**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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** **
| **ý**                                                 |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------|
|                                                       |
| **FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003** |
|                                                       |
| **OR**                                                     |
|                                                       |
| **o**                                                      |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

** **

**FOR THE TRANSITION PERIODFROM          TO          **

** **

**Commission file number 000-24643**

** **

**DIGITAL RIVER, INC.**

(Exactname of registrant as specified in its charter)

 
| **DELAWARE**                                                     |   | **41-1901640**                            |
|------------------------------------------------------------------|--------|-------------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification Number) |

 

**9625 WEST 76TH STREET, SUITE 150EDEN PRAIRIE, MINNESOTA 55344**(Address of principal executive offices)

** **

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

 

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)  Yes ý  No o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpractical date.

 
| **COMMON STOCK, $0.01 PAR VALUE** |   | **31,230,225 SHARES**                    |
|-----------------------------------|--------|------------------------------------------|
| (Class)                           |   | Outstanding  as of October 31, 2003 |

 

 

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DIGITALRIVER, INC.

 Form10-Q

Index

 
| PART I.       | FINANCIAL INFORMATION                                                                                                  |
|---------------|------------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                   |
| Item  1.      | Financial Statements                                                                                                   |
|          |                                                                                                                   |
|          | Condensed  Consolidated Balance Sheets as of September 30, 2003 and  December 31, 2002                       |
|          |                                                                                                                   |
|          | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2003 and 2002 |
|          |                                                                                                                   |
|          | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2003 and 2002           |
|          |                                                                                                                   |
|          | Notes  to Condensed Consolidated Financial Statements                                                                  |
|          |                                                                                                                   |
| Item  2.      | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                            |
|          |                                                                                                                   |
| Item  3.      | Qualitative and Quantitative  Disclosure about Market Risk                                                             |
|          |                                                                                                                   |
| Item  4.      | Controls and Procedures                                                                                                |
|          |                                                                                                                   |
| PART II.      | OTHER INFORMATION                                                                                                      |
|          |                                                                                                                   |
| Item  1.      | Legal Proceedings                                                                                                      |
|          |                                                                                                                   |
| Item  5.      | Other Information                                                                                                      |
|          |                                                                                                                   |
| Item  6.      | Exhibits and Reports on Form 8-K                                                                                       |
|          |                                                                                                                   |
| SIGNATURES    |
|          |
| EXHIBIT INDEX |

 

2

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**PART I****.  FINANCIAL INFORMATION**

 

**Item 1****. Financial Statements**

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(inthousands, except share data)

 
|                                                                                                                                |   | **September 30,  2003** |       | **December 31,  2002** |       |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                |   | **(unaudited)**              | ** ** |                        | ** ** |
| **ASSETS**                                                                                                                          |   |                         |       |                        |       |
| Current assets                                                                                                                      |   |                         |       |                        |       |
| Cash and cash equivalents                                                                                                           |   | $                            | 108,949    |                        | $          | 40,801 |   |
| Short-term investments                                                                                                              |   | 15,034                       |       | —                      |       |
| Accounts receivable, net  of allowance of $3,262 and $1,746                                                                         |   | 7,229                        |       | 10,397                      |       |
| Prepaid expenses and other                                                                                                          |   | 1,862                        |       | 1,807                       |       |
|                                                                                                                                |   |                         |       |                        |       |
| Total current assets                                                                                                                |   | 133,074                      |       | 53,005                      |       |
|                                                                                                                                |   |                         |       |                        |       |
| Property and equipment,  net                                                                                                        |   | 15,174                       |       | 15,637                      |       |
| Goodwill                                                                                                                            |   | 21,601                       |       | 18,698                      |       |
| Intangible and other  assets, net                                                                                                   |   | 8,116                        |       | 8,353                       |       |
|                                                                                                                                |   | $                            | 177,965    |                        | $          | 95,693 |   |
|                                                                                                                                |   |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      |   |                         |       |                        |       |
| Current liabilities                                                                                                                 |   |                         |       |                        |       |
| Accounts payable                                                                                                                    |   | $                            | 40,748     |                        | $          | 31,126 |   |
| Accrued payroll                                                                                                                     |   | 2,799                        |       | 1,788                       |       |
| Deferred revenue                                                                                                                    |   | 2,907                        |       | 1,865                       |       |
| Other accrued liabilities                                                                                                           |   | 8,258                        |       | 3,728                       |       |
|                                                                                                                                |   |                         |       |                        |       |
| Total current liabilities                                                                                                           |   | 54,712                       |       | 38,507                      |       |
|                                                                                                                                |   |                         |       |                        |       |
| Stockholders’ equity                                                                                                           |   |                         |       |                        |       |
| Preferred Stock, $.01 par  value; 5,000,000 shares authorized; no shares issued or outstanding                                      |   | —                       |       | —                      |       |
| Common Stock, $.01 par  value; 60,000,000 shares authorized; 31,118,836 and 27,537,240 shares issued  and outstanding, respectively |   | 311                          |       | 275                         |       |
| Additional paid-in capital                                                                                                          |   | 215,036                      |       | 160,535                     |       |
| Accumulated deficit                                                                                                                 |   | (92,094                      | )          | (103,624                    | )          |
|                                                                                                                                |   |                         |       |                        |       |
| Total stockholders’ equity                                                                                                     |   | 123,253                      |       | 57,186                      |       |
|                                                                                                                                |   | $                            | 177,965    |                        | $          | 95,693 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(inthousands, except per share data; unaudited)

 
| ** **                                                                                       | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2003**                                   | ** ** | **2002**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Revenue                                                                                          |       | $                                          | 26,748     |                                      | $          | 18,872 |   | $ | 74,112 |   | $ | 56,289 |   |
| Costs and expenses (exclusive of  depreciation and amortization expense shown separately below): |       |                                       |       |                                      |       |   |   |   |   |
| Direct cost of services                                                                          |       | 861                                        |       | 559                                       |       | 2,742 |   | 1,730 |   |
| Network and infrastructure                                                                       |       | 3,286                                      |       | 2,998                                     |       | 9,089 |   | 8,520 |   |
| Sales and marketing                                                                              |       | 9,895                                      |       | 7,854                                     |       | 28,145 |   | 24,269 |   |
| Product research and development                                                                 |       | 2,447                                      |       | 2,764                                     |       | 7,429 |   | 9,327 |   |
| General and administrative                                                                       |       | 2,472                                      |       | 1,807                                     |       | 6,741 |   | 5,130 |   |
| Litigation and other charges                                                                     |       | —                                     |       | —                                    |       | — |   | 2,500 |   |
| Depreciation and amortization                                                                    |       | 1,899                                      |       | 1,486                                     |       | 5,139 |   | 4,296 |   |
| Amortization of acquisition related  costs                                                       |       | 1,411                                      |       | 1,356                                     |       | 3,878 |   | 4,556 |   |
| Total costs and expenses                                                                         |       | 22,271                                     |       | 18,824                                    |       | 63,163 |   | 60,328 |   |
| Income (loss) from operations                                                                    |       | 4,477                                      |       | 48                                        |       | 10,949 |   | (4,039 | ) |
| Interest income – net                                                                       |       | 264                                        |       | 50                                        |       | 581 |   | 259 |   |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss)                                                                                |       | $                                          | 4,741      |                                      | $          | 98 |   | $ | 11,530 |   | $ | (3,780 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
|  Net income  (loss) per share                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                            |       | $                                          | 0.16       |                                      | $          | 0.00 |   | $ | 0.40 |   | $ | (0.14 | ) |
| Diluted                                                                                          |       | $                                          | 0.14       |                                      | $          | 0.00 |   | $ | 0.36 |   | $ | (0.14 | ) |
|                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average  common shares outstanding                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                            |       | 30,392                                     |       | 26,823                                    |       | 28,742 |   | 26,655 |   |
| Diluted                                                                                          |       | 34,608                                     |       |  29,054                              |       | 32,279 |   |  26,655 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(inthousands; unaudited)

 
|                                                                |   | **Nine months ended  September 30,** |    |
|---------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                |   | **2003**                                  |    | **2002** | ** ** |
|                                                                |   |                                      |    |   |   |
| Operating activities:                                               |   |                                      |    |   |   |
| Net income (loss)                                                   |   | $                                         | 11,530  |   | $ | (3,780 | )  |
| Adjustments to reconcile  net income (loss) to net cash provided by |   |                                      |    |   |   |
| Amortization of acquisition  related costs                          |   | 3,878                                     |    | 4,556 |   |
| Depreciation and  amortization                                      |   | 5,139                                     |    | 4,296 |   |
| Deferred compensation  expense                                      |   | —                                    |    | 37 |   |
| Litigation and other  charges                                       |   | —                                    |    | 2,500 |   |
| Change in operating assets  and liabilities:                        |   |                                      |    |   |   |
| Accounts receivable                                                 |   | 3,485                                     |    | (3,311 | ) |
| Other assets                                                        |   | (57                                       | )       | (753 | ) |
| Accounts payable                                                    |   | 8,947                                     |    | 8,711 |   |
| Other current liabilities                                           |   | 4,290                                     |    | (1,085 | ) |
| Deferred revenue                                                    |   | 1,006                                     |    | (72 | ) |
|                                                                |   |                                      |    |   |   |
| Net cash provided by  operating activities                          |   | 38,218                                    |    | 11,099 |   |
|                                                                |   |                                      |    |   |   |
| Investing activities:                                               |   |                                      |    |   |   |
| Purchases of investments                                            |   | (15,000                                   | )       | — |   |
| Sales of investments, net                                           |   | —                                    |    | 3,487 |   |
| Cash paid for acquisitions,  net of cash received                   |   | (3,873                                    | )       | (2,778 | ) |
| Purchases of equipment                                              |   | (4,675                                    | )       | (4,089 | ) |
|                                                                |   |                                      |    |   |   |
| Net cash used in investing  activities                              |   | (23,548                                   | )       | (3,380 | ) |
|                                                                |   |                                      |    |   |   |
| Financing activities:                                               |   |                                      |    |   |   |
| Proceeds from sales of  common stock                                |   | 43,380                                    |    | — |   |
| Exercise of stock options  and warrants                             |   | 9,298                                     |    | 1,486 |   |
| Sales of common stock under  employee stock purchase plan           |   | 800                                       |    | 380 |   |
| Repayment of notes payable                                          |   | —                                    |    | (2,500 | ) |
|                                                                |   |                                      |    |   |   |
| Net cash provided by (used  in) financing activities                |   | 53,478                                    |    | (634 | ) |
|                                                                |   |                                      |    |   |   |
| Net increase in cash and  cash equivalents                          |   | 68,148                                    |    | 7,085 |   |
| Cash and cash equivalents,  beginning of period                     |   | 40,801                                    |    | 21,677 |   |
|                                                                |   |                                      |    |   |   |
| Cash and cash equivalents,  end of period                           |   | $                                         | 108,949 |   | $ | 28,762 |   |
|                                                                |   |                                      |    |   |   |
| Supplemental cash flow  disclosure:                                 |   |                                      |    |   |   |
| Common stock issued in  acquisitions and earn-outs                  |   | $                                         | 1,025   |   | $ | 2,910 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**DIGITAL RIVER, INC.**

# **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

# ** **

**1. BASIS OFPRESENTATION**

 

The unaudited condensed consolidatedfinancial statements included herein reflect all adjustments, consisting ofnormal recurring adjustments, which in the opinion of management are necessaryto fairly state the Company’s consolidated financial position, results ofoperations and cash flows for the periods presented.  These condensed consolidatedfinancial statements should be read in conjunction with the Company’s auditedconsolidated financial statements included in the Company’s Form 10-K for theyear ended December 31, 2002 as filed with the Securities and ExchangeCommission. The results of operations for the three and nine months endedSeptember 30, 2003 are not necessarily indicative of the results to beexpected for any subsequent quarter or for the entire fiscal year endingDecember 31, 2003.  The December 31, 2002 balance sheet wasderived from audited financial statements, but does not include all disclosuresrequired by accounting principles generally accepted in the United States.

 

**2. PRINCIPLES OFCONSOLIDATION**

 

The condensed consolidated financialstatements include the accounts of Digital River, Inc. and its whollyowned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation.

 

**3. NET INCOME (LOSS)PER SHARE**

 

The table below sets forth thecomputation of basic and diluted net income (loss) per share:

 
|                                                |   | **Three  Months Ended  September 30,** |      | **Nine Months  Ended  September 30,** |       |
|-----------------------------------------------------|--------|---------------------------------------------|-----------|--------------------------------------------|------------|
|                                                |   | **2003**                                    |      | **2002**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Numerator:                                          |   |                                        |      |                                       |       |   |   |   |   |
| Net income (loss)                                   |   | $                                           | 4,741,000 |                                       | $          | 98,000 |   | $ | 11,530,000 |   | $ | (3,780,000 | ) |
|                                                |   |                                        |      |                                       |       |   |   |   |   |
| Denominator:                                        |   |                                        |      |                                       |       |   |   |   |   |
| Basic — weighted average  shares outstanding   |   | 30,392,000                                  |      | 26,823,000                                 |       | 28,742,000 |   | 26,655,000 |   |
| Effect of dilutive  securities:                     |   |                                        |      |                                       |       |   |   |   |   |
| Employee stock options and  warrants                |   | 4,216,000                                   |      | 2,231,000                                  |       | 3,537,000 |   | — |   |
| Diluted — weighted average  shares outstanding |   | 34,608,000                                  |      | 29,054,000                                 |       | 32,279,000 |   | 26,655,000 |   |
|                                                |   |                                        |      |                                       |       |   |   |   |   |
| Basic — net income (loss)  per share           |   | $                                           | 0.16      |                                       | $          | 0.00 |   | $ | 0.40 |   | $ | (0.14 | ) |
|                                                |   |                                        |      |                                       |       |   |   |   |   |
| Diluted — net income  (loss) per share         |   | $                                           | 0.14      |                                       | $          | 0.00 |   | $ | 0.36 |   | $ | (0.14 | ) |

 

Diluted — weighted averageshares outstanding have not been adjusted for employee stock options andwarrants for the nine months ended September 30, 2002 where the effect ofthose securities would have been anti-dilutive.

 

6

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**4. GOODWILL ANDINTANGIBLE ASSETS**

 

 In June 2001, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards (SFAS) No.141, “Business Combinations” and No. 142, “Goodwill and Other IntangibleAssets.” SFAS No. 141 requires all business combinations initiated afterJune 30, 2001 to be accounted for using the purchase method.  Under SFAS No. 142, goodwill and intangibleassets with indefinite lives will no longer be amortized but are reviewedannually (or more frequently if impairment indicators arise) forimpairment.  For acquisitionsconsummated by the Company subsequent to July 1, 2001, the Company adoptedthe provisions of SFAS No. 141 and 142 effective July 1, 2001.  The Company adopted the full provisions of SFASNo. 141 and 142 during the first quarter of 2002.

 

The Companyhas assessed goodwill impairment using a two-step approach based on reportablesegments and reassessed any intangible assets, including goodwill, recorded inconnection with earlier acquisitions. The Company completed its initial andannual required goodwill impairment tests under SFAS No. 142 in the first andfourth quarters of 2002, respectively, which indicated that there was noimpairment of goodwill or other intangibles.

 

The changes in the carrying amount ofgoodwill for the nine months ended September 30, 2003 by operatingsegment, are as follows:

 
|                                  |   | **Software and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Total** |   |
|---------------------------------------|--------|-------------------------------------------------------|------------|-----------------------------------|--------|-----------|--------|
|                                  |   |                                                  |       |                              |   |      |   |
| Balance as of December 31, 2002  |   | $                                                     | 11,070,000 |                              | $      | 7,628,000 |   | $ | 18,698,000 |   |
| Goodwill acquired during the period   |   | 2,903,000                                             |       | —                            |   | 2,903,000 |   |
| Balance as of September 30, 2003 |   | $                                                     | 13,973,000 |                              | $      | 7,628,000 |   | $ | 21,601,000 |   |

 

Information regarding the Company’sother intangible assets is as follows:

 
|                   |   | **As of September 30, 2003** |       |
|------------------------|--------|-----------------------------------|------------|
|                   |   | **Carrying amount**               |       | **Accumulated  amortization** |   | **Net** |   |
|                   |   |                              |       |   |   |   |   |
| Customer relationships |   | $                                 | 15,966,000 |   | $ | 10,538,000 |   | $ | 5,428,000 |   |
| Non-compete agreements |   | 3,600,000                         |       | 2,819,000 |   | 781,000 |   |
| Technology/tradename   |   | 7,003,000                         |       | 5,117,000 |   | 1,886,000 |   |
| Total                  |   | $                                 | 26,569,000 |   | $ | 18,474,000 |   | $ | 8,095,000 |   |

 
|                   |   | **As of December 31, 2002** |       |
|------------------------|--------|----------------------------------|------------|
|                   |   | **Carrying amount**              |       | **Accumulated  amortization** |   | **Net** |   |
|                   |   |                             |       |   |   |   |   |
| Customer relationships |   | $                                | 14,117,000 |   | $ | 8,171,000 |   | $ | 5,946,000 |   |
| Non-compete agreements |   | 3,150,000                        |       | 2,399,000 |   | 751,000 |   |
| Technology/tradename   |   | 5,675,000                        |       | 4,026,000 |   | 1,649,000 |   |
| Total                  |   | $                                | 22,942,000 |   | $ | 14,596,000 |   | $ | 8,346,000 |   |

 

7

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Amortization expense for thenine months ended September 30, 2003 was $3,878,000 and $4,556,000 for thenine months ended September 2002.  Estimated amortization expense forthe remaining life of the intangible assets, based on intangible assets as ofSeptember 30, 2003, is as follows:

 

| **Year ended December 31,** |   |      |      |
|----------------------------------|--------|-----------|-----------|
| 2003                             |   | $         | 1,484,000 |   |
| 2004                             |   | 4,399,000 |      |
| 2005                             |   | 1,638,000 |      |
| 2006                             |   | 574,000   |      |
|                                  |        |           |           |  |

 

**5.  STOCK BASED COMPENSATION**

 

At September 30, 2003, the Company has two stock-based employeecompensation plans, which are described more fully in the Company’s 2002 AnnualReport Note 7.  The Company accounts forthese plans under the recognition and measurement principles of AccountingPrinciples Board (APB) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related Interpretations. No stock-based employee compensation cost is reflected in net income(loss), as all options granted under these plans had an exercise price equal tothe market value of the underlying common stock on the date of the grant.  The following table illustrates the effecton net income (loss) and net income (loss) per share if the Company had appliedthe fair value recognition provision of Financial Accounting Standards BoardStatement No. 123, “Accounting for Stock-Based Compensation,” to stock-basedemployee compensation.

 

The Companyhas elected to apply the disclosure-only provisions of SFAS No. 123,“Accounting for Stock-Based Compensation” as amended by SFAS No. 148.Accordingly, the Company accounts for stock-based compensation using theintrinsic value method prescribed in APB Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations. Compensation cost forstock options is measured as the excess, if any, of the fair value of theCompany’s Common Stock at the date of grant over the stock option exerciseprice. Had compensation costs for these plans been determined consistent withSFAS No. 123, the Company’s net income (loss) would have been adjusted tothe following pro forma amounts:

 
|                                                                                            |   | **Three  Months Ended September 30,** |      | **Nine Months  Ended September 30** |   |
|-------------------------------------------------------------------------------------------------|--------|--------------------------------------------|-----------|------------------------------------------|--------|
|                                                                                            |   | **2003**                                   |      | **2002**                                 |   | **2003** |   | **2002** |   |
| Net income (loss), as  reported                                                                 |   | $                                          | 4,741,000 |                                     | $      | 98,000 |   | $ | 11,530,000 |   | $ | (3,780,000 | ) |
|                                                                                            |   |                                       |      |                                     |   |   |   |   |   |
| Add: Stock-based  compensation, as reported                                                     |   | —                                     |      | —                                   |   | — |   | 37,000 |   |
| Deduct: Total stock-based  compensation determined under fair value based method for all awards |   | (3,335,000                                 | )         | (2,750,000                               | )      | (9,040,000 | ) | (5,840,000 | ) |
| Adjusted net income  (loss), fair value method for all stock-based awards                       |   | $                                          | 1,406,000 |                                     | $      | (2,652,000 | ) | $ | 2,490,000 |   | $ | (9,583,000 | ) |
|                                                                                            |   |                                       |      |                                     |   |   |   |   |   |
| Basic income (loss) per  share — as reported                                               |   | $                                          | 0.16      |                                     | $      | 0.00 |   | $ | 0.40 |   | $ | (0.14 | ) |
| Basic income (loss) per  share — SFAS No. 123 adjusted                                     |   | $                                          | 0.05      |                                     | $      | (0.10 | ) | $ | 0.09 |   | $ | (0.36 | ) |
|                                                                                            |   |                                       |      |                                     |   |   |   |   |   |
| Diluted income (loss) per  share – as reported                                             |   | $                                          | 0.14      |                                     | $      | 0.00 |   | $ | 0.36 |   | $ | (0.14 | ) |
| Diluted income (loss) per  shares – SFAS No. 123 adjusted                                  |   | $                                          | 0.04      |                                     | $      | (0.10 | ) | $ | 0.08 |   | $ | (0.36 | ) |

 

The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted average assumptionsused: risk-free interest rates of 3.0% in 2003 and 2002, no expected dividends;expected lives of five years; and a volatility factor of 1.4 in 2003 and 2002.

 

8

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**6. ACQUISITIONSAND EARN-OUT ARRANGEMENTS**

 

In January 2003, the Company acquired certain assets and assumedcertain liabilities of Metatec® International, Inc.’s (“Metatec”) electronicsoftware distribution (“ESD”) business in exchange for approximately $1.2million.   Goodwill of  $826,000 was recorded as a result of thisagreement. The Company will amortize intangible assets acquired, consisting ofa non-compete agreement and technology/tradename, over a three-yearperiod.  The agreement also providesMetatec the opportunity for an additional earn-out based on the Companyachieving certain revenue metrics related to the ESD business over the courseof the twelve months following November 1, 2002.  Such earn-out amount, if any, will be recorded as additionalgoodwill.

 

In March 2003, the Company acquiredsubstantially all of the assets and assumed certain liabilities of HartsellHoldings, Inc., (“Hartsell”) d/b/a Infocon America Corporation in connectionwith its business of providing web services for business-to-business publishersin exchange for approximately $1.1 million. Goodwill of $921,000 was recordedas a result of this agreement. The Company will amortize intangible assetsacquired, consisting of non-compete agreements and technology/tradename, over athree-year period. The agreement also provides Hartsell the opportunity foradditional earn-outs based on the Company achieving certain gross margin andrevenue metrics related to the web services for business-to-business publishersover the course of the twelve months and, at the Company’s sole discretion, thetwenty-four months, following the closing of the acquisition. Such earn-outamount,

if any, will be recorded as additionalgoodwill.

 

On August 1, 2003, the Company acquiredsubstantially all of the assets and certain liabilities of The RegistrationNetwork, or Reg.Net, providers of e-commerce services for authors and vendorsof try-before-you-buy software for up to $2,500,000, of which $1,318,000 has been funded. The remaining amount issubject to the satisfaction of certain contractual obligations.   Additional goodwill of $30,000 was recordedas a result of this acquisition.

 

During the three months endedMarch 31, 2002, the Company acquired certain assets and liabilities ofInnuity Acquisition Corp. and Beyond.com Corporation.

 

The following unaudited pro formacondensed results of operations for the three and nine months endedSeptember 30, 2003 and 2002 have been prepared as if each of theacquisitions from the nine months ended September 30, 2002 had occurred onJanuary 1, 2002.  The pro formapresentation does not include pro forma presentation for the assets acquired inthe nine months ended September 30, 2003, as they are not deemed to besignificant.

 
|                                 |   | **Three  Months Ended  September 30,** |       | **Nine Months  Ended  September 30,** |       |
|--------------------------------------|--------|---------------------------------------------|------------|--------------------------------------------|------------|
|                                 |   | **2003**                                    |       | **2002**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                 |   |                                        |       |                                       |       |   |   |   |   |
| Revenue                              |   | $                                           | 26,748,000 |                                       | $          | 18,872,000 |   | $ | 74,112,000 |   | $ | 58,278,000 |   |
| Income (loss) from  operations       |   | 4,477,000                                   |       | 48,000                                     |       | 10,949,000 |   | (6,548,000 | ) |
| Net income (loss)                    |   | 4,741,000                                   |       | 98,000                                     |       | 11,530,000 |   | (7,124,000 | ) |
|                                 |   |                                        |       |                                       |       |   |   |   |   |
| Basic net income (loss)  per share   |   | $                                           | 0.16       |                                       | $          | 0.00 |   | $ | 0.40 |   | $ | (0.27 | ) |
| Diluted net income (loss)  per share |   | $                                           | 0.14       |                                       | $          | 0.00 |   | $ | 0.36 |   | $ | (0.27 | ) |

 

This financial information doesnot purport to represent results that would actually have been obtained if thetransactions had been in effect on January 1, 2002 or any future resultsthat may in fact be realized.

 

9

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**7. SEGMENTINFORMATION**

 

The Company has two operating segments,Software and Digital Commerce Services and E-Business Services, which have beenidentified as components of the Company that are reviewed regularly bymanagement to determine resource allocation and assess performance. Unallocated corporate items consist of pending litigation and other charges,depreciation, amortization of acquisition-related costs, and interest incomefor operational results, and consist of certain cash, investments and goodwilland other intangibles for total assets.  Segment information is as follows:

 
| ** **                                      | ** ** | **Software  and  Digital Commerce  Services Division** | ** ** | **E-Business  Services Division** | ** ** | **Unallocated  Corporate  Items** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------|------------|
| **Three months ended  September 30, 2003** |       |                                                   |       |                              |       |                              |       |             |       |
| Revenue                                         |       | $                                                      | 23,490,000 |                              | $          | 3,258,000                         |       | $                | —     |   | $ | 26,748,000 |   |
| Gross profit                                    |       | 20,457,000                                             |       | 2,144,000                         |       | —                            |       | 22,601,000       |       |
| Income (loss) from operations                   |       | 8,034,000                                              |       | (247,000                          | )          | (3,310,000                        | )          | 4,477,000        |       |
| Net income (loss)                               |       | 8,034,000                                              |       | (247,000                          | )          | (3,046,000                        | )          | 4,741,000        |       |
| Total assets at September 30,  2003        |       | $                                                      | 66,437,000 |                              | $          | 13,334,000                        |       | $                | 98,194,000 |   | $ | 177,965,000 |   |
|                                            |       |                                                   |       |                              |       |                              |       |             |       |
| **Three months ended  September 30, 2002** |       |                                                   |       |                              |       |                              |       |             |       |
| Revenue                                         |       | $                                                      | 15,430,000 |                              | $          | 3,442,000                         |       | $                | —     |   | $ | 18,872,000 |   |
| Gross profit                                    |       | 12,895,000                                             |       | 2,420,000                         |       | —                            |       | 15,315,000       |       |
| Income (loss) from operations                   |       | 5,131,000                                              |       | (2,242,000                        | )          | (2,841,000                        | )          | 48,000           |       |
| Net income (loss)                               |       | 5,131,000                                              |       | (2,242,000                        | )          | (2,791,000                        | )          | 98,000           |       |
| Total assets at September 30,  2002        |       | $                                                      | 32,975,000 |                              | $          | 15,267,000                        |       | $                | 43,178,000 |   | $ | 91,420,000 |   |

** **
|                                           | ** ** | **Software  and  Digital Commerce  Services Division** | ** ** | **E-Business  Services Division** | ** ** | **Unallocated  Corporate  Items** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------|------------|
| **Nine months ended  September 30, 2003** |       |                                                   |       |                              |       |                              |       |             |       |
| Revenue                                        |       | $                                                      | 63,198,000 |                              | $          | 10,914,000                        |       | $                | —     |   | $ | 74,112,000 |   |
| Gross profit                                   |       | 54,620,000                                             |       | 7,661,000                         |       | —                            |       | 62,281,000       |       |
| Income (loss) from operations                  |       | 20,715,000                                             |       | (749,000                          | )          | (9,017,000)                       |       | 10,949,000       |       |
| Net income (loss)                              |       | 20,715,000                                             |       | (749,000                          | )          | (8,436,000)                       |       | 11,530,000       |       |
| Total assets at September 30,  2003       |       | $                                                      | 66,437,000 |                              | $          | 13,334,000                        |       | $                | 98,194,000 |   | $ | 177,965,000 |   |
|                                           |       |                                                   |       |                              |       |                              |       |             |       |
| **Nine months ended  September 30, 2002** |       |                                                   |       |                              |       |                              |       |             |       |
| Revenue                                        |       | $                                                      | 45,231,000 |                              | $          | 11,058,000                        |       | $                | —     |   | $ | 56,289,000 |   |
| Gross profit                                   |       | 38,066,000                                             |       | 7,973,000                         |       | —                            |       | 46,039,000       |       |
| Income (loss) from operations                  |       | 14,116,000                                             |       | (6,804,000                        | )          | (11,351,000                       | )          | (4,039,000       | )          |
| Net income (loss)                              |       | 14,116,000                                             |       | (6,804,000                        | )          | (11,092,000                       | )          | (3,780,000       | )          |
| Total assets at September 30,  2002       |       | $                                                      | 32,975,000 |                              | $          | 15,267,000                        |       | $                | 43,178,000 |   | $ | 91,420,000 |   |

 

**8.  PUBLIC OFFERING**

 

In January 2002, the Company filed aregistration statement on Form S-3 to offer and sell, from time to time, equityand debt securities in one or more offerings up to a total dollar amount of$100 million. On February 12, 2002 the SEC declared this registration statementeffective.  On July 16, 2003, the Company sold 2.1 million shares ofits common stock pursuant to this registration in an underwritten publicoffering at a price to the public of $21.35 per share.   The offering resulted in netproceeds to the Company of approximately $43,380,000 after underwritingcommissions and discounts of approximately $1,100,000 and other expenses ofapproximately $300,000.

 

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

 

*The Companynotes that, except for the historical information contained herein, the mattersdiscussed below contain forward-looking statements that involve known andunknown risks, uncertainties and other factors that may cause the actualresults, performance or achievements of the Company, or industry results, to bematerially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements.  The Company expresslydisclaims any obligation to update this information or publicly release anyrevision or reflect events or circumstances after the date of thisreport.  Such factors include, among others:  the Company’s limitedoperating history and variability of operating results, possibility of futurelosses, risks associated with electronic software delivery, dependence on theInternet and growth in electronic commerce and Internet infrastructuredevelopment, dependence on software publishers, dependence on online retailers,system development and electronic commerce security risks, rapid technologicalchanges, competition in the electronic commerce industry, the importance ofattracting and retaining personnel, management of the Company’s growth,integration of acquired companies, dependence on key employees and other riskfactors referenced in the Company’s Form 10-K for the year endedDecember 31, 2002.*

 

**Overview**

 

The Companyis a leading provider of comprehensive electronic commerce outsourcingsolutions. The Company was incorporated in February 1994 and commencedoffering products for sale through its clients’ Web stores in August 1996.From inception through August 1996, the Company had no sales, and itsactivities related primarily to the development of its proprietary technologyplatform, known as Commerce Network Servers or CNS. In 1996, the Company beganto focus its business development efforts on the software industry, buildingits inventory of software products through contracts with software publishers.In 1997, the Company began to develop software distribution relationshipsthrough contracts with online retailers. As of September 30**,**2003, the Company had approximately14,000 software publisher clients and online retailer clients served by theSoftware and Digital Commerce Services Division. In late 1998, the Companybegan to offer its comprehensive electronic commerce outsourcing services inthe form of a transaction fee-based e-commerce service to clients outside ofthe software industry. As of September 30, 2003, the Company was operatingapproximately 20,000 sites under its E-Business Services Division.

 

The Companyhas approximately seven years of operating history upon which investors mayevaluate its business and prospects. Since inception, the Company has incurredsignificant losses, and as of September 30, 2003, had an accumulateddeficit of approximately $92 million. The Company intends to expendfinancial and management resources on the development of additional services,sales and marketing, technology and operations to support larger-scaleoperations and greater service offerings. Although the Company expects togenerate positive cash flow from operations in 2003, there can be no assurancethat the Company’s revenue will increase or even continue at its current levelor that the Company will maintain profitability or generate cash fromoperations in future periods.

 

TheCompany’s prospects must be considered in light of the risks, expenses anddifficulties frequently encountered by companies in new and rapidly evolvingmarkets such as electronic commerce. To address these risks, the Company must,among other things, attract and retain software publishers and online retailersas clients, attract and retain E-Business clients, introduce new Web sites, Webstores or services, continue to upgrade and develop the Company’s systems andinfrastructure to meet emerging market needs and remain competitive in theCompany’s service offerings, and retain and attract personnel commensurate withthe Company’s business needs. There can be no assurance that the Company willbe successful in addressing these risks, and any failure to do so could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

The Company’scurrent and future expense levels are based largely on its planned operationsand estimates of future revenue. Revenue and operating results generally dependon the volume and timing of orders received, which are difficult to forecast.The Company may be unable to adjust spending in a timely manner to compensatefor any unexpected revenue shortfall. Accordingly, any significant shortfall inrevenue could have an immediate adverse effect on the Company’s business,financial condition and results of operations. The Company is also likely tocontinue to see revenue fluctuate on a seasonal basis, which is typical for thesoftware publishing market in general and its current E-Business Serviceclients. The Company believes that its first and fourth quarters tend to beseasonally stronger than its second and third quarters due to the timing ofdemand for tax preparation software and the holiday season selling period. Inaddition, it is the Company’s belief that software publishers avoid new productreleases in the summer months. In view of the rapidly evolving nature of theCompany’s business, the Company is unable to accurately forecast its revenueand believes that period-to-period comparisons of its operating results are notnecessarily meaningful and should not be relied upon as an indication of futureperformance.

 

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Effective July 1, 2003, the European Union implemented new rulesregarding the collection and payment of Value Added Tax, or VAT. These newrules require VAT to be charged on supplies delivered over electronic networks,including software and computer services, as well as information and cultural,artistic, sporting, scientific, educational, entertainment and similarservices. These services are now taxed in the country where the purchaserresides rather than where the supplier is located. Historically, suppliers ofdigital products that existed outside the European Union were not required tocollect or remit VAT on digital orders made to purchasers in the EuropeanUnion. With the implementation of these new rules, the Company is required tocollect and remit VAT on digital orders received from purchasers in theEuropean Union which effectively raises the prices for these goods by the VATamount. This price increase could serve to discourage purchasing of theCompany’s products and services which in turn could adversely affect theCompany’s operating results and financial condition.

 

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**Results of Operations**

 

The following table sets forth certainitems from the Company’s condensed consolidated statements of operations as apercentage of total revenue for the periods indicated.

 
|                                       |   | **Three  Months Ended  September 30,** |   | **Nine Months  Ended  September 30,** |       |
|--------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|------------|
|                                       |   | **2003**                                    |   | **2002**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                       |   |                                        |   |                                       |       |   |   |   |   |
| Revenue                                    |   | 100.0                                       | %      | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Costs and expenses                         |   |                                        |   |                                       |       |   |   |   |   |
| Direct cost of services                    |   | 3.2                                         |   | 3.0                                        |       | 3.7 |   | 3.1 |   |
| Network and infrastructure                 |   | 12.3                                        |   | 15.9                                       |       | 12.3 |   | 15.1 |   |
| Sales and marketing                        |   | 37.0                                        |   | 41.6                                       |       | 38.0 |   | 43.1 |   |
| Product research and  development          |   | 9.2                                         |   | 14.6                                       |       | 10.0 |   | 16.6 |   |
| General and administrative                 |   | 9.2                                         |   | 9.6                                        |       | 9.1 |   | 9.1 |   |
| Litigation and other  charges              |   | —                                      |   | —                                     |       | — |   | 4.5 |   |
| Depreciation and  amortization             |   | 7.1                                         |   | 7.9                                        |       | 6.9 |   | 7.6 |   |
| Amortization of acquisition-related  costs |   | 5.3                                         |   | 7.2                                        |       | 5.2 |   | 8.1 |   |
| Total operating expenses                   |   | 83.3                                        |   | 99.8                                       |       | 85.2 |   | 107.2 |   |
| Income (loss) from  operations             |   | 16.7                                        |   | 0.2                                        |       | 14.8 |   | (7.2 | ) |
| Interest income, net                       |   | 1.0                                         |   | 0.3                                        |       | 0.8 |   | 0.5 |   |
| Net income (loss)                          |   | 17.7                                        | %      | 0.5                                        | %          | 15.6 | % | (6.7 | )% |

 

***REVENUE.***Revenue increased to $26,748,000 for the three months ended September 30,2003 from $18,872,000 for the same period in the prior year, an increase of$7,876,000 or 41.7%. For the nine months ended September 30, 2003 revenuetotaled $74,112,000, an increase of $17,823,000 or 31.7% from revenue of $56,289,000 recorded in the sameperiod of the prior year.  Revenue forthe Software and Digital Commerce Services division increased to $23,490,000and $63,198,000 for the three months and nine months ended September 30,2003 from $15,430,000 and $45,231,000 for the three months and nine monthsended September 30, 2002, respectively.  The increase can primarilybe attributed to sales generated from the recent, unanticipated virus outbreakparticularly with respect to the three months ended September 30 2003,growth in the number of the Company’s software publisher and online retailerclients, and an increase in product sales.   Revenue for theE-Business Services division was $3,258,000 and $10,914,000 for the threemonths and nine months ended September 30, 2003, compared with $3,442,000and $11,058,000 for the three months and nine months ended September 30,2002.

 

International sales representedapproximately 24% and 22% of total sales in the three-month periods endedSeptember 30, 2003 and 2002, respectively and approximately 23% and 21% oftotal sales in the nine months ended September 30, 2003 and 2002,respectively.

 

***GROSSPROFIT.***Cost of revenue, which consists ofdirect cost of services and network and infrastructure costs (both shown inthis paragraph and table above exclusive of depreciation and amortizationexpense), increased to $4,147,000 and $11,831,000 for the three months and ninemonths ended September 30, 2003 from $3,557,000 and $10,250,000 for thesame periods in the prior year.  The increase for the three-month andnine-month periods ended September 30, 2003 primarily resulted from directcosts related to client contracts and increased revenue for outsourcedprofessional services.    The grossprofit margin for the Software and Digital Commerce Services division increasedin the three months and nine months ended September 30, 2003 to 87.1% and86.4% from 83.6% and 84.2% for the same periods of the prior year,respectively.  The gross profit margin for the E-Business Servicesdivision decreased in the three months and nine months ended September 30,2003 to 65.8% and 70.2% compared to 70.3% and 72.1% for the same period of theprior year, respectively.  The increase in Software and Digital CommerceServices margins is primarily due to leveraging the Company’s infrastructureover significantly more revenue and clients.  The E-Business Servicesdivision incurred higher direct costs of labor related to client contracts foroutsourced professional services resulting in the decreased profit margins forthe three and nine month periods ending September 30, 2003.  The Company believes that Internet commerceand related services could become more competitive in the future.  In thatevent, the Company may reduce its pricing or alter its pricing structure andpolicies in the future and any such change could immediately reduce grossmargins.

 

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***SALESAND MARKETING.***Sales and marketing expense consists primarilyof personnel and related expenses, advertising and promotional expenses, baddebt/chargeback expense and credit card transaction fees.  Sales andmarketing expense increased to $9,895,000 and $28,145,000 for the three monthsand nine months ended September 30, 2003 from $7,854,000 and $24,269,000for the same period in the prior year, respectively, an increase of $2,041,000and $3,876,000 or 26.0% and 16.0%, respectively.  The increase primarilyresulted from credit card fees and chargeback costs directly associated withthe increase in revenue.  Sales and marketing expense for the Software andDigital Commerce Services division increased to $8,438,000 and $23,698,000 forthe three months and nine months ended September 30, 2003 from $5,513,000and $16,610,000 for the same period in the prior year, respectively. Sales and marketing expense for the E-Business Services division was $1,457,000and $4,447,000 for the three months and nine months ended September 30,2003, compared to $2,341,000 and $7,659,000 for the same period in the prioryear.  The decrease in E-Business Services sales and marketing expense wasa result of the previously announced consolidation of the teams that supportE-Business Services and Software and Digital Commerce Services, which hasresulted in increased efficiencies.  Asa percentage of revenue, sales and marketing expense was 37.0% and 38.0% in thethree months and nine months ended September 30, 2003, compared to 41.6%and 43.1% for the same period in the prior year, primarily reflecting theCompany’s increased revenue.  The Company expects that sales and marketingexpense will continue to increase in absolute dollars as the Company continuesto build its sales and marketing infrastructure and develops marketing programs,and as volume–driven credit card and bad debt/chargeback expensesincrease.  As a percentage of revenue, sales and marketing expenses areexpected to decrease as future revenue increases.

 

***PRODUCTRESEARCH AND DEVELOPMENT.*** Product research anddevelopment expense consists primarily of personnel and related expenses andconsulting costs associated with developing and enhancing the Company’s CNS andrelated internal systems.  Productresearch and development expense decreased to $2,447,000 and $7,429,000 for thethree months and nine months ended September 30, 2003 from $2,764,000 and$9,327,000 for the same periods in the prior year, a decrease of $317,000 and$1,898,000 or 11.5% and 20.3%, respectively.  The decrease was primarily driven by a reduction in personnel-relatedexpenses and outside consulting fees related to the substantial completion ofCNS enhancements.  Product research anddevelopment expense for the Software and Digital Commerce Services division was$1,994,000 and $4,586,000 for the three months and nine months endedSeptember 30, 2003 compared to $1,103,000 and $3,873,000 for the sameperiods of the prior year, respectively.  Product research and developmentexpense for the E-Business Services division decreased to $453,000 and$2,843,000 for the three and nine months ended September 30, 2003 from$1,661,000 and $5,454,000 in the same period in the prior year,respectively.  As a percentage of revenue, product research anddevelopment expense was 9.2% and 10.0% in the three months and nine monthsended September 30, 2003, compared to 14.6% and 16.6% for the same periodin the prior year.  The Company expects that product research anddevelopment costs will increase in absolute dollars as the Company continues todevelop the CNS and other related internal systems.

 

***GENERALAND ADMINISTRATIVE.***General and administrative expenseconsists primarily of executive, accounting and administrative personnel andrelated expenses, including professional fees and investor relationsexpenses.  General and administrative expenses increased to $2,472,000 and$6,741,000 for the three months and nine months ended September 30, 2003from $1,807,000 and $5,130,000 for the same period in the prior year, anincrease of $665,000 and $1,611,000 or 36.8% and 31.4% respectively.    The increase resulted primarily frompersonnel-related expenses and professional and legal fees associated withcompliance with the new Sarbanes-Oxley Act and related rules and regulations,foreign governance compliance, ongoing defense of pending lawsuits andincreased insurance premiums.  General and administrative expense for theSoftware and Digital Commerce Services division increased to $1,991,000 and$5,621,000 for the three months and nine months ended September 30, 2003,from $1,149,000 and $3,467,000 for the same period in the prior year,respectively.  General and administrative expense for the E-BusinessServices division decreased to $481,000 and $1,120,000 for the three months andnine months ended September 30, 2003, from $658,000 and $1,663,000 for thesame period in the prior year, respectively.  As a percentage of revenue,general and administrative expense was 9.2% and 9.1% for the three-month andnine-month periods ended September 30, 2003, compared to 9.6% and 9.1% forthe same periods in the prior year, respectively.  The Company expectsthat general and administrative expense will increase in absolute dollars overtime as the Company defends its positions related to legal claims and as itcontinues to build infrastructure to support its revenue growth and to complywith new governmental regulations.

 

***LITIGATIONAND OTHER CHARGES.***During the three months endedMarch 31, 2002, the Company recorded a charge for pending litigation of$2,300,000.  This reserve was established based upon developments in newand existing litigation for which management determined, in the first quarterof 2002, that payment was both probable and estimable.  Additionally, theCompany recorded a charge of $200,000 during the three months ended March 31,2002 in connection with its decision during the period to consolidate one ofits offices.  During the three monthsand nine months ended September 30, 2003, no charges were recorded forsettlement of litigation and other charges.

 

14

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***AMORTIZATIONOF INTANGIBLE ASSETS AND ACQUISITION-RELATED COSTS.***Amortizationof intangible assets and acquisition-related costs was $1,411,000 and$3,878,000 for the three months and nine months ended September 30, 2003compared to $1,356,000 and $4,556,000 for the same periods.  The decrease for the nine month period wasdue to assets acquired in 1999 becoming fully amortized. The amortizationrelated to assets acquired in the three months and nine months endedSeptember 30, 2003 was not significant.

 

***INCOME TAXES.***TheCompany paid no income taxes in any reported period.  As ofSeptember 30, 2003, the Company had approximately $70,170,000 of netoperating loss carryforwards for federal income tax purposes, which expirebeginning in 2009.  Due to theuncertainty of future profitability, a valuation allowance equal to thedeferred tax asset has been recorded.  Certain changes in ownership thatresulted from the sales of common and preferred stock will limit the futureannual realization of the tax operating loss carryforwards to a specifiedpercentage under Section 382 of the Internal Revenue Code.

 

**Liquidity andCapital Resources**

 

As of September 30, 2003, theCompany had $108,949,000 of cash and cash equivalents, $15,034,000 of short-terminvestments and working capital of approximately $78,362,000. TheCompany’s principal commitments consisted of obligations outstanding underoperating leases.  During the nine months ended September 30, 2003,the Company’s operations generated $38,218,000 of cash compared to $11,099,000for the same period of the prior year.  The improvement is mainly due tothe increase in net income, collection of accounts receivable and the increasein client payable related to increased revenue.  Net cash used ininvesting activities during the nine months ended September 30, 2003totaled $23,548,000.  This was comprised of purchases of investments of$15,000,000, investments in equipment of $4,675,000 and net investments inacquisitions of $3,873,000.  Net cash provided by financing activitiesduring the nine months ended September 30, 2003 totaled $53,478,000,comprised of cash received from the completion of a follow-on public offeringof the Company’s common stock, resulting in net proceeds of approximately$43,380,000 after underwriting commissions and discounts of approximately$1,100,000 and other expenses of approximately $300,000, and from the sale ofstock through the exercise of stock options and purchases through the employeestock purchase plan of $9,298,000.

 

Although the Company has no materialcommitments for capital expenditures, it anticipates continued capitalexpenditures consistent with its anticipated growth in operations,infrastructure and personnel.  The Company anticipates that it will expendapproximately $10,000,000 over the next 15 months on capital expenditures basedon its current anticipated growth rate in operations.  The Company furtheranticipates that it will expend approximately $13,000,000 over the next 15months on product development based on its current anticipated growth rate inoperations.  The Company may also use cash to acquire or licensetechnology, products or businesses related to the Company’s current business.

 

The Company believes that existingsources of liquidity and the results of its operations will provide adequatecash to fund its operations for the foreseeable future.

 

**Item 3****. Qualitative and Quantitative Disclosure About Market Risk**

 

The Company does not enter intofinancial instruments for trading or speculative purposes and does notcurrently utilize derivative financial instruments.  The operations of theCompany are conducted primarily in the United States currency and as such arenot currently subject to material foreign currency exchange rate risk.  TheCompany has no long-term debt.

 

However, the growth in the Company’sinternational operations is increasing the Company’s exposure to foreigncurrency fluctuations. The Company has foreign currency denominated netrevenues, costs and expenses. These income statement amounts are translatedinto U.S. dollars at the average exchange rates in each applicable period. Tothe extent the U.S. dollar weakens against foreign currencies, the translationof these foreign currency denominated transactions results in increased netrevenues, operating expenses and net income. Conversely, the Company’s netrevenues, operating expenses and net income will decrease when the U.S. dollarstrengthens against foreign currencies.  The Company expects international operations to continue to grow insignificance as it develops and deploys its global marketplace presence. As aresult, foreign currency fluctuations in future periods could become moresignificant and may have a negative impact on the Company’s net revenues andnet income.

 

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**Item 4****. Controls and Procedures**

 

The Company’s management, with the participation of the Company’s ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof the Company’s disclosure controls and procedures as of September 30,2003.  Based on this evaluation, theCompany’s Chief Executive Officer and Chief Financial Officer concluded thatthe Company’s disclosure controls and procedures are effective for gathering,analyzing, and disclosing the information the Company is required to disclosein the reports it files under the Securities Exchange Act of 1934, within thetime periods specified in the Securities and Exchange Commission’s rules andforms.  Such evaluation did not identifyany change in the Company’s internal control over financial reporting thatoccurred during the quarter ended September 30, 2003 that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**Limitations onthe Effectiveness of Controls**

 

The Company’s management, including theChief Executive Officer and Chief Financial Officer, does not expect that theCompany’s disclosure controls and procedures or internal controls will preventall error and all fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the control. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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**PART II****.  OTHERINFORMATION**

 

**Item 1****.  LegalProceedings**

 

Beginning in August 2001,the Company and certain of the Company’s officers and directors were named asdefendants in several class action shareholder complaints filed in the UnitedStates District Court for the Southern District of New York, now consolidatedas*In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355.  In the consolidated amended complaint, theplaintiffs allege that the Company, certain of the Company’s officers anddirectors and the underwriters of the Company’s initial public offering, orIPO, violated Section 11 of the Securities Act of 1933 based onallegations that the Company’s IPO registration statement and prospectus failedto disclose material facts regarding the compensation to be received by, andthe stock allocation practices of, the IPO underwriters.  The complaintalso contains a claim for violation of Section 10(b) of the SecuritiesExchange Act of 1934 based on allegations that this omission constituted adeceit on investors.  The plaintiffs seek unspecified monetary damages andother relief.  Similar complaints, referred to here as the IPO Lawsuits,were filed in the same court against hundreds of other public companies whoconducted IPOs between 1998 and 2000.  Thecompanies sued in the IPO Lawsuits, including the Company, are collectivelyreferred to here as the Issuers.

 

On August 8, 2001, the IPO Lawsuits were consolidated for pretrialpurposes before United States Judge Shira Scheindlin of the Southern Districtof New York.  Judge Scheindlin held an initial case management conferenceon September 7, 2001, at which time she ordered, among other things, thatthe time for all defendants in the IPO Lawsuits to respond to any complaint bepostponed until further order of the court.  Thus, the Company has notbeen required to answer any of the complaints, and no discovery has been servedon the Company.

 

On July 15, 2002, the Company joined in a global motion to dismissthe IPO Lawsuits filed by all Issuers (among others).  On October 9,2002, the court entered an order dismissing the Company’s named officers anddirectors from the IPO Lawsuits without prejudice, pursuant to an agreementtolling the statute of limitations with respect to these officers and directorsuntil September 30, 2003.  On February 19, 2003, the courtissued a decision denying the motion to dismiss the Section 11 claimsagainst the Company and almost all of the other Issuers and denying the motionto dismiss the Section 10(b) claims against the Company and many of theother Issuers.

 

OnSeptember 26, 2003, the plaintiffs in the IPO Lawsuits announced aproposed settlement with the Company and the other Issuers. The proposedsettlement provides that the insurers of all settling Issuers will guaranteethat the plaintiffs recover $1 billion from the investment banks who acted asunderwriters in the Issuers’ IPOs. In the event that the plaintiffs do notrecover $1 billion, the insurers for the settling Issuers will make up thedifference.  In September 2003, in connection withthe possible settlement, those officers and directors of the Company who hadentered tolling agreements with plaintiffs (described above) agreed to extendthose agreements so that they would not expire prior to any settlement beingfinalized.  The Company believes that ithas sufficient insurance coverage to cover the maximum amount that it may beresponsible for under the proposed settlement. It is possible that the partiesmay not reach agreement on the final settlement documents or that the FederalDistrict Court may not approve the settlement in whole or part.

 

OnAugust 21, 2001, the Company, along with other defendants, was named as adefendant in a patent litigation regarding United States Patent No. 6,014,651owned by Christopher M. Crawford of Washington, D.C.  The case was filedand is pending in the U.S. District Court in the District of Columbia. The court delayed substantive discovery in this case pending resolution ofcertain motions.  On October 27,2003, the parties jointly filed a request for a status hearing.  Once the court determines the scope of thepatent claims, the Company may file for a dismissal of the case if the court’sdecision is consistent with the Company’s and the other defendants’ positionregarding the interpretation of the patent claims.  At this time, Crawfordhas not made a definitive demand for the resolution of this case.

 

On April 25, 2002, theCompany, along with RegSoft.com, Inc., a subsidiary of the Company, andRegister Now!, a division of the Company, and other various defendants, werenamed as defendants in a patent litigation regarding United States Patent No.4,500,919 assigned to the Massachusetts Institute of Technology, or MIT, by theinventor William F. Schreiber of Cambridge, Massachusetts.  MIT licensedthe patent to Electronics for Imaging, Inc., or EFI, and these parties jointlyfiled a lawsuit in the U.S. District Court in the Eastern District ofTexas.  The Company, RegSoft.com, Inc. and RegisterNow! without admittingliability have recently agreed to a settlement of the lawsuit for $15,000,and the lawsuit against these defendants was dismissed on August 29, 2003.

 

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**Item 5****. OtherInformation**

 

In October 2003, GaryHoworka, Digital River’s Chief Technology Officer, announced that he will beleaving his position and role as an executive officer, to assume newresponsibilities as Senior Vice President, Advanced Technologies.

 

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**Item 6****. Exhibits and Reports on Form 8-K**

 

(A) Exhibits

 
| **EXHIBIT  NUMBER** |   | **DESCRIPTION  OF DOCUMENTS** |
|---------------------|--------|-------------------------------|
|                |   |                          |   |   |
| 3.1                 |   | (1)                           |   | Amended and Restated Certificate of  Incorporation, as amended, as currently in effect |
| 3.2                 |   | (2)                           |   | Amended and Restated Bylaws, as  currently in effect |
| 4.1                 |   | (3)                           |   | Specimen of Common Stock Certificate |
| 10.1                |   |                          |   | Employment agreement with Jay Kerutis |
| 31.1                |   |                          |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2                |   |                          |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1           |   |                          |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002* |

 

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| (1) |   | Filed as Exhibits 3.1 and 3.3 to the  Company’s Registration Statement on Form S-3, File No. 333-81626, filed on  January 29, 2002, declared effective on February 12, 2002, and  incorporated herein by reference. |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Filed as an exhibit to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2000, filed  on March 27, 2001, and incorporated herein by reference.                                              |
| (3) |   | Filed as an exhibit to the Company’s  Registration Statement on Form S-1, File No. 333-56787, declared effective on  August 11, 1998, and incorporated herein by reference.                                              |
| *   |   | Furnished as an exhibit to this  quarterly report on Form 10-Q                                                                                                                                                                     |

 

(B) Reports on Form 8-K.

 

On July 16, 2003, the Companyfiled a current report on Form 8-K announcing under Item 5 the financialresults for the quarter and six months ended June 30, 2003 and ane-commerce agreement with Macromedia, Inc.

 

On July 18, 2003, the Companyfiled a current report on Form 8-K under Item 5 announcing that it entered intoan underwriting agreement relating to the sale of 2,100,000 shares of commonstock at a price to the public of $21.35 per share.

 

On July 23, 2003, the Companyfiled a current report on Form 8-K furnishing under Item 9 (Informationprovided under Item 12), in accordance with SEC release No. 33-8216, thefinancial results for the quarter ended and six months ended June 30,2003.

 

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SIGNATURES

 

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

 
| Date:  | November 13, 2003 |   | DIGITAL  RIVER, INC.                                                    |   |
|--------|------------------------|--------|-------------------------------------------------------------------------|--------|
|   |                   |   |                                                                    |   |
|   |                   |   |                                                                    |   |
|   |                   | By:    | /s/  CARTER D. HICKS                                                    |   |
|   |                   |   |                                                                    |   |
|   |                   |   | Carter  D. Hicks                                                        |   |
|   |                   |   | *Chief Financial Officer  (Principal Financial and Accounting Officer)* |   |

 

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EXHIBIT INDEX

 
| **EXHIBIT  NUMBER** |   | **DESCRIPTION  OF DOCUMENTS** |
|---------------------|--------|-------------------------------|
|                |   |                          |   |   |
| 3.1                 |   | (1)                           |   | Amended and Restated Certificate of  Incorporation, as amended, as currently in effect |
| 3.2                 |   | (2)                           |   | Amended and Restated Bylaws, as  currently in effect |
| 4.1                 |   | (3)                           |   | Specimen of Common Stock Certificate |
| 10.1                |   |                          |   | Employment Agreement with Jay Kerutis |
| 31.1                |   |                          |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2                |   |                          |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1           |   |                          |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002* |

 

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|   | (1) |   | Filed as Exhibits 3.1 and 3.3 to the  Company’s Registration Statement on Form S-3, File No. 333-81626, filed on  January 29, 2002, declared effective on February 12, 2002, and  incorporated herein by reference. |
|--------|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (2) |   | Filed as an exhibit to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2000, filed  on March 27, 2001, and incorporated herein by reference.                                              |
|   | (3) |   | Filed as an exhibit to the Company’s  Registration Statement on Form S-1, File No. 333-56787, declared effective on  August 11, 1998, and incorporated herein by reference.                                              |
|   | *   |   | Furnished as an exhibit to the  quarterly report on Form 10-Q.                                                                                                                                                                     |

 

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