XNAS:WWWW Web.com Group Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

  

 

FORM 10-Q

 

 

 

(Mark One)

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

 

For the quarterly period ended March 31, 2012

 

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: 000-51595

 

 

Web.com Group, Inc.

(Exact name of registrant as specified in its charter)

  

 

  

Delaware   94-3327894

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

     
12808 Gran Bay Parkway, West, Jacksonville, FL   32258
(Address of principal executive offices)   (Zip Code)

 

(904) 680-6600

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

 

 

  

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 such filing requirements for the past 90 days.              x    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).                                                                                                                                                         x    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. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨   Accelerated filer x
Non-accelerated filer ¨   Smaller reporting company ¨
(Do not check if a smaller reporting company)    

 

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

 

Common Stock, par value $0.001 per share, outstanding as of May 1, 2012: 48,753,439

 

 
 

 

Web.com Group, Inc.

 

Quarterly Report on Form 10-Q

 

For the Quarterly Period ended March 31, 2012

 

Index

 

Part I   Financial Information   3
         
Item 1.   Financial Statements   3
         
    Consolidated Statements of Comprehensive Loss (unaudited)   3
         
    Consolidated Balance Sheets (unaudited)   5
         
    Consolidated Statements of Cash Flows (unaudited)   6
         
    Notes to Consolidated Financial Statements (unaudited)   7
         
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations   18
         
Item 3.   Quantitative and Qualitative Disclosures About Market Risk   31
         
Item 4.   Controls and Procedures   31
         
Part II   Other Information   32
         
Item 1.   Legal Proceedings   32
         
Item 1A.   Risk Factors   32
         
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds   40
         
Item 3.   Defaults Upon Senior Securities   40
         
Item 4.   Mine Safety Disclosures   40
         
Item 5.   Other Information   40
         
Item 6.   Exhibits   40
     
Signatures   41

 

2
 

 

PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

Web.com Group, Inc.

 

Consolidated Statements of Comprehensive Loss

(in thousands except per share amounts)

(unaudited)

 

   Three months ended March 31, 
   2012   2011 
Revenue:          
Subscription  $88,850   $38,779 
Professional services and other   2,664    702 
Total revenue   91,514    39,481 
Cost of revenue (excluding depreciation and amortization):          
Subscription   37,162    17,329 
Professional services and other   1,446    378 
Total cost of revenue   38,608    17,707 
Gross profit   52,906    21,774 
Operating expenses:          
Sales and marketing   26,844    10,441 
Research and development   9,707    3,549 
General and administrative   14,306    6,445 
Restructuring charges   912    96 
Depreciation and amortization   19,679    4,821 
Total operating expenses   71,448    25,352 
Loss from operations   (18,542)   (3,578)
           
Interest expense, net   (17,776)   (1,584)
Loss before income taxes from continuing operations   (36,318)   (5,162)
Income tax benefit (expense)   6,539    (573)
Net loss from continuing operations   (29,779)   (5,735)
Discontinued operations:          
Gain on sale of discontinued operations, net of tax       125 
Income from discontinued operations       125 
Net loss  $(29,779)  $(5,610)
Other comprehensive loss:          
Interest rate swap loss, net of tax benefit of $14, for the three months ended March 31, 2011       (25)
Total comprehensive loss  $(29,779)  $(5,635)

 

See accompanying notes to consolidated financial statements

 

3
 

 

Web.com Group, Inc.

 

Consolidated Statements of Comprehensive Loss

(in thousands, except per share amounts)

(unaudited)

(continued)

 

   Three months ended March 31, 
   2012   2011 
Basic earnings per share:          
Loss from continuing operations per common share  $(0.65)  $(0.21)
Income from discontinued operations per common share  $   $ 
Net loss per common share  $(0.65)  $(0.21)
Diluted earnings per share:          
Loss from continuing operations per common share  $(0.65)  $(0.21)
Income from discontinued operations per common share  $   $ 
Net loss per common share  $(0.65)  $(0.21)
           
Basic weighted average common shares outstanding   46,140    26,618 
Diluted weighted average common shares outstanding   46,140    26,618 

 

See accompanying notes to consolidated financial statements

 

4
 

 

Web.com Group, Inc.

 

Consolidated Balance Sheets

(in thousands, except share and per share amounts)

 

   March 31,
2012
   December 31,
2011
 
   (unaudited)     
Assets          
Current assets:          
Cash and cash equivalents  $12,325   $13,364 
Restricted investments   300    296 
Accounts receivable, net of allowance of $1,534 and $1,560, respectively   15,251    13,094 
Prepaid expenses   7,806    5,184 
Deferred expenses   59,031    57,302 
Deferred taxes   17,579    18,563 
Deferred financing fees and other current assets   5,581    4,716 
Total current assets   117,873    112,519 
Restricted investments   710    714 
Property and equipment, net   26,738    25,696 
Deferred expenses   67,445    68,136 
Goodwill   631,497    631,362 
Intangible assets, net   522,287    539,979 
Other assets   19,579    21,074 
Total assets  $1,386,129   $1,399,480 
Liabilities and stockholders’ equity          
Current liabilities:          
Accounts payable  $8,645   $4,931 
Accrued expenses   14,692    15,953 
Accrued compensation and benefits   7,949    15,956 
Accrued restructuring costs and other reserves   4,329    5,687 
Deferred revenue   163,936    142,157 
Current portion of debt   56,889    4,182 
Other liabilities   2,779    2,496 
Total current liabilities   259,219    191,362 
Deferred revenue   150,042    132,814 
Long-term debt   652,520    714,703 
Deferred tax liabilities   77,024    84,832 
Other long-term liabilities   3,751    4,013 
Total liabilities   1,143,156    1,127,724 
Stockholders’ equity:          
Common stock, $0.001 par value per share; 150,000,000 shares authorized, 48,620,389 and 47,359,304 shares issued and 48,608,129 and 47,359,304 shares outstanding at March 31, 2012 and December 31, 2011, respectively   49    47 
Additional paid-in capital   443,117    441,955 
Treasury stock, 12,260 shares and 0 at March 31, 2012 and December 31, 2011, respectively   (168)    
Accumulated deficit   (200,025)   (170,246)
Total stockholders’ equity   242,973    271,756 
Total liabilities and stockholders’ equity  $1,386,129   $1,399,480 

 

See accompanying notes to consolidated financial statements

 

5
 

 

Web.com Group, Inc.

 

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

   Three months ended
March 31,
 
   2012   2011 
Cash flows from operating activities          
Net loss  $(29,779)  $(5,610)
Adjustments to reconcile net loss to net cash provided by operating activities:          
Gain on sale of discontinued operations, net of tax       (125)
Depreciation and amortization   19,679    4,821 
Stock based compensation expense   2,680    1,533 
Deferred income tax (benefit) expense   (6,824)   402 
Amortization of debt issuance costs and other   3,725    306 
Changes in operating assets and liabilities:          
Accounts receivable, net   (2,156)   (1,402)
Prepaid expenses and other assets   (3,294)   (809)
Deferred expenses   (1,039)   (931)
Accounts payable   2,958    643 
Accrued expenses and other liabilities   (972)   (524)
Accrued compensation and benefits   (8,136)   (2,007)
Accrued restructuring   (1,624)   (1,026)
Deferred revenue   39,605    6,254 
Net cash provided by operating activities   14,823    1,525 
           
Cash flows from investing activities          
Proceeds from sale discontinued operations       125 
Purchase of property and equipment   (2,679)   (1,993)
Net cash used in investing activities   (2,679)   (1,868)
           
Cash flows from financing activities          
Stock issuance costs   (86)   (3)
Common stock repurchased   (3,199)   (448)
Payments of debt obligations   (11,500)   (4,528)
Proceeds from exercise of stock options   1,602    6,831 
Net cash (used in) provided by financing activities   (13,183)   1,852 
Net (decrease) increase in cash and cash equivalents   (1,039)   1,509 
Cash and cash equivalents, beginning of period   13,364    16,307 
Cash and cash equivalents, end of period  $12,325   $17,816 
           
Supplemental cash flow information          
Interest paid  $14,755   $1,290 
Income tax paid  $58   $497 

 

See accompanying notes to consolidated financial statements

 

6
 

 

Web.com Group, Inc.

Notes to Consolidated Financial Statements

(unaudited)

 

1. The Company and Summary of Significant Accounting Policies

 

Description of Company

 

Web.com Group, Inc. (referred to as “the Company”, “Web.com Group, Inc.” or “Web.com” herein) is a leading provider of internet services for small- to medium-sized businesses (“SMBs”) and is a global domain name registrar to further meet the internet needs of SMBs anywhere along their lifecycle, we provide SMBs with affordable subscription solutions including website design and related services, search engine optimization, search engine marketing, social media and mobile products, local sales leads, eCommerce solutions and call center services.

 

On October 27, 2011, the Company completed its acquisition (the “Acquisition”) of 100% of the equity interests in Net Sol Parent LLC (formerly known as GA-Net Sol Parent LLC) (“Network Solutions”), a provider of global domain names, web hosting and online marketing services, pursuant to the Purchase Agreement (the “Purchase Agreement”) dated August 3, 2011 by and among Web.com Group, Inc., a Delaware corporation, Net Sol Holdings LLC, a Delaware limited liability company, and GA-Net Sol Parent LLC, a Delaware limited liability company and wholly-owned subsidiary of Net Sol Holdings LLC (collectively, the “Sellers”). The purchase price paid to the Sellers was $570 million consisting of $405.1 million in cash and the issuance of 18 million shares of Web.com common stock valued at $9.16 per share. In connection with the Acquisition, the Company assumed the obligation to pay approximately $211.7 million of outstanding debt of Network Solutions and paid off such liabilities at closing with borrowings from the Company’s new credit facilities, and assumed certain other liabilities. See footnote 7, Business Combinations, to our financial statements for the fiscal year ended December 31, 2011 included in the our annual report on Form 10-K filed on March 13, 2012 with the Securities and Exchange Commission (“SEC”). Web.com and Network Solutions are referred to collectively as “the Combined Company” herein.

 

The Company has reviewed the criteria of Accounting Standards Codification (“ASC”) 280-10, Segment Reporting, and has determined that the Company is comprised of only one segment, Web services and products.

 

Basis of Presentation

 

The accompanying consolidated balance sheet as of March 31, 2012, the consolidated statements of comprehensive loss for the three months ended March 31, 2012 and 2011; the consolidated statements of cash flows for the three months ended March 31, 2012 and 2011, and the related notes to the consolidated financial statements are unaudited. The consolidated statement of comprehensive loss and consolidated statement of cash flows for the three months ended March 31, 2012 include the operations of Network Solutions. The consolidated balance sheets as of March 31, 2012 and December 31, 2011 include the assets and liabilities of Network Solutions.

 

The unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2011, except that certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the U.S. have been condensed or excluded as permitted.

 

In the opinion of management, the unaudited consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of the Company’s financial position as of March 31, 2012, and the Company’s results of operations for the three months ended March 31, 2012 and 2011 and cash flows for the three months ended March 31, 2012 and 2011. The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012.

 

These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC, on March 13, 2012.

 

7
 

 

Use of Estimates

 

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

Significant Accounting Policies

Goodwill and Other Intangible Assets

 

In accordance with ASC 350, Intangibles – Goodwill and Other, goodwill is determined to have an indefinite useful life and is tested for impairment, at least annually or more frequently if indicators of impairment arise. If impairment of the carrying value based on the calculated fair value exists, the Company measures the impairment through the use of discounted cash flows. The Company completed its annual goodwill impairment test during the fourth quarter of 2011 and determined goodwill was not impaired. In addition, there were no indicators of impairment during the three months ended March 31, 2012.

 

Intangible assets acquired as part of a business combination are accounted for in accordance with ASC 805, Business Combinations, and are recognized apart from goodwill if the intangible arises from contractual or other legal rights or the asset is capable of being separated from the acquired enterprise. Indefinite-lived intangible assets are tested for impairment annually and on an interim basis if events or changes in circumstances between annual tests indicate that the asset might be impaired in accordance with ASC 350. The Company completed its annual indefinite lived impairment test as of December 31, 2011 and determined that there was no impairment. There were no indicators of impairment during the three months ended March 31, 2012.

 

Definite-lived intangible assets are amortized over the periods in which the Company receives the related benefit, which range between one and sixteen years.

 

Deferred expenses

 

Deferred expenses primarily consist of prepaid domain name registry fees that are paid in full at the time a domain name is registered. The registry fees are recognized on a straight-line basis over the term of the domain registration period.

 

Debt issuance costs

 

The Company capitalizes certain loan origination discounts and other fees in connection with the issuance of long term debt. The loan origination discounts are recorded as a reduction in the carrying amount of the underlying debt and all other deferred costs are in deferred financing fees and other current or non-current assets. Debt issuance costs are amortized to interest expense over the life of the underlying debt using the effective interest method. In determining the periodic amortization expense, the Company includes estimates of prepayments based on the excess cash flow requirements as defined in the credit agreements. See Note 7, Long-term debt, for additional information.

 

Revenue Recognition and Deferred Revenue

 

The Company recognizes revenue in accordance with ASC 605, Revenue Recognition. The Company recognizes revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable; and (4) the collection of its fees is reasonably assured.

 

Thus, the Company recognizes subscription revenue on a daily basis, as services are provided. Customers are billed for the subscription on a 28-day, monthly, quarterly, semi-annual, annual or on a multi-year basis, at the customer’s option. For all of the Company’s customers, regardless of their billing method, subscription revenue is recorded as deferred revenue in the accompanying consolidated balance sheets. As services are performed, the Company recognizes subscription revenue on a daily basis over the applicable service period. When the Company provides a free trial period, it does not begin to recognize subscription revenue until the trial period has ended and the customer has been billed for the services.

 

The Company accounts for its multi-element arrangements, such as in the instances where it designs a custom website and separately offers other services such as hosting and marketing, in accordance with ASC 605-25, Revenue Recognition: Multiple-Element Arrangement. The Company identifies each element in an arrangement and assigns the relative selling price to each element. The additional services provided with a custom website are recognized separately over the period for which services are performed.

 

8
 

 

Income Taxes

 

The Company accounts for income taxes under the liability method of ASC 740, Income Taxes. ASC 740 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the difference is expected to reverse.

 

Stock-Based Employee Compensation

 

The Company accounts for stock-based compensation to employees in accordance with ASC 718, Compensation – Stock Compensation. Accordingly, the fair value of all stock awards is recognized in compensation expense over the requisite service period for awards expected to vest.

 

Earnings per Share

 

The Company computes earnings per share in accordance with ASC 260, Earnings Per Share. Basic net income per common share includes no dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per common share includes the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

 

New Accounting Standards

In 2011, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standards Update (“ASU”) to the Intangibles—Goodwill and Other Topics in the ASC which permits an entity to first use qualitative factors to determine if there is a potential impairment in goodwill. ASU No. 2011-08 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, it is necessary to perform the currently prescribed two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. This rule is effective for annual and interim goodwill impairment tests performed in fiscal years beginning after December 15, 2011. The Company does not expect the adoption of this guidance to have a material impact, if any, on the Company’s financial position or results of operations.

 

Recently Adopted Accounting Standards

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”, to eliminate the option to report comprehensive income and its components in the statement of changes in equity. Under ASU No. 2011-05, an entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. The Company adopted ASU No. 2011-05 on January 1, 2012 and has elected to present items of net income and other comprehensive income in one continuous statement.

 

2. Discontinued Operations

 

On May 26, 2009, the Company sold its NetObjects Fusion software business for $4.0 million. The Company no longer considered the NetObjects Fusion license software product core to its predominantly subscription business model. The NetObjects Fusion software enabled customers to build websites either for themselves or for others. The Company initially received partial payments, net of tax, of $1.4 million through December 31, 2011 in connection with the NetObjects Fusion sale. The remaining $2.6 million of proceeds are scheduled to be paid using a formula based on estimated revenue, with the entire balance scheduled to be paid by May 26, 2013. The remaining proceeds, if received, will be recorded as a gain from the sale of discontinued operations upon receipt. During the three months ended March 31, 2012 and 2011, the Company received $0 and $0.1 million, respectively, of proceeds from the buyer.

 

9
 

 

3. Business Combinations

 

On October 27, 2011, the Company completed Acquisition of 100% of the equity interests in Net Sol Parent LLC (formerly known as GA-Net Sol Parent LLC) (“Network Solutions”), a provider of global domain names, web hosting and online marketing services, pursuant to the Purchase Agreement dated August 3, 2011. In addition to bringing approximately 2 million subscribers, which present substantial cross- and up-sell opportunities, Network Solutions also brings highly complementary products, sales channels and operating capabilities. The purchase price paid to the Sellers was $570 million consisting of $405.1 million in cash and the issuance of 18 million shares of Web.com common stock valued at $9.16 per share. In connection with the Acquisition, the Company assumed the obligation to pay approximately $211.7 million of outstanding debt of Network Solutions and paid off such liabilities at closing with borrowings from the Company’s new credit facilities, and assumed certain other liabilities. See footnote 7 to the Company’s financial statements for the fiscal year ended December 31, 2011 included in the Company’s annual report on Form 10-K filed with the SEC on March 13, 2012. In connection with the acquisition, the Company incurred approximately $11.6 million of acquisition-related transaction costs during the year ended December 31, 2011, none of which were recorded during the three months ended March 31, 2011. These expenses were recorded in the General and Administrative line item in the Consolidated Statement of Comprehensive Loss.

 

The Company has accounted for the acquisition of Networks Solutions using the acquisition method as required in ASC 805, Business Combinations. As such, fair values have been assigned to the assets and liabilities acquired and the excess of the total purchase price over the fair value of the net assets acquired is recorded as goodwill. The Company, with the assistance of independent valuation professionals, has estimated fair value of certain intangible assets. The goodwill from the acquisition represents business benefits the Company anticipates realizing from optimizing resources and cross-sale opportunities. The goodwill from this acquisition is not expected to be deductible for tax purposes.

 

The Company is still reviewing information surrounding income tax considerations resulting from the acquisition, which may result in changes to the Company’s preliminary purchase price allocation in the second and third quarters of 2012. The following table summarizes the Company’s preliminary purchase price allocation based on the fair values of the assets acquired and liabilities assumed on October 27, 2011 (in thousands):

 

Tangible current assets  $15,369 
Property and equipment   17,506 
Other non-current assets   6,068 
Deferred expenses, current and non-current   99,701 
Developed technology   129,640 
Customer relationships   230,140 
Domain/trade names   98,230 
Non-compete agreements   600 
Goodwill   508,311 
Current liabilities   (25,861)
Long-term debt   (211,672)
Deferred revenue, current and non-current   (184,391)
Deferred tax liability   (113,641)
      
Net assets acquired  $570,000 

 

The customer relationships and developed technology intangible assets will be amortized over a weighted average period of 144 months and 47 months, respectively. The non-compete agreements are amortized over 12 months. The domain/trade names have indefinite lives and are not amortized.

 

Network Solutions contributed approximately $44.3 million in revenue during the three months ended March 31, 2012 and $28.0 million during the period from October 28, 2011 through December 31, 2011. The operations of Network Solutions have been incorporated with the existing Web.com Group Inc. operations subsequent to the transaction closing. As such, the determination of operating income and net income is not readily available nor would it be indicative of the standalone entity if presented.

 

The fair value and gross contractual amount of acquired accounts receivable was $5.3 million.

 

Pro Forma Condensed Consolidated Results of Operations

 

The Company has prepared unaudited condensed pro forma financial information to reflect the consolidated results of operations of the combined entities as though the Network Solutions acquisition had occurred on January 1, 2010 for the three months ended March 31, 2011 reflected below. The Company has made adjustments to the historical Web.com and Network Solutions financial information that are directly attributable to the acquisition, factually supportable and expected to have a continuing impact on the combined results. This pro forma presentation does not include any impact of transaction costs or expected synergies. The pro forma results are not necessarily indicative of our results of operations had the Company owned Network Solutions for the entire periods presented.

 

10
 

 

The Company has adjusted the results of operations to reflect the impact of amortizing into revenue, deferred revenue that was recorded at fair value. The fair value of the acquired deferred revenue was approximately 51 percent less than the pre-acquisition historical basis of Network Solutions. In addition, interest expense and amortization of intangible assets were adjusted to reflect the cost of the October 27, 2011 debt issued to finance the acquisition and the fair value of the intangible assets on the acquisition date, respectively. Finally, non-recurring acquisition related transaction and compensation costs were excluded. Basic weighted-average common shares have been calculated as though the issuance of 18 million shares had occurred on January 1, 2010.

 

The following summarizes unaudited pro forma total revenue and net loss (in thousands, except per share amounts):

  

   Three months
ended
 
   March 31, 2011  
Revenue  $93,537 
Net loss  $(37,661)
      
Basic loss per share:     
Net loss per share  $(0.84)
      
Diluted loss per share:     
Net loss per share  $(0.84)
      
Basic weighted-average common shares outstanding   44,618 
      
Diluted weighted-average common shares outstanding   44,618 

 

4. Earnings per Share

 

The following table sets forth the computation of basic and diluted net loss per common share (in thousands except per share amounts):

 

   Three months ended   Three months ended 
   March 31, 2012   March 31, 2011 
         
Loss from continuing operations  $(29,779)  $(5,735)
Income from discontinued operations       125 
Net loss   (29,779)   (5,610)
           
Weighted-average outstanding shares of common stock   46,140    26,618 
Dilutive effect of stock options and restricted stock        
Common stock and common stock equivalents   46,140    26,618 
Basic earnings per share:          
Loss from continuing operations  $(0.65)  $(0.21)
Income from discontinued operations        
Net loss per share  $(0.65)  $(0.21)
           
Diluted earnings per share:          
Loss from continuing operations  $(0.65)  $(0.21)
Income from discontinued operations        
Net loss per share  $(0.65)  $(0.21)

 

11
 

 

For the three months ended March 31, 2012 and 2011, options to purchase approximately 7.5 million and 6.6 million shares, respectively, of common stock were not included in the calculation of the weighted average shares for diluted net income per common share because the effect would have been anti-dilutive.

 

5. Goodwill and Intangible Assets

 

The following table summarizes changes in the Company’s goodwill balances as required by ASC 350-20 for the three months and year ended March 31, 2012 and December 31, 2011, respectively (in thousands):  

 

   March 31,   December 31, 
   2012 *   2011 * 
Goodwill balance at beginning of year  $733,656   $224,806 
Accumulated impaired goodwill at beginning of year   (102,294)   (102,294)
Goodwill balance at beginning of year, net   631,362    122,512 
Goodwill acquired during the year       508,176 
Goodwill adjusted during the year   135    674 
Goodwill balance at end of year, net  $631,497   $631,362 

*Gross goodwill balances were $733,791 and $733,656 as of March 31, 2012 and December 31, 2011, respectively. This includes accumulated impairment losses of $102,294 as of March 31, 2012 and December 31, 2011.

 

The Company’s intangible assets are summarized as follows (in thousands):

 

   March 31,
2012
   December 31,
2011
   Weighted-average
Amortization
Period as of March
31, 2012
 
Indefinite-lived intangible assets:               
Domain/Trade names  $128,000   $128,000      
Definite lived intangible assets:               
Non-compete agreements   4,008    4,008    7 months 
Customer relationships   285,135    285,135    131 months 
Developed technology   187,563    187,563    47 months 
Other   100    100      
Accumulated amortization   (82,519)   (64,827)     
   $522,287   $539,979      

 

The weighted-average amortization period for the amortizable intangible assets as of March 31, 2012, is approximately 8.3 years. Total amortization expense was $17.7 million and $3.9 million for the three months ended March 31, 2012 and 2011, respectively.

 

As of March 31, 2012, the amortization expense for the next five years is as follows (in thousands):

 

2012 (remainder of year)  $52,659 
2013   67,833 
2014   59,200 
2015   36,543 
2016   34,593 
Thereafter   143,459 
Total  $394,287 

 

6. Restructuring Costs

 

On March 31, 2012, the Company exited the sales and customer support call center located in Belleville, Illinois. A $0.2 million reserve for the future minimum lease payments was recorded as restructuring expense during the three months ended March 31, 2012. In addition, the net book value of the furniture and leasehold improvements was written off, resulting in a loss of $0.4 million which was recorded during the three months ended March 31, 2012 in the General and Administrative line item in the Consolidated Statement of Comprehensive Loss.

 

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The Company incurred approximately $9.5 million in restructuring costs during the fourth quarter ended December 31, 2011 primarily related to the Network Solutions acquisition. Approximately $5.0 million of severance expense was recorded from terminating employees. In addition, the Company recorded $4.2 million of restructuring expense from exiting approximately 54 percent of Network Solutions headquarters office lease located in Herndon, Virginia. The cease use date was December 31, 2011. The reserve that has been established includes the present value of the future minimum lease payments related to the exited area offset by estimated sublease payments based on market values of comparable spaces in the region. Also during the fourth quarter of 2011, the Company recorded $0.3 million of severance related liabilties that were included in the purchase price allocation.

 

The Company continues to incur restructuring charges for future service that is required by certain Network Solutions employees up to their scheduled termination dates throughout 2012. During the three months ended March 31, 2012, $0.7 million of additional severance and relocation charges were incurred. The Company incurred approximately $0.1 million in restructuring costs during the three months ended March 31, 2011 related to its 2010 acquition of Register.com LP. As of March 31, 2012 and December 31, 2011, $4.3 million and $5.7 million, respectively, were recorded as current restructuring expenses expected to be paid during the next twelve months. The non-current accrued restructuring was $1.7 million and $2.0 million as of March 31, 2012 and December 31, 2011, respectively.

 

The table below summarizes the activity of accrued restructuring costs and other reserves during the three months ended March 31, 2012 (in thousands):

 

 

   Balance as of
December 31,
2011
   Additions   Cash
Payments
   Change in
Estimates
   Balance as of
March 31,
2012
 
Contract termination  and other restructuring costs  $3,341   $249   $(344)  $   $3,246 
Employee termination benefits   4,308    663    (2,235)       2,736 
Total accrued restructuring  $7,649   $912   $(2,579)  $   $5,982 

 

7. Long-term debt

 

Financing of the Network Solutions Acquisition

On October 27, 2011, the Company entered into credit facilities, pursuant to (i) a First Lien Credit Agreement, dated as of October 27, 2011 (the “First Lien Credit Agreement”), and (ii) a Second Lien Credit Agreement, dated as of October 27, 2011, (the “Second Lien Credit Agreement”).  The First Lien Credit Agreement provides for (i) a six-year $600 million first lien term loan (the “First Lien Term Loan”) and (ii) a five-year first lien revolving credit facility of $50 million (the “Revolving Credit Facility”).  The Second Lien Credit Agreement provides for a seven-year $150 million second lien term loan (the “Second Lien Term Loan”). The proceeds were used to finance the acquisition of Network Solutions and to pay off the Company’s outstanding debt as well as the assumed debt of Network Solutions, totaling $298.7 million.

 

During the first quarter ended March 31, 2012, the Company paid down $11.5 million of the First Lien Term Loans. As of March 31, 2012 and December 31, 2011, the Company had $13.4 million available under the Revolving Credit Facility.

 

The Company is required to maintain certain financial ratios under the First Lien Credit Agreement and the Second Lien Credit Agreement. In addition, there are customary covenants that limit the incurrence of debt, the payment of dividends, the disposition of assets, and making of certain payments. Substantially all of the Company’s tangible and intangible assets are pledged as collateral under the credit agreements.

 

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Outstanding long-term debt and the interest rates in effect at March 31, 2012 and December 31, 2011 consist of the following (in thousands): 

 

   March 31,  
2012
   December 31,
2011
 
Revolving Credit Facility maturing 2016, 5.87% and 5.88% at 03/31/2012 and 12/31/2011, respectively, based on LIBOR plus 5.625%  $33,000   $33,000 
First Lien Term Loan due 2017, 7.0%, based on 1.5% LIBOR floor plus 5.5%, less unamortized discount of $24,097 and $25,974 at 03/31/2012 and 12/31/2011, effective rate of 9.11% and 9.14%, respectively.   564,403    574,026 
Second Lien Term Loan due 2018, 11.0%, based on 1.5% LIBOR floor plus 9.5%, less unamortized discount of $8,060 and $8,222 at 03/31/2012 and 12/31/2011, effective rate of 13.26% and 13.27%, respectively.   111,940    111,778 
Capital Lease Obligations   66    81 
Total Outstanding Debt   709,409    718,885 
Less: Current Portion of Long-Term Debt   56,889    4,182 
Long-Term Portion  $652,520   $714,703 

 

Debt discount and issuance costs

 

The First Lien Term Loan and Second Lien Term Loan resulted in total net proceeds of $733.5 million upon issuance. The unamortized original issuance discount is reported net in the long term debt line item in the Consolidated Balance Sheet. The total discount of $37.5 million is being amortized to interest expense using the effective interest method. At March 31, 2012 and December 31, 2011, $6.8 million is reflected as a reduction in the current debt obligations as of each of the periods ended and $25.4 million and $27.3 million, respectively, reduced the long term debt obligations.

 

The Company also incurred approximately $21.2 million of debt issuance costs for fees and expenses. These costs are also being amortized to interest expense using the effective interest method. As of March 31, 2012 and December 31, 2011 the current portion of unamortized debt issuance costs was $4.0 million and the non-current portion was $14.5 million and $15.7 million, respectively. These costs are reported in the deferred financing fees and other current and other non-current asset line items in the Consolidated Balance Sheet.

 

The Company recorded $3.3 million and $0.3 million, of interest expense from amortizing debt issuance and discount costs during the three months ended March 31, 2012 and 2011, respectively.

 

The First Lien Term Loan has repayment terms that are based on the excess cash flow generated by the Company as defined by the agreement. Excess cash flow payments are required to be made during the quarter following the calendar year ended. The Company has forecasted the excess cash flows expected to be generated during the year ended December 31, 2012 and reflected the estimate as current maturities. Subsequent to that, the minimum principal payments, excluding the excess cash flows, are presented due to the significant estimates required in determining such amounts. As of March 31, 2012, total estimated principal payments due for the next five years and thereafter are as follows:  

 

Year 1  $63,635 
Year 2   30,000 
Year 3   30,000 
Year 4   30,000 
Year 5   63,000 
Thereafter   524,865 
      
   $741,500 
Less current portion   (63,635)
Long-term principal payments  $677,865 

 

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8. Fair Value

 

The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company applies the following fair value hierarchy, which prioritizes the inputs used to measure fair value into three levels as follows:

 

Level 1-Quoted prices in active markets for identical assets or liabilities.


Level 2-Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3-Inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.

 

The Company also has financial assets and liabilities that are not required to be remeasured to fair value on a recurring basis. The Company’s Cash and Cash Equivalents as of March 31, 2012 and December 31, 2011 carrying value approximates fair market value due to the short maturity of these items. As of March 31, 2012 and December 31, 2011 the fair value of the Company’s First Lien and Second Lien Term Loans was $702.3 million and $658.2 million, respectively, based on a Level 2 fair value hierarchy calculation obtained from quoted market prices for identical instruments that may not be actively traded at each respective period end. The revolving credit facility is a variable rate debt instrument indexed to 1-Month LIBOR that resets monthly and the fair value approximates the carrying value as of March 31, 2012 and December 31, 2011.

 

9. Income Taxes

 

The Company accounts for income taxes under the provisions of ASC 740, using the liability method. ASC 740 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the difference is expected to reverse.

 

The Company recognized an income tax benefit and expense of $6.5 million and $0.6 million during the three months ended March 31, 2012 and 2011, respectively, based upon its estimated annual effective rate. The Company’s estimated annual effective tax rate for the three months ended March 31, 2012 reflects an increase in our projected year-end valuation allowance primarily related to a portion of our estimated pre-tax loss for 2012 and the increase in our non-reversing deferred tax liabilities.

 

10. Stock Based Compensation

 

The Company records compensation expense for employee and director stock-based compensation plans based upon the fair value of the award in accordance with ASC 718, Compensation - Stock Compensation. The Company has elected to use the with and without methodology for determining whether an excess tax benefit has been realized.

 

Equity Incentive Plans

 

At March 31, 2012, the Company had multiple stock based compensation plans. The Company’s Board of Directors adopted and stockholders approved the 1999 Equity Incentive Plan (“the 1999 Plan”), the 2005 Equity Incentive Plan (“the 2005 Plan”) and the 2008 Equity Incentive Plan (“the 2008 Plan”). The 1999 Plan provided for the issuance of 4.1 million incentive stock options, non-statutory stock options and stock bonuses. In November 2005, the 1999 Plan terminated and the Company no longer issues shares under the 1999 Plan, however forfeited or cancelled shares from this plan become available for issuance under the 2005 Plan. The 2005 and 2008 Plans provide for the issuance of 10.4 million incentive stock options, non-statutory stock options and restricted share awards. At March 31, 2012, approximately 2.9 million shares remain available for issuance under these two plans. The Company issues new shares of common stock upon the exercise of stock options and the granting of restricted shares.

 

The Company’s Board of Directors adopted and stockholders approved the 2005 Non-Employee Directors’ Stock Option Plan (“the 2005 Directors’ Plan”), which provides for the automatic grant of non-statutory stock options and restricted shares awards (“RSA’s”) to non-employee directors. Approximately 1 million shares were authorized under the 2005 Directors’ Plan. As of March 31, 2012, 472 thousand shares remain available for future issuance.

 

15
 

 

In addition to the plans discussed above, the Company has additional equity incentive plans that were established in conjunction with the acquisitions of Web.com, Solid Cactus, Register.com LP and Network Solutions. The Company reserved 2.4 million shares, 147 thousand shares, 466 thousand shares and 956 thousand shares, for the Web.com, Solid Cactus, Register.com LP and Network Solutions acquisitions, respectively. These plans are considered one-time, inducement awards of incentive stock options, non-statutory stock options and restricted shares. Once the inducement awards are granted, no additional shares, including forfeitures and cancellations, are available for future grant under these plans.

 

Vesting periods for the options issued under the Web.com grant range from zero to five years and have an option term of ten years. The options issued under the Solid Cactus grant have a ten year term and generally vest ratably each month over a four year period. The Register.com LP grant includes option grants to purchase 216 thousand shares that vest over four years, with 25 percent vesting on the one year anniversary of the grant date and 1/48 of the shares vesting monthly thereafter. The Register.com LP grant also includes options to purchase 125 thousand shares that vest over four years with 50 percent vesting on the second year anniversary and 1/48 of shares vesting monthly thereafter. These options have a ten year term. Finally, the Register.com LP grant included the issuance of 125 thousand restricted shares that also vest over the course of four years with 50 percent vesting on the second year, 25 percent on the third year and 25 percent on the fourth anniversary of the grant date.

 

Incentive stock options and non-statutory stock options issued under the 1999 Plan, the 2005 Plan and the 2008 Plan generally vest ratably over three to four years, are contingent upon continued employment and expire ten years from the grant date. Restricted share awards that have been granted under these plans generally vest 25 percent each year over a four year period.

 

The Board of Directors or a committee thereof, administers all of the equity incentive plans and determines the terms of options granted, including the exercise price, the number of shares subject to individual option awards and the vesting period of options, within the limits set forth in the plans. Options have a maximum term of 10 years and vest as determined by the Board of Directors.

 

The fair value of each option award is estimated on the date of the grant using the Black-Scholes option valuation model and the assumptions noted in the following table. Expected volatility rates are based on the Company’s historical volatility, since the Company’s initial public offering, on the date of the grant. The expected term of options granted represents the period of time that they are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Below are the assumption ranges used in calculating the fair value of options granted during the following periods:

  

   Three months ended March 31, 
   2012     2011   
Risk-free interest rate   0.81-0.82    1.87-2.40
Dividend yield   0%   0%
Expected life (in years)   5    5 
Volatility   70%   61%

 

Stock Option Activity

 

The following table summarizes option activity for the three months ended March 31, 2012 for all of the Company’s stock options:

 

   Shares
Covered
by
Options
   Exercise
Price per
Share
   Weighted
Average
Exercise
Price
   Weighted
Average
Remaining
Contractual
Term
(in years)
   Aggregate
Intrinsic
Value  (in
thousands)
 
Balance, December 31, 2011   7,117,787     0.50 to 40.15   $7.35           
Granted   1,586,150    13.24 to 13.29    13.29           
Exercised   (1,101,528)   0.50 to 13.29    2.52           
Forfeited   (127,488)   3.43 to 15.56    10.80           
Expired   (8,924)   3.43 to 31.13    22.09           
Balance, March 31, 2012   7,465,996    2.00 to 40.15    9.24    7.40   $38,785 
Exercisable at March 31, 2012   3,439,514       2.00 to 40.15   $7.97    5.34   $22,256 

 

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Compensation costs related to the Company’s stock option plans were $1.7 million and $0.9 million for the three months ended March 31, 2012 and 2011, respectively. Compensation expense is generally recognized on a straight-line basis over the vesting period of grants. As of March 31, 2012, the Company had $19.3 million of unrecognized compensation costs related to share-based payments, which is expected to recognized over a weighted average period of 3.1 years.

 

The total intrinsic value of options exercised during the three months ended March 31, 2012 and 2011 was $12.4 million and $9.9 million, respectively. The fair value of options vested during the three months ended March 31, 2012 and 2011 was $1.3 million and $0.8 million, respectively. The weighted average grant-date fair value of options granted during the three months ended March 31, 2012 and 2011 was $7.62 and $5.26, respectively.

 

Price ranges of outstanding and exercisable options as of March 31, 2012 are summarized below:

 

   Outstanding Options   Exercisable Options 
Exercise Price  Number
of Options
   Weighted
Average
Remaining
Life (Years)
   Weighted
Average
Exercise
Price
   Number
of Options
   Weighted
Average
Exercise
Price
 
$2.00 – $5.66   1,695,958    6.73   $4.59    926,600   $4.15 
$5.97 – $9.00   2,071,413    5.17    8.58    1,824,270    8.78 
$9.01 – $10.95   1,887,531    8.67    10.40    418,135    10.16 
$10.98 – $13.24   233,773    5.82    11.74    204,220    11.56 
$13.29 – $40.15   1,577,321    9.78    13.36    66,289    14.23 
    7,465,996    7.40         3,439,514      

 

Restricted Stock Activity

 

The following information relates to awards of restricted stock and restricted stock units that have been granted under the 2005 Directors’ Plan, the 2005 Plan, the 2008 Plan and the Register.com LP plan. The restricted stock is not transferable until vested and the restrictions lapse upon the completion of a certain time period, usually over a one- to four-year period. The fair value of each restricted stock grant is based on the closing price of the Company’s stock on the date of grant and is amortized to compensation expense over its vesting period, which ranges between one and four years.

 

The following restricted stock activity occurred under the Company’s equity incentive plans during the three months ended March 31, 2012:

 

Restricted Stock Activity  Shares   Weighted
Average
Grant–Date
Fair Value
 
Restricted stock outstanding at December 31, 2011   1,634,434   $5.98 
Granted   472,500   $13.29 
Lapse of restriction   (198,100)  $7.29 
Restricted stock outstanding at March 31, 2012   1,908,834   $7.86 

 

Compensation expense for the three months ended March 31, 2012 and 2011 was approximately $1.0 million and $0.6 million, respectively. As of March 31, 2012, there was approximately $9.1 million of total unrecognized compensation cost related to the restricted stock outstanding, which is expected to be recognized over a weighted average period of 2.1 years. The intrinsic value and fair value of outstanding restricted stock as of March 31, 2012 is $27.5 million and $24.0 million, respectively.

 

During the three months ended March 31, 2012 and 2011, $3.2 million and $0.4 million, respectively, was used to pay the minimum withholding tax requirements in lieu of receiving common shares.

 

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11. Related Party Transactions

 

The Company outsources telesales and marketing services to Red Ventures LLC (“Red Ventures”). General Atlantic LLC is one of the Company’s greater than 5 percent shareholders, and also has a 25 percent ownership interest in Red Ventures. This business relationship was an agreement between Red Ventures and Network Solutions and was acquired by the Company as a result of the Acquisition and commenced on October 27, 2011 upon the consummation of the Acquisition. The Company incurred approximately $5.8 million of expense for sales and marketing services provided by Red Ventures during the three months ended March 31, 2012. As of March 31, 2012, the Company had $4.1 million payable to Red Ventures for such services.

 

The Company also outsources data center services to Quality Technology Services LLC (“QTS”). General Atlantic LLC is one of the Company’s greater than 5 percent shareholders, and has approximately a 50 percent ownership interest in QTS. This business relationship was an agreement between QTS and Network Solutions and was acquired by the Company as a result of the Acquisition and commenced on October 27, 2011 upon the consummation of the Acquisition. The Company incurred approximately $0.2 million of expense for sales and marketing services provided by QTS during the three months ended March 31, 2012. As of March 31, 2012, the Company had $0.1 million payable to QTS for such services.

 

12. Commitments and Contingencies

 

The Company utilizes letters of credit to back certain payment obligations relating to its facility operating leases. The Company had approximately $4.7 million in standby letters of credit as of March 31, 2012, $3.6 million of which was drawn against the Revolving Credit Facility.

 

The Company and our subsidiaries are named from time to time as defendants in various legal actions that are incidental to our business and arise out of or are related to claims made in connection with our customer and vendor contracts and employment related disputes.  We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations. There were no material legal matters that were reasonably possible and estimable at March 31, 2012. 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Forward Looking Statements

 

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. We use words such as “anticipate”, “believe”, “plan”, “expect”, “future”, “intend” and similar expressions to identify forward-looking statements. These statements are within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. We can give no assurances that the assumptions upon which the forward-looking statements are based will prove to be correct and because forward-looking statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. These forward-looking statements appear throughout the Form 10-Q and are statements regarding our intent, belief, or current expectations, primarily with respect to our operations and related industry developments. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Form 10-Q. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A, entitled “Risk Factors,” and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Form 10-Q.

 

Safe Harbor

 

In the following discussion and analysis of results of operations and financial condition, certain financial measures may be considered “non-GAAP financial measures” under Securities and Exchange Commission rules. These rules require supplemental explanation and reconciliation, which is provided in this Quarterly Report on Form 10-Q.

 

We believe presenting non-GAAP net income attributable to common stockholders, non-GAAP net income per share attributable to common stockholders and non-GAAP operating income is useful to investors, because it describes the operating performance of the Company and helps investors gauge the Company’s ability to generate cash flow, excluding some recurring charges that are included in the most directly comparable measures calculated and presented in accordance with GAAP. We use these non-GAAP measures as important indicators of our past performance and in planning and forecasting performance in future periods. The non-GAAP financial information we present may not be comparable to similarly-titled financial measures used by other companies, and investors should not consider non-GAAP financial measures in isolation from, or in substitution for, financial information presented in compliance with GAAP.

 

18
 

 

Overview

 

We are a leading provider of internet services for small- to medium-sized businesses (“SMBs”) and a global domain name registrar. We seek to meet the internet needs of SMBs anywhere along their lifecycle with affordable subscription solutions including domain name registration, website design and related services, search engine optimization, search engine marketing, social media and mobile products, local sales leads, eCommerce solutions and call center services. We offer SMBs a single point of entry to an array of effective, affordable online products and services that will help drive their business.  The breadth and flexibility of our offerings allow us to address the web services needs of a wide variety of customers, ranging from those just establishing their websites to those that want to enhance their existing online presence with more sophisticated marketing and lead generation services. We offer our customers a full range of web services and products on an affordable subscription basis. With nearly 3 million subscribers as of March 31, 2012, we are one of the industry’s largest providers of domain names, affordable web services and products that enable SMBs to have an effective online presence.

 

We have positioned ourselves as a partner to SMBs across all phases of their business’s adaptation to internet technology, from their initial entry onto the web to their use of cutting-edge innovations as they mature. As a domain registrar, we allow the business to establish an online presence by buying a domain name. This basic service is the entry point to higher priced offerings. Having secured a domain, a business next needs a website and email service. Our offerings for these fundamental services span the range of customer budgets and expertise, from inexpensive Do It Yourself website and email hosting for the technically-savvy, to Do It For Me custom website design services, online marketing and eCommerce solutions. Customers can engage our experienced consultants for services that range from web design to online advertising campaign management. When online innovations emerge, we can help SMBs leverage the new capabilities.

 

On October 27, 2011, we completed the acquisition of Network Solutions, a provider of domain names, web hosting and online marketing services. The purchase price paid to the Sellers was $570 million consisting of $405.1 million in cash and the issuance of 18 million shares of Web.com common stock valued at $9.16 per share. In connection with the Acquisition, the Company assumed the obligation to pay approximately $211.7 million of outstanding debt of Network Solutions and paid off such liabilities at closing with borrowings from the Company’s new credit facilities, and assumed certain other liabilities. See footnote 7 to the Company’s financial statements for the fiscal year ended December 31, 2011 included in the Company’s annual report on Form 10-K filed on March 13, 2012 with the SEC. With approximately 2 million subscribers acquired, Network Solutions represents a substantial cross- and up-sell opportunity for us. We determined that the operations of Network Solutions are considered Web products and services and therefore, no change to our operating segment resulted. See Note 3, Business Combinations, for additional information on the acquisition.

 

We sell our products and services via our direct sales force, which operate in the U.S. and Canada. In addition to these sales centers, we acquire many customers through online and affiliate marketing activities. Recently, we rolled out a “Feet on the Street” direct sales initiative, as well as a Direct Response Television (“DRTV”) campaign. We also sell web services and products to customers identified by companies with which it has strategic marketing relationships. Typically, our strategic marketing partners have established brand names and attract a large number of SMB customers. We also acquire a large number of customers directly through online and affiliate marketing activities that target SMBs that want to establish or enhance their online presence.

 

To increase our revenue and take advantage of our market opportunity, we plan to expand our subscriber base as well as furthering our cross-sell/up-sell strategy with our domain name customers from Network Solutions and Register.com LP. We intend to continue to hire additional personnel, particularly in outbound and inbound sales and marketing; develop additional services and products; add to our infrastructure to support our growth; and expand our operational and financial systems to manage our growing business. As we have in the past, we will continue to evaluate acquisition opportunities to increase the value and breadth of our Web services and product offerings and expand our subscriber base.

 

 Key Business Metrics

 

Management periodically reviews certain key business metrics to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. These key business metrics include:

 

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Net Subscriber Additions

 

We maintain and grow our subscriber base through a combination of adding new subscribers and retaining existing subscribers. We define net subscriber additions in a particular period as the gross number of new subscribers added during the period, less subscriber cancellations during the period. For this purpose, we only count as new subscribers those customers whose subscriptions have extended beyond the free trial period. Additionally, we do not treat a subscription as cancelled, even if the customer is not current in their payments, until either we have made numerous attempts to contact the subscriber or 60 days have passed since the most recent failed billing attempt, whichever is sooner. In any event, a subscriber’s account is cancelled if payment is not received within approximately 80 days.

 

We review this metric to evaluate whether we are performing to our business plan. An increase in net subscriber additions could signal an increase in subscription revenue, higher customer retention, and an increase in the effectiveness of our sales efforts. Similarly, a decrease in net subscriber additions could signal decreased subscription revenue, lower customer retention, and a decrease in the effectiveness of our sales efforts. Net subscriber additions above or below our business plan could have a long-term impact on our operating results due to the subscription nature of our business.

 

Monthly Turnover (Churn)

 

Monthly turnover, or churn, is a metric we measure each quarter, and which we define as customer cancellations in the quarter divided by the sum of the number of subscribers at the beginning of the quarter and the gross number of new subscribers added during the quarter, divided by three months. Customer cancellations in the quarter include cancellations from gross subscriber additions, which is why we include gross subscriber additions in the denominator. In measuring monthly turnover, we use the same conventions with respect to free trials and subscribers who are not current in their payments as described above for net subscriber additions. Monthly turnover is the key metric that allows management to evaluate whether we are retaining our existing subscribers in accordance with our business plan. An increase in monthly turnover may signal deterioration in the quality of our service, or it may signal a behavioral change in our subscriber base. Lower monthly turnover signals higher customer retention.

 

Average Revenue per Subscriber

 

Average revenue per subscriber, or ARPU, is a metric we measure on a quarterly basis. We define ARPU as quarterly subscription revenue divided by the average of the number of subscribers at the beginning of the quarter and the number of subscribers at the end of the quarter, divided by three months. We exclude from subscription revenue the impact of the fair value adjustments to deferred revenue resulting from acquisition related write downs. The fair market value adjustment was $27.8 million and $5.6 million for the quarters ended March 31, 2012 and 2011, respectively. ARPU is the key metric that allows management to evaluate the impact on monthly revenue from product pricing, product sales mix trends, and up-sell/cross-sell effectiveness.

 

Sources of Revenue

 

We derive our revenue from a variety of services to SMBs, including web design and services, domain name registration and services, online marketing, search engine optimization, eCommerce solutions, logo design and home contractor lead services. Leads are generated through online advertising campaigns targeting customers in need of web design, hosting or online marketing solutions, through strategic partnerships with enterprise partners, or through our corporate websites. In addition, we up-sell to the acquired customer bases of Register.com and Network Solutions.

 

Subscription Revenue

 

We currently derive a substantial majority of our revenue from fees associated with our subscription services, which are generally sold through our web services, online marketing, eCommerce, and domain name registration offerings. A portion of our services are offered free of charge for a 30-day trial period during which the customer can cancel at any time. After the 30-day trial period has ended, the revenue is recognized on a daily basis over the life of the contract. We bill a majority of our customers in advance through their credit cards, bank accounts, or business merchant accounts, and revenue is also recognized on a daily basis over the life of the contract which can range from monthly up to 100 years.

 

For the quarter ended March 31, 2012, subscription revenue accounted for approximately 97% of our total revenue as compared to 98% for the quarter ended March 31, 2011. The number of paying subscribers of our Web services and lead generation products drives subscription revenue as well as the subscription price that we charge for these services. The number of paying subscribers is affected both by the number of new customers we acquire in a given period and by the number of existing customers we retain during that period. We expect other sources of revenue to decline as a percentage of total revenue over time.

 

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Professional Services and Other Revenue

 

We generate professional services revenue from custom website design, eCommerce store design and support services, and Do It Yourself logo design. Our custom website design and eCommerce store design work is typically billed on a fixed price basis and over very short periods. Our Do It Yourself logo design is typically billed upon the point-of-sale of the final product, which is created by the customer. Other revenue consists of all fees earned from granting customers licenses to use our patents.

 

 Cost of Revenue

 

Cost of Subscription Revenue

 

Cost of subscription revenue consists of expenses related to compensation expenses related to our Web page development staff, domain name registration fees, directory listing fees, customer support costs, search engine registration fees, billing costs, hosting expenses, marketing fees, and allocated overhead costs. We allocate overhead costs such as rent and utilities to all departments based on headcount. Accordingly, general overhead expenses are reflected in each cost of revenue and operating expense category. As our customer base and Web services usage grows, we intend to continue to invest additional resources in our website development and support staff.

  

Cost of Professional Services and Other Revenue

 

Cost of professional services revenue primarily consists of compensation expenses related to our Web page development staff, eCommerce store design, logo design, and allocated overhead costs. While in the near term, we expect to maintain or reduce costs in this area, in the long term, we may add additional resources in this area to support the growth in our professional services and custom design functions.

 

Operating Expenses

 

Sales and Marketing Expense

 

Our largest direct marketing expenses are the costs associated with the online marketing channels we use to acquire and promote our services. These channels include search marketing, affiliate marketing, direct television advertising and online partnerships. Sales costs consist primarily of compensation and related expenses for our sales and marketing staff. Sales and marketing expenses also include marketing programs, including advertising, events, corporate communications, other brand building and product marketing expenses and allocated overhead costs.

 

We plan to continue to invest in sales and marketing by increasing the number of direct sales personnel in order to add new subscription customers as well as increase sales of additional and new services and products to our existing customer base. In addition, we plan to expand our resources to direct response television advertising to further increase revenue growth. Our investments in this area will also help us to expand our strategic marketing relationships, to build brand awareness, and to sponsor additional marketing events. Accordingly, we expect that, in the future, sales and marketing expenses will increase in absolute dollars. 

 

Research and Development Expense

 

Research and development expenses consist primarily of compensation and related expenses for our research and development staff and allocated overhead costs. We have historically focused our research and development efforts on increasing the functionality of the technologies that enable our Web services and lead generation products. Our technology architecture enables us to provide all of our customers with a service based on a single version of the applications that serve each of our product offerings. As a result, we do not have to maintain multiple versions of our software, which enables us to have lower research and development expenses as a percentage of total revenue. We expect that, in the future, research and development expenses will increase as we continue to upgrade and extend our service offerings and develop new technologies.

 

General and Administrative Expense

 

General and administrative expenses consist of compensation and related expenses for executive, finance, administration, and management information systems personnel, as well as professional fees, corporate development costs, other corporate expenses, and allocated overhead costs. We expect that general and administrative expenses will increase in absolute dollars as we continue to add personnel to support the growth of our business.

 

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Depreciation and Amortization Expense

 

Depreciation and amortization expenses relate primarily to our intangible assets recorded due to the acquisitions we have completed, as well as, computer equipment, furniture and fixtures, and building and improvement expenditures.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and expenses and related disclosure of contingent assets and liabilities. We review our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies and estimates are described in more detail in Note 1, The Company and Summary of Significant Accounting Policies, to our consolidated financial statements included in this report, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition

 

We recognize revenue in accordance with ASC 605, Revenue Recognition. We recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable; and (4) the collection of our fees is reasonably assured.

 

Thus, we recognize subscription revenue on a daily basis, as services are provided. Customers are billed for the subscription on a 28-day, monthly, quarterly, semi-annual, annual or on a multi-year basis, at the customer’s option. For all of our customers, regardless of the method we use to bill them, subscription revenue is recorded as deferred revenue in the accompanying consolidated balance sheets. As services are performed, we recognize subscription revenue on a daily basis over the applicable service period. When we provide a free trial period, we do not begin to recognize subscription revenue until the trial period has ended and the customer has been billed for the services.

 

We account for our multi-element arrangements, such as in the instances where we design a custom website and separately offer other services such as hosting and marketing, in accordance with ASC 605-25, Revenue Recognition: Multiple-Element Arrangement. We identify each element in an arrangement and assign the relative selling price to each element. The additional services provided with a custom website are recognized separately over the period for which services are performed.

 

Allowance for Doubtful Accounts

 

In accordance with our revenue recognition policy, our accounts receivable are based on customers whose payment is reasonably assured. We monitor collections from our customers and maintain an allowance for estimated credit losses based on historical experience and specific customer collection issues. While credit losses have historically been within our expectations and the provisions established in our financial statements, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Because we have a large number of customers, we do not believe a change in liquidity of any one customer or our inability to collect from any one customer would have a material adverse impact on our consolidated financial position.

 

We also monitor failed direct debit billing transactions and customer refunds and maintain an allowance for estimated losses based upon historical experience. These provisions to our allowance are recorded as an adjustment to revenue. While losses from these items have historically been minimal, we cannot guarantee that we will continue to experience the same loss rates that we have in the past.

 

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Accounting for Stock-Based Compensation

  

We grant to our employees and directors options to purchase common stock at exercise prices equal to the quoted market values of the underlying stock at the time of each grant. We determine the fair value of each option award as of the grant date using the Black Scholes option pricing valuation model in accordance with ASC 718, Compensation-Stock Compensation.

 

The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model will be affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates, forfeitures and expected dividends.

 

Goodwill and Intangible Assets

 

In accordance with ASC 350, Intangibles - Goodwill and Other, we periodically evaluate goodwill and indefinite lived intangible assets for potential impairment. We test for the impairment of goodwill and indefinite lived intangible assets annually, and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill or indefinite lived intangible assets below its carrying amount. Other intangible assets include, among other items, customer relationships, developed technology and non-compete agreements, and they are amortized using the straight-line method over the periods benefited, which is up to twelve years. Other intangible assets represent long-lived assets and are assessed for potential impairment whenever significant events or changes occur that might impact recovery of recorded costs. During the year ended December 31, 2011, we completed our annual impairment test of goodwill and other indefinite lived intangible assets. The results of this test determined that goodwill and other indefinite lived intangible assets were not impaired at December 31, 2011. See Note 5, Goodwill and Intangible Assets in the consolidated financial statements for additional information on goodwill and intangible assets.

 

Accounting for Business Combinations

 

All of our acquisitions were accounted for as purchase transactions, and the purchase price is allocated based on the fair value of the assets acquired and liabilities assumed. The excess of the purchase price over the fair value of net assets acquired or net liabilities assumed are allocated to goodwill. Management weighs several factors in determining the fair value of amortizable intangibles, which primarily consists of developed technology, customer relationships, non-compete agreements and trade names, including using third-party valuation experts, valuation studies and other tools in determining the fair value of amortizable intangibles. While we use our best estimates and assumptions as a part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the acquisition date, our estimates are inherently uncertain and subject to refinement.

 

In addition, uncertain tax positions and tax related valuation allowances assumed in connection with a business combination are initially estimated as of the acquisition date and we reevaluate these items quarterly with any adjustments to our preliminary estimates being recorded to goodwill provided that we are within the measurement period and we continue to collect information in order to determine their estimated values. Subsequent to the measurement period or our final determination of the uncertain tax positions estimated value or tax related valuation allowances, changes to these uncertain tax positions and tax related valuation allowances will affect our provision for income taxes in our consolidated statement of operations and could have a material impact on our results of operations and financial position.

 

Provision for Income Taxes

 

We account for income taxes under the provisions of ASC 740, Income Taxes, using the liability method. ASC 740 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the difference is expected to reverse. Further, deferred tax assets are recognized for the expected realization of available net operating loss and tax credit carry forwards. A valuation allowance is recorded to reduce a deferred tax asset to an amount that we expect to realize in the future. We review the adequacy of the valuation allowance on an ongoing basis and recognize these benefits if a reassessment indicates that it is more likely than not that these benefits will be realized.

 

In addition, we believe that we have fully reserved for any tax uncertainties in accordance with ASC 740, Income Taxes, which clarifies the accounting for uncertainty in income tax positions recognized in financial statements. However, if actual results differ from our estimates, we will adjust the tax provision in the period the tax uncertainty is realized.

 

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Comparison of the Results for the Three Months Ended March 31, 2012 to the Results for the Three Months Ended March 31, 2011

 

The following table sets forth our key business metrics for the three months ended March 31:

 

   2012*   2011 
         
Net subscriber additions (reductions)   1,615    (15,233)
Churn   1.0%   1.8%
Average revenue per subscriber  $13.15   $15.64 

 

*The metrics for the three months ended March 31, 2012 include the operating results of Network Solutions.

 

Net subscribers increased by 1,615 customers during the three months ended March 31, 2012 as compared to a decrease of 15,233 during the three months ended March 31, 2011. In addition, due to a continued downward trend in churn as well as the acquisition of Network Solutions’ lower churning significant customer base, churn decreased by 0.8% to 1.0% in the three months ended March 31, 2012 compared to the same prior year period ended.

 

The average revenue per subscriber was $13.15 during the three months ended March 31, 2012 down from $15.64 for the same prior year period. The decrease in average revenue per subscriber was due to the addition of lower revenue subscribers from our acquisition of approximately two million Network Solutions’ customers. Excluding the impact of the Network Solutions acquisition, the average revenue per subscriber increased from the prior year period. Further, the average revenue per subscriber of $13.15 represents an increase of 2 percent over the pro forma average revenue per subscriber of $12.86 for the three months ended December 31, 2011 giving effect to the Network Solutions acquisition. The growth in average revenue per subscriber continues to be driven principally by our up-sell and cross-sell campaigns focused on selling higher revenue products to our existing customers as well as the introduction of new product offerings and sales channels oriented toward acquiring higher value customers.

 

Revenue

 

   Three months ended
March 31,
 
   2012   2011 
   (unaudited) 
Revenue:          
Subscription  $88,850   $38,779 
Professional services and other   2,664    702 
Total revenue  $91,514   $39,481 

 

Total revenue for the three months ended March 31, 2012 increased $52.0 million primarily due to the acquisition of Network Solutions in October 2011. The majority of the increase was associated with domain and web-related services. The operations of Network Solutions began integrating with the existing legacy Web.com operations immediately following the closing of the acquisition on October 27, 2011. Furthermore, we increased revenue by continuing to up-sell our Do It For Me products to the acquired Register.com LP and Network Solutions customer base, in addition to favorable results from our direct advertising television campaigns and increased marketing efforts for our online marketing products.

 

Subscription Revenue. Subscription revenue increased $50.1 million to $88.9 million in the three months ended March 31, 2012 from $38.8 million for the same prior year period. The increase is due to the overall revenue drivers discussed above.

 

Professional Services Revenue. Professional services revenue increased $2.0 million to $2.7 million in the three months ended March 31, 2012 from $0.7 million in the same prior year period ended. Professional services revenue increased primarily due to non-recurring website design revenue generated from a new partnership arrangement, in addition to other custom website development services.

 

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Cost of Revenue

 

   Three months ended
March 31,
 
   2012   2011 
   (unaudited) 
Cost of revenue        
Subscription  $37,162   $17,329 
Professional services and other   1,446    378 
Total cost of revenue  $38,608   $17,707 

 

Cost of Subscription Revenue. Cost of subscription revenue increased $19.8 million to $37.2 million, or 42% of subscription revenue, in the three months ended March 31, 2012 from $17.3 million, or 45% of subscription revenue, in the three months ended March 31, 2011 primarily due to additional costs related to the revenue from the Network Solutions acquisition.

 

Our gross margin on subscription revenue increased from 55% during the three months ended March 31, 2011 to 58% during the three months ended March 31, 2012. The gross margin was negatively impacted by amortizing into revenue, deferred revenue that was written down to fair value at the acquisition date which was approximately 51% lower than the historical basis of Register.com LP and Network Solutions. Excluding the $27.8 million and $5.6 million effect of the adjustment related to the fair value of acquired deferred revenue for the quarters ended March 31, 2012 and 2011, respectively, the gross margin was 68% and 61%, respectively. The increase in this gross margin is related to a favorable gross margin product mix, such as domain name registration and related services.

 

Cost of Professional Services Revenue. Cost of professional services revenue increased by $1.1 million to $1.4 million in the three months ended March 31, 2012 from $0.4 million during the same prior year period. The increase was primarily the result of the costs associated with the development of custom website design revenue.

 

Operating Expenses

 

   Three months ended
March 31,
 
   2012   2011 
   (unaudited) 
Operating expenses:          
Sales and marketing  $26,844   $10,441 
Research and development   9,707    3,549 
General and administrative   14,306    6,445 
Restructuring charges   912    96 
Depreciation and amortization   19,679    4,821 
Total operating expenses  $71,448   $25,352 

 

Sales and Marketing Expenses. Sales and marketing expenses increased $16.4 million to $26.8 million, or 29% of total revenue, during the three months ended March 31, 2012, up from $10.4 million, or 26% of total revenue, during the three months ended March 31, 2011. Our sales and marketing expenses increased primarily due to the acquisition of Network Solutions. However, the increase is also driven by our further investment in sales and marketing activities including direct response television advertising, additional sales resources and online marketing. Overall, there were increases in compensation and benefits of $8.2 million and customer acquisition and marketing expenses of $7.1 million as compared to the same prior year period.

 

Research and Development Expenses. Research and development expenses increased $6.2 million to $9.7 million, or 11% of total revenue, during the three months ended March 31, 2012 from $3.5 million, or 9% of total revenue, during the three months ended March 31, 2011. Our research and development expenses increased primarily due to the acquisition of Networks Solutions. Overall, there were increases in compensation and benefits of $3.5 million and data and software supporting costs of $2.2 million as compared to the same prior year period.

 

General and Administrative Expenses. General and administrative expenses increased $7.9 million to $14.3 million, or 16% of total revenue, during the three months ended March 31, 2012, up from $6.4 million, or 16% of total revenue, during the three months ended March 31, 2011. Our general and administrative expenses increased as compared to the same prior year period primarily due to the acquisition of Network Solutions. Overall, there were increases in compensation and benefits of $5.5 million, professional fees of $0.7 million, additional facilities expense of $0.9 million and corporate development expenses of $0.3 million. In addition, we incurred a loss of approximately $0.4 million resulting from the impairment of fixed assets as part of the Belleview, Illinois office restructuring.

 

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Restructuring Charges. Restructuring charges of $0.9 million were recorded in the first quarter ended March 31, 2012 and are related to employee-related termination costs and relocation expenses, in addition to the lease restructure of the Belleview, Illinois office resulting from the Network Solutions acquisition. See Note 6, Restructuring Costs, for additional information surrounding our restructuring charges and reserves.

 

Depreciation and Amortization Expense. Depreciation and amortization expense increased $14.9 million to $19.7 million during the three months ended March 31, 2012, up from $4.8 million during the same prior year period. The increase in amortization expense related to the intangible assets and depreciation expense from property and equipment acquired from Network Solutions were the drivers for this increase.

 

Interest (Expense) Income, net. Net interest expense of $17.8 million for the three months ended March 31, 2012 is primarily from the term loans and credit facility issued to finance the acquisition of Network Solutions. In addition, amortization of deferred financing fees during the three months ended March 31, 2012 contributed $3.3 million to interest expense.

 

Income Tax Expense. We recorded an income tax benefit of $6.5 million and income tax expense of $0.6 million in the three months ended March 31, 2012 and 2011, respectively, based upon our estimated annual effective tax rate. Our estimated annual effective tax rate for the three months ended March 31, 2012 reflects an increase in our projected year end valuation allowance primarily related to a portion of our estimated pre-tax loss for 2012 and the increase in our non-reversing deferred tax liabilities.

 

Outlook. We expect revenue to continue to increase during the remainder of 2012 as we continue to up-sell and cross-sell to our existing customer base of nearly 3 million subscribers. In addition, we expect our net subscriber growth resulting from our increased marketing efforts in the first quarter of 2012 to continue to trend upward throughout the year. As we continue to integrate our operations, realize the significant post-merger cost savings and benefit from increased scale, we believe that we have the opportunity to generate substantial shareholder value. We expect strong operating cash flows that will be used to pay down debt and fund incremental marketing investments. As the impact of the fair market value adjustment to deferred revenue acquired in the Register.com LP and Network Solutions transactions decreases over the course of 2012, we expect gross margins to improve.

 

Liquidity and Capital Resources

 

The following table summarizes total cash flows for operating, investing and financing activities for the three months ended March 31, (in thousands):  

 

   2012   2011 
         
Net Cash Provided by Operating Activities  $14,823   $1,525 
Net Cash Used in Investing Activities   (2,679)   (1,868)
Net Cash (Used in) Provided by Financing Activities   (13,183)   1,852 
           
(Decrease) increase in Cash and Cash Equivalents  $(1,039)  $1,509 

 

As of March 31, 2012, we had $12.3 million of unrestricted cash and cash equivalents and $141.3 million in negative working capital, as compared to $13.4 million of cash and cash equivalents and $78.8 million in negative working capital as of December 31, 2011. The deficit in working capital is due to the significant portion of deferred revenue from subscription revenue, partially offset by a reduction in accrued compensation and benefits of $8.1 million and increases in accounts receivable of $2.1 million and prepaid expenses of $4.4 million. In addition, current debt obligations of $56.9 million and $4.2 million as of March 31, 2012 and December 31, 2011, respectively, also contributed to the negative working capital.

 

Net cash provided by operations for the three months ended March 31, 2012 was $14.8 million as compared to the net cash provided by operations of $1.5 million for the three months ended March 31, 2011. The net loss of $29.8 million adjusted for non cash items including depreciation and amortization, stock based compensation expense and deferred income taxes resulted in net cash outflows of $10.5 million. Other balance sheet changes included $39.6 million of favorable cash flows from changes in deferred revenue, which more than offset the increase in cash uses from other working capital and balance sheet accounts. Included in the other balance sheet changes during the quarter ended March 31, 2012 was approximately $2.6 million of payments made for the restructuring activities resulting from the October 2011 acquisition of Network Solutions.

 

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Net cash used in investing activities in the three months ended March 31, 2012 was $2.7 million compared to $1.9 million for the same prior year period. Purchases of property and equipment of $2.7 million and $2.0 million were made in the three months ended March 31, 2012 and 2011, respectively, primarily to migrate and streamline data centers to a centralized location.

 

Net cash used for financing activities in the three months ended March 31, 2012 was $13.2 million as compared to net cash provided by financing activities of $1.9 million for the same prior year quarter ended. Proceeds from the exercise of stock options of $1.6 million and $6.8 million were received during the three months ended March 31, 2012 and 2011, respectively. Approximately $3.2 million and $0.4 million of cash was used to pay employee minimum tax withholding requirements in lieu of receiving common shares during the first quarter ended March 31, 2012 and 2011, respectively. Principal payments on long term debt obligations of $11.5 million were made in the first quarter of 2012. The same prior year quarter debt repayments totaled $4.5 million, of which $2.3 million was discretionary.

 

Long-term debt

On October 27, 2011, the Company entered into credit facilities, pursuant to (i) a First Lien Credit Agreement, dated as of October 27, 2011 (the “First Lien Credit Agreement”), and (ii) a Second Lien Credit Agreement, dated as of October 27, 2011, (the “Second Lien Credit Agreement”).  The First Lien Credit Agreement provides for (i) a six-year $600 million first lien term loan (the “First Lien Term Loan”) and (ii) a five-year first lien revolving credit facility of $50 million (the “Revolving Credit Facility”).  The Second Lien Credit Agreement provides for a seven-year $150 million second lien term loan (the “Second Lien Term Loan”). The proceeds were used to finance the acquisition of Network Solutions and to pay off the Company’s outstanding debt as well as the assumed debt of Network Solutions, totaling $298.7 million.

 

The First Lien Credit Agreement requires that we maintain a minimum First Lien Net Leverage Ratio and the Second Lien Credit Agreement requires that we maintain a minimum Total Secured Net Leverage Ratio. The First Lien Net Leverage Ratio is defined as the total of the outstanding first lien debt (which includes the First Lien Term Loan and the Revolving Credit Facility) less up to $50 million of unrestricted cash and cash equivalents, divided by Consolidated EBITDA. Consolidated EBITDA is defined as consolidated net income before (among other things) interest expense, income tax expense, depreciation and amortization, impairment charges, restructuring costs, changes in deferred revenue and deferred expenses, stock-based compensation expense, acquisition related costs and includes the benefit of annualized synergies due to the Network Solutions integration. The Total Secured Net Leverage Ratio is defined as the total secured debt outstanding (which includes the First Lien Credit Agreement and the Second Lien Credit Agreement) less up to $50 million of unrestricted cash and cash equivalents, divided by Consolidated EBITDA.

 

For purposes of determining the First Lien Net Leverage Ratio and the Total Secured Net Leverage Ratio, the value of Consolidated EBITDA is defined in the credit agreements for the fiscal quarters ended September 30, 2011 and June 30, 2011 as $34.6 million and $32.5 million, respectively. The Consolidated EBITDA for the quarter ended December 31, 2011 of $44.4 million is calculated on a pro forma basis to include the operations of Network Solutions for the full quarter. The outstanding net debt for purposes of the First Lien Net Leverage Ratio and the Total Secured Net Leverage Ratio as of March 31, 2012 was $609.2 million and $729.2 million, respectively.

 

The covenant calculations as of March 31, 2012 are calculated on a trailing 12-month basis:

 

Covenant Description  Covenant Requirement as of
March 31, 2012
   Ratio at
March 31, 2012
   Favorable /
(Unfavorable)
 
First Lien Net Debt to Consolidated EBITDA   Not greater than 5.50    3.87    1.63 
Total Secured Net Debt to Consolidated EBITDA   Not greater than 7.25    4.64    2.61 

 

In addition to the financial covenants listed above, the First Lien Credit Agreement and the Second Lien Credit Agreement include customary covenants that limit the incurrence of debt, the disposition of assets, and making of certain payments. Substantially all of our tangible and intangible assets collateralize the long-term debt as required by the credit agreements.

 

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We believe that our existing cash and cash equivalents will be sufficient to meet our projected operating requirements for at least the next 12 months, including our sales and marketing expenses, research and development expenses, capital expenditures and debt service requirements.

 

Non-GAAP Financial Measures

 

In addition to our financial information presented in accordance with U.S. GAAP, management uses certain “non-GAAP financial measures” within the meaning of the SEC Regulation G, to clarify and enhance understanding of past performance and prospects for the future. Generally, a non-GAAP financial measure is a numerical measure of a company’s operating performance, financial position or cash flows that excludes or includes amounts that are included in or excluded from the most directly comparable measure calculated and presented in accordance with GAAP. We monitor non-GAAP financial measures because it describes the operating performance of the company and helps management and investors gauge our ability to generate cash flow, excluding some recurring charges that are included in the most directly comparable measures calculated and presented in accordance with GAAP. Relative to each of the non-GAAP financial measures, we further set forth our rationale as follows:

 

Non-GAAP Revenue.  We exclude from non-GAAP revenue the impact of amortized deferred revenue (from acquisitions, primarily Register.com LP and Network Solutions) recorded at fair value at the acquisition date, because we believe that excluding such measures helps management and investors better understand our revenue trends.

 

Non-GAAP Operating Income and Non-GAAP Operating Margin.   We exclude from non-GAAP operating income and non-GAAP operating margin amortization of intangibles, fair value adjustments to deferred revenue and deferred expense, restructuring charges, gains and losses from asset sales, corporate development expenses, and stock-based compensation charges.  We believe that excluding these items assist investors in evaluating period-over-period changes in our operating income and operating margin without the impact of items that are not a result of our day-to-day business and operations.

 

Non-GAAP Net Income and Non-GAAP Net Income per Basic Share and per Diluted Share.  We exclude from non-GAAP net income and non-GAAP net income per diluted share and per basic share amortization of intangibles, income tax expense, fair value adjustments to deferred revenue and deferred expense, restructuring charges, gains and losses from asset sales, corporate development expenses and stock-based compensation, amortization of deferred financing fees, gains/losses on operating assets and liabilities and include cash income tax expense, because we believe that excluding such measures helps management and investors better understand our operating activities.

  

Adjusted EBITDA. We exclude from Adjusted EBITDA depreciation expense, amortization of intangibles, fair value adjustment to deferred revenue and deferred expense, income tax, interest expense, interest income, stock-based compensation, gains and losses from asset sales, corporate development expenses, and restructuring charges, because we believe that adjusting for such items helps management and investors better understand operating activities.

 

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The following table presents our non-GAAP measures for the periods indicated (in thousands):

 

  Three Months Ended March 31,  
   2012   2011 
Reconciliation of GAAP revenue to non-GAAP revenue          
GAAP revenue  $91,514   $39,481 
Fair value adjustment to deferred revenue   27,823    5,619 
Non-GAAP revenue  $119,337   $45,100 
           
Reconciliation of GAAP net loss to non-GAAP net income          
           
GAAP net loss  $(29,779)  $(5,610)
Amortization of intangibles   17,692    3,937 
Loss (gain) on sale of assets   402    (2)
Stock based compensation   2,680    1,533 
Income tax (benefit) expense   (6,539)   573 
Restructuring charges   912    96 
Corporate development   334    13 
Amortization of deferred financing fees   3,323    308 
Cash income tax expense   (285)   (174)
Fair value adjustment to deferred revenue   27,823    5,619 
Fair value adjustment to deferred expense   676    93 
Non-GAAP net income  $17,239   $6,386 
           
Reconciliation of GAAP diluted net loss per share to non-GAAP net income per share          
Fully diluted shares:          
Common stock   46,140    26,618 
Diluted stock options   2,279    2,569 
Diluted restricted stock   1,096    1,011 
Total   49,515    30,198 
           
Diluted GAAP net loss per share  $(0.65)  $(0.21)
Diluted equity per share   0.04    0.02 
Amortization of intangibles per share   0.37    0.13 
Loss (gain) on sale of assets per share   0.01    - 
Stock based compensation per share   0.05    0.05 
Income tax (benefit) expense per share   (0.13)   0.02 
Restructuring charges per share   0.02    - 
Corporate development per share   0.01    - 
Amortization of deferred financing fees per share   0.07    0.01 
Cash income tax expense per share   (0.01)   (0.01)
Fair value adjustment to deferred revenue per share   0.56    0.20 
Fair value adjustment to deferred expense per share   0.01    - 
Diluted Non-GAAP net income per share  $0.35   $0.21 

 

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   Three Months Ended March 31, 
   2012   2011 
Reconciliation of GAAP operating loss to non-GAAP operating income          
           
GAAP operating loss  $(18,542)  $(3,578)
Amortization of intangibles   17,692    3,937 
Loss (gain) on sale or disposal of assets   402    (2)
Stock based compensation   2,680    1,533 
Restructuring charges   912    96 
Corporate development   334    13 
Fair value adjustment to deferred revenue   27,823    5,619 
Fair value adjustment to deferred expense   676    93 
Non-GAAP operating income  $31,977   $7,711 
           
Reconciliation of GAAP operating margin to non-GAAP operating margin          
GAAP operating margin   -20%   -9%
Amortization of intangibles   15%   9%
Loss on sale or disposal of assets   0%   0%
Restructuring charges   1%   0%
Corporate development   0%   0%
Fair value adjustment to deferred revenue   28%   14%
Fair value adjustment to deferred expense   1%   0%
Stock based compensation   2%   3%
Non-GAAP operating margin   27%   17%
           
Reconciliation of GAAP operating loss to adjusted EBITDA          
           
GAAP operating loss  $(18,542)  $(3,578)
Depreciation and amortization   19,679    4,821 
Loss (gain) on sale or disposal of assets   402    (2)
Stock based compensation   2,680    1,533 
Restructuring charges   912    96 
Corporate development   334    13 
Fair value adjustment to deferred revenue   27,823    5,619 
Fair value adjustment to deferred expense   676    93 
Adjusted EBITDA  $33,964   $8,595 
           
Stock based compensation          
Subscription (cost of revenue)  $305   $188 
Sales and marketing   616    283 
Research and development   481    210 
General and administration   1,278    852 
Total  $2,680   $1,533 

 

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Contractual Obligations and Commitments

 

We have no material changes to the Contractual Obligations table as presented in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations of our 2011 Annual Report on Form 10-K. See Note 19, Commitments and Contingencies, for additional information.

 

Off-Balance Sheet Arrangements

 

As of March 31, 2012 and December 31, 2011, 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.

 

Item 3.Quantitative and Qualitative Disclosures About Market Risk.

 

Interest Rate Sensitivity

 

We had unrestricted cash and cash equivalents totaling $12.3 million and $13.4 million at March 31, 2012 and December 31, 2011, respectively. These amounts were invested primarily in money market funds. The unrestricted cash, cash equivalents and short-term marketable securities are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of these investments, we do not anticipate that the interest rates will materially fluctuate therefore; we believe we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income.

 

As of March 31, 2012, we have $741.5 million of total debt outstanding. We have exposure to market risk for changes in interest rates related to these borrowings. Our variable rate debt is based on 1-month LIBOR plus 5.5 percent on the First lien agreement and 1-month LIBOR plus 9.5 percent on the Second lien arrangement, both of which are subject to a 1.5 percent LIBOR floor. Our revolving credit facility’s interest rate is 1-month LIBOR plus 5.5 percent. Since the First lien and Second lien arrangements are subject to a LIBOR floor of 1.5 percent, a 10 percent increase or decrease in LIBOR would not impact our interest expense on those loans during the first quarter ended March 31, 2012. A hypothetical 10 percent increase interest rates in effect would have resulted in additional interest expense of $0.3 million during the three months ended March 31, 2012.

 

Item 4.Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures.

 

Based on their evaluation as of March 31, 2012, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) were effective at the reasonable assurance level to ensure that the information required to be disclosed by us in this quarterly report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules, and that such information is accumulated and communicated to us to allow timely decisions regarding required disclosures.

 

Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected.

 

Changes in Internal Controls Over Financial Reporting.

 

There have been no changes in our internal controls over financial reporting during the three months ended March 31, 2012  that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

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PART II—OTHER INFORMATION

 

Item 1.  Legal Proceedings.

 

 The Company and its subsidiaries are named from time to time as defendants in various legal actions that are incidental to our business and arise out of or are related to claims made in connection with our customer and vendor contracts and employment related disputes. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations. There were no material legal matters that were reasonably possible and estimable at March 31, 2012.

 

Item 1A.   Risk Factors.

 

 In addition to the risks discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our business is subject to the risks set forth below.

   

The failure to integrate successfully the businesses of Web.com and Network Solutions in the expected timeframe would adversely affect the Combined Company’s future results.

 

The success of the acquisition will depend, in large part, on the ability of the Combined Company to realize the anticipated benefits, including annual net operating synergies, from combining the businesses of Web.com and Network Solutions. To realize these anticipated benefits, the Combined Company must successfully integrate the businesses of Web.com and Network Solutions. This integration will be complex and time consuming.

 

The failure to integrate successfully and to manage successfully the challenges presented by the integration process may result in the Combined Company’s failure to achieve some or all of the anticipated benefits of the acquisition.

 

Potential difficulties that may be encountered in the integration process include the following:

 

lost sales and customers as a result of customers of either of the two companies deciding not to do business with the combined company;

 

complexities associated with managing the larger, more complex, combined business;

 

integrating personnel from the two companies while maintaining focus on providing consistent, high quality services and products;

 

potential unknown liabilities and unforeseen expenses, delays or regulatory conditions associated with the Acquisition; and

 

performance shortfalls at one or both of the companies as a result of the diversion of management’s attention caused by completing the Acquisition and integrating the companies’ operations.

 

In the future, we may be unable to generate sufficient cash flow to satisfy our debt service obligations.

 

In October 2011, we entered into debt financing arrangements totaling $800 million, of which $771.0 million of proceeds were used to pay off existing debt and to complete the acquisition of Network Solutions. As of March 31, 2012, $741.5 million of the debt is currently outstanding. Our ability to generate cash flow from operations to make principal and interest payments on our debt will depend on our future performance, which will be affected by a range of economic, competitive and business factors. If our operations do not generate sufficient cash flow from operations to satisfy our debt service obligations, we may need to seek additional capital to make these payments or undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets or reducing or delaying capital investments and acquisitions. We cannot assure you that such additional capital or alternative financing will be available on favorable terms, if at all. Our inability to generate sufficient cash flow from operations or obtain additional capital or alternative financing on acceptable terms could have a material adverse effect on our business, financial condition and results of operations.

 

Charges to earnings resulting from acquisitions may adversely affect our operating results.

 

Under applicable accounting, we allocate the total purchase price of a particular acquisition to an acquired company’s net tangible assets, and intangible assets based on their fair values as of the date of the acquisition and record the excess of the purchase price over those fair values as goodwill. Our management’s estimates of fair value are based upon assumptions believed to be reasonable but are inherently uncertain. Going forward, the following factors, among others, could result in material charges that would adversely affect our financial results:

 

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impairment of goodwill;
charges for the amortization of identifiable intangible assets and for stock-based compensation;
accrual of newly identified pre-merger contingent liabilities that are identified subsequent to the finalization of the purchase price allocation; and
charges to income to eliminate certain of our pre-merger activities that duplicate those of the acquired company or to reduce our cost structure.

 

 Additional costs may include costs of employee redeployment, relocation and retention, including salary increases or bonuses, accelerated amortization of deferred equity compensation and severance payments, reorganization or closure of facilities, taxes and termination of contracts that provide redundant or conflicting services. Some of these costs may have to be accounted for as expenses that would decrease our net income and earnings per share for the periods in which those adjustments are made.

 

Our operating results are difficult to predict and fluctuations in our performance may result in volatility in the market price of our common stock.

 

Due to our limited operating history, our evolving business model, and the unpredictability of our emerging industry, our operating results are difficult to predict. We expect to experience fluctuations in our operating and financial results due to a number of factors, such as:

 

our ability to retain and increase sales to existing customers, attract new customers, and satisfy our customers’ requirements;

 

the renewal rates and renewal terms for our services;

 

changes in our pricing policies;

 

the introduction of new services and products by us or our competitors;

 

our ability to hire, train and retain members of our sales force;

 

the rate of expansion and effectiveness of our sales force;

 

technical difficulties or interruptions in our services;

 

general economic conditions;

 

additional investment in our services or operations;

 

ability to successfully identify acquisition targets and integrate acquired businesses and technologies; and

 

our success in maintaining and adding strategic marketing relationships.

 

These factors and others all tend to make the timing and amount of our revenue unpredictable and may lead to greater period-to-period fluctuations in revenue than we have experienced historically.

 

Additionally, in light of current global and U.S. economic conditions, we believe that our quarterly revenue and results of operations are likely to vary significantly in the future and that period-to-period comparisons of our operating results may not be meaningful. The results of one quarter may not be relied on as an indication of future performance. If our quarterly revenue or results of operations fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially.

 

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We rely heavily on the reliability, security, and performance of our internally developed systems and operations, and any difficulties in maintaining these systems may result in service interruptions, decreased customer service, or increased expenditures.

 

The software and workflow processes that underlie our ability to deliver our Web services and products have been developed primarily by our own employees. The reliability and continuous availability of these internal systems are critical to our business, and any interruptions that result in our inability to timely deliver our Web services or products, or that materially impact the efficiency or cost with which we provide these Web services and products, would harm our reputation, profitability, and ability to conduct business. In addition, many of the software systems we currently use will need to be enhanced over time or replaced with equivalent commercial products, either of which could entail considerable effort and expense. If we fail to develop and execute reliable policies, procedures, and tools to operate our infrastructure, we could face a substantial decrease in workflow efficiency and increased costs, as well as a decline in our revenue.

 

Our failure to build brand awareness quickly could compromise our ability to compete and to grow our business.

 

As a result of the anticipated increase in competition in our market, and the likelihood that some of this competition will come from companies with established brands, we believe brand name recognition and reputation will become increasingly important. If we do not continue to build brand awareness quickly, we could be placed at a competitive disadvantage to companies whose brands are more recognizable than ours.

 

If we cannot adapt to technological advances, our Web services and products may become obsolete and our ability to compete would be impaired.

 

Changes in our industry occur very rapidly, including changes in the way the internet operates or is used by SMBs and their customers. As a result, our Web services and products could become obsolete quickly. The introduction of competing products employing new technologies and the evolution of new industry standards could render our existing products or services obsolete and unmarketable. To be successful, our Web services and products must keep pace with technological developments and evolving industry standards, address the ever-changing and increasingly sophisticated needs of our customers, and achieve market acceptance. If we are unable to develop new Web services or products, or enhancements to our Web services or products, on a timely and cost-effective basis, or if new Web services or products or enhancements do not achieve market acceptance, our business would be seriously harmed.

 

Providing Web services and products to SMBs designed to allow them to internet-enable their businesses is a new and emerging market; if this market fails to develop, we will not be able to grow our business.

 

Our success depends on a significant number of SMB outsourcing website design, hosting, and management as well as adopting other online business solutions. The market for our Web services and products is relatively new and untested. Custom website development has been the predominant method of internet enablement, and SMBs may be slow to adopt our template-based Web services and products. Further, if SMBs determine that having an online presence is not giving their businesses an advantage; they would be less likely to purchase our Web services and products. If the market for our Web services and products fails to grow or grows more slowly than we currently anticipate, or if our Web services and products fail to achieve widespread customer acceptance, our business would be seriously harmed.

 

Integrating Web.com and Network Solutions may divert management’s attention away from the Combined Company’s operations.

 

Successful integration of Web.com’s and Network Solutions’ operations, products and personnel may place a significant burden on the Combined Company’s management and internal resources. Challenges of integration include the combined company’s ability to incorporate acquired products and business technology into its existing product offerings and its ability to sell the acquired products through Web.com’s existing or acquired sales channels. Web.com may also experience difficulty in effectively integrating the different cultures and practices of Network Solutions, as well as in assimilating Network Solutions’ broad and geographically dispersed personnel. Further, the difficulties of integrating Network Solutions could disrupt the Combined Company’s ongoing business, distract its management focus from other opportunities and challenges, and increase the Combined Company’s expenses and working capital requirements. The diversion of management attention and any difficulties encountered in the transition and integration process could harm the Combined Company’s business, financial condition and operating results.

 

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Depressed general economic conditions or adverse changes in general economic conditions could adversely affect our operating results. If economic or other factors negatively affect the SMB sector, our customers may become unwilling or unable to purchase our Web services and products, which could cause our revenue to decline and impair our ability to operate profitably.

 

We have become increasingly subject to the risks arising from adverse changes in domestic and global economic conditions. Uncertainty about future economic conditions makes it difficult for us to forecast operating results and to make decisions about future investments. For example, the direction and relative strength of the global economy has been increasingly uncertain due to softness in the residential real estate and mortgage markets, volatility in fuel and other energy costs, difficulties in the financial services sector and credit markets, continuing geopolitical uncertainties and other macroeconomic factors affecting spending behavior. If economic growth in the United States is slowed, or if other adverse general economic changes occur or continue, many customers may delay or reduce technology purchases or marketing spending. This could result in reductions in sales of our Web services and products, longer sales cycles, and increased price competition.

 

Our existing and target customers are SMBs. We believe these businesses are more likely to be significantly affected by economic downturns than larger, more established businesses. For instance, the current global financial crisis affecting the banking system and financial markets and the possibility that financial institutions may consolidate or go out of business have resulted in a tightening in the credit markets, which could limit our customers’ access to credit. Additionally, these customers often have limited discretionary funds, which they may choose to spend on items other than our Web services and products. If SMBs experience economic hardship, or if they behave more conservatively in light of the general economic environment, they may be unwilling or unable to expend resources to develop their online presences, which would negatively affect the overall demand for our services and products and could cause our revenue to decline.

 

We may find it difficult to integrate recent and potential future business combinations, which could disrupt our business, dilute stockholder value, and adversely affect our operating results.

 

During the course of our history, we have completed several acquisitions of other businesses, and a key element of our strategy is to continue to acquire other businesses in the future. Most recently, we completed the acquisition of Network Solutions in October 2011, our largest acquisition to date. Integrating acquired businesses or assets we may acquire in the future, could add significant complexity to our business and additional burdens to the substantial tasks already performed by our management team. In the future, we may not be able to identify suitable acquisition candidates, and if we do, we may not be able to complete these acquisitions on acceptable terms or at all. In connection with our recent and possible future acquisitions, we may need to integrate operations that have different and unfamiliar corporate cultures. Likewise, we may need to integrate disparate technologies and Web service and product offerings, as well as multiple direct and indirect sales channels. The key personnel of the acquired company may decide not to continue to work for us. These integration efforts may not succeed or may distract our management’s attention from existing business operations. Our failure to successfully identify appropriate acquisition targets or to manage and integrate recent acquisitions, or any future acquisitions, could seriously harm our business.

 

We may not realize the anticipated benefits from an acquisition.

 

Acquisitions involve the integration of companies that have previously operated independently. We expect that acquisitions may result in financial and operational benefits, including increased revenue, cost savings and other financial and operating benefits. We cannot be certain, however, that we will be able to realize increased revenue, cost savings or other benefits from any acquisition, or, to the extent such benefits are realized, that they are realized timely or to the same degree as we anticipated. Integration may also be difficult, unpredictable, and subject to delay because of possible cultural conflicts and different opinions on product roadmaps or other strategic matters. We may integrate or, in some cases, replace, numerous systems, including those involving management information, purchasing, accounting and finance, sales, billing, employee benefits, payroll and regulatory compliance, many of which may be dissimilar. Difficulties associated with integrating an acquisition’s service and product offering into ours, or with integrating an acquisition’s operations into ours, could have a material adverse effect on the Combined Company and the market price of our common stock.

  

We may expand through acquisitions of, or investments in, other companies or technologies, which may result in additional dilution to our stockholders and consume resources that may be necessary to sustain our business.

 

One of our business strategies is to acquire complementary services, technologies or businesses. In connection with one or more of those transactions, we may:

 

issue additional equity securities that would dilute our stockholders;

 

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use cash that we may need in the future to operate our business; and

 

incur debt that could have terms unfavorable to us or that we might be unable to repay.

 

Business acquisitions also involve the risk of unknown liabilities associated with the acquired business. In addition, we may not realize the anticipated benefits of any acquisition, including securing the services of key employees. Incurring unknown liabilities or the failure to realize the anticipated benefits of an acquisition could seriously harm our business.

 

A portion of our Web services are sold on a month-to-month basis, and if our customers are unable or choose not to subscribe to our Web services, our revenue may decrease.

 

A portion of our Web service offerings are sold pursuant to month-to-month subscription agreements and our customers generally can cancel their subscriptions to our Web services at any time with little or no penalty.

 

While we cannot determine with certainty why our subscription renewal rates are not higher, we believe there are a variety of factors, which have in the past led, and may in the future lead, to a decline in our subscription renewal rates. These factors include the cessation of our customers’ businesses, the overall economic environment in the United States and its impact on SMBs, the services and prices offered by us and our competitors, and the evolving use of the internet by SMBs. If our renewal rates are low or decline for any reason, or if customers demand renewal terms less favorable to us, our revenue may decrease, which could adversely affect our financial performance.

 

Any growth could strain our resources and our business may suffer if we fail to implement appropriate controls and procedures to manage our growth.

 

Growth in our business may place a strain on our management, administrative, and sales and marketing infrastructure. If we fail to successfully manage our growth, our business could be disrupted, and our ability to operate our business profitably could suffer. Growth in our employee base may be required to expand our customer base and to continue to develop and enhance our Web service and product offerings. To manage growth of our operations and personnel, we would need to enhance our operational, financial, and management controls and our reporting systems and procedures. This would require additional personnel and capital investments, which would increase our cost base. The growth in our fixed cost base may make it more difficult for us to reduce expenses in the short term to offset any shortfalls in revenue.

 

We have a risk of system and internet failures, which could harm our reputation, cause our customers to seek reimbursement for services paid for and not received, and cause our customers to seek another provider for services.

 

We must be able to operate the systems that manage our network around the clock without interruption. Our operations depend upon our ability to protect our network infrastructure, equipment, and customer files against damage from human error, fire, earthquakes, hurricanes, floods, power loss, telecommunications failures, sabotage, intentional acts of vandalism and similar events. Our networks are currently subject to various points of failure. For example, a problem with one of our routers (devices that move information from one computer network to another) or switches could cause an interruption in the services that we provide to some or all of our customers. In the past, we have experienced periodic interruptions in service. We have also experienced, and in the future we may again experience, delays or interruptions in service as a result of the accidental or intentional actions of internet users, current and former employees, or others. Any future interruptions could:

  

·Cause customers or end users to seek damages for losses incurred;

 

·Require us to replace existing equipment or add redundant facilities;

 

·Damage our reputation for reliable service;

 

·Cause existing customers to cancel their contracts; or

 

·Make it more difficult for us to attract new customers.

 

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We are dependent on our executive officers, and the loss of any key member of this team may compromise our ability to successfully manage our business and pursue our growth strategy.

 

Our future performance depends largely on the continuing service of our executive officers and senior management team, especially those of David Brown, our Chief Executive Officer. Our executives are not contractually obligated to remain employed by us. Accordingly, any of our key employees could terminate their employment with us at any time without penalty and may go to work for one or more of our competitors after the expiration of their non-compete period. The loss of one or more of our executive officers could make it more difficult for us to pursue our business goals and could seriously harm our business.

 

Our growth will be adversely affected if we cannot continue to successfully retain, hire, train, and manage our key employees, particularly in the telesales and customer service areas.

 

Our ability to successfully pursue our growth strategy will depend on our ability to attract, retain, and motivate key employees across our business. We have many key employees throughout our organization that do not have non-competition agreements and may leave to work for a competitor at any time. In particular, we are substantially dependent on our telesales and customer service employees to obtain and service new customers. Competition for such personnel and others can be intense, and there can be no assurance that we will be able to attract, integrate, or retain additional highly qualified personnel in the future. In addition, our ability to achieve significant growth in revenue will depend, in large part, on our success in effectively training sufficient personnel in these two areas. New hires require significant training and in some cases may take several months before they achieve full productivity, if they ever do. Our recent hires and planned hires may not become as productive as we would like, and we may be unable to hire sufficient numbers of qualified individuals in the future in the markets where we have our facilities. If we are not successful in retaining our existing employees, or hiring, training and integrating new employees, or if our current or future employees perform poorly, growth in the sales of our services and products may not materialize and our business will suffer.

 

Though we were profitable for the year ended December 31, 2009, we were not profitable for the three months ended March 31, 2012 or for the years ended December 31, 2011, 2010 and 2008 and we may not become or stay profitable in the future.

 

Although we generated net income for the year ended December 31, 2009, we have not historically been profitable, were not profitable for the three months ended March 31, 2012 or for the years ended December 31, 2011, 2010 and 2008, and may not be profitable in future periods. As of March 31, 2012, we had an accumulated deficit of approximately $200.0 million. We expect that our expenses relating to the sale and marketing of our Web services, technology improvements and general and administrative functions, as well as the costs of operating and maintaining our technology infrastructure, will increase in the future. Accordingly, we will need to increase our revenue to be able to again achieve and, if achieved, to later maintain profitability. We may not be able to reduce in a timely manner or maintain our expenses in response to any decrease in our revenue, and our failure to do so would adversely affect our operating results and our level of profitability.

 

Our business depends in part on our ability to continue to provide value-added Web services and products, many of which we provide through agreements with third parties, and our business will be harmed if we are unable to provide these Web services and products in a cost-effective manner.

 

A key element of our strategy is to combine a variety of functionalities in our Web service offerings to provide our customers with comprehensive solutions to their online presence needs, such as internet search optimization, local yellow pages listings, and eCommerce capability. We provide many of these services through arrangements with third parties, and our continued ability to obtain and provide these services at a low cost is central to the success of our business. For example, we currently have agreements with several service providers that enable us to provide, at a low cost, internet yellow pages advertising. However, these agreements may be terminated on short notice, typically 60 to 90 days, and without penalty. If any of these third parties were to terminate their relationships with us, or to modify the economic terms of these arrangements, we could lose our ability to provide these services at a cost-effective price to our customers, which could cause our revenue to decline or our costs to increase.

 

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Our data centers are maintained by third parties. A disruption in the ability of one of these service providers to provide service to us could cause a disruption in service to our customers.

 

A substantial portion of the network services and computer servers we utilize in the provision of services to customers are housed in data centers owned by other service providers. In particular, a significant number of our servers are housed in data centers in Atlanta, Georgia; Jacksonville, Florida; Sterling, Virginia; and Ontario, Canada. We obtain internet connectivity for those servers, and for the customers who rely on those servers, in part through direct arrangements with network service providers and in part indirectly through the owners of those data centers. We also utilize other third-party data centers in other locations. In the future, we may house other servers and hardware items in facilities owned or operated by other service providers.

 

A disruption in the ability of one of these service providers to provide service to us could cause a disruption in service to our customers. A service provider could be disrupted in its operations through a number of contingencies, including unauthorized access, computer viruses, accidental or intentional actions, electrical disruptions, and other extreme conditions. Although we believe we have taken adequate steps to protect our business through contractual arrangements with our service providers, we cannot eliminate the risk of a disruption in service resulting from the accidental or intentional disruption in service by a service provider. Any significant disruption could cause significant harm to us, including a significant loss of customers. In addition, a service provider could raise its prices or otherwise change its terms and conditions in a way that adversely affects our ability to support our customers or could result in a decrease in our financial performance.

 

We face intense and growing competition. If we are unable to compete successfully, our business will be seriously harmed.

 

The market for our Web services and products is competitive and has relatively low barriers to entry. Our competitors vary in size and in the variety of services they offer. We encounter competition from a wide variety of company types, including:

 

Website design and development service and software companies;

 

Internet service providers and application service providers;

 

Internet search engine providers;

 

Local business directory providers;

 

Website domain name providers and hosting companies; and

 

eCommerce platform and service providers.

 

In addition, due to relatively low barriers to entry in our industry, we expect the intensity of competition to increase in the future from other established and emerging companies. Increased competition may result in price reductions, reduced gross margins, and loss of market share, any one of which could seriously harm our business. We also expect that competition will increase as a result of industry consolidations and formations of alliances among industry participants.

 

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, greater brand recognition and, we believe, a larger installed base of customers. These competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their services and products than we can. If we fail to compete successfully against current or future competitors, our revenue could increase less than anticipated or decline and our business could be harmed.

 

If our security measures are breached, our services may be perceived as not being secure, and our business and reputation could suffer.

 

Our Web services involve the storage and transmission of our customers’ proprietary information. Although we employ data encryption processes, an intrusion detection system, and other internal control procedures to assure the security of our customers’ data, we cannot guarantee that these measures will be sufficient for this purpose. If our security measures are breached as a result of third-party action, employee error or otherwise, and as a result our customers’ data becomes available to unauthorized parties, we could incur liability and our reputation would be damaged, which could lead to the loss of current and potential customers. If we experience any breaches of our network security or sabotage, we might be required to expend significant capital and other resources to remedy, protect against or alleviate these and related problems, and we may not be able to remedy these problems in a timely manner, or at all. Because techniques used by outsiders to obtain unauthorized network access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or implement adequate preventative measures.

 

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We may be unable to protect our intellectual property adequately or cost-effectively, which may cause us to lose market share or force us to reduce our prices.

 

Our success depends, in part, on our ability to protect and preserve the proprietary aspects of our technology, Web services, and products. If we are unable to protect our intellectual property, our competitors could use our intellectual property to market services and products similar to those offered by us, which could decrease demand for our Web services and products. We may be unable to prevent third parties from using our proprietary assets without our authorization. While we do rely on patents acquired from the Web.com acquisition, we do not currently rely on patents to protect all of our core intellectual property. To protect, control access to, and limit distribution of our intellectual property, we generally enter into confidentiality and proprietary inventions agreements with our employees, and confidentiality or license agreements with consultants, third-party developers, and customers. We also rely on copyright, trademark, and trade secret protection. However, these measures afford only limited protection and may be inadequate. Enforcing our rights to our technology could be costly, time-consuming and distracting. Additionally, others may develop non-infringing technologies that are similar or superior to ours. Any significant failure or inability to adequately protect our proprietary assets will harm our business and reduce our ability to compete.

 

If we fail to maintain an effective system of internal controls, we may not be able to accurately or timely report our financial results, which could cause our stock price to fall or result in our stock being delisted.

 

Effective internal controls are necessary for us to provide reliable and accurate financial reports. We will need to devote significant resources and time to comply with the requirements of Sarbanes-Oxley with respect to internal control over financial reporting. In addition, Section 404 under Sarbanes-Oxley requires that we assess and our auditors attest to the design and operating effectiveness of our controls over financial reporting. Our ability to comply with the annual internal control report requirement for our fiscal year ending on December 31, 2012 will depend on the effectiveness of our financial reporting and data systems and controls across our company and our operating subsidiaries. We expect these systems and controls to become increasingly complex to the extent that we integrate acquisitions and our business grows. To effectively manage this complexity, we will need to continue to improve our operational, financial, and management controls and our reporting systems and procedures. Any failure to implement required new or improved controls, or difficulties encountered in the implementation or operation of these controls, could harm our operating results or cause us to fail to meet our financial reporting obligations, which could adversely affect our business and jeopardize our listing on the NASDAQ Global Select Market, either of which would harm our stock price.

 

 We might require additional capital to support business growth, and this capital might not be available on acceptable terms, or at all.

 

We intend to continue to make investments to support our business growth and may require additional funds to respond to business challenges, including the need to develop new services and products or enhance our existing Web services, enhance our operating infrastructure and acquire complementary businesses and technologies. Accordingly, we may need to engage in equity or debt financings to secure additional funds. For example, as a result of the acquisition of the Network Solutions, we have entered into debt arrangements for a total of $800 million. Financial market disruption and general economic conditions in which the credit markets are severely constrained and the depressed equity markets may make it difficult for us to obtain additional financing on terms favorable to us, if at all. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we are unable to obtain adequate financing or financing on terms satisfactory to us, when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly impaired.

 

39
 

 

Provisions in our amended and restated certificate of incorporation and bylaws or under Delaware law might discourage, delay, or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.

 

Our amended and restated certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay, or prevent a change of control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:

 

establish a classified board of directors so that not all members of our board are elected at one time;

 

provide that directors may only be removed for cause and only with the approval of 66 2/3% of our stockholders;

 

require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and bylaws;

 

authorize the issuance of blank check preferred stock that our board of directors could issue to increase the number of outstanding shares to discourage a takeover attempt;

 

prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;

 

provide that the board of directors is expressly authorized to make, alter, or repeal our bylaws; and

 

establish advance notice requirements for nominations for elections to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings.

 

Additionally, we are subject to Section 203 of the Delaware General Corporation Law, which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with any “interested” stockholder for a period of three years following the date on which the stockholder became an “interested” stockholder and which may discourage, delay, or prevent a change of control of our company.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

 

Issuer Purchases of Equity Securities

None.

 

Item 3.Defaults Upon Senior Securities.

Not applicable.

 

Item 4.Mine Safety Disclosures.

Not applicable.

 

Item 5.Other Information.

Not applicable.

 

Item 6.Exhibits.

 

Exhibit No.   Description of Document
     
3.1   Amended and Restated Certificate of Incorporation of Web.com Group, Inc. (1)
     
3.2   Amended and Restated Bylaws of Web.com Group, Inc. (2)
     
3.3   Certificate of Ownership and Merger of Registration (3)
     
4.1   Reference is made to Exhibits 3.1 and 3.2
     
4.2   Specimen Stock Certificate. (3)
     
31.1   CEO Certification required by Rule 13a-14(a) or Rule 15d-14(a).
     
31.2   CFO Certification required by Rule 13a-14(a) or Rule 15d-14(a).
     
32.1   Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350). (4)
     
101.1   XBRL Instance Document.*
     
101.2   XBRL Taxonomy Extension Schema Document.*
     
101.3   XBRL Taxonomy Extension Calculation Linkbase Document.*
     
101.4   XBRL Taxonomy Extension Definition Linkbase Document.*
     
101.5   XBRL Taxonomy Extension Label Linkbase Document.*

 + Indicates management contract or compensatory plan.

 

 (1) Filed as an Exhibit to the Company’s registration statement on Form S-1 (No. 333-124349), filed with the SEC on April 27, 2005, as amended, and incorporated herein by reference.
(2) Filed as an Exhibit to the Company’s current report on Form 8-K (000-51595), filed with the SEC on February 10, 2009, and incorporated herein by reference.
(3) Filed as an Exhibit to the Company’s current report on Form 8-K (000-51595), filed with the SEC on October 30, 2008, and incorporated herein by reference.

 

(4) The certification attached as Exhibit 32.1 accompanying this Quarterly Report on Form 10-Q, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Web.com Group, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.

 

*The XBRL information is being furnished with this Form 10-Q, not filed.

 

40
 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    Web.com Group, Inc.
    (Registrant)
     
    /s/ Kevin M. Carney
May 7, 2012    
Date  

Kevin M. Carney

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

41
 

 

INDEX OF EXHIBITS

 

Exhibit No.   Description of Document
     
3.1   Amended and Restated Certificate of Incorporation of Web.com Group, Inc. (1)
     
3.2   Amended and Restated Bylaws of Web.com Group, Inc. (2)
     
3.3   Certificate of Ownership and Merger of Registration (3)
     
4.1   Reference is made to Exhibits 3.1 and 3.2
     
4.2   Specimen Stock Certificate. (3)
     
31.1   CEO Certification required by Rule 13a-14(a) or Rule 15d-14(a).
     
31.2   CFO Certification required by Rule 13a-14(a) or Rule 15d-14(a).
     
32.1   Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350). (4)
101.1   XBRL Instance Document.*
     
101.2   XBRL Taxonomy Extension Schema Document.*
     
101.3   XBRL Taxonomy Extension Calculation Linkbase Document.*
     
101.4   XBRL Taxonomy Extension Definition Linkbase Document.*
     
101.5   XBRL Taxonomy Extension Label Linkbase Document.*

 

(1) Filed as an Exhibit to the Company’s registration statement on Form S-1 (No. 333-124349), filed with the SEC on April 27, 2005, as amended, and incorporated herein by reference.
(2) Filed as an Exhibit to the Company’s current report on Form 8-K (000-51595), filed with the SEC on February 10, 2009, and incorporated herein by reference.
(3) Filed as an Exhibit to the Company’s current report on Form 8-K (000-51595), filed with the SEC on October 30, 2008, and incorporated herein by reference.

 

(4) The certification attached as Exhibit 32.1 accompanying this Quarterly Report on Form 10-Q, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Web.com Group, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.

 

*The XBRL information is being furnished with this Form 10-Q, not filed.

 

42

XNAS:WWWW Web.com Group Inc Quarterly Report 10-Q Filling

Web.com Group Inc XNAS:WWWW Stock - Get Quarterly Report SEC Filing of Web.com Group Inc XNAS:WWWW stocks, including company profile, shares outstanding, strategy, business segments, operations, officers, consolidated financial statements, financial notes and ownership information.

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