**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-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 JUNE 30, 2003**

 

**OR**

 

| **o** |   | **TRANSITION REPORT PURSUANT TO SECTION  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------|-----------------------------------------------------------------------------------------------|

** **

**FOR THE TRANSITION PERIOD FROM       TO       **

 

**Commission file number 000-24643**

 

**DIGITALRIVER, 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 principalexecutive offices)

 

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

 

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

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule12b-2)  Yes ý No o

 

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

 

| **COMMON STOCK, $0.01 PAR VALUE** |   | **30,707,273 SHARES**            |
|-----------------------------------|--------|----------------------------------|
| (Class)                           |   | Outstanding  as of July 31, 2003 |

 

 

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DIGITAL RIVER, INC.

Form 10-Q

Index

 
| PART I.        | FINANCIAL INFORMATION |
|----------------|-----------------------|
|           |                  |   |
|           | Item 1.               | Financial Statements |
|           |                  |   |
|           |                  | Condensed Consolidated Balance Sheets as of  June 30, 2003 and December 31, 2002 |
|           |                  |   |
|           |                  | Condensed Consolidated Statements of  Operations for the three and six months ended June 30, 2003 and 2002 |
|           |                  |   |
|           |                  | Condensed Consolidated Statements of Cash  Flows for the six months ended June 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 4.               | Submission of Matters to a Vote of Security  Holders |
|           |                  |   |
|           | Item 5.               | Other Information |
|           |                  |   |
|           | Item 6.               | Exhibits and Reports on Form 8-K |
|           |                  |   |
| SIGNATURES     |
|           |
| EXHIBIT  INDEX |                  |
|                |                       |  |  |

 

2

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**PARTI.  FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(inthousands, except share data)

 
|                                                                                                                               |   | **June  30,  2003** |       | **December  31,  2002** |       |
|------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
|                                                                                                                               |   | **(unaudited)**     |       |                    |       |
| **ASSETS**                                                                                                                         |   |                | ** ** |                    | ** ** |
| Current Assets                                                                                                                     |   |                |       |                    |       |
| Cash and cash equivalents                                                                                                          |   | $                   | 57,895     |                    | $          | 40,801 |   |
| Accounts receivable, net of allowance of $2,819 and $1,746                                                                         |   | 7,259               |       | 10,397                  |       |
| Prepaid expenses and other                                                                                                         |   | 1,728               |       | 1,807                   |       |
|                                                                                                                               |   |                |       |                    |       |
| Total current assets                                                                                                               |   | 66,882              |       | 53,005                  |       |
|                                                                                                                               |   |                |       |                    |       |
| Property and equipment, net                                                                                                        |   | 15,527              |       | 15,637                  |       |
| Goodwill                                                                                                                           |   | 21,505              |       | 18,698                  |       |
| Intangible and other assets                                                                                                        |   | 6,734               |       | 8,353                   |       |
|                                                                                                                               |   | $                   | 110,648    |                    | $          | 95,693 |   |
|                                                                                                                               |   |                |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                     |   |                |       |                    |       |
| Current liabilities                                                                                                                |   |                |       |                    |       |
| Accounts payable                                                                                                                   |   | $                   | 31,033     |                    | $          | 31,126 |   |
| Accrued payroll                                                                                                                    |   | 2,679               |       | 1,788                   |       |
| Deferred revenue                                                                                                                   |   | 2,080               |       | 1,865                   |       |
| Other accrued liabilities                                                                                                          |   | 4,729               |       | 3,728                   |       |
|                                                                                                                               |   |                |       |                    |       |
| Total current liabilities                                                                                                          |   | 40,521              |       | 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;  28,502,350 and 27,537,240 shares issued and outstanding, respectively |   | 285                 |       | 275                     |       |
| Additional paid-in capital                                                                                                         |   | 166,677             |       | 160,535                 |       |
| Accumulated deficit                                                                                                                |   | (96,835             | )          | (103,624                | )          |
|                                                                                                                               |   |                |       |                    |       |
| Total stockholders’ equity                                                                                                    |   | 70,127              |       | 57,186                  |       |
|                                                                                                                               |   |                |       |                    |       |
|                                                                                                                               |   | $                   | 110,648    |                    | $          | 95,693 |   |
|                                                                                                                               |   |                |       |                    |       |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data; unaudited)

 
|                                                                                             |   | **Three months ended  June 30,** |   | **Six months ended  June 30,** |   |
|--------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                             |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                                                             |   |                             |   |                           |   |   |   |   |   |
| Revenue                                                                                          |   | $                                | 22,764 |                           | $      | 19,347 |   | $ | 47,364 |   | $ | 37,417 |   |
| Costs and expenses (exclusive of depreciation  and amortization expense shown separately below): |   |                             |   |                           |   |   |   |   |   |
| Direct cost of services                                                                          |   | 939                              |   | 556                            |   | 1,881 |   | 1,171 |   |
| Network and infrastructure                                                                       |   | 2,857                            |   | 2,810                          |   | 5,803 |   | 5,522 |   |
| Sales and marketing                                                                              |   | 8,978                            |   | 8,402                          |   | 18,250 |   | 16,415 |   |
| Product research and development                                                                 |   | 2,594                            |   | 3,289                          |   | 4,982 |   | 6,563 |   |
| General and administrative                                                                       |   | 1,978                            |   | 1,708                          |   | 4,269 |   | 3,323 |   |
| Litigation and other charges                                                                     |   | —                           |   | —                         |   | — |   | 2,500 |   |
| Depreciation and amortization                                                                    |   | 1,652                            |   | 1,436                          |   | 3,240 |   | 2,810 |   |
| Amortization of acquisition related costs                                                        |   | 1,246                            |   | 1,651                          |   | 2,467 |   | 3,200 |   |
| Total costs and expenses                                                                         |   | 20,244                           |   | 19,852                         |   | 40,892 |   | 41,504 |   |
| Income  (loss) from operations                                                                   |   | 2,520                            |   | (505                           | )      | 6,472 |   | (4,087 | ) |
| Interest  income – net                                                                      |   | 247                              |   | 157                            |   | 317 |   | 209 |   |
|                                                                                             |   |                             |   |                           |   |   |   |   |   |
| Net income  (loss)                                                                               |   | $                                | 2,767  |                           | $      | (348 | ) | $ | 6,789 |   | $ | (3,878 | ) |
|                                                                                             |   |                             |   |                           |   |   |   |   |   |
| Net income  (loss) per share                                                                     |   |                             |   |                           |   |   |   |   |   |
| Basic                                                                                            |   | $                                | 0.10   |                           | $      | (0.01 | ) | $ | 0.24 |   | $ | (0.15 | ) |
| Diluted                                                                                          |   | $                                | 0.09   |                           | $      | (0.01 | ) | $ | 0.22 |   | $ | (0.15 | ) |
|                                                                                             |   |                             |   |                           |   |   |   |   |   |
| Weighted  average common shares outstanding                                                      |   |                             |   |                           |   |   |   |   |   |
| Basic                                                                                            |   | 28,195                           |   | 26,688                         |   | 27,903 |   | 26,569 |   |
| Diluted                                                                                          |   | 31,790                           |   | 26,688                         |   | 31,101 |   | 26,569 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)

 
|                                                                                      |   | **Six months  ended  June 30,** |   |
|-------------------------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                                      |   | **2003**                        |   | **2002** |   |
|                                                                                      |   |                            |   |   |   |
| Operating activities:                                                                     |   |                            |   |   |   |
| Net income (loss)                                                                         |   | $                               | 6,789  |   | $ | (3,878 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by operating  activities: |   |                            |   |   |   |
| Amortization of acquisition related costs                                                 |   | 2,467                           |   | 3,200 |   |
| Depreciation and amortization                                                             |   | 3,240                           |   | 2,810 |   |
| Deferred compensation expense                                                             |   | —                          |   | 37 |   |
| Litigation and other charges                                                              |   | —                          |   | 2,500 |   |
| Change in operating assets and liabilities:                                               |   |                            |   |   |   |
| Accounts receivable                                                                       |   | 3,394                           |   | (2,359 | ) |
| Other assets                                                                              |   | 69                              |   | 60 |   |
| Accounts payable                                                                          |   | (266                            | )      | 6,860 |   |
| Other current liabilities                                                                 |   | 1,664                           |   | (2,051 | ) |
| Deferred revenue                                                                          |   | 179                             |   | 62 |   |
|                                                                                      |   |                            |   |   |   |
| Net cash provided by operating activities                                                 |   | 17,536                          |   | 7,241 |   |
|                                                                                      |   |                            |   |   |   |
| Investing activities:                                                                     |   |                            |   |   |   |
| Sales of investments, net                                                                 |   | —                          |   | (3,481 | ) |
| Cash paid for acquisitions, net of cash received                                          |   | (2,442                          | )      | (2,778 | ) |
| Purchases of equipment                                                                    |   | (3,127                          | )      | (2,636 | ) |
|                                                                                      |   |                            |   |   |   |
| Net cash used in investing activities                                                     |   | (5,569                          | )      | (8,895 | ) |
|                                                                                      |   |                            |   |   |   |
| Financing activities:                                                                     |   |                            |   |   |   |
| Exercise of stock options and warrants                                                    |   | 4,327                           |   | 807 |   |
| 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                                       |   | 5,127                           |   | (1,313 | ) |
|                                                                                      |   |                            |   |   |   |
| Net increase/decrease in cash and cash equivalents                                        |   | 17,094                          |   | (2,967 | ) |
| Cash and cash equivalents, beginning of period                                            |   | 40,801                          |   | 21,677 |   |
|                                                                                      |   |                            |   |   |   |
| Cash and cash equivalents, end of period                                                  |   | $                               | 57,895 |   | $ | 18,710 |   |
|                                                                                      |   |                            |   |   |   |
| 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.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**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 condensedconsolidated financial statements should be read in conjunction with the Company’saudited consolidated financial statements included in the Company’s Form 10-Kfor the year ended December 31, 2002 as filed with the Securities and ExchangeCommission. The results of operations for the three and sixth months ended June30, 2003 are not necessarily indicative of the results to be expected for anysubsequent quarter or for the entire fiscal year ending December 31,2003.  The December 31, 2002 balance sheet was derived from auditedfinancial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States.

 

**2. PRINCIPLES OF CONSOLIDATION**

 

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 the computation ofbasic and diluted net income (loss) per share:

 
|                                               |   | **Three  months ended  June 30,** |      | **Six  months ended  June 30,** |   |
|----------------------------------------------------|--------|-----------------------------------|-----------|---------------------------------|--------|
|                                               |   | **2003**                          |      | **2002**                        |   | **2003** |   | **2002** |   |
|                                               |   |                              |      |                            |   |   |   |   | ** ** |
| Numerator:                                         |   |                              |      |                            |   |   |   |   |   |
| Net income (loss)                                  |   | $                                 | 2,767,000 |                            | $      | (348,000 | ) | $ | 6,789,000 |   | $ | (3,878,000 | ) |
|                                               |   |                              |      |                            |   |   |   |   |   |
| Denominator:                                       |   |                              |      |                            |   |   |   |   |   |
| Basic — weighted average shares outstanding   |   | 28,195,000                        |      | 26,688,000                      |   | 27,903,000 |   | 26,569,000 |   |
| Effect of dilutive securities:                     |   |                              |      |                            |   |   |   |   |   |
| Employee stock options and warrants                |   | 3,595,000                         |      | —                          |   | 3,198,000 |   | — |   |
| Diluted — weighted average shares outstanding |   | 31,790,000                        |      | 26,688,000                      |   | 31,101,000 |   | 26,569,000 |   |
|                                               |   |                              |      |                            |   |   |   |   |   |
| Basic — net income (loss) per share           |   | $                                 | 0.10      |                            | $      | (0.01 | ) | $ | 0.24 |   | $ | (0.15 | ) |
|                                               |   |                              |      |                            |   |   |   |   |   |
| Diluted — net income (loss) per share         |   | $                                 | 0.09      |                            | $      | (0.01 | ) | $ | 0.22 |   | $ | (0.15 | ) |

 

Diluted — weighted average shares outstandinghave not been adjusted for employee stock options and warrants for the threeand six months ended June 30, 2002 where the effect of those securities wouldhave been anti-dilutive.

 

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**4. GOODWILLAND INTANGIBLE ASSETS**

 

 In June 2001, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards(SFAS) No. 141, “Business Combinations” and No. 142, “Goodwill and OtherIntangible Assets.” SFAS No. 141 requires all business combinations initiatedafter June 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) for impairment.  For acquisitions consummated by the Companysubsequent to July 1, 2001, the Company adopted the provisions of SFAS No. 141and 142 effective July 1, 2001.  TheCompany adopted the full provisions of SFAS No. 141 and 142 during the firstquarter of 2002.

 

The Company has assessed goodwillimpairment using a two-step approach based on reportable segments andreassessed any intangible assets, including goodwill, recorded in connectionwith earlier acquisitions. The Company completed its initial and annualrequired goodwill impairment tests under SFAS No. 142 in the first and fourthquarters of 2002, respectively, which indicated that there was no impairment ofgoodwill or other intangibles.

 

The changes in the carrying amount ofgoodwill for the six months ended June 30, 2003 by operating segment, are asfollows:

 
|                                |   | **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 |   | 2,807,000                                              |       | —                            |   | 2,807,000 |   |
| Balance as of June 30, 2003         |   | $                                                      | 13,877,000 |                              | $      | 7,628,000 |   | $ | 21,505,000 |   |

 

Information regarding the Company’s otherintangible assets is as follows:

 
|                   |   | **As of  June 30, 2003** |       |
|------------------------|--------|--------------------------|------------|
|                   |   | **Carrying  amount**     |       | **Accumulated  amortization** |   | **Net** |   |
|                   |   |                     |       |   |   |   |   |
| Customer relationships |   | $                        | 14,117,000 |   | $ | 9,681,000 |   | $ | 4,436,000 |   |
| Non-compete agreements |   | 3,375,000                |       | 2,665,000 |   | 710,000 |   |
| Technology/tradename   |   | 6,278,000                |       | 4,717,000 |   | 1,561,000 |   |
| Total                  |   | $                        | 23,770,000 |   | $ | 17,063,000 |   | $ | 6,707,000 |   |

 
|                   |   | **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 the six months endedJune 30, 2003 was $2,467,000 and $3,200,000 for the six months ended June2002.  Estimated amortization expense for the remaining life of theintangible assets, based on intangible assets as of June 30, 2003, is asfollows:

 

 
| **Year ended  December 31,** |   |      |      |
|------------------------------|--------|-----------|-----------|
| 2003                         |   | $         | 4,968,000 |   |
| 2004                         |   | 3,466,000 |      |
| 2005                         |   | 706,000   |      |
| 2006                         |   | 34,000    |      |
|                              |        |           |           |  |

 

**5.  STOCK BASED COMPENSATION**

 

At June 30, 2003, the Companyhas two stock-based employee compensation plans, which are described more fullyin the Company’s 2002 Annual Report Note 7. The Company accounts for these plans under the recognition andmeasurement principles of Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees,” and related Interpretations.  No stock-based employee compensation cost isreflected in net income (loss), as all options granted under these plans had anexercise price equal to the market value of the underlying common stock on thedate of the grant.  The following tableillustrates the effect on net income (loss) and net income (loss) per share ifthe Company had applied the fair value recognition provision of Financial AccountingStandards Board Statement No. 123, “Accounting for Stock-Based Compensation,”to stock-based employee compensation.

 

The Company has elected toapply the disclosure-only provisions of SFAS No. 123, “Accounting forStock-Based Compensation” as amended by SFAS No. 148. Accordingly, the Companyaccounts for stock-based compensation using the intrinsic value methodprescribed in APB Opinion No. 25, “Accounting for Stock Issued toEmployees”, and related interpretations. Compensation cost for stock options ismeasured as the excess, if any, of the fair value of the Company’s Common Stockat the date of grant over the stock option exercise price. Had compensationcosts for these plans been determined consistent with SFAS No. 123, theCompany’s net income (loss) would have been adjusted to the following pro formaamounts:

 
|                                                                                            |   | **Three Months Ended June 30,** |      | **Six Months Ended June 30,** |   |
|-------------------------------------------------------------------------------------------------|--------|---------------------------------|-----------|-------------------------------|--------|
|                                                                                            |   | **2003**                        |      | **2002**                      |   | **2003** |   | **2002** |   |
| Net income (loss), as reported                                                                  |   | $                               | 2,767,000 |                          | $      | (348,000 | ) | $ | 6,789,000 |   | $ | (3,878,000 | ) |
|                                                                                            |   |                            |      |                          |   |   |   |   |   |
| Add: Stock-based compensation, as reported                                                      |   | —                          |      | 8,000                         |   | — |   | 37,000 |   |
| Deduct: Total stock-based compensation determined under fair value  based method for all awards |   | (2,943,000                      | )         | (55,000                       | )      | (5,705,000 | ) | (3,090,000 | ) |
| Adjusted net income (loss), fair value method for all stock-based  awards                       |   | $                               | (176,000  | )                             | $      | (395,000 | ) | $ | 1,084,000 |   | $ | (6,931,000 | ) |
|                                                                                            |   |                            |      |                          |   |   |   |   |   |
| Basic income (loss) per share — as reported                                                |   | $                               | 0.10      |                          | $      | (0.02 | ) | $ | 0.24 |   | $ | (0.15 | ) |
| Basic income (loss) per share — SFAS No. 123 adjusted                                      |   | $                               | (0.01     | )                             | $      | (0.02 | ) | $ | 0.04 |   | $ | (0.26 | ) |
|                                                                                            |   |                            |      |                          |   |   |   |   |   |
| Diluted income (loss) per share — as reported                                              |   | $                               | 0.09      |                          | $      | (0.02 | ) | $ | 0.22 |   | $ | (0.15 | ) |
| Diluted income (loss) per shares — SFAS No. 123 adjusted                                   |   | $                               | (0.01     | )                             | $      | (0.02 | ) | $ | 0.04 |   | $ | (0.26 | ) |

 

The fair value of each option grantis estimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions used: risk-free interest ratesof 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.ACQUISITIONS AND EARN-OUT ARRANGEMENTS**

 

In January 2003, the Companyacquired certain assets and assumed certain liabilities of Metatec®International, Inc.’s (“Metatec”) electronic software distribution (“ESD”)business in exchange for approximately $1.2 million.   Goodwill of  $826,000 wasrecorded as a result of this agreement. The Company will amortize intangibleassets acquired, consisting of a non-compete agreement andtechnology/tradename, over a three-year period.  The agreement also provides Metatec the opportunity for anadditional earn-out based on the Company achieving certain revenue metricsrelated to the ESD business over the course of the twelve months followingNovember 1, 2002.  Such earn-out amount,if any, will be recorded as additional goodwill.

 

In March 2003, the Companyacquired substantially all of the assets and assumed certain liabilities ofHartsell Holdings, Inc., (“Hartsell”) d/b/a Infocon America Corporation inconnection with its business of providing web services for business-to-businesspublishers in exchange for approximately $1.1 million. Goodwill of $921,000 wasrecorded as a result of this agreement. The Company will amortize intangibleassets acquired, consisting of non-compete agreements and technology/tradename,over a three-year period. The agreement also provides Hartsell the opportunityfor additional earn-outs based on the Company achieving certain gross marginand revenue metrics related to the web services for business-to-businesspublishers over the course of the twelve months and, at the Company’s solediscretion, the twenty-four months, following the closing of the acquisition.Such earn-out amount, if any, will be recorded as additional goodwill.

 

During the three months ended March 31, 2002,the Company acquired certain assets and liabilities of Innuity AcquisitionCorp. and Beyond.com Corporation.

 

The following unaudited pro forma condensedresults of operations for the three and six months ended June 30, 2003 and 2002have been prepared as if each of the acquisitions from the six months endedJune 30, 2002 had occurred on January 1, 2002. The pro forma presentation does not include pro forma presentation forthe assets acquired in the six months ended June 30, 2003, as they are notdeemed to be significant.

 
|                                |   | **Three  months ended  June 30,** |       | **Six  months ended  June 30,** |   |
|-------------------------------------|--------|-----------------------------------|------------|---------------------------------|--------|
|                                |   | **2003**                          |       | **2002**                        |   | **2003** |   | **2002** |   |
|                                |   |                              |       |                            |   |   |   |   |   |
| Revenue                             |   | $                                 | 22,764,000 |                            | $      | 19,347,000 |   | $ | 47,364,000 |   | $ | 39,406,000 |   |
| Income (loss) from operations       |   | 2,520,000                         |       | (505,000                        | )      | 6,472,000 |   | (6,596,000 | ) |
| Net income (loss)                   |   | 2,767,000                         |       | (348,000                        | )      | 6,789,000 |   | (7,222,000 | ) |
|                                |   |                              |       |                            |   |   |   |   |   |
| Basic net income (loss) per share   |   | $                                 | 0.10       |                            | $      | (0.01 | ) | $ | 0.24 |   | $ | (0.27 | ) |
| Diluted net income (loss) per share |   | $                                 | 0.09       |                            | $      | (0.01 | ) | $ | 0.22 |   | $ | (0.27 | ) |

 

This financial information does not purportto represent results that would actually have been obtained if the transactionshad been in effect on January 1, 2002 or any future results that may in fact berealized.

 

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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 asfollows:

 
|                                         |   | **Software  and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Unallocated  Corporate  Items** |   | **Consolidated** |       |
|----------------------------------------------|--------|--------------------------------------------------------|------------|-----------------------------------|--------|-----------------------------------|--------|------------------|------------|
| **Three  months ended  June  30, 2003** |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                                      |   | $                                                      | 18,671,000 |                              | $      | 4,093,000                         |   | $                | —     |   | $ | 22,764,000 |   |
| Gross profit                                 |   | 15,961,000                                             |       | 3,007,000                         |   | —                            |   | 18,968,000       |       |
| Income (loss) from operations                |   | 5,322,000                                              |       | 96,000                            |   | (2,898,000                        | )      | 2,520,000        |       |
| Net income (loss)                            |   | 5,322,000                                              |       | 96,000                            |   | (2,651,000                        | )      | 2,767,000        |       |
| Total assets at June 30, 2003                |   | $                                                      | 49,138,000 |                              | $      | 14,166,000                        |   | $                | 47,344,000 |   | $ | 110,648,000 |   |
|                                         |   |                                                   |       |                              |   |                              |   |             |       |
| **Three  months ended  June 30, 2002**       |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                                      |   | $                                                      | 15,104,000 |                              | $      | 4,243,000                         |   | $                | —     |   | $ | 19,347,000 |   |
| Gross profit                                 |   | 12,789,000                                             |       | 3,192,000                         |   | —                            |   | 15,981,000       |       |
| Income (loss) from operations                |   | 4,610,000                                              |       | (2,028,000                        | )      | (3,087,000                        | )      | (505,000         | )          |
| Net income (loss)                            |   | 4,610,000                                              |       | (2,028,000                        | )      | (2,930,000                        | )      | (348,000         | )          |
| Total assets at June 30, 2002                |   | $                                                      | 29,913,000 |                              | $      | 16,622,000                        |   | $                | 41,425,000 |   | $ | 87,960,000 |   |

 
|                                 |   | **Software  and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Unallocated  Corporate  Items** |   | **Consolidated** |       |
|--------------------------------------|--------|--------------------------------------------------------|------------|-----------------------------------|--------|-----------------------------------|--------|------------------|------------|
| **Six  months ended  June 30, 2003** |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                              |   | $                                                      | 39,708,000 |                              | $      | 7,656,000                         |   | $                | —     |   | $ | 47,364,000 |   |
| Gross profit                         |   | 34,163,000                                             |       | 5,517,000                         |   | —                            |   | 39,680,000       |       |
| Income (loss) from operations        |   | 12,681,000                                             |       | (502,000                          | )      | (5,707,000                        | )      | 6,472,000        |       |
| Net income (loss)                    |   | 12,681,000                                             |       | (502,000                          | )      | (5,390,000                        | )      | 6,789,000        |       |
| Total assets at June 30, 2003        |   | $                                                      | 49,138,000 |                              | $      | 14,166,000                        |   | $                | 47,344,000 |   | $ | 110,648,000 |   |
|                                 |   |                                                   |       |                              |   |                              |   |             |       |
| **Six  months ended  June 30, 2002** |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                              |   | $                                                      | 29,801,000 |                              | $      | 7,616,000                         |   | $                | —     |   | $ | 37,417,000 |   |
| Gross profit                         |   | 25,171,000                                             |       | 5,553,000                         |   | —                            |   | 30,724,000       |       |
| Income (loss) from operations        |   | 8,985,000                                              |       | (4,562,000                        | )      | (8,510,000                        | )      | (4,087,000       | )          |
| Net income (loss)                    |   | 8,985,000                                              |       | (4,562,000                        | )      | (8,301,000                        | )      | (3,878,000       | )          |
| Total assets at June 30, 2002        |   | $                                                      | 29,913,000 |                              | $      | 16,622,000                        |   | $                | 41,425,000 |   | $ | 87,960,000 |   |

 

**8.SUBSEQUENT EVENTS**

 

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 of itscommon stock pursuant to this registration in an underwritten public offeringand granted the underwriters an option to purchase up to an additional 310,000shares to cover over-allotments, if any. The Company received approximately$44.8 million in gross proceeds before underwriting discounts and commissionsand offering expenses.

 

On August 1, 2003, the Companyacquired substantially all of the assets and certain liabilities of TheRegistration Network, or Reg.Net, providers of e-commerce services for authorsand vendors of try-before-you-buy software for up to  $2,500,000, of which, $1,318,000 has been funded, the remainingamount is subject to the satisfaction of certain contractual obligations.

 

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**Item2.  Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

*TheCompany notes that, except for the historical information contained herein, thematters discussed below contain forward-looking statements that involve knownand unknown 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 Companyexpressly disclaims any obligation to update this information or publiclyrelease any revision 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 ended December 31,2002.*

 

**Overview**

 

 The Company is a leadingprovider of comprehensive electronic commerce outsourcing solutions. TheCompany was incorporated in February 1994 and commenced offering productsfor sale through its clients’ Web stores in August 1996. From inceptionthrough August 1996, the Company had no sales, and its activities relatedprimarily to the development of its proprietary technology platform, known asCommerce Network Servers or CNS. In 1996, the Company began to focus itsbusiness development efforts on the software industry, building its inventoryof software products through contracts with software publishers. In 1997, theCompany began to develop software distribution relationships through contractswith online retailers. As of June 30**,**2003,the Company had approximately 14,000 software publisher clients and onlineretailer clients served by the Software and Digital Commerce Services Division.In late 1998, the Company began to offer its comprehensive electronic commerceoutsourcing services in the form of a transaction fee-based e-commerce serviceto clients outside of the software industry. As of June 30, 2003, the Companywas operating approximately 20,000 sites under its E-Business ServicesDivision.

 

The Company regards theprotection of its trademarks, copyrights, trade secrets and other intellectualproperty as critical to the Company’s success. The Company relies on acombination of patent, copyright, trademark, service mark and trade secret lawsand contractual restrictions to protect its proprietary rights. The Companycurrently has six U.S. patents issued with 12 to 13 years remaining prior toexpiration. The Company pursues the registration of its trademarks and servicemarks in the U.S. and internationally, and currently has 15 U.S. registeredtrademarks and one trademark application pending in the U.S., and 10 registeredtrademarks in the European Union and other countries.

 

The Company has approximatelyseven years of operating history upon which investors may evaluate its businessand prospects. Since inception, the Company has incurred significant losses,and as of June 30, 2003, had an accumulated deficit of approximately$97 million. The Company intends to expend financial and managementresources on the development of additional services, sales and marketing,technology and operations to support larger-scale operations and greaterservice offerings. Although the Company expects to generate positive cash flowfrom operations in 2003, there can be no assurance that the Company’s revenuewill increase or even continue at its current level or that the Company willmaintain profitability or generate cash from operations in future periods.

 

The Company’s prospects must beconsidered in light of the risks, expenses and difficulties frequentlyencountered by companies in new and rapidly evolving markets such as electroniccommerce. To address these risks, the Company must, among other things, attractand retain software publishers and online retailers as clients, attract andretain E-Business clients, introduce new Web sites, Web stores or services,continue to upgrade and develop the Company’s systems and infrastructure tomeet emerging market needs and remain competitive in the Company’s serviceofferings, and retain and attract personnel commensurate with the Company’sbusiness needs. There can be no assurance that the Company will be successfulin addressing these risks, and any failure to do so could have a materialadverse effect on the Company’s business, financial condition and results ofoperations.

 

The Company’s current andfuture expense levels are based largely on its planned operations and estimatesof future revenue. Revenue and operating results generally depend on the volumeand timing of orders received, which are difficult to forecast. The Company maybe unable to adjust spending in a timely manner to compensate for anyunexpected revenue shortfall. Accordingly, any significant shortfall in revenuecould have an immediate adverse effect on the Company’s business, financialcondition and results of operations. The Company is also likely to continue tosee revenue fluctuate on a seasonal basis, which is typical for the softwarepublishing market in general and its current E-Business

 

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Service clients. The Companybelieves that its first and fourth quarters tend to be seasonally stronger thanits second and third quarters due to the timing of demand for tax preparationsoftware and the holiday season selling period. In addition, it is theCompany’s belief that software publishers avoid new product releases in thesummer months. In view of the rapidly evolving nature of the Company’sbusiness, the Company is unable to accurately forecast its revenue and believesthat period-to-period comparisons of its operating results are not necessarilymeaningful and should not be relied upon as an indication of futureperformance.

 

Effective July 1, 2003, theEuropean Union implemented new rules regarding the collection and payment ofValue Added Tax, or VAT. These new rules require VAT to be charged on supplydelivered over electronic networks, including software and computer services,as well as information and cultural, artistic, sporting, scientific,educational, entertainment and similar services. These services are now taxedin the country where the purchaser resides rather than where the supplier islocated. Historically, suppliers of digital products that existed outside theEuropean Union were not required to collect or remit VAT on digital orders madeto purchasers in the European Union. With the implementation of these newrules, the Company is required to collect and remit VAT on digital ordersreceived from purchasers in the European Union which effectively raises theprices for these goods by the VAT amount. This price increase could serve todiscourage purchasing of the Company’s products and services which in turncould adversely affect the Company’s operating results and financial condition.

 

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**Results ofOperations**

 

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

 
|                                      |   | **Three  months ended  June 30,** |       | **Six  months ended  June 30,** |       |
|-------------------------------------------|--------|-----------------------------------|------------|---------------------------------|------------|
|                                      |   | **2003**                          |       | **2002**                        |       | **2003** |   | **2002** |   |
|                                      |   |                              | ** ** |                            | ** ** |   | ** ** |   | ** ** |
| Revenue                                   |   | 100                               | %          | 100                             | %          | 100 | % | 100 | % |
| Operating expenses                        |   |                              |       |                            |       |   |   |   |   |
| Direct cost of services                   |   | 4.1                               |       | 2.9                             |       | 4.0 |   | 3.1 |   |
| Network and infrastructure                |   | 12.6                              |       | 14.5                            |       | 12.3 |   | 14.8 |   |
| Sales and marketing                       |   | 39.4                              |       | 43.4                            |       | 38.5 |   | 43.9 |   |
| Product research and development          |   | 11.4                              |       | 17.0                            |       | 10.5 |   | 17.5 |   |
| General and administrative                |   | 8.7                               |       | 8.8                             |       | 9.0 |   | 8.9 |   |
| Litigation and other charges              |   | —                            |       | —                          |       | — |   | 6.7 |   |
| Depreciation and amortization             |   | 7.3                               |       | 7.4                             |       | 6.8 |   | 7.5 |   |
| Amortization of acquisition-related costs |   | 5.4                               |       | 8.6                             |       | 5.2 |   | 8.5 |   |
| Total operating expenses                  |   | 88.9                              |       | 102.6                           |       | 86.3 |   | 110.9 |   |
| Income (loss) from operations             |   | 11.1                              |       | (2.6                            | )          | 13.7 |   | (10.9 | ) |
| Interest income, net                      |   | 1.1                               |       | 0.8                             |       | 0.6 |   | 0.5 |   |
| Net income (loss)                         |   | 12.2                              | %          | (1.8                            | )%         | 14.3 | % | (10.4 | )% |

 

***REVENUE.***Revenue increased to $22,764,000 for the three months ended June 30, 2003 from$19,347,000 for the same period in the prior year, an increase of $3,417,000 or17.7%. For the six months ended June 30, 2003 revenue totaled $47,364,000, anincrease of  $9,947,000 or 26.6% fromrevenue of $37,417,000 recorded in the same period of the prior year.  Revenue for the Software and DigitalCommerce Services division increased to $18,671,000 and $39,708,000 for thethree months and six months ended June 30, 2003 from $15,104,000 and$29,801,000 for the three months and six months ended June 30, 2002respectively.  The increase primarily resulted from growth in the numberof the Company’s software publisher and online retailer clients, as well asincreasing market acceptance of electronic software delivery.  Revenue for the E-Business Services division was $4,093,000 and $7,656,000 forthe three months and six months ended June 30, 2003, compared with $4,243,000and $7,616,000 for the three months and six months ended June 30, 2002.

 

International sales represented approximately24% and 22% of total revenue in the three-month periods ended June 30, 2003 and2002, respectively and approximately 23% and 20% of total revenue in thesix-month periods ended June 30, 2003 and 2002, respectively.

 

***GROSS PROFIT.***Cost of revenue, which consists of direct cost of services and networkand infrastructure costs (both shown in this paragraph and table above exclusiveof depreciation and amortization expense), increased to $3,796,000 and$7,684,000 for the three months and six months ended June 30, 2003 from$3,366,000 and $6,693,000 for the same periods in the prior year.  Theincrease for the three-month and six month period primarily resulted fromdirect costs 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 six months ended June 30, 2003 to 85.5% and 86% from84.7% and 84.5% for the same period of the prior year, respectively.  Thegross profit margin for the E-Business Services division decreased in the threemonths and six months ended June 30, 2003 to 73.5% and 72.1% compared to 75.2%and 72.9% for the same period of the prior year, respectively.  Theincrease in Software and Digital Commerce Services margins is primarily due toleveraging the Company’s infrastructure over significantly more revenue and clients. The E-Business Services division incurred higher direct costs of labor relatedto client contracts for outsourced professional services.  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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***SALES AND MARKETING.***Sales and marketing expense consists primarily of personnel and relatedexpenses, advertising and promotional expenses, bad debt/chargeback expense andcredit card transaction fees.  Sales and marketing expense increased to$8,978,000 and $18,250,000 for the three months and six months ended June 30,2003 from $8,402,000 and $16,415,000 for the same period in the prior year,respectively, an increase of $576,000 and $1,835,000 or 6.9% and 11.2%. The increase primarily resulted from an increase in credit card fees andchargeback costs directly associated with the increase in revenue.  Salesand marketing expense for the Software and Digital Commerce Services divisionincreased to $7,543,000 and $15,260,000 for the three months and six monthsended June 30, 2003 from $5,585,000 and $11,097,000 for the same period in theprior year, respectively.  Sales and marketing expense for the E-BusinessServices division was $1,435,000 and $2,990,000 for the three months and sixmonths ended June 30, 2003, compared to $2,817,000 and $5,318,000 for the sameperiod in the prior year.  The decrease in E-Business sales and marketingexpense is a result of the previously announced consolidation of the teams thatsupport E-Business and Software and Digital Commerce Services, which has resultedin increased efficiencies.  As apercentage of revenue, sales and marketing expense was 39.4% and 38.5% in thethree months and six months ended June 30, 2003, compared to 43.4% and 43.9%for the same period in the prior year, primarily reflecting the Company’sincreased revenue.  The Company expects that sales and marketing expensewill continue to increase in absolute dollars as the Company continues to buildits sales and marketing infrastructure and develops marketing programs, and asvolume–driven credit card and bad debt/chargeback expenses increase.  As apercentage of revenue, sales and marketing expenses are expected to decrease asfuture revenue increases.

 

***PRODUCT RESEARCH AND DEVELOPMENT.*** Product research and developmentexpense consists primarily of personnel and related expenses and consultingcosts associated with developing and enhancing the Company’s CNS and relatedinternal systems.  Product research anddevelopment expense decreased to $2,594,000 and $4,982,000 for the three monthsand six months ended June 30, 2003 from $3,289,000 and $6,563,000 for the sameperiod in the prior year, respectively, a decrease of $695,000 and $1,581,000or 21.1% and 24.1%.   The decrease wasprimarily driven by a reduction in personnel-related expenses and outsideconsulting fees related to the significant completion of CNS enhancements.  Product research and development expense forthe Software and Digital Commerce Services division was $1,429,000 and2,592,000 for the three months and six months ended June 30, 2003 compared to$1,364,000 and $2,770,000 for the same periods of the prior yearrespectively.  Product research and development expense for the E-BusinessServices division decreased to $1,165,000 and $2,390,000 from $1,925,000 and$3,793,000 in the same period in the prior year, respectively.  As apercentage of revenue, product research and development expense was 11.4% and10.5% in the three months and six months ended June 30, 2003, compared to 17.0%and 17.5% for the same period in the prior year.  The Company expects thatproduct research and development costs will increase in absolute dollars as theCompany continues to develop the CNS and other related internal systems.

 

***GENERAL AND ADMINISTRATIVE.***General and administrative expense consistsprimarily of executive, accounting and administrative personnel and relatedexpenses, including professional fees and investor relations expenses. General and administrative expenses increased to $1,978,000 and $4,269,000 forthe three months and six months ended June 30, 2003 from $1,708,000 and$3,323,000 for the same period in the prior year, an increase of $270,000 and946,000 or 15.8% and 28.5% respectively.   The increase resulted primarily from personnel-related expenses andprofessional and legal fees associated with compliance with the newSarbanes-Oxley Act and related rules and regulations, foreign governanceissues, ongoing defense of pending lawsuits and increased insurancepremiums.  General and administrative expense for the Software and DigitalCommerce Services division increased to $1,667,000 and $3,630,000 for the threemonths and six months ended June 30, 2003, from $1,230,000 and $2,319,000 forthe same period in the prior year, respectively.  General andadministrative expense for the E-Business Services division decreased to$311,000 and $639,000 for the three months and six months ended June 30, 2003,from $478,000 and $1,005,000 for the same period in the prior yearrespectively.  As a percentage of revenue, general and administrativeexpense was 8.7% and 9.0% for the three- month and six-month period ended June30, 2003, compared to 8.8% and 8.9% for the same period in the prior year,respectively.  The Company expects that general and administrative expensewill increase in absolute dollars over time as the Company defends itspositions related to legal claims and as it continues to build infrastructureto support its revenue growth and to comply with new governmental regulations.The Company expects that general and administrative expenses will increase onan absolute basis and decrease as a percentage of revenue as future revenueincreases.

 

***LITIGATION AND OTHER CHARGES.***During the three months ended March 31, 2002,the Company recorded a charge for pending litigation of $2,300,000.  Thisreserve was established based upon developments in new and existing litigationfor which management determined, in the first quarter of 2002, that payment wasboth probable and estimable.  Additionally, the Company recorded a chargeof $200,000 during the three months ended March 31, 2002 in connection with itsdecision during the period to consolidate one of its offices.  During the three months and six months endedJune 30 2003, no charges were recorded for settlement of litigation and other charges.

 

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***AMORTIZATION OF INTANGIBLE ASSETS AND ACQUISITION-RELATED COSTS.***Amortization of intangible assets andacquisition-related costs decreased to $1,246,000 and $2,467,000 for the threemonths and six months ended June 30, 2003 from $1,651,000 and $3,200,000 forthe same period in the prior year due to assets acquired in 1999 becoming fullyamortized. The amortization related to assets acquired in the three months andsix months ended June 30, 2003 was not significant.

 

***INCOME TAXES.***The Company paid no income taxes in any reported period.  As ofJune 30, 2003, the Company had approximately $74,900,000 of net operating losscarryforwards for federal income tax purposes, which expire beginning in 2009. Due to the uncertainty of future profitability, a valuation allowance equal tothe deferred tax asset has been recorded.  Certain changes in ownershipthat resulted from the sales of common and preferred stock will limit thefuture annual realization of the tax operating loss carryforwards to aspecified percentage under Section 382 of the Internal Revenue Code.

 

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**Liquidityand Capital Resources**

 

As of June 30, 2003, the Company had$57,895,000 of cash and cash equivalents and working capital of approximately$26,361,000.  In July 2003, the Company completed a follow-on public offering of its common stock,resulting in net proceeds of approximately $43,200,000 after underwritingcommissions and discounts of approximately $1,100,000 and other expenses ofapproximately $500,000.  The Company’s principal commitments consistedof obligations outstanding under operating leases.  During the six monthsended June 30, 2003, the Company’s operations generated $17,536,000 of cashcompared to $7,241,000 for the same period of the prior year.  Theimprovement is mainly due to the increase in net income in the current yearsix-month period and additions due to the collections of accountsreceivable.  Net cash used in investing activities during the six monthsended June 30, 2003 totaled $5,569,000.  This was comprised of investmentsin equipment of $3,127,000 and net investments in acquisitions of$2,442,000.  Net cash provided in financing activities during the six monthsended June 30, 2003 totaled $5,127,000, comprised of cash received upon thesale of stock through the exercise of stock options and employee stock purchaseplans.

 

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 $12,000,000 over the next 18 months on capital expenditures basedon its current anticipated growth rate.  The Company further anticipatesthat it will expend approximately $16,000,000 over the next 18 months onproduct 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 existing sources ofliquidity and the results of its operations will provide adequate cash to fundits operations for the foreseeable future.

 

**Item3.  Qualitative and Quantitative Disclosure About Market Risk**

 

The Company does not enter into financialinstruments for trading or speculative purposes and does not currently utilizederivative financial instruments.  The operations of the Company areconducted primarily in the United States currency and as such are not currentlysubject to material foreign currency exchange rate risk.  The Company hasno long-term debt.

 

However, the growth in theCompany’s international operations is increasing the Company’s exposure toforeign currency 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. To theextent the U.S. dollar weakens against foreign currencies, the translation ofthese foreign currency denominated transactions results in increased netrevenues, operating expenses and net income. Similarly, 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 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.

 

**Item4.  Controls and Procedures**

 

The Company’s management, withthe participation of the Company’s Chief Executive Officer and Chief FinancialOfficer, has evaluated the effectiveness of the Company’s disclosure controlsand procedures as of June 30, 2003. Based on this evaluation, the Company’s Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective for gathering, analyzing, and disclosing theinformation the Company is required to disclose in the reports it files underthe Securities Exchange Act of 1934, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  Such evaluation did not identify any change in the Company’sinternal control over financial reporting that occurred during the quarterended June 30, 2003 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**Limitationson the Effectiveness of Controls**

 

The Company’s management, including the ChiefExecutive 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.  OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

Beginning in August 2001, theCompany and certain of the Company’s officers and directors were named as defendantsin several class action shareholder complaints filed in the United StatesDistrict Court for the Southern District of New York, now consolidated as*In re Digital River, Inc. Initial Public OfferingSecurities Litigation,* Case No. 01-CV-7355.  In theconsolidated amended complaint, the plaintiffs allege that the Company, certainof the Company’s officers and directors and the underwriters of the Company’sinitial public offering, or IPO, violated Section 11 of the Securities Act of1933 based on allegations that the Company’s IPO registration statement andprospectus failed to disclose material facts regarding the compensation to bereceived by, and the stock allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of Section 10(b) of theSecurities Exchange Act of 1934 based on allegations that this omissionconstituted a deceit on investors.  The plaintiffs seek unspecifiedmonetary damages and other relief.  Similar complaints, referred to hereas the IPO Lawsuits, were filed in the same court against hundreds of otherpublic companies.

 

On August 8, 2001, the IPOLawsuits were consolidated for pretrial purposes before United States JudgeShira Scheindlin of the Southern District of New York.  Judge Scheindlinheld an initial case management conference on September 7, 2001, at which timeshe ordered, among other things, that the time for all defendants in the IPOLawsuits to respond to any complaint be postponed until further order of thecourt.  Thus, the Company has not been required to answer any of thecomplaints, and no discovery has been served on the Company.

 

On July 15, 2002, the Companyjoined in a global motion to dismiss the IPO Lawsuits filed by all of theissuers (among others).  On October 9, 2002, the court entered an orderdismissing the Company’s named officers and directors from the IPO Lawsuitswithout prejudice, pursuant to an agreement tolling the statute of limitationswith respect to these officers and directors until September 30, 2003.  OnFebruary 19, 2003, the court issued a decision denying the motion to dismissthe Section 11 claims against the Company and almost all of the other issuersand denying the motion to dismiss the Section 10(b) claims against the Companyand many of the other issuers.

 

On June 26, 2003, the plaintiffs in the consolidated IPO Lawsuitscurrently pending against the Company and over 300 other issuers who wentpublic between 1998 and 2000, announced a proposed settlement with the Companyand the other issuer defendants. The proposed settlement provides that theinsurers of all settling issuers will guarantee that the plaintiffs recover $1billion from non-settling defendants, including the investment banks who actedas underwriters in those offerings. In the event that the plaintiffs do notrecover $1 billion, the insurers for the settling issuers will make up thedifference.  The Company believes thatit has 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.

 

On August 21, 2001, theCompany, along with other defendants, was named as a defendant in a patentlitigation regarding United States Patent No. 6,014,651 owned by Christopher M.Crawford of Washington, D.C.  The case was filed and is pending in theU.S. District Court in the District of Columbia.  No substantive actionshave taken place as yet in this case.  The court has delayed substantivediscovery in this case, pending a preliminary determination of the legal scopeof Crawford’s claim.  During this time period, the Company has monitoredthe case, but has not taken substantive action.  Once the court determines the scope of the claims, the Companymay file for a dismissal of the case if the court’s decision is consistent withthe Company’s and the other defendants’ position regarding the interpretationof this patent claim.  At this time, Crawford has not made a definitivedemand for the resolution of this case.

 

On April 25, 2002, the Company, along withRegSoft.com, Inc., a subsidiary of the Company, and Register Now!, a divisionof the Company, and other various defendants, were named as defendants in apatent litigation regarding United States Patent No. 4,500,919 assigned to theMassachusetts Institute of Technology, or MIT, by the inventor William F.Schreiber of Cambridge, Massachusetts.  MIT licensed the patent toElectronics for Imaging, Inc., or EFI, and these parties jointly filed alawsuit in the U.S. District Court in the Eastern District of Texas. 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 should soon be dismissed.

 

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In March 2002, pursuant to anAmended and Restated Asset Purchase Agreement (the “Agreement”) between theCompany and Beyond.com Corporation (“Beyond.com”), the Company purchased thoseassets and assumed those liabilities of Beyond.com related to its eStoresbusiness, which manages online stores for clients, in exchange for 179,096shares of the Company’s Common Stock.  Atotal of 70,000 of such shares were placed in escrow (the “Escrow”) to securecertain indemnification obligations of Beyond.com under the Agreement. Thepurchase was approved by the U.S. Bankruptcy Court following Beyond.com’sfiling for Chapter 11 bankruptcy protection. Immediately following the closing of the Agreement, the Company enteredinto a Post-Closing Amendment to the Agreement with Beyond.com (the“Post-Closing Amendment”), pursuant to which, among other things, the Company agreedto increase the number of shares to be delivered to Beyond.com under theAgreement to 222,842, in exchange for a release of certain claims of Beyond.comagainst the Company.  The Post-ClosingAmendment was subject to approval by the U.S. Bankruptcy Court.  The Official Committee of UnsecuredCreditors (the “Committee”) of Beyond.com’s bankruptcy estate objected to thePost-Closing Amendment, asserting that the increase in shares to be deliveredto Beyond.com under the Post-Closing Amendment was inadequate, and alsoasserting the right to additional shares of the Company’s Common Stock undercertain provisions of the Agreement.

 

On April 11, 2003, Beyond.com,the Committee and Digital River entered into a Settlement Agreement (the“Settlement Agreement”) pursuant to which the Company agreed to transfer anadditional 50,919 shares (in addition to the 222,842 shares previously agreedto) to Beyond.com, in exchange for the release by Beyond.com and the Committeeof their claims against the Company. The parties also agreed to resolve certain claims by the Company againstthe 70,000 shares in the Escrow by transferring 55,123 of such shares toBeyond.com and returning 14,877 of such shares to the Company.

 

On May 23, and June 13, 2003the Settlement Agreement  and thePost-Closing Amendment were approved by the Bankruptcy Court.  The Company subsequently consummated theSettlement Agreement and Post-Closing Amendment.

 

**Item4.   Submission of matters to a voteof  security holders**

 

The Company’s annual meeting ofstockholders was held on May 19, 2003 (the “Annual Meeting”).  The following matters were considered andvoted upon at the Annual Meeting:

 

The first matter related to theelection of the two director nominees, William Lansing and Frederic Seegal, asdirectors to serve until the 2006 annual meeting of the stockholders.  The votes cast for and against such nomineeswere as follows:

 
| **Name**         |   | **For**    |   | **Withheld** |   |
|------------------|--------|------------|--------|--------------|--------|
|             |   |       |   |         |   |
| William  Lansing |   | 23,319,896 |   | 1,513,812    |   |
|             |   |       |   |         |   |
| Frederic  Seegal |   | 23,309,568 |   | 1,524,140    |   |

 

The second matter related tothe approval of an amendment to the Company’s 1998 Stock Option Plan (the“Option Plan”), increasing the number of shares available under the Option Planfrom 3,983,333 to 5,983,333 shares. There were 7,657,667 votes cast for the approval,and there were 6,404,218 votes cast against the approval.  There were 24,007 abstentions and 10,747,816broker non-votes.

 

The third matter related to theapproval of an amendment to the Company’s 2000 Employee Stock Purchase Plan(the “Purchase Plan”), increasing the number of shares available under thePurchase Plan from 600,000 to 1,200,000. There were 13,099,656 votes cast for the approval, and there were974,469 votes cast against the approval. There were 11,667 abstentions and 10,747,916 broker non-votes.

 

The fourth matter related tothe ratification of the appointment of Ernst & Young, LLP as independentauditors of the Company’s financial statements for its fiscal year endingDecember 31, 2003.  There were 20,855,605votes cast for approval, and there were 3,929,165 cast against theapproval.  There were 18,938 abstentionsand no broker non-votes.

 

**Item 5. Other Information**

 

In July 2003, the Company completed a follow-onpublic offering of its common stock, resulting in net proceeds of approximately$43.2 million.

 

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In August 2003, Jay Kerutis, Digital River’spresident of software and digital commerce services, announced that he will beleaving his executive position and transitioning from his current role toassume new responsibilities for strategic business development. Kerutis willremain an employee of Digital River.

 

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**Item6.  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                | (4)    |                         | 1998  Stock Option Plan, as amended |
| 10.2                |   |                         | 1999  Stock Option Plan, as amended |
| 10.3                | (4)    |                         | 2000  Employee Stock Purchase Plan, as amended, and Offering |
| 31.1                |   |                         | Certification  pursuant to Section 302 of Sarbanes-Oxley Act of 2002 |
| 31.2                |   |                         | Certification  pursuant to Section 302 of 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 theCompany’s Registration Statement on Form S-3, File No. 333-81626, filed onJanuary 29, 2002, declared effective on February 12, 2002, and incorporatedherein by reference.

(2)          Filed as an exhibit to the Company’s AnnualReport 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’sRegistration Statement on Form S-1, File No. 333-56787, declared effective onAugust 11, 1998, and incorporated herein by reference.

(4)          Filed as an exhibit to the Company’sRegistration Statement on Form S-8 File No. 333-105864, and incorporated hereinby reference.

 

(B) Reports on Form 8-K:  On April 23, 2003, the Company filed acurrent report on Form 8-K furnishing under Item 9 (Information provided underItem 12), in accordance with SEC release No. 33-8216, the financial results forthe quarter ended March 31, 2003.

 

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SIGNATURES

 

 

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

 
| Date:  | August 14,  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                | (4)    |                         | 1998  Stock Option Plan, as amended |
| 10.2                |   |                         | 1999  Stock Option Plan, as amended |
| 10.3                | (4)    |                         | 2000  Employee Stock Purchase Plan, as amended, and Offering |
| 31.1                |   |                         | Certification  pursuant to Section 302 of Sarbanes-Oxley Act of 2002 |
| 31.2                |   |                         | Certification  pursuant to Section 302 of 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 theCompany’s Registration Statement on Form S-3, File No. 333-81626, filed onJanuary 29, 2002, declared effective on February 12, 2002, and incorporatedherein by reference.

(2)          Filed as an exhibit to the Company’s AnnualReport 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’sRegistration Statement on Form S-1, File No. 333-56787, declared effective onAugust 11, 1998, and incorporated herein by reference.

(4)          Filed as an exhibit to the CompanyRegistration Statement on Form S-8 File No. 333-105864, and incorporated hereinby reference.

 

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