UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

 

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☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED September 30, 2014

 

OR

 

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE TRANSITION PERIOD FROM         TO        

 

Commission file number 000-24643

 

DIGITAL RIVER, INC.

(Exact name of registrant as specified in its charter)

 

 

10380 BREN ROAD WEST
MINNETONKA, MINNESOTA 55343
(Address of principal executive offices)

 

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

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒  No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined in Exchange Act Rule 12b-2). See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

The number of shares of common stock outstanding at October 1, 2014, was 31,888,021 shares.

 

 

 

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DIGITAL RIVER, INC.

Form 10-Q

Index

 

 

 

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PART I.  FINANCIAL INFORMATION

 

Item 1.  Financial Statements

DIGITAL RIVER, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 

 

See accompanying notes to consolidated financial statements.

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DIGITAL RIVER, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data; unaudited)

 

 

 

 

See accompanying notes to consolidated financial statements.

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DIGITAL RIVER, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands; unaudited)

 

 

 

 

 

See accompanying notes to consolidated financial statements.

 

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DIGITAL RIVER, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)

 

 

 

 

 

 

See accompanying notes to consolidated financial statements.

 

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1. BASIS OF PRESENTATION

 

The unaudited consolidated financial statements of Digital River, Inc. and our wholly owned subsidiaries (we, our, Digital River, or the Company) included herein have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information, and, accordingly, do not include all financial information and footnotes normally required for a complete set of financial statements.  These consolidated financial statements should be read in conjunction with our audited consolidated financial statements included in our Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission.

 

The unaudited consolidated statements reflect all adjustments, including normal recurring adjustments, which in our opinion are necessary to fairly state our consolidated financial position, results of operations and cash flows for the periods presented.  The results of operations for the three and nine months ended September 30, 2014, are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire fiscal year ending December 31, 2014, due to seasonality and other factors.  The December 31, 2013, information was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP.

 

Summary of Significant Accounting Policies

 

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

 

Recent Accounting Pronouncements

 

ASU 2014-09 – Revenue from Contracts with Customers:  In May 2014, the Financial Accounting Standards Board (FASB) issued ASU 2014-09, which revises revenue recognition guidance in order to create a single standard that is intended to improve comparability over a range of industries, companies and geographic areas. The ASU is effective for reporting periods beginning after December 15, 2016, and will be applied retrospectively. We are currently reviewing the revised guidance and assessing the potential impact on our consolidated financial statements.

 

ASU 2013-11 - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists:  In July 2013, the FASB issued ASU 2013-11, which requires an entity to present unrecognized tax benefits as a reduction of the deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, if net settlement is required or expected. To the extent that net settlement is not required or expected, the unrecognized tax benefit must be presented as a liability. The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist at the reporting date and should be made presuming disallowance of the tax position at the reporting date. ASU No. 2013-11 is effective for reporting periods beginning after December 15, 2013, and should be applied prospectively to all unrecognized tax benefits that exist at the effective date. We adopted the new guidance in ASU 2013-11 as of the period ended March 31, 2014, and its adoption did not have a material impact on our Consolidated Financial Statements.

 

We have determined that all other recently issued accounting standards will not have a material impact on our Consolidated Financial Statements, or do not apply to our operations.

 

 

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2. NET INCOME (LOSS) PER SHARE

 

The following table summarizes the computation of basic and diluted net income (loss) per share from continuing operations (in thousands, except per share amounts):

 

 

 

Incremental shares of 544,629 for the three months ended September 30, 2013, and 492,244 and 313,695 incremental shares for the nine months ended September 30, 2014 and 2013, respectively, related to dilutive securities were not included in the diluted net income (loss) per share calculation because the Company reported a loss for these periods.  Incremental shares related to dilutive securities have an anti-dilutive impact on net income (loss) per share when a net loss is reported and therefore are not included in the calculation.

 

Options to purchase 377,235 and 589,943 shares for the three months ended September 30, 2014 and 2013, respectively, and 377,235 and 589,943 shares for the nine months ended September 30, 2014 and 2013 were not included in the computation of diluted net income (loss) per share because their effect on diluted net income (loss) per share would have been anti-dilutive.

 

Our remaining 2004 senior convertible notes were repurchased in the second quarter of 2014.  Prior to the repurchase, the unissued shares underlying our 2004 senior convertible notes, 199,828 weighted average shares for the three months ended September 30, 2013, and weighted average shares of 583 and 199,828 for the nine months ended September 30, 2014 and 2013, respectively, were excluded for the purposes of calculating diluted net income (loss) per share, because their effect on diluted net income (loss) per share would have been anti-dilutive. 

 

The unissued shares underlying our 2010 senior convertible notes, 2,751,414 and 6,019,607 weighted average shares for the three months ended September 30, 2014 and 2013, respectively, and 3,499,945 and 6,070,600 weighted average shares for the nine months ended September 30, 2014 and 2013, respectively, were excluded for the purpose of calculating diluted net income (loss) per share, because their effect on diluted net income (loss) per share would have been anti-dilutive.

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3. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

 

Comprehensive income (loss) includes revenues, expenses, and gains and losses that are excluded from net earnings under GAAP. Items of comprehensive income (loss) are unrealized gains and losses on investments and foreign currency translation adjustments which are added to net income (loss) to compute comprehensive income (loss). Comprehensive income (loss) related to cumulative translation adjustments has no tax expense or benefit as these funds are indefinitely invested.

 

The following table summarizes the changes in accumulated other comprehensive income (loss), net of tax, by component for the periods ended September 30, 2014 and 2013, (in thousands):

 

 

 

The following table shows the gross amounts reclassified from accumulated other comprehensive income (loss) into the Consolidated Statements of Operations and the associated financial statement line item, for the periods ended September 30, 2014 (in thousands):

 

 

 

 

 

 

 

 

 

4. FAIR VALUE MEASUREMENTS

 

Financial assets and liabilities that are remeasured and reported at fair value at each reporting period are classified and disclosed in one of the following three categories:

 

Level 1 — Observable inputs such as quoted prices in active markets;

 

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Level 2 — Other observable inputs available at the measurement date, other than quoted prices included in Level 1, either directly or indirectly, including:

 

 

Level 3 — Unobservable inputs that cannot be corroborated by observable market data and reflect the use of significant management judgment.  These values are generally determined using pricing models for which the assumptions utilize management’s estimate of market participant assumptions.

 

Assets and Liabilities that are Measured at Fair Value on a Recurring Basis

 

The following table sets forth by level within the fair value hierarchy, our financial assets that were accounted for at fair value on a recurring basis at September 30, 2014 and December 31, 2013, (in thousands):

 

 

 

The assets held at September 30, 2014 and December 31, 2013 had no transfers between levels of the hierarchy during the respective periods then ended.

 

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The following table is a reconciliation of assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3 inputs) (in thousands):

 

 

 

The following methods and assumptions were used to estimate the fair value of each class of financial instrument. There have been no changes in the valuation techniques used by the Company to fair value our financial instruments:

 

Cash and Cash equivalents.  Consist of cash on hand in bank deposits, highly liquid investments and money market accounts. The fair value was measured using quoted market prices and is classified as Level 1.  The carrying amount approximates fair value.

 

Restricted Cash.  Consist of cash and cash equivalents that are held in escrow accounts and restricted by agreements with third parties for a particular purpose.  The carrying amount approximates fair value and is classified as Level 1.

 

Certificate of deposits. Consist of bank deposits with a carrying amount that approximates fair value and is classified as Level 1.  Maturity dates within one year.

 

Commercial Paper. Consist of primarily high grade commercial paper.  The fair value of these investments was measured using quoted market prices and is classified as Level 1.  As of December 31, 2013, the contractual maturities of these investments were within one year.

 

U.S government sponsored entities.  Consist of Fannie Mae, Freddie Mac and Federal Home Loan Bank investment grade bonds that are traded in less active markets than Level 1 investments.  The fair value of these bonds is classified as Level 2.  The contractual maturities of these investments are within four years.

 

Corporate Bonds.  Consist of investment grade corporate bonds that trade with sufficient frequency and volume to enable us to obtain pricing information on an ongoing basis.  The fair value of these bonds was measured using quoted market prices and is classified as Level 1. The contractual maturities of these investments are within three years.

 

Asset Backed Securities.    Consist of securities backed by automobile loan receivables that are traded in less active markets than our Level 1 investments. The fair value is classified as Level 2. The contractual maturity of these investments is within six years.

 

Market Basis Equity Investments. Consist of available-for-sale equity securities that trade with sufficient frequency and volume to enable us to obtain pricing information on an ongoing basis.  The fair value of these investments was measured using quoted market prices and is classified as Level 1.

 

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Auction Rate Securities.  As of September 30, 2014, we held $40.7 million of Auction Rate Securities (ARS) at par value which we have recorded at $39.1 million fair value. As of December 31, 2013, we held $45.7 million of ARS at par value which was recorded at $42.0 million fair value.  As of September 30, 2014 the ARS are 105—142% over-collateralized and the underlying student loans are guaranteed by the U.S. government.

 

Due to the illiquid market conditions, the fair value of our ARS is recorded at a discount to par value of $1.6 million, or 4.0%, as of September 30, 2014.  This reduction from par value is considered temporary and is recorded in “Accumulated other comprehensive income (loss)”.  The temporary reduction from par value recorded in “Accumulated other comprehensive income (loss)” was $3.7 million, 8.2%, as of December 31, 2013.  For the three months ended September 30, 2014 and 2013, we recorded unrealized gains on our ARS of $0.2 million and $0.1 million, respectively.  For the nine months ended September 30, 2014 and 2013, we recorded unrealized gains on our ARS of $2.1 million and $3.3 million.  Unrealized gains on our ARS are recorded in “Unrealized gain (loss) on investments” in our Consolidated Statements of Comprehensive Income (Loss). 

 

In evaluating our ARS portfolio, we note sustained performance of our securities, strong parity levels, observed market redemption activity, continued receipt of interest and penalty payments, and an increase in fair value at September 30, 2014 compared to December 31, 2013. As we expect to receive all contractual cash flows, we do not believe the unrealized losses to be credit related.  We continue to believe that we will be able to liquidate at par over time. We also anticipate we will have sufficient cash flow from operations to execute our business strategy and fund our operational needs.  We do not intend to sell, or believe we will be required to sell, these investments prior to recovery of their amortized cost basis.  Accordingly, we treated the fair value decline as temporary.

 

The discounted cash flow model we used to value these securities included the following assumptions:

 

 

 

Management makes estimates and assumptions about the ARS, which can be sensitive to changes and effect the determination of fair value.  An increase in the length of redemption period or an increase in the discount rate assumption would decrease our fair value.  Also, a decrease in the securities’ credit ratings would decrease our fair value.

 

The portfolio had a weighted average maturity of 30.1 years at September 30, 2014, and 29.8 years as of December 31, 2013.

 

We classify our ARS as Level 3 long-term investments until we receive a call or partial call on the securities.  As of September 30, 2014 and December 31, 2013, our entire ARS portfolio was classified as Level 3 long-term investments. During the quarter ended September 30, 2014, we settled $5.0 million of ARS due to a call at par.  During the year ended December 31, 2013, we settled $0.1 million of ARS due to a partial call at par. The amount of Level 3 assets as a percentage of total assets measured at fair value on a recurring basis was 9.1% and 6.5% as of September 30, 2014 and December 31, 2013, respectively.

 

Assets and Liabilities that are Measured at Fair Value on a Nonrecurring Basis

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, they are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances

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like evidence of impairment.  For the three and nine months ended September 30, 2014 and 2013, other than the goodwill impairment recorded during the first quarter of 2013, as further discussed in Note 6 — Goodwill, we had no significant fair value adjustments of assets or liabilities on a nonrecurring basis subsequent to their initial recognition.  The inputs used in goodwill impairment fair value calculations fall within Level 3 inputs due to the significant unobservable inputs used to determine fair value.

 

 

5.  INVESTMENTS

 

As of September 30, 2014 and December 31, 2013, our available-for-sale securities consisted of the following (in thousands):

 

 

 

We consider the fair value decline of our investments to be temporary, as we do not intend to sell the investments and it is not likely that we will be required to sell the investments before recovery of their amortized cost basis.  See Note 4 — Fair Value Measurements, for further discussion regarding the fair value of ARS.  Temporary, unrealized, gains and losses on available for sale securities are recorded in “Accumulated other comprehensive income (loss)” within our Consolidated Balance Sheets.

 

Realized gains or losses on investments are recorded in our Consolidated Statements of Operations within “Other income (expense), net”.  Upon the sale of a security classified as available for sale, the amount reclassified out of “Accumulated other comprehensive income (loss)” into earnings is based on the specific identification method.

 

As of September 30, 2014 and December 31, 2013, the balance of our cost method equity investment was $11.4 million and $10.5 million, respectively, which is included in “Long-term investments” in our Consolidated Balance Sheets.  During the first quarter of 2014, we invested an additional $0.6 million and converted a note receivable of $0.3 million into shares in our cost method equity investment.  We have not estimated the fair value of

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our cost method equity investment as of September 30, 2014 as we are not aware of any facts or circumstances that would indicate a decline in the fair value of this investment below its carrying value.

 

During the first quarter of 2013, we sold a cost method equity investment to a third party and recorded a gain of $11.1 million. During the second quarter of 2013, we received additional funds based on our sales agreement and as a result we recorded an additional gain of $6.5 million.  In the third quarter of 2014, we received the third of four anticipated payments under the sales agreement and recorded a gain of $2.2 million.  All gains related to this cost basis investment have been recorded in “Other income (expense), net” in our Consolidated Statements of Operations.   The fourth and final payment under the sales agreement is due in the third quarter of 2017 and we may receive up to $0.9 million of additional sale proceeds at that time.  We have concluded that these additional funds represent contingent gains and have not accounted for them in our consolidated financial statements in accordance with U.S. GAAP.

 

6.  GOODWILL

 

In the fourth quarter 2012, we determined our goodwill was impaired and recorded a preliminary non-cash pretax goodwill impairment charge.  During the first quarter of 2013, we completed our goodwill impairment analysis and recorded an additional non-cash pretax goodwill impairment charge of $21.2 million relating to our single reporting unit. The tax benefit associated with the first quarter impairment was offset by our tax valuation allowance.  As previously disclosed, a blended income and market approach was used to determine the applicable impairment changes.  The application of goodwill impairment tests is a level 3 fair value measurement and requires management judgment for many of the inputs.  Goodwill impairment charges are included as a separate operating expense line item, “Goodwill impairment” within Continuing Operations in our Consolidated Statements of Operations.

 

7.  STOCK-BASED COMPENSATION

 

The following table summarizes stock-based compensation expense recognized related to employee stock options, restricted and performance stock awards and employee stock purchases (in thousands):

 

 

 

 

 

 

 

 

 

 

 

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8. INCOME TAXES

 

The provision (benefit) for income taxes from continuing operations is composed of the following (in thousands):

 

 

 

 

During the quarter ended September 30, 2014,  $9.1 million of previously unrecognized tax benefits, including $1.4 million of related interest, were released due to the expiration of a statute of limitations. We have taken no new tax positions that result in unrecognized tax benefits during the three and nine month periods ended September 30, 2014.  As of September 30, 2014, we had $2.7 million of remaining unrecognized tax benefits, excluding related interest.  Approximately $2.1 million of these unrecognized tax benefits would affect our effective tax rate if recognized.  As of September 30, 2014, we had approximately $0.4 million of accrued interest related to uncertain tax positions.  Due to the potential resolution of examinations currently being performed by taxing authorities and the expiration of various statutes of limitation, it is reasonably possible that the balance of our gross unrecognized tax benefits may change within the next twelve months by a range of zero to $1.4 million.

 

Our quarterly estimate of our annual effective tax rate is subject to variation due to several factors, including our mix of earnings between tax jurisdictions and the corresponding statutory rates, discrete items and the non-recognition of tax benefits generated by net operating losses in jurisdictions with a valuation allowance.

 

On a quarterly basis, we assess whether a valuation allowance for net operat