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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2012
For the transition period from to
Commission file number 001-35048
DEMAND MEDIA, INC.
(Exact name of registrant as specified in its charter)
(Registrant’s telephone number, including area code)
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. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company’ in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes o No x
As of August 9, 2012, there were 85,043,856 shares of the registrant’s common stock, $0.0001 par value, outstanding.
DEMAND MEDIA, INC.
INDEX TO FORM 10-Q
Part I. FINANCIAL INFORMATION
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Demand Media, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except per share amounts)
The accompanying notes are an integral part of these condensed consolidated financial statements.
Demand Media, Inc. and Subsidiaries
Consolidated Statements of Operations
(In thousands, except per share amounts)
The accompanying notes are an integral part of these condensed consolidated financial statements.
Demand Media, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
(In thousands, except per share amounts)
The accompanying notes are an integral part of these condensed consolidated financial statements.
Demand Media, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
The accompanying notes are an integral part of these condensed consolidated financial statements.
Demand Media, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these condensed consolidated financial statements.
Demand Media, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
(In thousands, except per share amounts)
Demand Media, Inc., together with its consolidated subsidiaries (the “Company”) is a Delaware corporation headquartered in Santa Monica, California. The Company’s business is focused on an Internet-based model for the professional creation of content at scale, and is comprised of two distinct and complementary service offerings, Content & Media and Registrar.
Content & Media
The Company’s Content & Media service offering is engaged in creating long-lived media content, primarily consisting of text articles and videos, and delivering it along with social media and monetization tools to the Company’s owned and operated websites and network of customer websites. Content & Media services are delivered through the Company’s Content & Media platform, which includes its content creation studio, social media applications and a system of monetization tools designed to match content with advertisements in a manner that is optimized for revenue yield and end-user experience.
The Company’s Registrar service offering provides domain name registration and related value added service subscriptions to third parties through its wholly owned subsidiary, eNom.
Initial Public Offering
In January 2011, the Company completed its initial public offering whereby it received proceeds, net of underwriters discounts but before deducting offering expenses, of $81,817 from the issuance of 5,175 shares of common stock. As a result of the initial public offering, all shares of the Company’s convertible preferred stock converted into 61,672 shares of common stock and warrants to purchase common stock or convertible preferred stock net exercised into 477 shares of common stock.
In October 2010, the Company’s stockholders approved a 1-for-2 reverse stock split of its outstanding common stock, and a proportional adjustment to the existing conversion ratios for each series of preferred stock which was effected in January 2011. Accordingly, all common stock share and per share amounts for all periods presented in these consolidated financial statements and notes thereto, have been adjusted retrospectively, where applicable, to reflect this reverse split and adjustment of the preferred stock conversion ratio.
A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows.
Basis of Preparation
The accompanying interim consolidated balance sheet as of June 30, 2012, the consolidated statements of operations and statements of comprehensive income for the three and six month periods ended June 30, 2011 and 2012, the consolidated statements of cash flows for the six month periods ended June 30, 2011 and 2012 and the consolidated statement of stockholders’ equity (deficit) for the six month period ended June 30, 2012 are unaudited.
In the opinion of the Company’s management, the unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair statement of the Company’s statement of financial position as of June 30, 2012 and its results of operations for the three and six month periods ended June 30, 2011 and 2012 and its cash flows for the six month periods ended June 30, 2011 and 2012. The results for the three and six month periods ended June 30, 2012 are not necessarily indicative of the results expected for the full year. The consolidated balance sheet as of December 31, 2011 has been derived
from the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
The interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”), for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. They do not include all of the information and footnotes required by GAAP for complete financial statements. Therefore, these financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC.
Principles of Consolidation
The consolidated financial statements include the accounts of Demand Media, Inc. and its wholly owned subsidiaries. Acquisitions are included in the Company’s consolidated financial statements from the date of the acquisition. The Company’s purchase accounting resulted in all assets and liabilities of acquired businesses being recorded at their estimated fair values on the acquisition dates. All significant intercompany transactions and balances have been eliminated in consolidation.
Investments in affiliates over which the Company has the ability to exert significant influence, but does not control and is not the primary beneficiary of, including NameJet, LLC (“NameJet”), are accounted for using the equity method of accounting. Investments in affiliates which the Company has no ability to exert significant influence are accounted for using the cost method of accounting. The Company’s proportional shares of affiliate earnings or losses accounted for under the equity method of accounting, which are not material for all periods presented, are included in other income (expense) in the Company’s consolidated statements of operations. Affiliated companies are not material individually or in the aggregate to the Company’s financial position, results of operations or cash flows for any period presented.
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant items subject to such estimates and assumptions include revenue, allowance for doubtful accounts, investments in equity interests, fair value of issued and acquired stock warrants, the assigned value of acquired assets and assumed liabilities in business combinations, useful lives and impairment of property and equipment, intangible assets, goodwill and other assets, the fair value of the Company’s equity-based compensation awards, and deferred income tax assets and liabilities. Actual results could differ materially from those estimates. On an ongoing basis, the Company evaluates its estimates compared to historical experience and trends, which form the basis for making judgments about the carrying value of assets and liabilities.
The Company recognizes revenue when four basic criteria are met: persuasive evidence of a sales arrangement exists; performance of services has occurred; the sales price is fixed or determinable; and collectability is reasonably assured. The Company considers persuasive evidence of a sales arrangement to be the receipt of a signed contract or insertion order. Collectability is assessed based on a number of factors, including transaction history with the customer and the credit worthiness of the customer. If it is determined that the collection is not reasonably assured, revenue is not recognized until collection becomes reasonably assured, which is generally upon receipt of cash. The Company records cash received in advance of revenue recognition as deferred revenue.
For arrangements with multiple deliverables, the Company allocates revenue to each deliverable if the delivered item(s) has value to the customer on a standalone basis and, if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company. The fair value of the selling price for a deliverable is determined using a hierarchy of (1) Company specific objective and reliable evidence, then (2) third-party evidence, then (3) best estimate of selling price. The Company allocates any arrangement fee to each of the elements based on their relative selling prices.
The Company’s revenue is principally derived from the following services:
Content & Media
Advertising Revenue. Advertising revenue is generated by performance-based Internet advertising, such as cost-per-click, or CPC, in which an advertiser pays only when a user clicks on its advertisement that is displayed on the Company’s owned and operated websites and customer websites; fees generated by users viewing third-party website banners and text-link advertisements; fees generated by enabling customer leads or registrations for partners; and fees from referring users to, or from users making purchases on, sponsors’ websites. In determining whether an arrangement exists, the Company ensures that a binding arrangement is in place, such as a standard insertion order or a fully executed customer-specific agreement. Obligations pursuant to the Company’s advertising revenue arrangements typically include a minimum number of impressions or the satisfaction of the other performance criteria. Revenue from performance-based arrangements, including referral revenue, is recognized as the related performance criteria are met. The Company assesses whether performance criteria have been met and whether the fees are fixed or determinable based on a reconciliation of the performance criteria and an analysis of the payment terms associated with the transaction. The reconciliation of the performance criteria generally includes a comparison of third-party performance data to the contractual performance obligation and to internal or customer performance data in circumstances where that data is available.
When the Company enters into advertising revenue sharing arrangements where it acts as the primary obligor, the Company recognizes the underlying revenue on a gross basis. In determining whether to report revenue gross for the amount of fees received from the advertising networks, the Company assesses whether it maintains the principal relationship with the advertising network, whether it bears the credit risk and whether it has latitude in establishing prices. In circumstances where the customer acts as the primary obligor, the Company recognizes the underlying revenue on a net basis.
In certain cases, the Company records revenue based on available and preliminary information from third parties. Amounts collected on the related receivables may vary from reported information based upon third party refinement of estimated and reported amounts owing that occurs typically within 30 days of the period end. For the three and six months ended June 30, 2011 and 2012, the difference between the amounts recognized based on preliminary information and cash collected was not material.
Content Revenue. Content revenue is generated through the sale or license of media content. Revenue from the sale or perpetual license of content is recognized when the content has been delivered and the contractual performance obligations has been fulfilled. Revenue from the license of content is recognized over the period of the license as content is delivered or when other related performance criteria are fulfilled.
Subscription Services and Social Media Services. Subscription services revenue is generated through the sale of membership fees paid to access content available on certain owned and operated websites. The majority of the memberships range from 6 to 12 month terms, and renew automatically at the end of the membership term, if not previously canceled. Subscription services revenue is recognized on a straight-line basis over the membership term.
The Company configures, hosts, and maintains its platform social media services under private-labeled versions of software for commercial customers. The Company earns revenue from its social media services through initial set-up fees, recurring management support fees, overage fees in excess of standard usage terms, and outside consulting fees. Due to the fact that social media services customers have no contractual right to take possession of the Company’s private labeled software, the Company accounts for its social media services revenue as service arrangements, whereby social media services revenue is recognized when persuasive evidence of an arrangement exists, delivery of the service has occurred and no significant obligations remain, the selling price is fixed or determinable, and collectability is reasonably assured.
Social media service arrangements may contain multiple deliverables, including, but not limited to, single arrangements containing set-up fees, monthly support fees and overage billings, consulting services and advertising services. To the extent that consulting services have value on a standalone basis, the Company allocates revenue to each element in the multiple deliverable arrangement based upon their relative fair values. Fair value is determined based upon the best estimate of the selling price. To date, substantially all consulting services entered into concurrent with the original social media service arrangements are not treated as separate deliverables as such services do not have value to the customer on a standalone basis. In such cases, the arrangement is treated as a single unit of accounting with the arrangement fee recognized over the term of the arrangement on a straight-line basis. Set-up fees are recognized as revenue on a straight-line basis over the greater of the contractual or estimated customer life once monthly recurring services have commenced. The Company determines the estimated customer life based on analysis of historical attrition rates, average contractual term and renewal expectations. The Company periodically reviews the estimated customer life at least quarterly and when events or changes in circumstances, such as significant customer attrition relative to expected historical of projected future results, occur. Overage billings are recognized when delivered and at contractual rates in excess of standard usage terms.
Outside consulting services performed for customers that have value on a stand-alone basis are recognized as services are
Domain Name Registration Service Fees. Registration fees charged to third parties in connection with new, renewed, and transferred domain name registrations are recognized on a straight-line basis over the registration term, which customarily range from one to two years but can extend to ten years. Payments received in advance of the domain name registration term are included in deferred revenue in the accompanying consolidated balance sheets. The registration term and related revenue recognition commences once the Company confirms that the requested domain name has been recorded in the appropriate registry under contractual performance standards. Associated direct and incremental costs, which principally consist of registry and Internet Corporation for Assigned Names and Numbers ("ICANN") fees, are also deferred and amortized to service costs on a straight-line basis over the registration term.
The Company’s wholly owned subsidiary, eNom, is an ICANN accredited registrar. Thus, the Company is the primary obligor with its reseller and retail registrant customers and is responsible for the fulfillment of its registrar services. As a result, the Company reports revenue derived from the fees it receives from resellers and retail registrant customers for registrations on a gross basis in the accompanying consolidated statements of operations. A minority of the Company’s resellers have contracted with the Company to provide billing and credit card processing services to the resellers’ retail customer base in addition to domain name registration services. Under these circumstances, the cash collected from these resellers’ retail customer base is in excess of the fixed amount per transaction that the Company charges for domain name registration services. As such, these amounts, which are collected for the benefit of the reseller, are not recognized as revenue and are recorded as a liability until remitted to the reseller on a periodic basis. Revenue from these resellers is reported on a net basis because the reseller determines the price to charge retail customers and maintains the primary customer relationship.
Value Added Services. Revenue from online value added services, which includes, but is not limited to, web hosting services, email services, domain name identification protection, charges associated with alternative payment methods, and security certificates, is recognized on a straight-line basis over the period in which services are provided. Payments received in advance of services being provided are included in deferred revenue.
Auction Service Revenue. Domain name auction service revenue represents fees received from selling third-party owned domains via an online bidding process primarily through NameJet, a domain name aftermarket auction company formed in October 2007 by the Company and an unrelated third party. For names sold through the auction process that are registered on the Company’s registrar platform upon sale, the Company has determined that auction revenue and related registration revenue represent separate units of accounting given the domain name has value to the customers on a standalone basis. As a result, the Company recognizes the related registration fees on a straight-line basis over the registration term. The Company recognizes the bidding portion of auction revenue upon sale, net of payments to third parties since it is acting as an agent only.
Service costs consist primarily of fees paid to registries and ICANN associated with domain registrations, advertising revenue recognized by the Company and shared with its customers or partners as a result of its revenue-sharing arrangements, such as traffic acquisition costs and content revenue-sharing arrangements, Internet connection and co-location charges and other platform operating expenses associated with the Company’s owned and operated and customer websites, including depreciation of the systems and hardware used to build and operate the Company’s Content & Media platform and Registrar, personnel costs relating to in-house editorial, customer service, information technology and certain content production costs such as our multi-channel video deal with Youtube.
Registry fee expenses consist of payments to entities accredited by ICANN as the designated registry related to each top level domain (“TLD”). These payments are generally fixed dollar amounts per domain name registration period and are recognized on a straight-line basis over the registration term. The costs of renewal registration fee expenses for owned and operated undeveloped websites are also included in service costs. Amortization of the cost of website names and media content owned by the Company is included in amortization of intangible assets.
Deferred Revenue and Deferred Registration Costs
Deferred revenue consists substantially of amounts received from customers in advance of the Company’s performance for domain name registration services, subscription services for premium media content, social media services and online value added services. Deferred revenue is recognized as revenue on a systematic basis that is proportionate to the unexpired term of the related domain name registration, media subscription as services are rendered, over customer useful life, or online value
added service period.
Deferred registration costs represent incremental direct cost paid in advance to registries, ICANN, and other third parties for domain name registrations and are recorded as a deferred cost on the balance sheets. Deferred registration costs are amortized to expense on a straight-line basis concurrently with the recognition of the related domain name registration revenue and are included in service costs.
The Company evaluates the recoverability of its long-lived assets with finite useful lives for impairment when events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Such trigger events or changes in circumstances may include: a significant decrease in the market price of a long-lived asset, a significant adverse change in the extent or manner in which a long-lived asset is being used, significant adverse change in legal factors or in the business climate, including those resulting from technology advancements in the industry, the impact of competition or other factors that could affect the value of a long-lived asset, a significant adverse deterioration in the amount of revenue or cash flows we expect to generate from an asset group, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or development of a long-lived asset, current or future operating or cash flow losses that demonstrate continuing losses associated with the use of a long-lived asset, or a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The Company performs impairment testing at the asset group level that represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable and the expected undiscounted future cash flows attributable to the asset group are less than the carrying amount of the asset group, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. Fair value is determined based upon estimated discounted future cash flows. Through June 30, 2012, the Company has identified no such impairment loss. Assets to be disposed of would be separately presented on the balance sheets and reported at the lower of their carrying amount or fair value less costs to sell, and would no longer be depreciated or amortized.
Google, the largest provider of search engine referrals to the majority of the Company's websites, regularly deploys changes to its search engine algorithms, some of which have led the Company to experience fluctuations in the total number of Google search referrals to its owned and operated and network of customer websites. In 2011, the overall impact of these changes on the Company's owned and operated websites was negative primarily due to a decline in traffic to eHow.com, the Company's largest website. From October 2011 to March 2012, and in response to the changes in search engine algorithms in 2011, the Company performed an evaluation of its existing content library to identify potential improvements in its content creation and distribution platform. As a result of this evaluation, the Company elected to remove certain content assets from service, resulting in $1,818 of accelerated amortization expense in the first quarter of 2012.
We intend to evolve and continuously improve our content creation and distribution platform and to create new content formats to enhance our content product offerings. In 2012 to date, such changes included ongoing improvements to our content creation process to enhance quality, diversifying our content investment into video, long-form content, images and diagrams, publishing content directed at international markets and in languages other than English as well as increasing and expanding distribution of our content to our network of customer websites.
There can be no assurance that these changes or any future changes that may be implemented by the Company, by search engines to their algorithms and search methodologies, or by consumers in their web usage habits will not adversely impact the carrying value, estimated useful life or intended use of our long-lived assets. The Company will continue to monitor these changes as well as any future changes and emerging trends in search engine algorithms and methodologies, including the resulting impact that these changes may have on future operating results, the economic performance of the Company's long-lived assets and in its assessment as to whether significant changes in circumstances might provide an indication of potential impairment of the carrying value of its long-lived assets, including its media content and goodwill arising from acquisitions.
Property and equipment
Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Computer equipment is amortized over two to five years, software is amortized over two to three years, and furniture and fixtures are amortized over seven to ten years. Leasehold improvements are amortized straight-line over the shorter of the remaining lease term or the estimated useful lives of the improvements ranging from one to six years. Upon the sale or retirement of property or equipment, the cost and related accumulated depreciation or amortization is removed from the Company’s financial statements with the resulting gain or loss reflected in the
Company’s results of operations. Repairs and maintenance costs are expensed as incurred. In the event that property and equipment is no longer in use, the Company will record a loss on disposal of the property and equipment, which is computed as the net remaining value (gross amount of property and equipment less accumulated depreciation expense) of the related equipment at the date of disposal.
The Company capitalizes costs incurred to acquire and to initially register its owned and operated undeveloped websites (i.e. Uniform Resource Locators). The Company amortizes these costs over the expected useful life of the underlying undeveloped websites on a straight-line basis. The expected useful lives of the website names range from 12 months to 84 months. The Company determines the appropriate useful life by performing an analysis of expected cash flows based on historical experience with domain names of similar quality and value.
In order to maintain the rights to each undeveloped website acquired, the Company pays periodic renewal registration fees, which generally cover a minimum period of twelve months. The Company records renewal registration fees of website name intangible assets in deferred registration costs and recognizes the costs over the renewal registration period, which is included in service costs.
The Company capitalizes the direct costs incurred to acquire its media content that is determined to embody a probable future economic benefit. Costs are recognized as finite lived intangible assets based on their acquisition cost to the Company. Direct content costs primarily represent amounts paid to unrelated third parties for completed content units, and to a lesser extent, specifically identifiable internal direct labor costs incurred to enhance the value of specific content units acquired prior to their publication. Internal costs not directly attributable to the enhancement of an individual content unit acquired are expensed as incurred. All costs incurred to deploy and publish content are expensed as incurred, including the costs for the ongoing maintenance of the Company’s websites in which the Company’s content is deployed.
Capitalized media content is amortized on a straight-line basis over five years, representing the Company’s estimate of the pattern that the underlying economic benefits are expected to be realized and based on its estimates of the projected cash flows from advertising revenue expected to be generated by the deployment of its content. These estimates are based on the Company’s plans and projections, comparison of the economic returns generated by its content of comparable quality and an analysis of historical cash flows generated by that content to date. Amortization of media content is included in amortization of intangible assets in the accompanying statement of operations and the acquisition costs are included in purchases of intangible assets within cash flows from investing activities in the Consolidated Statements of Cash Flows.
Intangibles—Acquired in Business Combinations
The Company performs valuations on each acquisition accounted for as a business combination and allocates the purchase price of each acquired business to its respective net tangible and intangible assets. Intangible assets acquired in business combinations include: trade names, non-compete agreements, owned website names, customer relationships, technology, media content, and content publisher relationships. The Company determines the appropriate useful life by performing an analysis of expected cash flows based on historical experience of the acquired businesses. Intangible assets are amortized over their estimated useful lives using the straight line method which approximates the pattern in which the economic benefits are consumed.
Goodwill represents the excess of the cost of an acquired entity over the fair value of the acquired net assets. The Company tests goodwill for impairment annually during the fourth quarter of its fiscal year or when events or circumstances change that would indicate that goodwill might be impaired. Events or circumstances which could trigger an impairment review include, but are not limited to a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key personnel, significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business, significant negative industry or economic trends or significant underperformance relative to expected historical or projected future results of operations.
The testing for a potential impairment of goodwill involves a two-step process. The first step is to identify whether a potential impairment exists by comparing the estimated fair values of the Company’s reporting units with their respective book values, including goodwill. If the estimated fair value of the reporting unit exceeds book value, goodwill is considered not to be
impaired and no additional steps are necessary. If, however, the fair value of the reporting unit is less than book value, then the second step is performed to determine if goodwill is impaired and to measure the amount of impairment loss, if any. The amount of the impairment loss is the excess of the carrying amount of the goodwill over its implied fair value. The estimate of implied fair value of goodwill is primarily based on an estimate of the discounted cash flows expected to result from that reporting unit but may require valuations of certain internally generated and unrecognized intangible assets such as the Company’s software, technology, patents and trademarks. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.
Business acquisitions and supplemental pro forma information
The Company did not complete any business acquisitions in the six months ended June 30, 2012.
Supplemental information on an unaudited pro forma basis, as if the four acquisitions completed in 2011 had been consummated as of January 1, 2011 is as follows:
The unaudited pro forma supplemental information is based on estimates and assumptions which the Company believes are reasonable and reflects amortization of intangible assets as result of the acquisitions. The pro forma results are not necessarily indicative of the results that have been realized had the acquisitions been consolidated as of the beginning of the periods presented.
Other Long-Term Assets
The Internet Corporation for Assigned Names and Numbers, or ICANN, has approved a framework for the significant expansion of the number of generic Top Level Domains ("gTLDs") in 2012 ("New gTLD Program"). During the six months ended June 30, 2012, the Company paid $18.2 million for certain gTLD applications under the New gTLD Program. The Company capitalizes the costs incurred to pursue the acquisition of gTLD operator rights that are determined to embody probable economic benefit. Capitalized payments for gTLD applications are included in long-term other assets during the application process. While there can be no assurance that the Company will be awarded any gTLDs, capitalized payments will be reclassified as finite lived intangible assets following the delegation of operator rights for each gTLD by ICANN. Payments for gTLD applications primarily represent amounts paid directly to ICANN or third parties in the pursuit of gTLD operator rights. The Company may receive partial cash refunds for certain gTLD applications, and to the extent the Company elects to sell or dispose of its interest in certain gTLD applications throughout the process, it may also incur gains or losses on amounts invested. Gains on the sale of the Company's interest in gTLD applications will be recognized when realized, while losses will be recognized when deemed probable. Other costs incurred by the Company as part of its gTLD initiative not directly attributable to the acquisition of gTLD operator rights are expensed as incurred. Capitalized costs will be amortized on a straight-line basis over the estimated useful life of the gTLD operator rights acquired commencing the date that each asset is available for its intended use, which is expected to occur following commencement of delegation by ICANN in 2013.
Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is the vesting period, on a straight-line basis. The Company uses the Black-Scholes option pricing model to determine the fair value of stock options that do not include market conditions. Stock-based awards are comprised principally of stock options, restricted stock awards (“RSA”) and restricted stock units ("RSU").
Under the Company's Employee Stock Purchase Plan (the "ESPP"), eligible officers and employees may purchase a limited amount of our common stock at a discount to the market price in accordance with the terms of the plan as described in Note 11 - Share-based Compensation Plans and Awards. The Company uses the Black-Scholes option pricing model to determine the fair value of the ESPP awards granted which is recognized straight-line over the total offering period.
Some equity awards granted by the Company contain certain performance and/or market conditions. The Company recognizes compensation cost for awards with performance conditions based upon the probability of that performance condition being met, net of an estimate of pre-vesting forfeitures. Awards granted with performance and/or market conditions are amortized using the graded vesting method.
The effect of a market condition is reflected in the award’s fair value on the grant date. The Company uses a Monte Carlo simulation model or binomial lattice model to determine the grant date fair value of awards with market conditions. Compensation cost for an award that has a market condition is recognized as the requisite service period is fulfilled, even if the market condition is never satisfied.
Stock-based awards issued to non-employees are accounted for at fair value determined using the Black-Scholes option-pricing model. Management believes that the fair value of the stock options is more reliably measured than the fair value of the services received. The fair value of each non-employee stock-based compensation award is re-measured each period until a commitment date is reached, which is generally the vesting date.
Under a stock repurchase plan, shares repurchased by the Company are accounted for when the transaction is settled. Repurchased shares held for future issuance are classified as treasury stock. Shares formally or constructively retired are deducted from common stock at par value and from additional paid in capital for the excess over par value. If additional paid in capital has been exhausted, the excess over par value is deducted from retained earnings. Direct costs incurred to acquire the shares are included in the total cost of the repurchased shares.
Deferred income taxes are recognized for differences between financial reporting and tax bases of assets and liabilities at the enacted statutory tax rates in effect for the years in which the temporary differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The Company evaluates the realizability of deferred tax assets and recognizes a valuation allowance for its deferred tax assets when it is more likely than not that a future benefit on such deferred tax assets will not be realized.
The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. The Company recognizes interest and penalties accrued related to unrecognized tax benefits in its income tax (benefit) provision in the accompanying statements of operations.
Net Income (Loss) Per Share
Basic income (loss) per share is computed by dividing the net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. Net income (loss) attributable to common stockholders is increased for cumulative preferred stock dividends earned during the period. Diluted income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted average common shares outstanding plus potentially dilutive common shares. Because the Company reported losses in certain the periods presented, potentially dilutive common shares comprising of stock options, RSUs, stock from the employee stock purchase plan, warrants and convertible preferred stock are antidilutive in those periods.
RSUs and other restricted awards are considered outstanding common shares and included in the computation of basic earnings per share as of the date that all necessary conditions of vesting are satisfied. RSUs are excluded from the dilutive earnings per share calculation when their impact is antidilutive.
Fair Value of Financial Instruments
Fair value represents the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company measures its financial assets and liabilities in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
Valuations are usually obtained from third party pricing services for identical or comparable assets or liabilities.
In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as considers counterparty credit risk in its assessment of fair value.
The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, receivables from domain name registries, registry deposits, restricted cash, accounts payable, accrued liabilities and customer deposits approximate fair value because of their short maturities. The Company’s investments in marketable securities are recorded at fair value. Certain assets, including equity investments, investments held at cost, goodwill and intangible assets are also subject to measurement at fair value on a nonrecurring basis, if they are deemed to be impaired as the result of an impairment review. For the year ended December 31, 2011 and six month period ended June 30, 2012, no impairments were recorded on those assets required to be measured at fair value on a nonrecurring basis.
Financial assets and liabilities carried at fair value on a recurring basis were as follows:
December 31, 2011
(1)Comprises money market funds which are included in Cash and cash equivalents in the accompanying balance sheet
June 30, 2012
(1)Comprises money market funds which are included in Cash and cash equivalents in the accompanying balance sheet
For financial assets that utilize Level 1 and Level 2 inputs, the Company utilizes both direct and indirect observable price quotes, including quoted market prices (Level 1 inputs) or inputs that are derived principally from or corroborated by observable market data (Level 2 inputs).
Recent Accounting Pronouncements
In May 2011, the FASB issued Accounting Standards Update 2011-04, “Fair Value Measurement” (“ASU 2011-04”). The primary focus of ASU 2011-04 is the convergence of accounting requirements for fair value measurements and related financial statement disclosures under U.S. GAAP and International Financial Reporting Standards (“IFRS”). While ASU 2011-04 does not significantly change existing guidance for measuring fair value, it does require additional disclosures about fair value measurements and changes the wording of certain requirements in the guidance to achieve consistency with IFRS. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011, and is required to be applied prospectively. There was not a material impact to the consolidated financial statements upon adoption in 2012.
In June 2011, the FASB issued Accounting Standards Update 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”). This guidance requires companies to present the components of comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under either method, amounts reclassified from Other Comprehensive Income ("OCI") to net income for each reporting period must be displayed as components of both net income and OCI on the face of the financial statements. The guidance does not change the items that are reported in OCI. ASU 2011-05 is effective for interim and annual periods beginning after December 15, 2011. Other than presentational changes, there was not a significant impact to the consolidated financial statements upon adoption in 2012.
In September 2011, FASB issued amendments to its accounting guidance on testing goodwill for impairment. The amendments allow entities to use a qualitative approach to test goodwill for impairment. This 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 required to perform the currently prescribed two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. This guidance is effective for annual and interim goodwill impairment test performed for fiscal years beginning after December 15, 2011 and early adoption is permitted. The Company did not early adopt this guidance and does not anticipate a material impact to the consolidated financial statements upon adoption in 2012.
Property and equipment consisted of the following:
Depreciation and software amortization expense by classification for the three and six months ended June 30, 2011 and 2012 is shown below:
Intangible assets consist of the following:
Identifiable finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives commencing the date that the asset is available for its intended use.
Amortization expense by classification for the three and six months ended June 30, 2011 and 2012 is shown below:
The following table presents the changes in the Company’s goodwill balance:
Goodwill in 2011 arose from four acquisitions completed in that year. The movement in 2012 relates to revisions to the preliminary purchase price allocation in respect of acquisitions in the second half of 2011. There were no business acquisitions during the six months ended June 30, 2012.
The Company's most recent annual impairment analysis was performed in the fourth quarter of the year ended December 31, 2011 and indicated that the fair value of each of its three reporting units significantly exceeded the carrying amount of the respective reporting unit's book value of goodwill at that time.
Other long term assets consisted of the following:
During the six months ended June 30, 2012, the Company paid $18.2 million for certain gTLD applications under the New gTLD Program. Payments for gTLD applications, represent amounts paid directly to ICANN or third parties in the pursuit of gTLD operator rights. The majority of this balance has been paid to Donuts Inc as described in Note 8 - Commitments and Contingencies.
Other includes $855 of restricted cash comprising a collateralized letter of credit connected with the Company's applications under the New gTLD Program. The restrictions require the cash to be maintained in a bank account for a minimum of five years from the delegation of the gTLDs.
Accounts receivable consisted of the following:
Accrued expenses and other liabilities consisted of the following:
The Company conducts its operations utilizing leased office facilities in various locations and leases certain equipment under non-cancellable operating and capital leases. The Company’s leases expire between July 2012 and July 2024.
In June 2012, the Company entered into an eleven year lease commitment to replace its existing corporate headquarter space in Santa Monica, California that commences in 2013 with an average expense of approximately $2,000 per annum over the life of the lease. The lease expires in 2024 and the Company has an early termination option after six years.
In April 2011, the Company and eleven other defendants were named in a patent infringement lawsuit filed in the U.S. District Court, Eastern District of Texas. The plaintiff filed and served a complaint making several claims related to a method for displaying advertising on the Internet. In May 2011, the Company filed its response to the complaint, denying all liability, and is in the process of discussing a resolution with the plaintiff. The Company intends to vigorously defend its position and does not expect to incur a material loss in respect of this matter.
From time to time, the Company is a party to other various litigation matters incidental to the conduct of its business. There is no pending or threatened legal proceeding to which Company is a party that, in our opinion, is likely to have a material adverse effect on the Company’s future financial results.
From time to time, various federal, state and other jurisdictional tax authorities undertake review of the Company and its filings. In evaluating the exposure associated with various tax filing positions, the Company accrues charges for possible exposures. The Company believes any adjustments that may ultimately be required as a result of any of these reviews will not be material to its consolidated financial statements.
Domain Name Agreement
In April 2011, the Company entered an agreement to provide domain name registration services and manage certain domain names owned and operated by a customer over a 27 month term (the "Domain Agreement"). In conjunction with the Domain Agreement, the Company committed to purchase at least $175 of expired domain names every calendar quarter or a total of $1,575 over the term of the agreement. The contract can be terminated by either the Company or the counter party providing notice at least 60 days prior to the end of each annual renewal period. The aggregate value of expired domain names purchased by the Company from inception through June 30, 2012 was $1,080.
As part of its initiative to pursue the acquisition of gTLD operator rights, the Company has entered into a gTLD acquisition agreement ("Agreement") with Donuts Inc. ("Donuts"). The Agreement provides the Company with rights to acquire the operating and economic rights to certain gTLDs. These rights are shared equally with Donuts and are associated with specific gTLDs ("Covered gTLDs") for which Donuts is the applicant under the New gTLD Program. The Company has the right, but not the obligation, to make further deposits with Donuts in the pursuit of acquisitions of Covered gTLDs, for example as part of the ICANN auction process. The operating and economic rights for each Covered gTLD will be determined
through a process whereby the Company and Donuts each select gTLDs from the pool of Covered gTLDs, with the number of selections available to each party based upon the proportion of the total acquisition price of all Covered gTLDs that they funded. Gains on sale of the Company's interest in Covered gTLDs will be recognized when realized, while losses will be recognized when deemed probable. Separately, the Company entered into an agreement to provide certain back-end registry services for gTLD operator rights owned by Donuts for a period of five years commencing from the launch of Donut's first gTLD. Demand Media and its affiliates are neither investors in Donuts and its affiliates nor are they involved in any joint venture with Donuts and its affiliates.
In its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. Those indemnities include intellectual property indemnities to the Company’s customers, indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware and indemnifications related to the Company’s lease agreements. In addition, the Company’s advertiser and distribution partner agreements contain certain indemnification provisions which are generally consistent with those prevalent in the Company’s industry. The Company has not incurred significant obligations under indemnification provisions historically and does not expect to incur significant obligations in the future. Accordingly, the Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying balance sheets.
The Company’s effective tax rate differs from the statutory rate primarily as a result of state taxes, foreign taxes, nondeductible stock option expenses and changes in the Company’s valuation allowance.
During the six months ended June 30, 2012, the Company recorded an income tax benefit of $569 compared to an expense of $2,345 during the same period in 2011, representing a change of $2,914. The change was primarily due to a benefit from the change in California apportionment methodology during the quarter ended March 31, 2012 which reduced the Company's effective state tax rate compared to the prior period. In addition, the company settled various tax issues concerning certain overseas tax filings for 2008, 2009, and 2010 providing an additional tax benefit during the quarter ended June 30, 2012 of approximately $300.
The Company reduces its deferred tax assets resulting from future tax benefits by a valuation allowance if, based on the weight of the available evidence it is more likely than not that some portion or all of these deferred taxes will not be realized. The timing of the reversal of deferred tax liabilities associated with tax deductible goodwill is not certain and thus not available to assure the realization of deferred tax assets. Due to the limitation associated with deferred tax liabilities from tax deductible goodwill, the Company has deferred tax assets in excess of deferred tax liabilities before application of a valuation allowance for the periods presented. As the Company has insufficient history of generating book income, the ultimate future realization of these excess deferred tax assets is not more likely than not and thus subject to a valuation allowance. Accordingly, the Company has established a valuation allowance against its deferred tax assets.
The Company is subject to the accounting guidance for uncertain income tax positions. The Company believes that its income tax positions and deductions will be sustained on audit and does not anticipate any adjustments that will result in a material adverse effect on the Company's financial condition, results of operations, or cash flow. The Company acquired an $84 uncertain tax position as a result of a business acquisition during 2011.
The Company's policy for recording interest and penalties associated with audits and uncertain tax positions is to record such items as a component of income tax expense, and amounts recognized to date are insignificant. No uncertain income tax positions were recorded during the six months ended June 30, 2011 or 2012 other than the acquired uncertain tax position, and the Company does not expect its uncertain tax position to change materially during the next twelve months. The Company files a U.S. federal and many state tax returns as well as tax returns in multiple foreign jurisdictions. All tax years since the Company's incorporation remain subject to examination by the IRS and various state authorities.
10. Related Party Transactions
The Company’s Chairman and Chief Executive Officer and certain members of the board of directors are on the board of directors of The FRS Company (“FRS”). The Company recognized approximately $381 and $30 in revenue from FRS for advertising and creative services during the six months ended June 30, 2011 and 2012, respectively. As of December 31, 2011 and June 30, 2012, the Company’s receivable balance due from FRS was $45 and $0, respectively. The creative services
agreement was terminated by the parties effective May 31, 2011.
11. Share-based Compensation Plans and Awards
Valuation of Stock Option Awards
The following table presents the weighted-average assumptions used to estimate the fair values of the stock options granted in the periods presented:
The Company did not grant any stock options to employees during the six months ended June 30, 2012.
Stock option activity (in thousands, except term, exercise price and per share data) for the six months ended June 30, 2012 is as follows:
The pre-tax aggregate intrinsic value of outstanding and exercisable stock options is calculated as the difference between the exercise price of the underlying awards and the closing stock price of $11.20 of the Company’s common stock on June 30, 2012 for all awards where that stock price exceeds the exercise price. Options expected to vest reflect an estimated forfeiture rate.
The following table summarizes additional information concerning outstanding and exercisable options at June 30, 2012:
The total grant date fair value of stock options vested during the six months ended June 30, 2011 and 2012 was $8,943 and $4,525, respectively. The aggregate intrinsic value of all options exercised during the six months ended June 30, 2011 and 2012 was $10,650 and $6,356 respectively.
As of June 30, 2012, there was $27,178 of unrecognized stock-based compensation expense related to the non-vested portion of stock options, which is expected to be recognized over a weighted average period of 3.1 years. To the extent that the forfeiture rate is different from that anticipated, stock-based compensation expense related to these awards will be different.
Restricted stock units
The following table summarizes the activity of RSUs and other restricted shares for the six months ended June 30, 2012 is as follows:
As of June 30, 2012, there was approximately $38,397 of unrecognized compensation cost related to employee non-vested RSUs and restricted shares. The amount is expected to be recognized over a weighted average period of 2.7 years. To the extent that the forfeiture rate is different from that anticipated, stock-based compensation expense related to these awards will be different.
Included in the above is $423 of expense related to the issuance of 50 shares of common stock to a consultant during the three months ended June 30, 2012 upon the fulfillment of certain performance conditions in that period. No additional stock is expected to be issued under this agreement.
Employee Stock Purchase Plan
In May 2011, the Company commenced its first offering under the Demand Media, Inc. 2010 Employee Stock Purchase Plan (the “ESPP”), which allows eligible employees to purchase a limited amount of the Company's common stock at a 15% discount to the market price through payroll deductions. Participants can authorize payroll deductions for amounts up to the lesser of 15% of their qualifying wages or the statutory limit under the U.S. Internal Revenue Code. The ESPP provides for up to four concurrent offering periods of twenty-four, eighteen, twelve and six-month durations, which correspondingly have four,
three, two and one, six-month purchase periods, respectively. A maximum of one thousand two hundred fifty shares of common stock may be purchased by each participant at six-month intervals during each purchase period within an offering. The fair value of the ESPP options granted is determined using a Black-Scholes model and is amortized over the life of the 24-month offering period of the ESPP. The Black-Scholes model included an assumption for expected volatility of between 34% and 43% for each of the four purchase periods. During the three and six months ended June 30, 2012, the Company recognized an expense of $358 and $940, respectively, in relation to the ESPP and there were 9,535 shares of common stock remaining authorized for issuance under the ESPP at June 30, 2012. As of June 30, 2012, there was approximately $2,900 of unrecognized compensation cost related to the ESPP which is expected to be recognized on a straight-line basis over the remainder of the offering period.
In January 2008, the Company entered into a license agreement with the Lance Armstrong Foundation, Inc. (the “License Agreement”). The Lance Armstrong Foundation (“LAF”) is a non-profit organization dedicated to uniting people to fight cancer. In consideration for the License Agreement, the Company issued warrants to purchase an aggregate of 312 shares of the Company's common stock at an exercise price of $12.00 per share to the LAF (the “LAF Warrant”). The LAF Warrant was automatically net exercised upon the closing date of the Company's IPO and as a result the Company issued 184 shares of common stock to LAF in January 2011.
In June 2010, the Company entered into a website development, endorsement and license agreement with Bankable Enterprises, Inc. (“BEI”) (the “BEI Agreement”). BEI is wholly owned by Tyra Banks (“Ms. Banks”), a business woman and celebrity.
Under the terms of the BEI Agreement, which commenced on July 1, 2010 and ends on July 1, 2014, Ms. Banks provides certain services and endorsement rights to the Company, and licenses to the Company certain intellectual property. The Company used this intellectual property to build an owned and operated website on beauty and fashion, typeF.com, which was launched during the three months ended March 31, 2011. As consideration for Ms. Banks’ services, the Company issued a fully-vested four-year warrant to purchase 375 shares of the Company’s common stock at an exercise price of $12.00 per share. The warrant terminates on the earlier of (i) June 30, 2014 or (ii) the closing of a change of control (as defined). In addition, BEI will receive certain royalties on advertising revenue in excess of certain minimum royalty thresholds (as defined).
Stock-based Compensation Expense
Stock-based compensation expense related to all employee and non-employee stock-based awards was as follows:
Stock-based compensation expense in the six months ended June 30, 2011 includes $5,051 related to 1,625 performance and market-based stock options and 1,000 restricted stock awards granted to certain executive officers in prior years that vested in 2011 on the fulfillment of certain market and performance conditions: the completion of the Company’s initial public offering and the meeting of an average closing price of the Company’s stock for a stipulated period of time.
12. Stockholders' Equity
Under the February 8, 2012 stock repurchase plan, as amended, the Company is authorized to repurchase up to $50,000 of its common stock from time to time. During the six months ended June 30, 2012, the Company repurchased 532 shares at an
average price of $7.43 per share for an aggregate amount of $3,956. As of June 30, 2012, approximately $28,980 of the stock repurchase authorization remained. The timing and actual number of shares repurchased will depend on various factors including price, corporate and regulatory requirements, debt covenant requirements, alternative investment opportunities and other market conditions.
Shares repurchased by the Company are accounted for when the transaction is settled. As of June 30, 2012, there were no unsettled share repurchases. Shares repurchased and retired are deducted from common stock for par value and from additional paid in capital for the excess over par value. Direct costs incurred to acquire the shares are included in the total cost of the shares.
Each share of common stock has the right to one vote per share. Each restricted stock purchase right has the right to one vote per share and the right to receive dividends or other distributions paid or made with respect to common shares, subject to restrictions for continued employment service.
The Company operates in one operating segment. The Company’s chief operating decision maker (“CODM”) manages the Company’s operations on a consolidated basis for purposes of evaluating financial performance and allocating resources. The CODM reviews separate revenue information for its Content & Media and Registrar offerings. All other financial information is reviewed by the CODM on a consolidated basis. All of the Company’s principal operations and decision- making functions are located in the United States. Revenue generated outside of the United States is not material for any of the periods presented.
Revenue derived from the Company’s Content & Media and Registrar Services is as follows
14. Net Income (Loss) Per Share
The following table sets forth the computation of basic and diluted net income (loss) per share of common stock:
As of each period end, the following common equivalent shares were excluded from the calculation of the Company’s diluted net income (loss) per share in for the period shown as their inclusion would have been antidilutive:
15. Subsequent Events
During the period from July 1, 2012 to August 9, 2012, the Company issued 254 restricted stock units as part of employee compensation.
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our 2011 Annual Report on Form 10-K.
This Quarterly Report on Form 10-Q contains forward-looking statements. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy and plans and our objectives for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our estimates of our financial results and our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the section entitled “Risk Factors” in Part II Item 1A of this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.
You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results or to changes in our expectations.
You should read this Quarterly Report on Form 10-Q and the documents that we reference in this Quarterly Report on Form 10-Q and have filed with the Securities and Exchange Commission (the “SEC”) with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect.
As used herein, “Demand Media,” “the Company,” “our,” “we,” or “us” and similar terms include Demand Media, Inc. and its subsidiaries, unless the context indicates otherwise.
“Demand Media” and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.
We are a leader in an Internet-based model for the professional creation and distribution of high-quality, commercially valuable, long-lived content at scale. Our business is comprised of two distinct and complementary service offerings: Content & Media and Registrar. Our Content & Media offering is engaged in creating media content, primarily consisting of text articles and videos, and delivering it along with our social media and monetization tools to our owned and operated websites and to our network of customer websites. Our Content & Media service offering also includes a number of websites primarily containing advertising listings, which we refer to as undeveloped websites. Our Registrar is the world’s largest wholesale registrar of Internet domain names and the world’s second largest registrar overall, based on the number of names under management, and provides domain name registration and related value-added services.
Our principal operations and decision-making functions are located in the United States. We report our financial results as one operating segment, with two distinct service offerings. Our operating results are regularly reviewed by our chief operating decision maker on a consolidated basis, principally to make decisions about how we allocate our resources and to measure our consolidated operating performance. Together, our service offerings provide us with proprietary data that enable commercially valuable, long-lived content production at scale combined with broad distribution and targeted monetization capabilities. We
currently generate the vast majority of our Content & Media revenue through the sale of advertising, and to a lesser extent through subscriptions to our social media applications and licensing and sales of select content and service offerings. Substantially all of our Registrar revenue is derived from domain name registration and related value-added service subscriptions. Our chief operating decision maker regularly reviews revenue for each of our Content & Media and Registrar service offerings in order to gain more depth and understanding of the key business metrics driving our business. Accordingly, we report Content & Media and Registrar revenue separately.
In January 2011, we completed our initial public offering and received proceeds, net of underwriters discounts but before deducting offering expenses, of $81.8 million from the issuance of 5.2 million shares of common stock. As a result of the initial public offering, all shares of our convertible preferred stock converted into 61.7 million shares of common stock and warrants to purchase common stock or convertible preferred stock net exercised into 0.5 million shares of common stock.
For the six months ended June 30, 2011 and 2012, we reported revenue of $159.0 million and $179.3 million, respectively. For the six months ended June 30, 2011 and 2012, our Content & Media offering accounted for 64% and 63% of our total revenue, respectively, and our Registrar service accounted for 36% and 37% of our total revenue, respectively.
Key Business Metrics
We regularly review a number of business metrics, including the following key metrics, to evaluate our business, measure the performance of our business model, identify trends impacting our business, determine resource allocations, formulate financial projections and make strategic business decisions. Measures which we believe are the primary indicators of our performance are as follows:
Content & Media Metrics
• page views: We define page views as the total number of web pages viewed across (1) our owned and operated websites and/or (2) our network of customer websites, to the extent that the viewed customer web pages host the Company's monetization, social media and/or content services. Page views are primarily tracked through internal systems, such as our Omniture web analytics tool, contain estimates for our customer websites using our social media tools and may use data compiled from certain customer websites. We periodically review and refine our methodology for monitoring, gathering, and counting page views in an effort to improve the accuracy of our measure.
•RPM: We define RPM as Content & Media revenue per one thousand page views.
•domain: We define a domain as an individual domain name paid for by a third-party customer where the domain name is managed through our Registrar service offering. Beginning July 1, 2011, the number of net new domains has been adjusted to include only new registered domains added to our platform for which we have recognized revenue. This metric does not include any of the company’s owned and operated websites.
• average revenue per domain: We calculate average revenue per domain by dividing Registrar revenues for a period by the average number of domains registered in that period. The average number of domains is the simple average of the number of domains at the beginning and end of the period. Average revenue per domain for partial year periods is annualized.
The following table sets forth additional performance highlights of key business metrics for the periods presented:
Opportunities, Challenges and Risks
To date, we have derived the majority of our revenue through the sale of advertising in connection with our Content & Media service offering and through domain name registration subscriptions in our Registrar service offering. Our advertising revenue is primarily generated by advertising networks, which include both performance based Internet advertising, such as cost-per-click where an advertiser pays only when a user clicks on its advertisement, and display Internet advertising where an advertiser pays when the advertising is displayed. For the six months ended June 30, 2012, the majority of our advertising revenue was generated by our relationship with Google. We deliver online advertisements provided by Google on our owned and operated websites as well as on certain of our customer websites where we share a portion of the advertising revenue. For the six months ended June 30, 2012 approximately 36% of our total consolidated revenue was derived from our advertising arrangements with Google. Google maintains the direct relationships with the advertisers and provides us with cost-per-click and display advertising services.
Our historical growth in Content & Media revenue has principally come from growth in RPMs and page views due to both the increased volume of commercially valuable content published on our owned and operated websites as well as an increase in the number of visitors to our existing content. To a lesser extent, Content & Media revenue growth has resulted from the publishing of our content on our network of customer websites and from utilizing our social media tools on certain of these sites. We believe that there are opportunities to grow our revenue and our page views by creating and publishing more content in a greater variety of formats on our owned and operated sites as well as by increasing our distribution to and expanding our network of customer websites. We also believe there is long term revenue growth opportunity from improving advertising yields to several of our owned and network websites and from introducing innovative new products.
We believe that there is an opportunity to further grow our Content & Media service offering by publishing and distributing our content to an increased number of distribution outlets. For example, we launched our premium multi-channel YouTube initiative in December 2011, and we currently have arrangements with a number of third-party customers to distribute and license our content on their websites. We also expanded our audience on our network of customer websites via our recent acquisition of IndieClick and believe that IndieClick's innovative product offerings provide us an opportunity to increase revenue.
Google, the largest provider of search engine referrals to the majority of the Company's websites, regularly deploys changes to its search engine algorithms, some of which have led the Company to experience fluctuations in the total number of Google search referrals to its owned and operated and network of customer websites. Other search engines may deploy similar changes. In 2011, the overall impact of these changes on the Company's owned and operated websites was negative primarily
due to a decline in traffic to eHow.com, the Company's largest website. From October 2011 to March 2012, and in response to the changes in search engine algorithms in 2011, the Company performed an evaluation of its existing content library to identify potential improvements in its content creation and distribution platform. As a result of this evaluation, the Company elected to remove certain content assets from service, resulting in $5,898 of accelerated amortization expense in the fourth quarter of 2011 and $1,818 of accelerated amortization expense in the first quarter of 2012.
We intend to evolve and continuously improve our content creation and distribution platform and to create new content formats to enhance our content product offerings. In 2012 to date, such changes included increasing our investment in video and long-form content, images and diagrams, publishing content directed at international markets and in languages other than English, as well as increasing and expanding distribution of our content to our network of customer websites. In the near term, we anticipate increased expenditures in new content formats designed to further diversify our content offering and an overall reduction in the volume of shorter-form text articles published on eHow.com. These potential changes to our content creation platform could increase our per unit content creation costs, including costs associated with our community of creative professionals, potentially resulting in higher service costs as a percentage of revenue if the changes are unsuccessful in generating additional revenue. While we make such improvements to our content creation and distribution platform, we expect a reduced level of overall investment in media content in 2012 when compared to 2010 and 2011.
There can be no assurance that these or any future changes that may be implemented by the Company, by search engines to their algorithms and search methodologies, or by consumers in their web usage habits will not adversely impact the carrying value, estimated useful life or intended use of our long-lived assets. The Company will continue to monitor these changes as well as any future changes and emerging trends in search engine algorithms and methodologies, including the resulting impact that these changes may have on future operating results, the economic performance of the Company's long-lived assets and in its assessment as to whether significant changes in circumstances might provide an indication of potential impairment of the carrying value of its long-lived assets, including its media content and goodwill arising from acquisitions.
The growth in our Registrar revenue is dependent upon our ability to attract and retain customers to our Registrar platform through competitive pricing on domain registrations and value added services. Beginning in the first quarter of 2010 and extending through the first quarter of 2011, we added several customers with large volumes of domains to our Registrar platform. This resulted in fluctuations in our average revenue per domain over these periods, from which we only recognized revenue on a portion of these domain names while deferring revenue recognition on the remainder. Beginning July 1, 2011, we adjusted the number of net new domains to include only new registered domains added to our platform for which we have recognized revenue. Excluding the impact of this change, end of period domains at June 30, 2012 would have increased 15% and average revenue per domain during the three and six month period ended June 30, 2012 would have decreased 4% and 3% respectively, each compared to the corresponding prior-year period. In the near term, we anticipate our average revenue per domain to continue to fluctuate as a result of the large volume customers added in 2011 and certain registry price increases in early 2012. Due in part to the higher mix of large volume customers in 2012 as compared to 2011, we also expect that the associated service costs as a percentage of revenue will increase when compared to our historical results.
The Internet Corporation for Assigned Names and Numbers, or ICANN, has approved a framework for the significant expansion of the number of generic Top Level Domain ("gTLDs") in 2012 ("the New gTLD Program"). We believe that such expansion, once completed, could result in an increase in the number of domains registered on our platform in 2013. In addition, we believe that the New gTLD Program could also provide us with new revenue opportunities commencing in 2013, which include operating the back-end infrastructure for new gTLD registries and/or owning one or more gTLDs in our own right.
During the six months ended June 30, 2012, the Company paid $18.2 million for certain gTLD applications under the New gTLD Program. Payments for gTLD applications represent amounts paid directly to ICANN and third parties in the pursuit of the Company's ownership in certain gTLD operator rights. While there can be no assurance that the Company will be awarded any gTLDs, the Company capitalizes payments made for gTLD applications that are determined to embody probable economic benefit, which are included in other long-term assets at June 30, 2012. During the second half of 2012 and as part of the New gTLD Program, the Company may receive partial cash refunds for certain gTLD applications, and to the extent the Company elects to sell or dispose of certain gTLD applications throughout the process, it may also incur gains or losses on amounts invested. Gains on the sale of the Company's interest in gTLDs will be recognized when realized, while losses will be recognized when deemed probable. Upon the delegation of operator rights for each gTLD by ICANN, which the Company expects to commence in 2013, gTLD application fees will be reclassified as finite lived intangible assets and amortized on a straight-line basis over their estimated useful life. Other costs incurred by the Company as part of its gTLD initiative and not directly attributable to the acquisition of gTLD operator rights rights are expensed as incurred.
We expect to incur up to $4 million of formation expenses related to the New gTLD Program in 2012 and the amount of
our investment at the completion of the New gTLD Program could be substantially higher or lower than the $18.2 million invested to date. Revenue is not expected to commence until 2013.
Our service costs, the largest component of our operating expenses, can vary from period to period, particularly as a percentage of revenue, based upon the mix of the underlying Content & Media and Registrar services revenues we generate. In the near term, we expect that the period-over-period growth in our Content & Media revenue will exceed the growth in our Registrar revenue, which would typically provide for higher operating margins. We expect that service costs will increase in 2012 compared to 2011 in line with revenue growth and also due to our new premium multi-channel initiative with YouTube as well the impact of our acquisition of IndieClick. We believe that these factors, together with costs associated with our preparation for new gTLDs becoming available for registration in 2013, will constrain our operating margin growth in the short-term as we increase our investment in new business initiatives to support future growth.
Our content studio identifies and creates online text articles and videos through a community of freelance creative professionals and is core to our business strategy and long-term growth initiatives. Historically, we have made substantial investments in our platform to support our expanding community of freelance creative professionals and the growth of our content production and distribution and expect to continue to make such investments. As we develop new content formats, we may not be able to attract and retain qualified creative professionals to produce such new content at scale, which may adversely impact our ability to execute against emerging business opportunities or retain existing content creators.
For the six months ended June 30, 2012, more than 90% of our revenue has been derived from websites and customers located in the United States. While our content is primarily targeted towards English-speaking users in the United States today, we believe that there is an opportunity in the longer term for us to create content targeted to users outside of the United States and thereby increase our revenue generated from countries outside of the United States. We plan to further expand our operations internationally to address this opportunity, including through our recent acquisition of a Latin American content creation company in July 2011 and building on the recent launches of eHow en Español and eHow Brasil. As we expand our business internationally, we may incur additional expenses associated with this growth initiative.
Basis of Presentation
Our revenue is derived from our Content & Media and Registrar service offerings.
Content & Media Revenue
We currently generate substantially all of our Content & Media revenue through the sale of advertising, and to a lesser extent through subscriptions to our social media applications and select content and service offerings. Articles and videos, each of which we refer to as a content unit, generate revenue both directly and indirectly. Direct revenue is that directly attributable to a content unit, such as advertisements, including sponsored advertising links, display advertisements and in-text advertisements, on the same webpage on which the content is displayed. Indirect revenue is also derived primarily by our content library, but is not directly attributable to a specific content unit. Indirect revenue includes advertising revenue generated on our owned and operated websites’ home pages (e.g., home page of eHow), on topic category webpages (e.g., home and garden category page), on user generated article pages that feature content that was not acquired through our proprietary content acquisition process, and subscription revenue. Our revenue generating advertising arrangements, for both our owned and operated websites and our network of customer websites, include cost-per-click performance-based advertising; display advertisements where revenue is dependent upon the number of page views; and lead generating advertisements where revenue is dependent upon users registering for, or purchasing or demonstrating interest in, advertisers’ products and services. We generate revenue from advertisements displayed alongside our content offered to consumers across a broad range of topics and categories on our owned and operated websites and on certain customer websites. Our advertising revenue also includes revenue derived from cost-per-click advertising links we place on undeveloped websites owned both by us, which we acquire and sell on a regular basis, and certain of our customers. To a lesser extent, we also generate revenue from our subscription-based offerings, which include our social media applications deployed on our network of customer websites and subscriptions to premium content or services offered on certain of our owned and operated websites.
Where we enter into revenue sharing arrangements with our customers, such as those relating to IndieClick and our undeveloped customer websites, and when we are considered the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record these revenue-sharing payments to our customers as traffic acquisition costs, or TAC, which are included in service costs. In circumstances where we distribute our content on third-party websites and the customer acts as the primary obligor we recognize revenue on a net basis.
Our Registrar revenue is principally comprised of registration fees charged to resellers and consumers in connection with new, renewed and transferred domain name registrations. In addition, our Registrar also generates revenue from the sale of other value-added services that are designed to help our customers easily build, enhance and protect their domains, including security services, e-mail accounts and web-hosting. Finally, we generate revenue from fees related to auction services we provide to facilitate the selling of third-party owned domains. Our Registrar revenue varies based upon the number of domains registered, the rates we charge our customers and our ability to sell value-added services. We market our Registrar wholesale services under our eNom brand, and our retail registration services under the eNomCentral brand, among others.
Operating expenses consist of service costs, sales and marketing, product development, general and administrative, and amortization of intangible assets. Included in our operating expenses are stock based compensation and depreciation expenses associated with our capital expenditures.
Service costs consist of: fees paid to registries and ICANN associated with domain registrations; advertising revenue recognized by us and shared with others as a result of our revenue-sharing arrangements, such as TAC and content creator revenue-sharing arrangements; Internet connection and co-location charges and other platform operating expenses including depreciation of the systems and hardware used to build and operate our Content & Media platform and Registrar; personnel costs related to in-house editorial, customer service and information technology; and certain content production costs such as our new premium multi-channel video deal with YouTube. We anticipate that content production costs will comprise a higher proportion of total service costs in 2012 than prior years as we increase our production of content under the new premium multi-channel video initiative with YouTube and as we create and test new content formats. Our service costs are dependent on a number of factors, including the number of page views generated across our platform and the volume of domain registrations and value-added services supported by our Registrar. In the near term, we expect that the new premium multi-channel initiative with the production of video for YouTube, an increase in advertising revenue through third-party publishers resulting from our acquisition of IndieClick and higher overall registration costs due to registry price increases in 2012 together with costs associated with our investment in new business initiatives in 2012 (including our preparation for new gTLDs) will result in higher service costs when compared to historical results.
Sales and Marketing
Sales and marketing expenses consist primarily of sales and marketing personnel costs, sales support, public relations, advertising and promotional expenditures. Fluctuations in our sales and marketing expenses are generally the result of our efforts to support the growth in our Content & Media service, including expenses required to support the expansion of our direct advertising sales force. We currently anticipate that our sales and marketing expenses will continue to increase in the near term as a percent of revenue as we continue to build our sales and marketing organizations to support the growth of our business.
Product development expenses consist primarily of expenses incurred in our software engineering, product development and web design activities and related personnel costs. Fluctuations in our product development expenses are generally the result of hiring personnel to support and develop our platform, including the costs to further develop our content algorithms, our owned and operated websites and future product and service offerings of our Registrar. We currently anticipate that our product development expenses will increase as we continue to hire more product development personnel and further develop our products and offerings to support the growth of our business, but remain relatively flat as a percentage of revenue compared to 2011.
General and Administrative
General and administrative expenses consist primarily of personnel costs from our executive, legal, finance, human resources and information technology organizations and facilities related expenditures, as well as third party professional fees, insurance and bad debt expenses. Professional fees are largely comprised of outside legal, audit and information technology consulting. During the six months ended June 30, 2011 and 2012, our allowance for doubtful accounts and bad debt expense were not significant and we expect that this trend will continue in the near term. However, as we grow our revenue from direct
advertising sales, which tend to have longer collection cycles, our allowance for doubtful accounts may increase, which may lead to increased bad debt expense. As we continue to expand our business and incur additional expenses associated with being a publicly traded company, we anticipate general and administrative expenses will increase in the near term, but at a lesser rate than our projected revenue growth. Specifically, we expect that we will incur additional general and administrative expenses to provide insurance for our directors and officers and to comply with the regulatory and listing exchange requirements.
Amortization of Intangibles
We capitalize certain costs allocated to the purchase price of certain identifiable intangible assets acquired in connection with business combinations, to acquire content that our models show embody probable economic benefit, and to acquire undeveloped websites, including initial registration costs. We amortize these costs on a straight-line basis over the related expected useful lives of these assets, which have a weighted average useful life of approximately 5.3 years on a combined basis as of June 30, 2012. We estimate our capitalized content to have a weighted average useful life of 5.1 years as of June 30, 2012. The Company determines the appropriate useful life of intangible assets by performing an analysis of expected cash flows based on its historical experience of intangible assets of similar quality and value. We expect amortization expense to decrease in the near term as we intend to reduce our investment in content intangible assets as compared to the prior year. Amortization as percentage of revenue will depend upon a variety of factors, such as the amounts and mix of our investments in content and identifiable intangible assets acquired in business combinations.
Included in our operating expenses are expenses associated with stock-based compensation, which are allocated and included in service costs, sales and marketing, product development and general and administrative expenses. Stock-based compensation expense is largely comprised of costs associated with stock options and restricted stock units granted to employees, restricted stock issued to employees and expenses relating to our Employee Stock Purchase Plan.
We record the fair value of these equity-based awards and expense at their cost ratably over related vesting periods. In addition, stock-based compensation expense includes the cost of warrants to purchase common and preferred stock issued to certain non-employees. In addition, during the first quarter of 2011, we recognized approximately $5.0 million in additional stock-based compensation expense related to awards granted to certain executive officers in prior years to acquire approximately 2.6 million of our shares that vested in that quarter upon meeting an average closing price of our stock for a stipulated period of time subsequent to our initial public offering.
As of June 30, 2012, we had approximately $65.6 million of unrecognized employee related stock-based compensation, net of estimated forfeitures, that we expect to recognize over a weighted average period of approximately 2.9 years. In addition we also had approximately $2.9 million of unrecognized compensation expense related to our Employee Stock Purchase Plan that we expect to recognize on a straight-line basis through the second quarter of 2013. Stock-based compensation expense is expected to increase in 2012 compared to 2011 as a result of our existing unrecognized stock-based compensation and as we issue additional stock-based awards to continue to attract and retain employees and non-employee directors.
Interest expense principally consists of interest on outstanding debt and amortization of debt issuance costs associated with our revolving credit facility. As of June 30, 2012 no principal balance was outstanding under the revolving credit facility.
Interest income consists of interest earned on cash balances and short-term investments. We typically invest our available cash balances in money market funds and short-term United States Treasury obligations.
Other Income (Expense), Net
Other income (expense), net consists primarily of transaction gains and losses on foreign currency-denominated assets and liabilities and changes in the value of certain long term investments and, prior to our initial public offering, changes in the fair value of our preferred stock warrant liability. We expect our transaction gains and losses will vary depending upon movements in underlying currency exchange rates, and could become more significant when we expand internationally. Our preferred stock warrants were net exercised for common stock upon our initial public offering in January 2011 and thus we no longer record changes in the value of the warrant subsequent to that date.
Provision for Income Taxes
Since our inception, we have been subject to income taxes principally in the United States, and certain other countries where we have legal presence, including the United Kingdom, the Netherlands, Canada, Sweden and beginning in 2011, Ireland and Argentina. We anticipate that as we expand our operations outside the United States, we will become subject to taxation based on the foreign statutory rates and our effective tax rate could fluctuate accordingly.
Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
We currently believe that based on the available information, it is more likely than not that our deferred tax assets will not be realized, and accordingly we have taken a full valuation allowance against all of our United States federal and certain state and foreign deferred tax assets. As of December 31, 2011, we had approximately $54 million of federal and $12 million of state operating loss carry-forwards available to offset future taxable income which expire in varying amounts beginning in 2020 for federal and 2013 for state purposes if unused. Federal and state laws impose substantial restrictions on the utilization of net operating loss and tax credit carry-forwards in the event of an “ownership change,” as defined in Section 382 of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. Currently, we do not expect the utilization of our net operating loss and tax credit carry-forwards in the near term to be materially affected as no significant limitations are expected to be placed on these carry-forwards as a result of our previous ownership changes. If an ownership change is deemed to have occurred as a result of our initial public offering, potential near term utilization of these assets could be reduced.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates.
We believe that the assumptions and estimates associated with our revenue recognition, accounts receivable and allowance for doubtful accounts, capitalization and useful lives associated with our intangible assets, including our internal software and website development and content costs, income taxes, stock-based compensation and the recoverability of our goodwill and long-lived assets have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates and have discussed those in our 2011 Annual Report on Form 10-K. There have been no material changes to our critical accounting policies and estimates since the date of our 2011 Annual Report on Form 10-K.
Results of Operations
The following tables set forth our results of operations for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of future results.