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QUINSTREET, INC – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations
| Edgar Online, Inc. |
You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in the sections titled "Special Note Regarding Forward-Looking Statements" and "Risk Factors".
Management Overview
QuinStreet is a leader in performance marketing online. We have built a strong set of capabilities to engage Internet visitors with targeted media and to connect our marketing clients with their potential customers online. We focus on serving clients in large, information-intensive industry verticals where relevant, targeted media and offerings help visitors make informed choices, find the products that match their needs, and thus become qualified customer prospects for our clients. We deliver cost-effective marketing results to our clients most typically in the form of a qualified lead or inquiry, in the form of a qualified click, or call. Leads, clicks or calls can then convert into a customer or sale for clients at a rate that results in an acceptable marketing cost to them. We are typically paid by clients when we deliver qualified leads, clicks, calls or customers as defined by our agreements with them. Because we bear the costs of media, our programs must deliver value to our clients and provide for a media yield, or generation of an acceptable margin on our media costs, that provides a sound financial outcome for us. To deliver leads, clicks, calls, and customers to our clients, generally we: • own or access targeted media;
• run advertisements or other forms of marketing messages and programs in
that media to create visitor responses in the form most typically of leads
(visitor generated contact information and requests), clicks (to further
qualification or matching steps, or to online client applications or
offerings), or calls (to our owned and operated call centers or that of
our clients or their agents);
• match these leads, clicks, calls, or customers to client offerings or
brands that we believe can meet visitor interests or needs, converting
visitors into qualified leads, clicks, calls, or customers for our clients; and
• optimize client matches and media yield such that we achieve desired
results for clients and a sound financial outcome for us.
Our primary financial objective has been and remains creating revenue growth from sustainable sources, at target levels of profitability. Our primary financial objective is not to maximize profits, but rather to achieve target levels of profitability while investing in various growth initiatives, as we continue to believe we are in the early stages of a large, long-term market. Our Direct Marketing Services ("DMS"), business accounted for substantially all of our net revenue in fiscal years 2013, 2012 and 2011. Our DMS business derives its net revenue from fees earned through the delivery of qualified leads, clicks, calls or customers and, to a lesser extent, display advertisements, or impressions. Through a vertical focus, targeted media presence and our technology platform, we are able to deliver targeted, measurable marketing results to our clients. Our two largest client verticals within our DMS business are education and financial services. Our education client vertical represented 44%, 42% and 44% of net revenue in fiscal years 2013, 2012 and 2011. Our financial services client vertical represented 40%, 42% and 45% of net revenue in fiscal years 2013, 2012 and 2011. Other DMS client verticals, consisting primarily of business-to-business technology, home services and medical, represented 16%, 16% and 11% of net revenue in fiscal years 2013, 2012 and 2011. 32
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In addition, we derived less than 1% of our net revenue in fiscal years 2013, 2012 and 2011 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 ("DSS") business.
We generated substantially all of our revenue from sales to clients in
Trends Affecting our Business
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 2014 will be generated from clients in these two client verticals.
Our education client vertical has been significantly affected by the adoption of regulations affecting for-profit educational institutions over the past several years. The regulations have affected and are expected to continue to affect our clients' businesses and marketing practices, including an overall decrease in our clients' external marketing expenditures. The effect of these regulations or any future regulations may continue to result in fluctuations in the volume and mix of our business with these clients. Our financial services client vertical continued to be negatively affected due to reduced availability of high quality media at acceptable margins caused by changes in search engine algorithms, acquisition of media sources by competitors and increased competition for quality media. These effects may continue to impact our business in the near future.
Acquisitions
Acquisitions in Fiscal Year 2013
We did not complete any acquisitions during fiscal year 2013.
Acquisitions in Fiscal Year 2012
InFebruary 2012 , we acquired certain assets of Ziff Davis Enterprise fromEnterprise Media Group, Inc. , aNew York -based online media and marketing company in the business-to-business technology market, in exchange for$17.3 million in cash, to broaden our registered user database and brand name in the business-to-business technology market. InAugust 2011 , we acquired 100% of the outstanding equity interests ofNarrowCast Group, LLC , or IT BusinessEdge, aKentucky -based Internet media company in the business-to-business technology market, in exchange for$24.0 million in cash, to broaden our registered user database and media access in the business-to-business technology market. During fiscal year 2012, in addition to certain assets of Ziff Davis Enterprise and all of the equity interests of IT BusinessEdge, we acquired eleven other online publishing businesses.
Acquisitions in Fiscal Year 2011
InNovember 2010 , we acquired 100% of the outstanding shares ofCar Insurance.com, Inc. , or CarInsurance.com, aFlorida -based online insurance business, and certain of its affiliated companies, in exchange for$49.7 million in cash, for its capacity to generate online visitors in the financial services market. InJuly 2010 , we acquired the website business Insurance.com fromInsurance.com Group, Inc. , anOhio -based online insurance business, in exchange for$33.0 million in cash and the issuance of a$2.6 million non-interest-bearing, unsecured promissory note, for its capacity to generate online visitors in the financial services market. During fiscal year 2011, in addition to the acquisitions of CarInsurance.com and Insurance.com, we acquired 13 other online publishing businesses. 33
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Development, Acquisition and Retention of Targeted Media
One of the primary challenges of our business is acquiring or creating media that is high quality and targeted enough to attract prospects for our clients at costs that work for our business model. In order to grow our business, we must be able to develop or acquire and retain quality targeted media on a cost-effective basis. Changes in search engine algorithms, our ability to develop or acquire and retain high quality targeted media and increased competition on available media has, during some periods, limited and may continue to limit our ability to generate revenue.
Seasonality
Our results are subject to significant fluctuation as a result of seasonality. In particular, our quarters endingDecember 31 (our second fiscal quarter) are typically characterized by seasonal weakness. In our second fiscal quarters, there is lower availability of lead supply from some forms of media during the holiday period on a cost effective basis and some of our clients have lower budgets. In our quarters endingMarch 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 endingDecember 31 .
Regulations
Our revenue has fluctuated as a result of newly-adopted or amended regulations and the increased enforcement of existing regulations. Our business is affected directly because we operate websites and conduct telemarketing and email marketing, and indirectly as clients in our education and financial services client verticals adjust their operations as a result of regulatory changes that affect their industries. One example of recent regulatory change that may affect our business is the TCPA, which theFederal Communications Commission recently amended, among other things, impose heightened consent and opt-out requirements that companies conducting telemarketing must follow. Certain provisions of the regulations became effective inJuly 2012 , and additional regulations requiring prior express written consent for telemarketing calls to wireless numbers become effective inOctober 2013 . We generate a significant amount of revenue from calls made by our internal call centers as well as by third party call centers. Our efforts to comply with the new regulations may negatively affect media conversion rates and, thus, our revenue or profitability. In addition, our education client vertical has been significantly affected by the adoption of regulations affecting for-profit educational institutions over the past several years, and a higher level of legislative scrutiny is expected to continue. Clients in our financial services vertical have increasingly been affected by laws and regulations as a result of the adoption of new regulations under The Dodd-Frank Wall Street Reform and Consumer Protection Act and the increased enforcement of new and pre-existing laws and regulations. The effect of these regulations, or any future regulations, may continue to result in fluctuations in the volume and mix of our business with these clients.
Basis of Presentation
General
We operate in two segments: DMS and DSS. See Note 14, Segment Information, to our consolidated financial statements for further discussion and financial information regarding our reporting segments.
Net Revenue
DMS. Our DMS business generates revenue from fees earned through the delivery of qualified leads, clicks, calls, customers and, to a lesser extent, display advertisements, or impressions. We deliver targeted and measurable results through a vertical focus that we classify into the following client verticals: education, financial services and "other" (which includes business-to-business technology, home services and medical). 34
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DSS. Our DSS business generated less than 1% of net revenue in fiscal years 2013, 2012 and 2011. 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 intangible assets, depreciation expense and amortization of internal software development costs relating to 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 revenue-share, a cost-per-lead, or CPL, cost-per-click, or CPC, and cost-per-thousand-impressions, or CPM, basis. Personnel costs include salaries, stock-based compensation expense, bonuses and employee benefit costs. Personnel costs are primarily related to individuals associated with maintaining our servers and websites, our editorial staff, client management, creative team, content, compliance group and media purchasing analysts. Costs associated with software incurred in the development phase or obtained for internal use are capitalized and amortized in cost of revenue over the software's estimated useful life. We anticipate that our cost of revenue will increase more than our revenue in the near term as we invest in opportunities we see in the financial services client vertical. Operating Expenses We classify our operating expenses into three categories: product development, sales and marketing, and general and administrative. Our operating expenses consist primarily of personnel costs and, to a lesser extent, professional services fees, rent and other costs. Personnel costs for each category of operating expenses generally include salaries, stock-based compensation expense, bonuses, commissions and employee benefit costs. Product Development. Product development expenses consist primarily of personnel costs and professional services fees associated with the development and maintenance of our technology platforms, development and launching of our websites, product-based quality assurance and testing. In the current period of business challenges, we are constraining expenses generally to the extent practicable. However, we believe that continued investment in technology is critical to attaining our strategic objectives and, as a result, we expect product development expenses to increase in absolute dollars in the future. Sales and Marketing. Sales and marketing expenses consist primarily of personnel costs and, to a lesser extent, professional services fees, travel costs and advertising. In the current period of business challenges, we are constraining expenses generally to the extent practicable. However, we expect sales and marketing expenses to increase in absolute dollars as we hire additional personnel in sales and marketing to support our offerings. General and Administrative. General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, corporate and business development, employee benefits and compliance, technical support and other administrative personnel, as well as accounting and legal professional services fees, and insurance. In the current period of business challenges, we are constraining expenses generally to the extent practicable. However, we expect general and administrative expenses, including increased legal and accounting costs to increase in absolute dollars in future periods as we continue to invest in corporate infrastructure and expand our business internationally.
Interest and Other Income (Expense), Net
Interest and other income (expense), net, consists primarily of interest expense, other income and expense, net and interest income. Interest expense is related to our credit facility, including the related interest rate swap and promissory notes issued in connection with our acquisitions, and includes imputed interest on non-interest bearing notes. Borrowings under our credit facility, the aggregate principal amount of outstanding promissory notes and related interest expense could increase if we make additional acquisitions through debt financing. Interest income represents interest earned on our cash, cash equivalents and marketable securities, which may increase or decrease depending on market interest rates and the amounts invested. 35
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Other income (expense), net, includes foreign currency exchange gains and losses and other non-operating items.
Income Tax Benefit from (Provision for)
We are subject to tax inthe United States as well as other tax jurisdictions or countries in which we conduct business. Earnings from our limited non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Results of Operations The following table sets forth our consolidated statement of operations for the periods indicated: Fiscal Year Ended June 30, 2013 2012 2011 (In thousands) Net revenue$ 305,101 100.0 %$ 370,468 100.0 %$ 403,021 100.0 % Cost of revenue (1) 251,591 82.5 283,466 76.5 291,991 72.5 Gross profit 53,510 17.5 87,002 23.5 111,030 27.5 Operating expenses: (1) Product development 19,048 6.2 21,051 5.7 24,163 6.0 Sales and marketing 14,705 4.8 14,074 3.8 17,382 4.3 General and administrative 16,226 5.3 23,375 6.3 20,396 5.0 Impairment of goodwill 92,350 30.3 - - - - Operating (loss) income (88,819 ) (29.1 ) 28,502 7.7 49,089 12.2 Interest income 115 0.0 134 0.0 169 0.0 Interest expense (5,200 ) (1.7 ) (4,462 ) (1.2 ) (4,213 ) (1.0 ) Other (expense) income, net (69 ) (0.0 ) (42 ) (0.0 ) 56 0.0
(Loss) income before income taxes (93,973 ) (30.8 ) 24,132
6.5 45,101 11.2 Benefit from (provision for) taxes 26,601 8.7 (11,131 ) (3.0 ) (17,887 ) (4.4 ) Net (loss) income$ (67,372 ) (22.1 )%$ 13,001 3.5 %$ 27,214 6.8 % (1) Cost of revenue and operating expenses include stock-based compensation expense as follows: Cost of revenue$ 3,930 1.3 %$ 4,293 1.2 %$ 4,506 1.1 % Product development 2,765 0.9 2,570 0.7 2,705 0.7 Sales and marketing 3,264 1.1 3,096 0.8 3,747 0.9 General and administrative 2,057 0.7 3,037 0.8 2,992 0.7 Net Revenue Fiscal Year Ended June 30, 2013 - 2012 2012 - 2011 2013 2012 2011 % Change % Change (In thousands) Net revenue$ 305,101 $ 370,468 $ 403,021 (18 %) (8 %) Cost of revenue 251,591 283,466 291,991 (11 %) (3 %) Gross profit$ 53,510 $ 87,002 $ 111,030 (38 %) (22 %) 36
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Net revenue decreased$65.4 million , or 18%, in fiscal year 2013 compared to fiscal year 2012. Our financial services client vertical revenue decreased$35.4 million , or 23%, primarily due to reduced availability of quality publisher media as a result of search engine algorithm changes, acquisitions of media sources by competitors and increased competition for quality media. Our education client vertical revenue decreased$19.6 million , or 13%, primarily as a result of our education clients' lower budgets, largely due to uncertainty surrounding regulations affecting for-profit educational institutions and their operational adjustment to those regulation changes. Revenue from other client verticals decreased$10.3 million , or 17%, primarily due to decreased client demand in our home services and business-to-business technology client verticals. Net revenue decreased$32.6 million , or 8%, in fiscal year 2012 compared to fiscal year 2011. This was primarily due to a decrease in revenue from our financial services and education client verticals, which was partially offset by growth in revenue in our other client verticals. Our financial services client vertical revenue decreased$26.2 million , or 14%, due to lower volumes resulting from reduced availability of quality publisher media and, to a lesser degree, lower click prices as compared to fiscal year 2011. Pricing in our financial services client vertical was relatively stable throughout fiscal year 2012. Our education client vertical revenue decreased$20.4 million , or 12%, as a result of our education clients purchasing fewer inquiries due to uncertainty surrounding new regulations affecting for-profit educational institutions. Lower inquiry volumes were marginally offset by higher prices. Revenue from other client verticals increased$14.1 million , or 31%, primarily due to the acquisition of IT BusinessEdge and certain assets of Ziff Davis Enterprise in the business-to-business technology client vertical and, to a lesser extent, higher lead volumes in our home services client vertical.
Cost of Revenue
Cost of revenue decreased$31.9 million , or 11%, in fiscal year 2013 compared to fiscal year 2012, driven by decreased media costs of$26.1 million due to lower lead and click volumes, decreased personnel costs of$4.9 million and other decreases of$1.7 million , partially offset by increased amortization of intangible assets and depreciation of$1.2 million . The decreased personnel costs were attributable to a reduction in average headcount. Gross margin, which is the difference between net revenue and cost of revenue as a percentage of net revenue was 18% in fiscal year 2013 compared to 23% in fiscal year 2012, driven primarily by an increase as a percent of net revenue in media cost, amortization expense, personnel and other fixed costs on a lower revenue base. Cost of revenue decreased$8.5 million , or 3%, in fiscal year 2012 compared to fiscal year 2011, driven by decreased media costs of$12.6 million due to lower click volumes and decreased personnel costs of$2.0 million , partially offset by increased amortization of acquisition-related intangible assets of$4.1 million , professional service fees of$1.0 million and a one-time offline marketing event expense of$0.8 million related to an acquisition. The decreased personnel costs were attributable to a reduction in average headcount. Gross margin, which is the difference between net revenue and cost of revenue as a percentage of net revenue was 23% in fiscal year 2012 compared to 28% in fiscal year 2011, primarily due to a lower mix of traffic from owned and operated media, lower margins from publisher arrangements and higher amortization expenses, partially offset by decreased personnel costs. Operating Expenses Fiscal Year Ended June 30, 2013 - 2012 2012 - 2011 2013 2012 2011 % Change % Change (In thousands) Product development$ 19,048 $ 21,051 $ 24,163 (10 %) (13 %) Sales and marketing 14,705 14,074 17,382 4 % (19 %) General and administrative 16,226 23,375 20,396 (31 %) 15 % Impairment of goodwill 92,350 - - 100 % 0 % Operating expenses$ 142,329 $ 58,500 $ 61,941 143 % (6 %) 37
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Product Development Expenses
Product development expenses decreased$2.0 million , or 10%, in fiscal year 2013 compared to fiscal year 2012, primarily due to decreased personnel costs of$1.5 million resulting from a reduction in average headcount and other decreases in various product development expenses. Product development expenses decreased$3.1 million , or 13%, in fiscal year 2012 compared to fiscal year 2011, primarily due to decreased personnel costs of$1.7 million resulting from a reduction in average headcount, increased capitalized software expenses of$0.6 million and decreased professional services of$0.4 million . Sales and Marketing Expenses Sales and marketing expenses increased$0.6 million , or 4%, in fiscal year 2013 compared to fiscal year 2012, primarily due to increased personnel costs of$0.8 million and increased stock-based compensation expense of$0.2 million partially offset by decreased advertising cost of$0.2 million . Sales and marketing expenses decreased$3.3 million , or 19%, in fiscal year 2012 compared to fiscal year 2011, primarily due to decreased personnel costs of$2.3 million resulting from decreased performance bonus expenses and decreased stock-based compensation expense of$0.7 million .
General and Administrative Expenses
General and administrative expenses decreased$7.1 million , or 31%, in fiscal year 2013 compared to fiscal year 2012. This was due to a$2.5 million payment to the attorneys general of multiple states in connection with a settlement related to online marketing for education companies in the prior year and additional decreased legal costs of$1.9 million related primarily to litigation expense, decreased bad debt expense of$1.4 million resulting from the insolvency of an advertising agency of record of one of our clients in the prior year, and decreased stock-based compensation expense of$1.0 million related to the departure of one of our directors and reduction in average headcount. General and administrative expenses increased$3.0 million , or 15%, in fiscal year 2012 compared to fiscal year 2011. This was due to a$2.5 million payment to the attorneys general of multiple states in connection with a settlement related to online marketing for education companies, increased bad debt expense of$1.4 million resulting from the insolvency of an advertising agency of record of one of our clients, partially offset by decreased personnel costs of$1.4 million attributable to a reduction in average headcount.
Interest and Other Income (Expense), Net
Fiscal Year Ended June 30, 2013 - 2012 2012 - 2011 2013 2012 2011 % Change % Change (In thousands) Interest income$ 115 $ 134 $ 169 (14 %) (21 %) Interest expense (5,200 ) (4,462 ) (4,213 ) 17 % 6 % Other (expense) income, net (69 ) (42 ) 56 64 % (175 %)
Interest and other (expense), net
18 % 10 % Interest and other (expense), net increased by$0.8 million , or 18%, in fiscal year 2013 compared to fiscal year 2012, primarily due to increased interest expense related to accelerated amortization of approximately$0.7 million of unamortized deferred upfront costs incurred in connection with the amendment of our loan agreement during the third quarter of fiscal 2013. See Note 9, Debt, to our consolidated financial statements for more information about our credit facility. 38
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Interest and other (expense), net increased by$0.4 million , or 10%, in fiscal year 2012 compared to fiscal year 2011, primarily due to increased interest expense of$0.2 million in fiscal year 2012 and$0.2 million attributable to proceeds from a settlement of a legal matter in fiscal year 2011.
Benefit from (Provision for) Taxes
Fiscal Year Ended June 30, 2013 2012 2011 (In thousands) Benefit from (provision for) taxes$ 26,601 $ (11,131 ) $ (17,887 ) Effective tax rate 28.3 % 46.1 % 39.7 % The decrease in our effective tax rate for fiscal year 2013 compared to fiscal year 2012, was primarily due to a goodwill impairment charge of$92.4 million for fiscal year 2013. The goodwill impairment charge had an associated tax benefit of$28.7 million due to the impairment of goodwill that is deductible for tax purposes. The increase in our effective tax rate for fiscal year 2012 compared to fiscal year 2011, was primarily due to higher non-deductible stock-based compensation expense. The effective tax rate differs from the annual federal statutory rate of 35% due to various permanent differences primarily related to stock-based compensation. As ofJune 30, 2013 , we had net deferred tax assets of$47.0 million . Our net deferred tax assets consist primarily of goodwill impairment expense, stock-based compensation expense, accruals and reserves not currently deductible for tax purposes. See Note 8, Income Taxes, to our consolidated financial statements for more information about our deferred tax assets.
Selected Quarterly Financial Data
The following table sets forth our unaudited quarterly consolidated statements of operations data for the eight quarters endedJune 30, 2013 . We have prepared the statements of operations for each of these quarters on the same basis as the audited consolidated financial statements included elsewhere in this report and, in the opinion of management, each statement of operations includes all adjustments, consisting solely of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This 39
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information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this report. These quarterly operating results are not necessarily indicative of our operating results for any future period.
Three Months Ended June 30, Mar 31, Dec 31, Sept 30, June 30, Mar 31, Dec 31, Sept 30, 2013 2013 2012 2012 2012 2012 2011 2011 (In thousands)
Net revenue$ 75,707 $ 79,017 $ 71,751 $ 78,626 $ 85,698 $ 93,023 $ 90,523 $ 101,224 Costs of revenue 60,826 63,863 61,712 65,190 67,044 72,278 68,396 75,748 Gross profit 14,881 15,154 10,039 13,436 18,654 20,745 22,127 25,476 Operating expenses: Product development 4,760 4,891 4,504 4,893 4,806 5,069 5,102 6,074 Sales and marketing 3,835 3,683 3,496
3,691 2,960 3,394 3,686 4,034 General and administrative
3,887 4,394 4,019
3,926 7,072 6,239 4,847 5,217 Imapirment of goodwill
- - 92,350 - - - - - Operating income (loss) 2,399 2,186 (94,330 ) 926 3,816 6,043 8,492 10,151 Interest income 31 28 28 28 29 31 36 38 Interest expense (1,024 ) (1,810 ) (1,354
) (1,012 ) (1,153 ) (1,111 ) (1,115 ) (1,083 ) Other (expense) income, net
(72 ) (39 ) (4 ) 46 79 3 (93 ) (31 ) Income (loss) before income taxes 1,334 365 (95,660
) (12 ) 2,771 4,966 7,320 9,075 (Provision for) benefit from taxes (2,916 ) (2,527 ) 32,169
(125 ) (2,570 ) (2,093 ) (2,887 ) (3,581 ) Net (loss) income$ (1,582 ) $ (2,162 ) $ (63,491 ) $ (137 ) $ 201 $ 2,873 $ 4,433 $ 5,494 Net (loss) income per share: (1) Basic$ (1,582 ) $ (0.05 ) $ (1.48 ) $ (0.00 ) $ 0.00 $ 0.06 $ 0.09 $ 0.12 Diluted$ (1,582 ) $ (0.05 ) $ (1.48 ) $ (0.00 ) $ 0.00 $ 0.06 $ 0.09 $ 0.11 Other Financial Data: Adjusted EBITDA$ 12,261 $ 12,407 $ 11,228 $ 11,975 $ 15,214 $ 17,271 $ 19,530 $ 20,633
(1) Net (loss) 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 benefit from (provision for) taxes, depreciation expense, amortization expense, stock-based compensation expense, interest, other income (expense), net, and impairment of goodwill. We use adjusted EBITDA as a key performance measure because we believe it facilitates operating performance comparisons from period to period by excluding potential differences caused by variations in capital structures (affecting interest expense), tax positions (such as the impact on periods or companies of changes in 40
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effective tax rates or fluctuations in permanent differences or discrete quarterly items) and the non-cash impact of depreciation, amortization, stock-based compensation expense, and impairment of goodwill. Since adjusted EBITDA facilitates internal comparisons of our historical operating performance on a more consistent basis, we also use adjusted EBITDA for business planning purposes, to incentivize and compensate our management personnel and in evaluating acquisition opportunities. In addition, we believe adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of adjusted EBITDA has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:
• adjusted EBITDA does not reflect our cash expenditures for capital
equipment or other contractual commitments; • although depreciation and amortization are non-cash charges, the assets
being depreciated and amortized may have to be replaced in the future, and
adjusted EBITDA does not reflect cash capital expenditure requirements for
such replacements;
• adjusted EBITDA does not reflect changes in, or cash requirements for, our
working capital needs; • adjusted EBITDA does not consider the potentially dilutive impact of
issuing stock-based compensation to our management team and employees;
• adjusted EBITDA does not reflect the interest expense or the cash requirements necessary to service interest or principal payments on our indebtedness;
• adjusted EBITDA does not reflect certain tax payments that may represent a
reduction in cash available to us; and • other companies, including companies in our industry, may calculate
adjusted EBITDA measures differently, which reduces their usefulness as a
comparative measure.
Due to these limitations, adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. When evaluating our performance, adjusted EBITDA should be considered alongside other financial performance measures, including various cash flow metrics, net (loss) income and our other GAAP results. The following table presents a reconciliation of adjusted EBITDA to net (loss) income, the most comparable GAAP measure, for each of the periods indicated: Three Months Ended June 30, Mar 31, Dec 31, Sept 30, June 30, Mar 31, Dec 31, Sept 30, 2013 2013 2012 2012 2012 2012 2011 2011 (In thousands) Net (loss) income$ (1,582 )</money> $ (2,162 ) $ (63,491 ) $ (137 ) $ 201 $ 2,873 $ 4,433 $ 5,494 Interest and other income (expense), net 1,065 1,821 1,330 938 1,045 1,077 1,172 1,076 Provision for (benefit from) taxes 2,916 2,527 (32,169 ) 125 2,570 2,093 2,887 3,581 Depreciation and amortization 6,659 7,208 10,179
8,279 8,493 8,032 7,517 7,108 Stock-based compensation expense 3,203 3,013 3,029
2,770 2,905 3,196 3,521 3,374 Impairment of goodwill - - 92,350 - - - - - Adjusted EBITDA$ 12,261 $ 12,407 $ 11,228 $ 11,975 $ 15,214 $ 17,271 $ 19,530 $ 20,633 Adjusted EBITDA as a percentage of net revenue 16 % 16 % 16 % 15 % 18 % 19 % 22 % 20 % 41
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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 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 and we expect our adjusted EBITDA margins to vary from quarter to quarter.
Liquidity and Capital Resources
As ofJune 30, 2013 , our principal sources of liquidity consisted of cash and cash equivalents of$90.1 million , short-term marketable securities of$37.8 million , cash we expect to generate from operations, and our$100.0 million revolving credit line, which is committed untilNovember 2016 , a portion of which is available to be drawn subject to compliance with applicable covenants. Our cash and cash equivalents are maintained in highly liquid investments with remaining maturities of 90 days or less at the time of purchase. We believe our cash equivalents are liquid and accessible. Our short-term and long-term liquidity requirements primarily arise from our working capital requirements, debt service on our$90.0 million term loan balance atJune 30, 2013 , and acquisitions from time to time. Our primary operating cash requirements include the payment of media costs, personnel costs, costs of information technology systems and office facilities. Our ability to fund these requirements will depend on our future cash flows, which are determined, in part, by future operating performance and are, therefore, subject to prevailing global macroeconomic conditions and financial, business and other factors, some of which are beyond our control, and also our ability to access our credit facility. Even though we may not need additional funds, we may still elect to obtain additional debt or equity securities or draw down on or increase our borrowing capacity under our current credit facility for other reasons. We believe that our existing cash, cash equivalents, short-term marketable securities, cash generated from operations and our available borrowings under the credit facility will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Fiscal Year Ended June 30, 2013 2012 2011 (In thousands) Cash flows from operating activities$ 51,916 $ 47,727 $ 78,171 Cash flows used in investing activities (8,720 )
(67,906 ) (134,763 ) Cash flows (used in) from financing activities (21,616 ) (43,447 ) 33,072
Net Cash Provided by Operating Activities
Our net cash provided by operating activities is primarily the result of our net (loss) income adjusted for non-cash expenses such as depreciation and amortization, stock-based compensation expense, impairment of goodwill and changes in working capital components. It is influenced by the timing of cash collections from our clients and cash payments for purchases of media and other expenses. Net cash flow provided by operating activities in fiscal year 2013 consisted of non-cash charges of$137.8 million , partially offset by net loss of$67.4 million and an increase in working capital of$18.5 million . The non-cash charges primarily consisted of impairment of goodwill of$92.4 million , depreciation and amortization of$32.3 million and stock-based compensation expense net of tax benefits of$11.9 million . The contribution to working capital accounts was primarily due to an increase in deferred taxes of$30.8 million resulting from tax deductible goodwill write-off, a decrease in accounts receivable of$15.3 million , net decrease in accounts payable and accrued liabilities of$6.0 million , and a decrease in prepaid expenses and other assets of$3.2 million . The decrease in accounts receivable are primarily due to better collections. The net decrease in accounts payable and accrued and prepaid expenses and other assets are primarily due to timing of payments. 42
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Net cash flow provided by operating activities in fiscal year 2012 consisted of non-cash charges of$46.0 million and net income of$13.0 million , partially offset by contributions to working capital of$11.3 million . The non-cash charges primarily consisted of depreciation and amortization of$31.2 million and stock-based compensation expense net of tax benefits of$12.8 million . The contribution to working capital accounts was primarily due to a decrease in accounts payable and accrued liabilities of$7.8 million and a decrease in deferred taxes of$2.8 million , partially offset by an increase in prepaid expenses and other assets of$2.7 million , and an increase in accounts receivable of$2.0 million . The decrease in accounts payable and accrued liabilities is due to timing of payments and decreased cost of revenue associated with decreased revenue. The decrease in deferred taxes is due to larger temporary differences between the financial statement carrying amount and the tax basis of certain existing assets and liabilities. The increase in prepaid expenses and other assets is primarily due to timing of payments. The increase in accounts receivable is attributable to timing of receipts. Net cash provided by operating activities in fiscal year 2011 consisted of non-cash charges of$33.8 million , net income of$27.2 million , and changes in working capital components of$17.1 million . The non-cash charges primarily consisted of depreciation and amortization of$27.3 million , and stock-based compensation expense and related tax benefits of$6.5 million . The changes in working capital components was primarily due to an increase in accounts payable and accrued liabilities of$8.9 million , a decrease in prepaid expenses and other assets of$4.9 million and a decrease in accounts receivable of$3.9 million , partially offset by an increase in other noncurrent assets comprised primarily of deferred taxes of$3.3 million . The increase in accounts payable and accrued liabilities is due to timing of payments and increased cost of revenue associated with increased revenue. The decrease in prepaid expenses and other assets is primarily due to timing of payments. The decrease in accounts receivable is attributable 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.
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 2013 was primarily due to net investments in marketable securities of$2.4 million and licenses of intangible assets of$2.5 million . Capital expenditures and internal software development costs totaled$3.9 million in fiscal year 2013. Cash used in investing activities in fiscal year 2012 was primarily due to our acquisition of IT Business Edge for a cash payment of$24.0 million , acquisition of certain assets of Ziff Davis Enterprise of$17.3 million and the purchases of the operations of eleven other online publishing businesses for an aggregate of$14.6 million in cash payments, as well as net investments in marketable securities of$3.2 million . Capital expenditures and internal software development costs totaled$4.6 million in fiscal year 2012. Cash used in investing activities in fiscal year 2011 was primarily due to our acquisition of CarInsurance.com for an initial cash payment of$49.7 million and Insurance.com for an initial cash payment of$33.0 million . Cash used in investing activities was also impacted by purchases of the operations of 13 other online publishing businesses for an aggregate of$9.2 million in cash payments, which included$4.5 million of contingent consideration related to a prior period acquisition, as well as net investments in marketable securities of$35.2 million . Capital expenditures and internal software development costs totaled$7.2 million in fiscal year 2011.
Net Cash Provided by or Used in Financing Activities
Cash used in financing activities in fiscal year 2013 was primarily due to principal payments on acquisition-related notes payable and our term loan and related fees of$15.8 million and repurchases of our common stock of$6.2 million under our stock repurchase program partially offset by proceeds received from exercises of stock options of$0.5 million . 43
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Cash used in financing activities in fiscal year 2012 was primarily due to repurchases of our common stock of$43.9 million under our stock repurchase program and principal payments on acquisition-related notes payable and our term loan and related fees of$9.9 million , partially offset by proceeds from bank debt of$5.9 million and exercises of stock options of$4.7 million . Cash provided by financing activities in fiscal year 2011 was primarily due to net proceeds from the draw-down of our revolving credit line of$24.4 million , proceeds from the exercise of stock options of$16.7 million and excess tax benefits from stock-based compensation of$7.5 million , partially offset by$15.4 million in principal payments on acquisition-related promissory notes and our term loan.
Off-Balance Sheet Arrangements
During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations
Our contractual obligations relate primarily to borrowings under the credit facility, acquisition-related notes payable, and operating leases.
The following table sets forth payments due under our contractual obligations as ofJune 30, 2013 : Promissory Credit Operating Year Ending June 30, Notes Facility Leases Total 2014$ 3,364 $ 12,500 $ 3,556 $ 19,420 2015 560 17,500 3,310 21,370 2016 50 20,000 3,191 23,241 2017 - 40,000 2,748 42,748 2018 and thereafter - - 3,728 3,728 Total$ 3,974 $ 90,000 $ 16,533 $ 110,507
The above table does not include approximately
Credit Facility
InNovember 2011 , we entered into the Second Amended and Restated Revolving Credit and Term Loan Agreement ("Second Loan Agreement") withComerica Bank (the "Bank"), the administrative agent and lead arranger. The Second Loan Agreement consists of a$100.0 million five-year term loan, with annual principal amortization of 5%, 10%, 15%, 20% and 50%, and a$200.0 million five-year revolving credit line. OnFebruary 15, 2013 , we entered into the First Amendment to Credit Agreement and Amendment to Guaranty ("First Amendment to the Second Loan Agreement") with the Bank to, among other things: (1) amend the definition of adjusted EBITDA, effective as ofDecember 31, 2012 , to exclude extraordinary or non-recurring non-cash expenses of losses including, without limitation, goodwill impairments, and any extraordinary or non-recurring cash expenses in an aggregate amount not to exceed$5.0 million for the life of the Second Loan Agreement; and (2) reduce the$200.0 million five-year revolving credit line portion of the facility to$100.0 million , effective as ofFebruary 15, 2013 . 44
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Borrowings under the Second Loan Agreement are secured by substantially all of our assets. Interest is payable at specified margins above either the Eurodollar Margin or the Prime Rate. The interest rate varies based upon the ratio of funded debt to adjusted EBITDA and ranges from Eurodollar Margin + 1.625% to 2.375% or Prime + 1.00% for the revolving credit line and from Eurodollar Margin + 2.00% to 2.75% or Prime + 1.00% for the term loan. Adjusted EBITDA is defined as net (loss) income less benefit from (provision for) taxes, depreciation expense, amortization expense, stock-based compensation expense, interest and other income (expense), acquisition costs for business combinations, extraordinary or non-recurring non-cash expenses of losses including, without limitation, goodwill impairments, and any extraordinary or non-recurring cash expenses in an aggregate amount not to exceed$5.0 million for the life of this Second Loan Agreement. The revolving credit line requires an annual facility fee of 0.375% of the revolving credit line capacity. To reduce our exposure to rising interest rates under the term loan, onFebruary 24, 2012 , we entered into an interest rate swap encompassing the principal balances scheduled to be outstanding inJanuary 2014 and thereafter, such principal amount totaling$85.0 million inJanuary 2014 and amortizing to$35.0 million inNovember 2016 . The interest rate swap effectively fixes the Eurodollar Margin at 0.97%. The Second Loan Agreement expires inNovember 2016 . The Second Loan Agreement restricts our ability to raise additional debt financing and pay dividends, and also requires us to comply with other nonfinancial covenants. In addition, we are required to maintain financial ratios computed as follows: 1. A minimum fixed charge coverage ratio of 1.15:1, calculated as the 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 capacity exists such that the relevant debt payment could be made from the credit facility. 2. A maximum funded debt to adjusted EBITDA ratio of 3:1, calculated as the 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.
We were in compliance with the covenants of our loan agreements as of
Upfront arrangement fees incurred in connection with the First Amendment of the Second Loan Agreements totaled$0.2 million and were deferred and will be amortized over the remaining term of the arrangement. In connection with the reduction of the revolving credit line capacity, during the third quarter of fiscal year 2013 we accelerated amortization of approximately$0.7 million of unamortized deferred upfront costs.
Interest Rate Swap
As described above, we entered into an interest rate swap to reduce our exposure to the financial impact of changing interest rates under our term loan. We do not speculate using derivative instruments. The effective date of the swap isApril 9, 2012 with a maturity date ofNovember 4, 2016 . AtJune 30, 2013 , we had approximately$85.0 million of notional amount outstanding under the swap agreement that exchanges a variable interest rate base (Eurodollar margin) for a fixed interest rate of 0.97% over the term of the agreement. This interest rate swap is designated as a cash flow hedge of the interest rate risk attributable to forecasted variable interest payments. The effective portion of the fair value gains or losses on this swap will be included as a component of accumulated other comprehensive loss in the consolidated balance sheets. AtJune 30, 2013 , our interest rate swap qualified as a cash flow hedge. For this qualifying hedge, the effective portion of the change in fair value will be recognized through earnings when the underlying transaction being hedged affects earnings, thereby allowing the swap's gains and losses to offset interest expense from the term loan on the statement of operations. Any hedge ineffectiveness is recognized in earnings in the current period. 45
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Headquarters Lease
We entered into a lease agreement inFebruary 2010 for approximately 63,998 square feet of office space located at950 Tower Lane ,Foster City, California . The term of the lease began onNovember 1, 2010 and expires onOctober 31, 2018 . The monthly base rent was abated for the first 12 calendar months under the lease, and remained at$0.1 million through the 24th calendar month of the term of the lease. After this 24 month period, monthly base rent increased to$0.2 million for the subsequent 12 months and then increases approximately 3% after each 12-month anniversary during the remaining term, including any extensions under our options to extend. We have two options to extend the term of the lease for one additional year for each option following the expiration date of the lease or renewal term, as applicable.
Critical Accounting Policies and Estimates
We have prepared our consolidated financial statements in conformity with accounting principles generally accepted inthe United States of America ("GAAP"). In doing so, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Actual results may differ significantly from these estimates. We believe that the critical accounting policies listed below involve our more significant judgments, estimates and assumptions and, therefore, could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understand and evaluate the consolidated financial statements contained in this report.
See Note 2, Summary of Significant Accounting Principles, of our consolidated financial statements for further information on our critical and other significant accounting policies.
Revenue Recognition
We derive our revenue from two sources: DMS and DSS.
DMS revenue is derived primarily from fees which are earned through the delivery of qualified leads, clicks, calls, customers and, to a lesser extent, display advertisements, or impressions. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is reasonably assured. Delivery is deemed to have occurred at the time a qualified lead or click is delivered to the client provided that no significant obligations remain. Under our revenue recognition policies, we allocate revenue in an arrangement using the estimated selling price ("ESP") of deliverables if vendor-specific objective evidence ("VSOE") of selling price based on historical stand-alone sales or third-party evidence ("TPE") of selling price does not exist. Due to the unique nature of some of our multiple deliverable revenue arrangements, we may not be able to establish selling prices based on historical stand-alone sales or third party evidence, therefore we may use our best estimate to establish selling prices for these arrangements under the new standard. We establish best estimates within a range of selling prices considering multiple factors including, but not limited to, factors such as class of client, size of transaction, available media inventory, pricing strategies and market conditions. We believe the use of the best estimate of selling price allows revenue recognition in a manner consistent with the underlying economics of the transaction. 46
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From time to time, we may agree to credit a client for certain leads, clicks, calls or customers if they fail to meet the contractual or other guidelines of a particular client. We have established a sales reserve based on historical experience. To date, such credits have been within our expectations. For a portion of our revenue, we have agreements with providers of online media or third-party publishers used in the generation of qualified leads, clicks, calls or customers. We receive a fee from our clients and pay a fee to publishers either on a revenue-share, cost-per-lead, cost-per-click or cost-per-thousand-impressions basis. We are the primary obligor in the transaction. As a result, the fees paid by our clients are recognized as revenue and the fees paid to our publishers are included in cost of revenue. DSS revenue is comprised of (i) set-up and professional services fees and (ii) usage fees. Set-up and professional service fees that do not provide stand-alone value to a client are recognized over the contractual term of the agreement or the expected client relationship period, whichever is longer, effective when the application reaches the "go-live" date. We define the "go-live" date as the date when the application enters into a production environment or all essential functionalities have been delivered. Usage fees are recognized on a monthly basis as earned.
Deferred revenue is comprised of contractual billings in excess of recognized revenue and payments received in advance of revenue recognition.
Stock-Based Compensation
We measure and record the expense related to stock-based transactions based on the fair values of the awards as determined on the date of grant. For stock options, we selected and have historically used the Black-Scholes option pricing model to estimate the fair value. In applying the Black-Scholes option pricing model, our determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the stock options and the employees' actual and projected stock option exercise and pre-vesting employment termination behaviors. Since we do not have extensive trading history, we estimate the expected volatility of our common stock based on the historical volatility of comparable public companies over the stock option's expected term. We have no history or expectation of paying dividends on our common stock. The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected term of the stock options. The fair value of restricted stock units is determined based on the closing price of our common stock on the date of grant. We recognize stock-based compensation expense over the requisite service period using the straight-line method, based on awards ultimately expected to vest. We estimate future forfeitures at the date of grant and revise the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
Goodwill
We conduct a test for the impairment of goodwill on at least an annual basis but will conduct the test at an earlier date if indicators of possible impairment arise that would cause a triggering event. We have two reporting units, DMS and DSS. The impairment test first compares the fair value of our reporting unit to its carrying amount, including goodwill, to assess whether impairment is present. Our public market capitalization sustained a decline afterDecember 31, 2012 , to a value below the net book carrying value of our equity. As a result, we determined that this triggered the necessity to conduct an interim goodwill impairment test. We first tested our long-lived assets related to the DMS reporting unit as ofDecember 31, 2012 and, based on the undiscounted cash flows, determined that these assets were not impaired. Additionally, a two-step process was then required to test goodwill impairment. To estimate the fair value for step one, we utilized a combination of income and market approaches evenly weighted to estimate the fair value of the reporting units. The income approach involves discounting future estimated cash flows. The discount rate used is the value-weighted average 47
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of the reporting unit's estimated cost of equity and debt ("cost of capital") derived using both known and estimated customary market metrics. We performed sensitivity tests with respect to growth rates and discount rates used in the income approach. In applying the market approach, valuation multiples are derived from historical and projected operating data of selected peer companies, evaluated and adjusted, if necessary, based on our strengths and weaknesses relative to the selected peer companies, and applied to the appropriate historical and/or projected operating data to arrive at a fair value. We completed step one of the impairment analysis for each of our reporting units and concluded that, as of December 31, 2012 , the fair value of our DMS reporting unit was below its carrying value, including goodwill. As such, step two of the impairment test was initiated to determine the amount of the impairment by comparing the implied fair value of the reporting unit's goodwill with its carrying value. We recorded an estimated goodwill impairment charge of $92.4 million in the second quarter of fiscal year 2013. We completed the second step of the goodwill impairment test as described above in the third quarter of fiscal year 2013. The completion of this second step did not result in an adjustment to the goodwill impairment charge previously recorded in the second quarter of fiscal year 2013. In our quarter ending June 30, 2013 , we determined that the estimated fair value of our DMS reporting unit was in excess of its carrying value. As described above, we utilized a combination of income and market approaches evenly weighted to estimate the fair value of the reporting units. The carrying value of our DMS reporting unit was approximately $277.4 million in our quarter ending June 30, 2013 . The estimated fair value of our DMS reporting unit was approximately $301.0 million in our quarter ending June 30, 2013 . This resulted in an excess of fair value over the carrying value of approximately $23.6 million or 8.5%. The excess fair value over the carrying value in our quarter ending June 30, 2012 was 28%. The decline in the excess carrying value was primarily a result of the decline in market capitalization at the time our annual goodwill impairment test during the quarter ending June 30, 2013 compared to the market capitalization during the quarter ending June 30, 2012 . In our quarter ending June 30, 2013 , we determined that the estimated fair value of our DSS reporting unit was in excess of its carrying value. The carrying value of our DSS reporting unit was approximately $1.3 million in our quarter ending June 30, 2013 . The estimated fair value of our DSS reporting unit under an income approach was approximately $2.3 million in our quarter ending June 30, 2013 based on the present value of estimated future cash flows. This resulted in a significant excess of fair value over the carrying value.
Based on our re-evaluation of impairment as part of our annual impairment test during the quarter ending
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions. We base these estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. Actual results could differ from those estimates, and such differences could affect the estimated fair value of the reporting units and hence the valuation of goodwill could be affected. 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. The application of the goodwill impairment test requires judgment, including the identification of reporting units, the assignment of assets, liabilities and goodwill to reporting units and the determination of the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows and determining appropriate discount rates, growth rates, an appropriate control premium and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value which could trigger impairment.
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
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may not be recoverable. We apply judgment when estimating the fair value of the assets based on the undiscounted future cash flows the assets are expected to generate and recognize an impairment loss if estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. As mentioned in the Goodwill section above, our public market capitalization sustained a decline afterDecember 31, 2012 , to a value below the net book carrying value of our equity. As such, we tested our long-lived assets related to the DMS reporting unit as ofDecember 31, 2012 and, based on the undiscounted cash flows, determined that these assets were not impaired. We re-evaluated our long-lived assets as part of our annual impairment test during the quarter endingJune 30, 2013 and determined that there was no indicator of impairment. Income Taxes We account for income taxes using an asset and liability approach to record deferred taxes. Our deferred income tax assets represent temporary differences between the financial statement carrying amount and the tax basis of existing assets and liabilities that will result in deductible amounts in future years, including net operating loss carry forwards. A valuation allowance is recorded against our deferred tax assets which are not expected to be realized. Our judgment regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors.
Recent Accounting Pronouncements
See Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements for information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements.
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