cost of Revenue
Cost of revenue increased $59.1 million, or 33%, in fiscal year 2010 compared to fiscal year 2009, driven by a $41.2 million increase in media costs due to lead and click volume increases, increased personnel costs of $10.7 million and increased amortization of acquisition-related intangible assets of $3.2 million resulting from acquisitions in fiscal year 2009 and 2010. The increase in personnel costs was attributable to a 17% increase in average headcount and related compensation expense increases, resulting from the acquisition of the website business of Internet.com, as well as the expansion of our business. Gross margin, which is the difference between net revenue and cost of revenue as a percentage of net revenue, declined from 30% in fiscal year 2009 to 28% in fiscal year 2010, due to the above-mentioned increase in headcount and related compensation expense, as well as due to a higher mix of traffic from third parties. Cost of revenue increased $50.7 million, or 39%, in fiscal year 2009 compared to fiscal year 2008, driven by a $43.3 million increase in media costs due to lead and click volume increases and, to a lesser extent, increased amortization of acquisition-related intangible assets of $4.2 million resulting from acquisitions in the previous twelve months. Gross margin declined from 32% in fiscal year 2008 to 30% in fiscal year 2009 due primarily to a higher mix of traffic from third parties. Operating Expenses Fiscal Year Ended June 30, 2010 - 2009 2009 - 2008 2010 2009 2008 % Change % Change (In thousands) Product development $ 19,726 $ 14,887 $ 14,051 33 % 6 % Sales and marketing 16,698 16,154 12,409 3 % 30 % General and administrative 18,464 13,172 13,371 40 % (1 )% Operating expenses $ 54,888 $ 44,213 $ 39,831 24 % 11 %
Product Development Expenses
Product development expenses increased $4.8 million, or 33%, in fiscal year 2010 compared to fiscal year 2009, due to increased personnel costs of $4.2 million and, to a lesser extent, increased professional services fees of $433,000. The increase in personnel costs was attributable to increased compensation expense of $2.7 million and increased stock-based compensation expense of $1.5 million. The increase in compensation expense was due to a 20% increase in average headcount affected by additional hiring in connection with software development projects, as well as increased performance bonus expense due to the achievement of specified financial metrics during fiscal 43
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year 2010 and an increase in the number of individuals eligible for such bonus. Professional services fees also increased due to these development projects.
Product development expenses increased $836,000, or 6%, in fiscal year 2009 compared to fiscal year 2008, due to increased personnel costs of $1.0 million. The increase in personnel costs was due to increased performance bonuses and increased stock-based compensation expense. The increased performance bonuses were paid in connection with our achievement of specified financial metrics during fiscal year 2009 that were not achieved in the corresponding prior year period, as well as an increase in the number of individuals eligible for such bonuses. The increase in bonus and stock-based compensation expense was partially offset by lower compensation expense from a reduction in workforce in the third quarter of fiscal year 2009.
Sales and Marketing Expenses
Sales and marketing expenses increased $544,000, or 3%, in fiscal year 2010 compared to fiscal year 2009, due to increased personnel costs of $1.0 million partially offset by decreases in various smaller items. The increase in personnel costs was due to increased stock-based compensation expense of $1.7 million, partially offset by a decline in compensation expense of $730,000 due to a decrease of 18% in average headcount and related compensation expense affected by a reduction in workforce since the third quarter of fiscal year 2009, while bonuses and commissions increased due to the achievement of specified financial metrics during fiscal year 2010. Sales and marketing expenses increased $3.7 million, or 30%, in fiscal year 2009 compared to fiscal year 2008, due to increased personnel costs of $2.1 million, increased consulting fees of $340,000 and increased advertising and marketing expenses associated with marketing campaigns of $331,000. The increase in personnel costs was due to increased stock-based compensation expense of $1.2 million, increased compensation expense of $888,000 due to an 18% increase in average headcount and related compensation expenses driven by the acquisition of ReliableRemodeler in the third quarter of fiscal year 2008. Increased consulting, advertising and marketing expenses were due to overall increases in sales and marketing activities associated with the growth of our business in fiscal year 2009 as compared to the prior year period.
General and Administrative Expenses
General and administrative expenses increased $5.3 million, or 40%, in fiscal year 2010 compared to fiscal year 2009, due to increased personnel costs of $3.9 million, increased professional services fees of $832,000, increased direct acquisition costs of $323,000 and various smaller increases in general and administrative expenses, partially offset by a decline in legal fees of $551,000. The increase in personnel costs was due to increased stock-based compensation expense of $2.8 million and increased compensation expense of $1.1 million. The increase in stock-based compensation expense was driven by the grant of fully-vested options to certain members of our board of directors in conjunction with an increase in the fair value our common stock. The increase in compensation expense was due to a 21% increase in average headcount due to our continued investment in corporate infrastructure, as well as increased performance bonus expense associated with the achievement of specified financial metrics. Professional services fees increased due to our continued investment in corporate infrastructure and related expenses associated with being a public company, including increased accounting and tax fees, higher insurance premiums, investor relations and compliance costs. The decline in legal fees was due to the settlement of an ongoing legal matter prior to the fourth quarter of fiscal year 2009. General and administrative expenses remained relatively flat in fiscal year 2009 compared to fiscal year 2008. The slight decline consisted of a decrease in legal expenses of $987,000, partially offset by an increase in stock-based compensation expense of $741,000. The decline in legal expenses was attributable to a decrease in expenses related to an ongoing legal matter which was settled prior to the fourth quarter of fiscal year 2009. In connection with the settlement, we paid a one-time, non-refundable fee of $850,000. We recognized an intangible asset of $226,000 related to the estimated fair value of a license received by us as part of the settlement and expensed the remaining $624,000 as a settlement expense. 44
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Interest and Other Income (Expense), Net
Fiscal Year Ended June 30, 2010 - 2009 2009 - 2008 2010 2009 2008 % Change % Change (In thousands) Interest income $ 97 $ 245 $ 1,482 (60 )% (83 )% Interest expense (3,977 ) (3,544 ) (1,214 ) 12 % 192 % Other income (expense), net 1,523 (239 ) 145 (737 )% (265 )%
Interest and other income (expense), net $ (2,357 ) $ (3,538 ) $
413 (33 )% (957 )% Interest and other income (expense), net increased $1.2 million, or 33%, in fiscal year 2010 compared to fiscal year 2009, due to an increase in other income (expense), net of $1.8 million, partially offset by an increase in interest expense of $433,000 and a decline in interest income of $148,000. Other income (expense), net increased due to a gain on the extinguishment of acquisition-related notes payable of $1.2 million, which were paid off before their maturity and to a lesser extent, a gain recorded in connection with a payment received for a legal settlement, as well as reduced foreign exchange losses. The increase in interest expense is attributable to the draw down on our credit facility, partially offset by lower non-cash imputed interest on acquisition-related notes payable. The decline in interest income is attributable to lower interest rates on our investments. Interest and other income (expense), net declined $4.0 million in fiscal year 2009 compared to fiscal year 2008 due to increased interest expense of $2.3 million, lower interest income of $1.2 million and other income (expense), net of $384,000. The increase in interest expense is due to an increase in non-cash imputed interest on acquisition-related notes payable and a draw down on our credit facility. Decreased interest income is due to a decline in our invested cash balances. The decline in other income (expense), net was due to foreign currency losses driven by the weakening of the Canadian dollar against the U.S. dollar. Provision for Taxes Fiscal Year Ended June 30, 2010 2009 2008 (In thousands) Provision for taxes $ 16,276 $ 13,909 $ 8,876 Effective tax rate 44.2 % 44.6 % 40.8 % Our effective tax rate remained largely unchanged in fiscal year 2010 compared to fiscal year 2009 as higher non-deductible stock-based compensation expense was largely offset by a tax benefit in foreign jurisdictions and the release of ASC 740-10 reserves. The increase in our effective tax rate in fiscal year 2009 compared to fiscal year 2008 was affected by increased state income tax expense in connection with our acquisitions of businesses in various jurisdictions within the U.S. in which we did not previously have a presence and, to a lesser extent, increased foreign income taxes and non-deductible stock-based compensation expense. The increase in our effective tax rate was partially offset by increased research and development tax credits recorded in connection with the "Emergency Economic Stabilization Act of 2008," or the Act. On October 3, 2008, the Act, which contains the "Tax Extenders and Alternative Minimum Tax Relief Act of 2008" was signed into law. Under the Act, the research credit was retroactively extended for amounts paid or incurred after December 31, 2007 and before January 1, 2010. 45
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Selected Quarterly Financial Data
The following table sets forth our unaudited quarterly consolidated statements of operations data for the eight quarters ended June 30, 2010. We have prepared the statements of operations for each of these quarters on the same basis as the audited consolidated financial statements included elsewhere in this report and, in the opinion of the management, each statement of operations includes all adjustments, consisting solely of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this report. These quarterly operating results are not necessarily indicative of our operating results for any future period. Three Months Ended Sept 30, Dec 31, Mar 31, June 30, Sept 30, Dec 31, Mar 31, June 30, 2008 2008 2009 2009 2009 2009 2010 2010 (In thousands) Net revenue $ 63,678 $ 59,235 $ 69,813 $ 67,801 $ 78,552 $ 76,963 $ 90,773 $ 88,547 Costs of revenue 45,281 42,969 46,780 46,563 55,047 56,557 66,268 62,858 Gross profit 18,397 16,266 23,033 21,238 23,505 20,406 24,505 25,689 Operating expenses: Product development 3,757 3,723 3,512 3,895 4,470 4,739 5,325 5,192 Sales and marketing 4,259 4,164 3,594 4,137 3,625 3,990 4,575 4,508 General and administrative 3,736 3,171 2,865 3,400 3,441 6,203 4,467 4,353 Operating income 6,645 5,208 13,062 9,806 11,969 5,474 10,138 11,636 Interest income 90 87 44 24 9 8 16 64 Interest expense (763 ) (1,107 ) (879 )
(795 ) (748 ) (881 ) (1,302 ) (1,046 ) Other income (expense), net 51 (291 ) (16 )
17 120 165 (64 ) 1,302
Income before income taxes 6,023 3,897 12,211 9,052 11,350 4,766 8,788 11,956 Provision for taxes
(2,719 ) (1,547 ) (5,818 ) (3,825 ) (4,837 ) (2,356 ) (3,538 ) (5,545 ) Net income $ 3,304 $ 2,350 $ 6,393 $ 5,227 $ 6,513 $ 2,410 $ 5,250 $ 6,411 Net income per share(1) Basic $ 0.07 $ 0.04 $ 0.16 $ 0.13 $ 0.16 $ 0.05 $ 0.12 $ 0.14 Diluted $ 0.07 $ 0.04 $ 0.15 $ 0.12 $ 0.16 $ 0.04 $ 0.11 $ 0.13 Other Financial Data: Adjusted EBITDA $ 12,157 $ 10,957 $ 18,571 $ 15,187 $ 18,150 $ 14,989 $ 18,339 $ 19,901
(1) Net income per share for the four quarters of each fiscal year may not sum to
the total for the fiscal year because of the different number of shares
outstanding during each period.
Adjusted EBITDA
Our use of Adjusted EBITDA. We include Adjusted EBITDA in this report because (i) we seek to manage our business to a consistent level of Adjusted EBITDA as a percentage of net revenue, (ii) it is a key basis upon which our management assesses our operating performance, (iii) it is one of the primary metrics investors use in evaluating Internet marketing companies, (iv) it is a factor in the evaluation of the performance of our management in determining compensation, and (v) it is an element of certain financial covenants under our debt agreements. We define Adjusted EBITDA as net income less provision for taxes, depreciation expense, amortization expense, stock-based compensation expense, interest and other income (expense), net.
We use Adjusted EBITDA as a key performance measure because we believe it facilitates operating performance comparisons from period to period by excluding potential differences caused by variations in capital
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structures (affecting interest expense), tax positions (such as the impact on periods or companies of changes in effective tax rates or fluctuations in permanent differences or discrete quarterly items) and the non-cash impact of depreciation and amortization and stock-based compensation expense. Because Adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we also use Adjusted EBITDA for business planning purposes, to incentivize and compensate our management personnel and in evaluating acquisition opportunities. In addition, we believe Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:
• Adjusted EBITDA does not reflect our cash expenditures for capital
equipment or other contractual commitments;
• although depreciation and amortization are non-cash charges, the assets
being depreciated and amortized may have to be replaced in the future, and
Adjusted EBITDA does not reflect cash capital expenditure requirements for
such replacements;
• Adjusted EBITDA does not reflect changes in, or cash requirements for, our
working capital needs; • Adjusted EBITDA does not consider the potentially dilutive impact of
issuing stock-based compensation to our management team and employees;
• Adjusted EBITDA does not reflect the significant interest expense or the
cash requirements necessary to service interest or principal payments on
our indebtedness;
• Adjusted EBITDA does not reflect certain tax payments that may represent a
reduction in cash available to us; and
• other companies, including companies in our industry, may calculate
Adjusted EBITDA measures differently, which reduces their usefulness as a comparative measure. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. When evaluating our performance, Adjusted EBITDA should be considered alongside other financial performance measures, including various cash flow metrics, net income and our other GAAP results.
The following table presents a reconciliation of Adjusted EBITDA to net income, the most comparable GAAP measure, for each of the periods indicated:
Three Months Ended Sept 30, Dec 31, Mar 31, June 30, Sept 30, Dec 31, Mar 31, June 30, 2008 2008 2009 2009 2009 2009 2010 2010 (In thousands) Net income $ 3,304 $ 2,350 $ 6,393 $ 5,227 $ 6,513 $ 2,410 $ 5,250 $ 6,411 Interest and other (income) expense, net 622 1,311 851 754 619 708 1,350 (320 ) Provision for taxes 2,719 1,547 5,818 3,825 4,837 2,356 3,538 5,545 Depreciation and amortization 4,114 4,237 4,035 3,592 3,952 4,651 5,075 5,113 Stock-based compensation expense 1,398 1,512 1,474 1,789 2,229 4,864 3,126 3,152 Adjusted EBITDA $ 12,157 $ 10,957 $ 18,571 $ 15,187 $ 18,150 $ 14,989 $ 18,339 $ 19,901 Adjusted EBITDA quarterly trends. We seek to manage our business to a consistent level of Adjusted EBITDA as a percentage of net revenue. We do so on a fiscal year basis by varying our operations to balance 47
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revenue growth and costs throughout the fiscal year. We do not seek to manage our business to a consistent level of Adjusted EBITDA on a quarterly basis.
For quarterly periods ending from September 30, 2008 to June 30, 2010, Adjusted EBITDA as a percentage of revenue was 19%, 18%, 27%, 22%, 23%, 19%, 20% and 22%, respectively. In general, Adjusted EBITDA as a percentage of revenue tends to be seasonally weaker in the quarters ending September 30 and, particularly, December 31, and stronger in quarters ending March 31 and June 30. For the three months ended March 31, 2009, Adjusted EBITDA as a percentage of revenue was 27% due to a reduction in work force undertaken at the beginning of that period based on concerns held by our management team regarding the deteriorating economic climate at that time. We manage our business to a desired Adjusted EBITDA margin level on a fiscal year basis, not on a quarterly basis, and investors should expect our Adjusted EBITDA margins to vary from quarter to quarter.
Liquidity and Capital Resources
Our primary operating cash requirements include the payment of media costs, personnel costs, costs of information technology systems and office facilities.
Our principal sources of liquidity as of June 30, 2010, consisted of cash and cash equivalents of $155.8 million and our credit facility which had $98.2 million available for borrowing. We believe that our existing cash and cash equivalents, available borrowings under the credit facility and cash generated from operations will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Fiscal Year Ended June 30, 2010 2009 2008 (In thousands) Cash flows from operating activities $ 38,509 $ 32,570 $
24,751
Cash flows from investing activities (72,233 ) (27,326 ) (49,248 )
Cash flows from financing activities 164,324 (5,012 )
22,756
Net Cash Provided by Operating Activities
Our net cash provided by operating activities is primarily the result of our net income adjusted for non-cash expenses such as depreciation and amortization, stock-based compensation expense and changes in working capital components, and is influenced by the timing of cash collections from our clients and cash payments for purchases of media and other expenses. Net cash provided by operating activities in fiscal 2010 was due to net income of $20.6 million, non-cash depreciation, amortization and stock-based compensation expense of $32.2 million and an increase in accounts payable and accrued liabilities of $11.3 million, partially offset by an increase in accounts receivable of $14.4 million, an increase in deferred taxes of $6.8 million, an increase in excess tax benefits from the exercise of stock options of $1.9 million, as well as a gain from the early extinguishment of debt of $1.2 million. The increase in accounts payable and accrued liabilities is due to timing of payments and increased cost of sales associated with increased revenue. The increase in accounts receivable is attributable to increased revenue, as well as timing of receipts. The increase in deferred taxes is primarily due to larger temporary differences between the financial statement carrying amount and the tax basis of certain existing assets and liabilities. The increase in excess tax benefits is attributable to exercises of stock options resulting in tax deductions in excess of recorded stock-based compensation expense. Net cash provided by operating activities in fiscal 2009 was due to net income of $17.3 million, non-cash depreciation, amortization and stock-based compensation expense of $22.2 million and increased accounts payable and accrued liabilities of $5.9 million, partially offset by an increase in accounts receivable of $9.0 million and increased deferred taxes of $4.1 million. The increase in accounts payable and accrued liabilities is due to timing of payments. The increase in accounts receivable is due to increased revenue, as well as due to timing of receipts. The increase in deferred taxes is due to larger temporary differences between the financial statement carrying amount and the tax basis of certain existing assets and liabilities. 48
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Net cash provided by operating activities in fiscal 2008 was due to net income of $12.9 million, non-cash depreciation, amortization and stock-based compensation expense of $14.9 million and increased accounts payable and accrued liabilities of $3.0 million, partially offset by an increase in deferred taxes of $3.8 million and excess tax benefits from exercise of stock options of $1.7 million. The increase in accounts payable and accrued liabilities is due to timing of payments. The increase in deferred taxes is due to larger temporary differences between the financial statement carrying amount and the tax basis of certain existing assets and liabilities. The increase in excess tax benefits is attributable to exercises of stock options resulting in tax deductions in excess of recorded stock-based compensation expense.
Net Cash Used in Investing Activities
Our investing activities include acquisitions of media websites and businesses; purchases, sales and maturities of marketable securities; capital expenditures; and capitalized internal development costs. Cash used in investing activities in fiscal year 2010 was primarily due to our acquisitions of Internet.com, Insure.com and HSH. We acquired the website business of the Internet.com division of WebMediaBrands, Inc., a New York-based Internet media company, for an initial cash payment of $15.9 million. We acquired the website business of Insure.com from LifeQuotes, Inc., an Illinois-based online insurance quote service and brokerage business, for an initial cash payment of $15.0 million. We acquired HSH, a New Jersey-based online company providing comprehensive mortgage rate information, for an initial cash payment of $6.0 million. Cash used in investing activities in fiscal year 2010 was also affected by purchases of the operations of 30 other website publishing businesses for an aggregate of $31.2 million in cash payments, which included $4.5 million of contingent consideration related to the acquisition of SureHits in fiscal year 2008. Capital expenditures and internal software development costs totaled $4.1 million in fiscal year 2010. Cash used in investing activities in fiscal year 2009 was affected by the acquisition of CardRatings for an initial cash payment of $10.4 million, as well as purchases of the operations of 33 other website publishing businesses for an aggregate of $14.6 million in cash payments. Capital expenditures and internal software development costs totaled $2.4 million in fiscal year 2009. Cash used in investing activities in fiscal year 2009 was partially offset by proceeds from sales and maturities of marketable securities of $2.3 million. Cash used in investing activities in fiscal year 2008 was driven by the acquisitions of SureHits, ReliableRemodeler and Vendorseek for an aggregate initial cash payment of $54.7 million, as well as purchases of the operations of 20 website publishing businesses for an aggregate of $9.5 million in cash payments. Capital expenditures and internal software development costs totaled $3.6 million in fiscal year 2008. Cash used in investing activities in fiscal year 2008 was partially offset by proceeds from sales and maturities of marketable securities, net of purchases of marketable securities, of $17.5 million.
Net Cash Provided by or Used in Financing Activities
Cash provided by financing activities in fiscal year 2010 was primarily due to proceeds from our IPO, net of issuance costs, of $136.8 million, draw-down of our credit facility, net of principal payments, of $40.2 million, proceeds from stock option exercises of $1.6 million and excess tax benefits of $1.9 million, partially offset by $15.5 million of principal payments on acquisition-related notes payable.
Cash used in financing activities in fiscal year 2009 was due to principal payments on acquisition-related notes payable and our term loan of $13.1 million and stock repurchases of $1.3 million, partially offset by proceeds from a draw-down of our revolving credit line of $8.6 million.
Cash provided by financing activities in fiscal year 2008 was driven by proceeds from our term loan of $29.0 million and proceeds from stock option exercises of $2.6 million, partially offset by payments of $5.6 million in common stock repurchases and $4.9 million of principal payments on acquisition-related notes payable.
Off-Balance Sheet Arrangements
During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have
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been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations
Our contractual obligations relate primarily to borrowings under the credit facility, notes payables, operating leases and purchase obligations.
The following table sets forth payments due under our contractual obligations as of June 30, 2010: Payments Due by Period Total Less Than 1 Year 1 to 3 Years 3 to 5 Years More Than 5 Years (In thousands) Credit facility $ 75,904 $ 3,963 $ 19,688 $ 52,253 $ - Notes payable 19,544 12,278 5,143 2,123 - Operating lease obligations 17,641 1,442 3,219 4,711 8,269 $ 113,089 $ 17,683 $ 28,050 $ 59,087 $ 8,269
The above table does not include approximately $2.5 million of long-term income tax liabilities for uncertainty in income taxes due to the fact that we are unable to reasonably estimate the timing of these potential future payments.
In connection with the acquisition of SureHits, we may be required to make certain earn-out payments in the aggregate amount of $9.0 million, payable in increments in the amount of $4.5 million annually in January of 2011 and 2012, contingent upon the achievement of specified financial targets.
New Credit Facility
In January 2010, we replaced our existing credit facility with a credit facility totaling $175.0 million. The new facility consists of a $35.0 million four-year term loan, with principal amortization of 10%, 15%, 35% and 40% annually, and a $140.0 million four-year revolving credit line with an optional increase of $50.0 million. Borrowings under the credit facility are collateralized by our assets and interest is payable quarterly at specified margins above either LIBOR or the Prime Rate. The interest rate varies dependent upon the ratio of funded debt to adjusted EBITDA and ranges from LIBOR + 2.125% to 2.875% or Prime + 1.00% to 1.50% for the revolving credit line and from LIBOR + 2.50% to 3.25% or Prime + 1.00% to 1.50% for the term loan. Adjusted EBITDA is defined as net income less provision for taxes, depreciation expense, amortization expense, stock-based compensation expense, interest and other income (expense), net and acquisition costs for business combinations. The revolving credit line also requires a quarterly facility fee of 0.375% of the revolving credit line capacity. The credit facility expires in January 2014. The credit facility agreement restricts our ability to raise additional debt financing and pay dividends. In addition, we are required to maintain financial ratios computed as follows: 1. Quick ratio: ratio of (i) the sum of unrestricted cash and cash equivalents and trade receivables less than 90 days from invoice date to (ii) current liabilities and face amount of any letters of credit less the current portion of deferred revenue. 2. Fixed charge coverage: ratio of (i) trailing twelve months of adjusted EBITDA to (ii) the sum of capital expenditures, net cash interest expense, cash taxes, cash dividends and trailing twelve months payments of indebtedness. Payment of unsecured indebtedness is excluded to the degree that sufficient unused revolving credit line exists such that the relevant debt payment could be made from the credit facility. 3. Funded debt to adjusted EBITDA: ratio of (i) the sum of all obligations owed to lending institutions, the face amount of any letters of credit, indebtedness owed in connection with acquisition-related notes and indebtedness owed in connection with capital lease obligations to (ii) trailing twelve months of adjusted EBITDA.
Under the terms of the credit facility we must maintain a minimum quick ratio of 1.15 to 1.00, a minimum fixed charge coverage ratio of 1.15 to 1.00 and a maximum funded debt to adjusted EBITDA ratio of 2.75 to 1.00 through
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December 31, 2010 and 2.50 to 1.00 for all fiscal quarters thereafter and we must comply with other non-financial covenants. We were in compliance with the financial ratios and other covenants as of June 30, 2010 and 2009.
New Lease
As the existing lease for our corporate headquarters located at 1051 Hillsdale Boulevard, Foster City, California expires in October 2010, we entered into a new lease agreement in February 2010 for approximately 63,998 square feet of office space located at 950 Tower Lane, Foster City, California. The term of the lease begins on November 1, 2010 and expires on the last day of the 96th full calendar month commencing on or after November 1, 2010. The monthly base rent will be abated for the first 12 calendar months under the lease. Thereafter the base rent will be $118,000 through the 24th calendar month of the term of the lease, after which the monthly base rent will increase to $182,000 for the subsequent 12 months. In the following years the monthly base rent will increase approximately 3% after each 12-month anniversary during the term of the lease, including any extensions under our options to extend.
We have two options to extend the term of the lease for one additional year for each option following the expiration date of the lease or renewal term, as applicable.
Critical Accounting Policies and Estimates
We have prepared our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP). In doing so, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Actual results may differ significantly from these estimates. We believe that the critical accounting policies listed below involve our more significant judgments, estimates and assumptions and, therefore, could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understand and evaluate the consolidated financial statements contained in this report.
For further information on our critical and other significant accounting policies, see Note 2 of our consolidated financial statements included in this report.
Revenue Recognition
We derive our revenue from two sources: Direct Marketing Services ("DMS") and Direct Selling Services ("DSS").
DMS revenue is derived primarily from fees which are earned through the delivery of qualified leads or clicks. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is reasonably assured. Delivery is deemed to have occurred at the time a qualified lead or click is delivered to the client provided that no significant obligations remain. From time to time, we may agree to credit a client for certain leads or clicks if they fail to meet the contractual or other guidelines of a particular client. We have established a sales reserve based on historical experience. To date, such credits have been immaterial and within our expectations. For a portion of our revenue, we have agreements with providers of online media or traffic ("Publishers") used in the generation of leads or clicks. We receive a fee from our clients and pay a fee to Publishers either on a cost per lead, cost per click or cost per thousand impressions basis. We are the primary obligor in the transaction. As a result, the fees paid by our clients are recognized as revenue and the fees paid to our Publishers are included in cost of revenue. 51
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DSS revenue comprises (i) set-up and professional services fees and (ii) usage fees. Set-up and professional service fees that do not provide stand-alone value to a client are recognized over the contractual term of the agreement or the expected client relationship period, whichever is longer, effective when the application reaches the "go-live" date. We define the "go-live" date as the date when the application enters into a production environment or all essential functionalities have been delivered. Usage fees are recognized on a monthly basis as earned.
Deferred revenue is comprised of contractual billings in excess of recognized revenue and payments received in advance of revenue recognition.
Stock-Based Compensation
We record stock-based compensation expense for employee stock options granted or modified on or after July 1, 2006 based on estimated fair values for these stock options. We continue to account for stock options granted to employees prior to July 1, 2006 based on the intrinsic value of those stock options. We measure and record the expense related to share-based transactions based on the fair values of the awards as determined on the date of grant using an option-pricing model. We have selected the Black-Scholes option pricing model to estimate the fair value of our stock options awards to employees. In applying the Black-Scholes option pricing model, our determination of fair value of the share-based payment award on the date of grant is affected by our estimated fair value of common shares for grants made prior to our IPO, as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the stock options awards and the employees' actual and projected stock option exercise and pre-vesting employment termination behaviors. We recognize stock-based compensation expense over the requisite service period using the straight-line method, based on awards ultimately expected to vest. We estimate future forfeitures at the date of grant and revise the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
Goodwill
Goodwill is tested for impairment at the reporting unit level on an annual basis and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows and determining appropriate discount rates, growth rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit which could trigger impairment. We concluded that DMS and DSS constitute two separate reporting units. We determined the fair value of our DMS reporting unit by adjusting the fair value of the business enterprise based on our market capitalization for the fair value of the DSS reporting unit. The fair value of our DSS reporting unit was estimated using the income approach. Under the income approach, we calculated the fair value of our DSS reporting unit based on the present value of estimated future cash flows. We performed our annual goodwill impairment test in the fourth quarter for our DMS and DSS reporting units. Our assessment of goodwill impairment indicated that the fair value of our DMS reporting unit was substantially in excess of its carrying value. The estimated fair value of our DSS reporting unit also exceeded its carrying value as of June 30, 2010. The carrying value of our DSS reporting unit includes allocated goodwill of $1.2 million which represents less than 1% of our total goodwill balance. The fair value of the reporting units and hence the valuation of goodwill could be affected if actual results differ substantially from our estimates. Circumstances that could affect the valuation of goodwill include, among other things, a significant change in our market capitalization, the business climate and buying habits of our subscriber base and with respect to the DSS reporting unit the loss of a significant customer.
Long-Lived Assets
We evaluate long-lived assets, such as property and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may
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not be recoverable. We apply judgment when assessing the fair value of the assets based on the undiscounted future cash flows the assets are expected to generate and recognize an impairment loss if estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. When we identify an impairment, we reduce the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values.
Income Taxes
We account for income taxes using an asset and liability approach to record deferred taxes. Our deferred income tax assets represent temporary differences between the financial statement carrying amount and the tax basis of existing assets and liabilities that will result in deductible amounts in future years, including net operating loss carry forwards. Based on estimates, the carrying value of our net deferred tax assets assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions. Our judgment regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. On July 1, 2007, we adopted the authoritative accounting guidance prescribing a threshold and measurement attribute for the financial recognition and measurement of a tax position taken or expected to be taken in a tax return. The guidance also provides for de-recognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure and transition. The guidance utilizes a two-step approach for evaluating uncertain tax positions. Step one, Recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. If a tax position is not considered "more likely than not" to be sustained then no benefits of the position are to be recognized. Step two, Measurement, is based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement. The cumulative effect of adoption to the opening balance of retained earnings was $1.7 million.
Recent Accounting Pronouncements
In December 2007, the Financial Accounting Standards Board ("FASB") issued a new accounting standard that changes the accounting for business combinations, including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition-related transaction costs and the recognition of changes in the acquirer's income tax valuation allowance. The new standard applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and to changes in valuation allowances for deferred tax assets and acquired income tax uncertainties arising from past business combinations. The adoption of the new standard on July 1, 2009 did not have a material effect on our consolidated financial statements.
In October 2009, the FASB amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product's essential functionality from the scope of industry-specific software revenue recognition guidance. In October 2009, the FASB also amended the accounting standards for multiple deliverable revenue arrangements to
• provide updated guidance on whether multiple deliverables exist, how the
deliverables in an arrangement should be separated, and how the
consideration should be allocated;
• require an entity to allocate revenue in an arrangement using estimated
selling price ("ESP") of deliverables if a vendor does not have
vendor-specific objective evidence ("VSOE") of selling price or third-party
evidence ("TPE") of selling price; • and eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method. 53
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Both standards should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We do not anticipate the adoption of these standards in the first quarter of fiscal year 2011 to have a material impact on our consolidated financial statements. In January 2010, the FASB issued a new fair value accounting standard update. This update requires additional disclosures about (i) the different classes of assets and liabilities measured at fair value, (ii) the valuation techniques and inputs used, (iii) the activity in Level 3 fair value measurements, and (iv) the transfers between Levels 1, 2, and 3. This update is effective for interim and annual reporting periods beginning after December 15, 2009. The adoption of the new standard in the third quarter of fiscal 2010 did not have a material effect on our consolidated financial statements. In February 2010, the FASB amended its accounting guidance for the accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued. In particular, the new amendment sets forth that a registrant is no longer required to disclose the date through which it has evaluated subsequent events. The amended guidance became effective in February 2010 and was adopted by us in the third quarter of fiscal 2010. The adoption of the new standard did not have a material effect on our consolidated financial statements.
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