##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED June 30, 2006
 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
 DIGITAL RIVER, INC.
  DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    41-1901640
(I.R.S. Employer
Identification Number)
 9625 WEST 76TH STREET
EDEN PRAIRIE, MINNESOTA 55344
 (952) 253-1234
 
 þ o
  þ o o
 o þ




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##### 



PART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    3Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005
    
    3Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005
    
    4Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005
    
    5Notes to Condensed Consolidated Financial Statements
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    16Item 3.
    
    Qualitative and Quantitative Disclosure about Market Risk
    
    23Item 4.
    
    Controls and Procedures
    
    24PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    25Item 1A.
    
    Risk Factors
    
    25Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    36Item 6.
    
    Exhibits
    
    38SIGNATURES
    
    39EXHIBIT INDEX
    
    40Computation of Ratio of Earnings to Fixed ChargesCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906Certification Pursuant to Section 906
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 DIGITAL RIVER, INC.
 
   (Unaudited)June 30,
    
    
    December 31,2006
    
    
    2005ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    300,449
    
    
    $
    131,770Short-term investments
    
    
    236,766
    
    
    
    220,569Accounts receivable, net of allowance of $820 and $1,023
    
    
    38,116
    
    
    
    34,883Deferred income taxes
    
    
    18,065
    
    
    
    22,251Prepaid expenses and other
    
    
    7,581
    
    
    
    3,741Total current assets
    
    
    600,977
    
    
    
    413,214Property and equipment, net
    
    
    26,212
    
    
    
    17,955Goodwill
    
    
    237,025
    
    
    
    195,299Intangible assets, net of accumulated amortization of $43,210 and $36,798
    
    
    26,644
    
    
    
    20,054Deferred income taxes
    
    
    4,132
    
    
    
    10,444Other assets
    
    
    12,001
    
    
    
    12,174TOTAL ASSETS
    
    $
    906,991
    
    
    $
    669,140LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    120,298
    
    
    $
    127,846Accrued payroll
    
    
    7,724
    
    
    
    8,866Deferred revenue
    
    
    6,825
    
    
    
    5,403Accrued acquisition costs
    
    
    7,312
    
    
    
    5,651Other accrued liabilities
    
    
    32,697
    
    
    
    21,210Total current liabilities
    
    
    174,856
    
    
    
    168,976NON-CURRENT LIABILITIES:Convertible senior notes
    
    
    195,000
    
    
    
    195,000Deferred income taxes
    
    
    
    
    
    
    22Total non-current liabilities
    
    
    195,000
    
    
    
    195,022TOTAL LIABILITIES
    
    
    369,856
    
    
    
    363,998COMMITMENTS AND CONTINGENCIESSTOCKHOLDERS EQUITY:Preferred Stock, $.01 par value; 5,000,000 shares authorized; no
shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 120,000,000 shares authorized;
39,767,881 and 35,033,741 shares issued and outstanding
    
    
    397
    
    
    
    350Additional paid-in capital
    
    
    508,809
    
    
    
    315,489Deferred compensation
    
    
    
    
    
    
    (1,942
    )Retained earnings/(accumulated deficit)
    
    
    23,342
    
    
    
    (6,324
    )Accumulated other comprehensive income (loss)
    
    
    4,587
    
    
    
    (2,431
    )Total stockholders equity
    
    
    537,135
    
    
    
    305,142TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    906,991
    
    
    $
    669,140
  3




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##### Table of Contents



DIGITAL RIVER, INC.
 
   Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    71,277
    
    
    $
    51,143
    
    
    $
    149,291
    
    
    $
    105,672Costs and expenses:Direct cost of services
    
    
    1,914
    
    
    
    1,187
    
    
    
    3,777
    
    
    
    2,488Network and infrastructure
    
    
    6,298
    
    
    
    4,738
    
    
    
    13,741
    
    
    
    9,216Sales and marketing
    
    
    27,628
    
    
    
    15,740
    
    
    
    54,567
    
    
    
    32,116Product research and development
    
    
    7,488
    
    
    
    5,127
    
    
    
    15,090
    
    
    
    9,585General and administrative
    
    
    8,247
    
    
    
    5,301
    
    
    
    16,497
    
    
    
    10,917Depreciation and amortization
    
    
    2,475
    
    
    
    2,375
    
    
    
    4,728
    
    
    
    4,497Amortization of acquisition-related intangibles
    
    
    3,038
    
    
    
    2,110
    
    
    
    5,878
    
    
    
    4,506Total costs and expenses
    
    
    57,088
    
    
    
    36,578
    
    
    
    114,278
    
    
    
    73,325Income from operations
    
    
    14,189
    
    
    
    14,565
    
    
    
    35,013
    
    
    
    32,347Other income, net
    
    
    6,392
    
    
    
    891
    
    
    
    9,327
    
    
    
    2,046Income before income tax expense
    
    
    20,581
    
    
    
    15,456
    
    
    
    44,340
    
    
    
    34,393Income tax expense
    
    
    7,292
    
    
    
    5,230
    
    
    
    14,674
    
    
    
    10,130Net income
    
    $
    13,289
    
    
    $
    10,226
    
    
    $
    29,666
    
    
    $
    24,263Net income per share  basic
    
    $
    0.34
    
    
    $
    0.30
    
    
    $
    0.79
    
    
    $
    0.71Net income per share  diluted
    
    $
    0.30
    
    
    $
    0.26
    
    
    $
    0.70
    
    
    $
    0.61Shares used in per-share calculation  basic
    
    
    39,452
    
    
    
    34,176
    
    
    
    37,386
    
    
    
    34,097Shares used in per-share calculation  diluted
    
    
    45,458
    
    
    
    41,154
    
    
    
    43,319
    
    
    
    41,347
  4




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##### Table of Contents



DIGITAL RIVER, INC.
 
   Six Months EndedJune 30,2006
    
    
    2005OPERATING ACTIVITES:Net income
    
    $
    29,666
    
    
    $
    24,263Adjustments to reconcile net income to net cash provided by operating activities:Amortization of acquisition-related intangibles
    
    
    5,878
    
    
    
    4,506Change in accounts receivable allowance, net of acquisitions
    
    
    126
    
    
    
    (390
    )Depreciation and amortization
    
    
    4,728
    
    
    
    4,497Stock-based compensation expense related to stock options and
employee stock purchase plans
    
    
    6,932
    
    
    
    Tax benefit of stock-based compensation
    
    
    
    
    
    
    6,269Excess tax benefits from stock-based compensation
    
    
    (2,705
    )
    
    
    Deferred and other income taxes
    
    
    12,679
    
    
    
    3,870Change in operating assets and liabilities (net of acquisitions):Accounts receivable
    
    
    (622
    )
    
    
    1,392Prepaid and other assets
    
    
    (2,538
    )
    
    
    (475
    )Accounts payable
    
    
    (14,263
    )
    
    
    (6,705
    )Deferred revenue
    
    
    553
    
    
    
    633Income tax payable
    
    
    919
    
    
    
    3,651Accrued payroll and other accrued liabilities
    
    
    2,624
    
    
    
    (3,056
    )Net cash provided by operating activities
    
    
    43,977
    
    
    
    38,455INVESTING ACTIVITIES:Purchases of investments
    
    
    (103,413
    )
    
    
    (69,089
    )Sales of investments
    
    
    86,913
    
    
    
    53,227Cash paid for acquisitions, net of cash received
    
    
    (37,235
    )
    
    
    (7,825
    )Purchases of equipment and capitalized software
    
    
    (9,162
    )
    
    
    (6,021
    )Net cash used in investing activities
    
    
    (62,897
    )
    
    
    (29,708
    )FINANCING ACTIVITIES:Proceeds from sales of common stock
    
    
    172,700
    
    
    
    Exercise of stock options
    
    
    9,616
    
    
    
    10,453Sales of common stock under employee stock purchase plan
    
    
    933
    
    
    
    1,488Repurchase of common stock
    
    
    
    
    
    
    (3,205
    )Excess tax benefits from stock-based compensation
    
    
    2,705
    
    
    
    Net cash provided by financing activities
    
    
    185,954
    
    
    
    8,736EFFECT OF EXCHANGE RATE CHANGES ON CASH
    
    
    1,645
    
    
    
    (2,996
    )NET INCREASE IN CASH AND CASH EQUIVALENTS
    
    
    168,679
    
    
    
    14,487CASH AND CASH EQUIVALENTS, beginning of period
    
    
    131,770
    
    
    
    127,734CASH AND CASH EQUIVALENTS, end of period
    
    $
    300,449
    
    
    $
    142,221SUPPLEMENTAL DISCLOSURES:Cash paid for interest on Convertible Senior Notes
    
    $
    1,219
    
    
    $
    1,422Cash paid for income taxes
    
    $
    1,083
    
    
    $
    
  5




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##### Table of Contents



DIGITAL RIVER, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  1. BASIS OF PRESENTATION
  Summary of Significant Accounting Policies
  Foreign Currency Translation
  Research and Development and Software Development
  Stock-Based Compensation Expense
    6




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    Recent Accounting Pronouncement
  2. NET INCOME PER SHARE
    7




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Earnings per share  basicNet income  basic
    
    $
    13,289
    
    
    $
    10,226
    
    
    $
    29,666
    
    
    $
    24,263Weighted average shares outstanding  basic
    
    
    39,452
    
    
    
    34,176
    
    
    
    37,386
    
    
    
    34,097Earnings per share  basic
    
    $
    0.34
    
    
    $
    0.30
    
    
    $
    0.79
    
    
    $
    0.71Earnings per share  dilutedNet income  basic
    
    
    13,289
    
    
    
    10,226
    
    
    
    29,666
    
    
    
    24,263Exclude: Interest expense and amortized
financing cost of convertible senior notes,
net of tax benefit
    
    
    435
    
    
    
    457
    
    
    
    870
    
    
    
    969Net income  diluted
    
    $
    13,724
    
    
    $
    10,683
    
    
    $
    30,536
    
    
    $
    25,232Weighted average shares outstanding  basic
    
    
    39,452
    
    
    
    34,176
    
    
    
    37,386
    
    
    
    34,097Dilutive impact of non-vested stock and options outstanding
    
    
    1,581
    
    
    
    2,553
    
    
    
    1,508
    
    
    
    2,825Dilutive impact of convertible senior notes
    
    
    4,425
    
    
    
    4,425
    
    
    
    4,425
    
    
    
    4,425Weighted average shares outstanding  diluted
    
    
    45,458
    
    
    
    41,154
    
    
    
    43,319
    
    
    
    41,347Net income per share  diluted
    
    $
    0.30
    
    
    $
    0.26
    
    
    $
    0.70
    
    
    $
    0.61
 3. BUSINESS COMBINATIONS, GOODWILL AND INTANGIBLE ASSETS
      8




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   Accrual
    
    
    
    
    
    
    
    
    
    Accrual
    
    
    
    
    
    
    
    
    
    Accrual
    
    
    
    
    
    AccrualApril 16,
    
    Net
    
    
    
    
    
    December
    
    Adjust-
    
    
    
    
    
    December
    
    
    
    
    
    June 30,2004
    
    Additions
    
    Charges
    
    31, 2004
    
    ments
    
    Charges
    
    31, 2005
    
    Charges
    
    2006Shareholder escrow
    
    $
    
    
    
    $
    2,500
    
    
    $
    
    
    
    $
    2,500
    
    
    $
    
    
    
    $
    (1,250
    )
    
    $
    1,250
    
    
    $
    (1,250
    )
    
    $
    Employee severance
costs
    
    
    700
    
    
    
    2,100
    
    
    
    (400
    )
    
    
    2,400
    
    
    
    (200
    )
    
    
    (1,250
    )
    
    
    950
    
    
    
    (300
    )
    
    
    650Facilities
consolidation
    
    
    200
    
    
    
    100
    
    
    
    (300
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    900
    
    
    $
    4,700
    
    
    $
    (700
    )
    
    $
    4,900
    
    
    $
    (200
    )
    
    $
    (2,500
    )
    
    $
    2,200
    
    
    $
    (1,550
    )
    
    $
    650
   Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenue
    
    $
    72,583
    
    
    $
    56,114
    
    
    $
    152,749
    
    
    $
    116,127Income from operations
    
    
    13,996
    
    
    
    13,721
    
    
    
    34,631
    
    
    
    30,297Net income
    
    
    13,110
    
    
    
    9,244
    
    
    
    29,064
    
    
    
    22,698Basic net income per share
    
    $
    0.33
    
    
    $
    0.27
    
    
    $
    0.78
    
    
    $
    0.67Diluted net income per share
    
    $
    0.30
    
    
    $
    0.24
    
    
    $
    0.69
    
    
    $
    0.58
  Goodwill and Other Intangible Assets
   9




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  As of June 30, 2006Carrying Amount
    
    
    Accumulated
    
    
    Carrying AmountGross
    
    
    Amortization
    
    
    NetCustomer relationships
    
    $
    41,826
    
    
    $
    25,139
    
    
    $
    16,687Non-compete agreements
    
    
    5,860
    
    
    
    4,685
    
    
    
    1,175Technology/tradename
    
    
    22,168
    
    
    
    13,386
    
    
    
    8,782Total
    
    $
    69,854
    
    
    $
    43,210
    
    
    $
    26,644
 As of December 31, 2005Carrying Amount
    
    
    Accumulated
    
    
    Carrying AmountGross
    
    
    Amortization
    
    
    NetCustomer relationships
    
    $
    34,666
    
    
    $
    21,103
    
    
    $
    13,563Non-compete agreements
    
    
    5,121
    
    
    
    4,300
    
    
    
    821Technology/tradename
    
    
    17,065
    
    
    
    11,395
    
    
    
    5,670Total
    
    $
    56,852
    
    
    $
    36,798
    
    
    $
    20,054
  Year2006
    
    
    6,5582007
    
    
    8,2182008
    
    
    5,7082009
    
    
    4,7622010
    
    
    1,0022011
    
    
    396Total
    
    $
    26,644
 4. STOCK-BASED COMPENSATION PLANS
 Option and Restricted Stock Awards
    10




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  WeightedShares
    
    
    
    
    
    
    Options
    
    
    AverageAvailable
    
    
    Options
    
    
    Price
    
    
    Pricefor Grant
    
    
    Outstanding
    
    
    Per Share
    
    
    Per ShareBalance, December 31, 2004
    
    
    2,456,343
    
    
    
    5,714,740
    
    
    $
    1.69 - $31.13
    
    
    $
    13.94Granted
    
    
    (846,678
    )
    
    
    846,678
    
    
    
    23.90 - 30.69
    
    
    
    28.15Exercised
    
    
    
    
    
    
    (1,719,114
    )
    
    
    1.69 - 30.69
    
    
    
    13.50Canceled/expired
    
    
    318,919
    
    
    
    (318,919
    )
    
    
    3.88 - 27.40
    
    
    
    15.15Balance, December 31, 2005
    
    
    1,928,584
    
    
    
    4,523,385
    
    
    
    2.59 - 31.13
    
    
    
    16.69Granted
    
    
    (308,500
    )
    
    
    308,500
    
    
    
    29.75 - 45.24
    
    
    
    35.20Restricted stock effect
on shares available for
grant
    
    
    (128,250
    )
    
    
    N/A
    
    
    
    N/A
    
    
    
    N/AExercised
    
    
    
    
    
    
    (570,299
    )
    
    
    2.59 - 31.13
    
    
    
    16.86Canceled/expired
    
    
    58,417
    
    
    
    (58,417
    )
    
    
    2.59 - 27.40
    
    
    
    18.93Balance, June 30, 2006
    
    
    1,550,251
    
    
    
    4,203,169
    
    
    $
    2.59 - $45.24
    
    
    $
    17.99
   Options Outstanding
    
    
    Options ExercisableWeighted
    
    
    Weighted
    
    
    Aggregate
    
    
    
    
    
    
    Weighted
    
    
    AggregateNumber
    
    
    Average
    
    
    Average
    
    
    Intrinsic
    
    
    Number
    
    
    Average
    
    
    IntrinsicExercise Price
    
    Outstanding
    
    
    Life Remaining
    
    
    Price
    
    
    Value
    
    
    Exercisable
    
    
    Price
    
    
    Value$1.69 - $  3.88
    
    
    136,496
    
    
    2.6 years
    
    $
    3.04
    
    
    $
    5,098,520
    
    
    
    136,496
    
    
    $
    3.04
    
    
    $
    5,098,5204.56 -     7.55
    
    
    934,186
    
    
    4.9 years
    
    
    5.38
    
    
    
    32,707,501
    
    
    
    917,468
    
    
    
    5.34
    
    
    
    32,157,1529.13 -   13.92
    
    
    835,957
    
    
    6.3 years
    
    
    11.54
    
    
    
    24,120,661
    
    
    
    591,304
    
    
    
    11.86
    
    
    
    16,870,58716.72 -   22.98
    
    
    839,579
    
    
    7.1 years
    
    
    22.03
    
    
    
    15,417,129
    
    
    
    543,244
    
    
    
    22.29
    
    
    
    9,832,46123.01 -   31.13
    
    
    1,200,451
    
    
    8.4 years
    
    
    27.27
    
    
    
    15,753,948
    
    
    
    260,754
    
    
    
    26.79
    
    
    
    3,546,17431.14 -   45.24
    
    
    256,500
    
    
    9.7 years
    
    
    36.30
    
    
    
    1,163,280
    
    
    
    13,218
    
    
    
    35.13
    
    
    
    69,506$1.69 - $31.13
    
    
    4,203,169
    
    
    6.8 years
    
    $
    17.99
    
    
    $
    94,261,040
    
    
    
    2,462,484
    
    
    $
    12.95
    
    
    $
    67,574,401
   WeightedRestricted
    
    
    AverageStock
    
    
    Intrinsic ValueNon-Vested Balance, December 31, 2005
    
    
    
    
    
    $
    Granted
    
    
    85,500
    
    
    
    39.45Vested
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Non-Vested Balance, June 30, 2006
    
    
    85,500
    
    
    $
    39.45
 11




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 Employee Stock Purchase Plan
  Inducement Equity Incentive Plan
  Expense Information under SFAS 123(R)
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Costs and expensesDirect cost of services
    
    $
    218
    
    
    $
    
    
    
    $
    432
    
    
    $
    Network and infrastructure
    
    
    84
    
    
    
    
    
    
    
    170
    
    
    
    Sales and marketing
    
    
    1,323
    
    
    
    
    
    
    
    2,612
    
    
    
    Product research and development
    
    
    591
    
    
    
    
    
    
    
    1,176
    
    
    
    General and administrative
    
    
    1,303
    
    
    
    
    
    
    
    2,542
    
    
    
    Stock-based compensation
included in costs and expenses
    
    
    3,519
    
    
    
    
    
    
    
    6,932
    
    
    
    Tax benefit
    
    
    (1,309
    )
    
    
    
    
    
    
    (2,579
    )
    
    
    Stock-based compensation expense,
net of tax
    
    $
    2,210
    
    
    $
    
    
    
    $
    4,353
    
    
    $
    
 12




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,Pro forma
    
    
    
    
    
    
    Pro forma2006
    
    
    2005
    
    
    2006
    
    
    2005Net income, as reported for prior periods (1)
    
    
    N/A
    
    
    $
    10,226
    
    
    
    N/A
    
    
    $
    24,263Stock-based compensation expense
    
    $
    (3,519
    )
    
    
    (3,347
    )
    
    $
    (6,932
    )
    
    
    (6,581
    )Tax benefit (2)
    
    
    1,309
    
    
    
    
    
    
    
    2,579
    
    
    
    Stock-based compensation expense, net of tax (3)
    
    
    (2,210
    )
    
    
    (3,347
    )
    
    
    (4,353
    )
    
    
    (6,581
    )Net income, including the effect of stock-based compensation
expense (4)
    
    $
    13,289
    
    
    
    6,879
    
    
    $
    29,666
    
    
    
    17,682Basic net income per share  as reported for prior periods (1)
    
    
    N/A
    
    
    $
    0.30
    
    
    
    N/A
    
    
    $
    0.71Diluted net income per share  as reported for prior periods (1)
    
    
    N/A
    
    
    $
    0.26
    
    
    
    N/A
    
    
    $
    0.61Basic net income per share, including the effect of stock-based
compensation expense (4)
    
    $
    0.34
    
    
    $
    0.20
    
    
    $
    0.79
    
    
    $
    0.52Diluted net income per share, including the effect of
stock-based compensation expense (4)
    
    $
    0.30
    
    
    $
    0.18
    
    
    $
    0.70
    
    
    $
    0.45
 
 (1)
    
    Net income and net income per share prior to 2006 did not include stock-based compensation expense under
SFAS 123 because we did not adopt the recognition provisions of SFAS 123.(2)
    
    No tax benefit was recorded prior to the removal of the valuation allowance on certain deferred tax assets
in the fourth quarter of 2005.(3)
    
    Stock-based compensation expense prior to 2006 is calculated based on the pro forma application of SFAS 123.(4)
    
    Net income and net income per share prior to 2006 represents pro forma information based on SFAS 123. Valuation Information under SFAS 123(R)
  Six Months EndedJune 30,2006
    
    2005Risk-free interest rate
    
    
    4.7
    %
    
    
    4.0
    %Expected life (years)
    
    
    3.14
    
    
    
    4Volatility factor
    
    
    0.60
    
    
    
    0.93Expected dividends
    
    
    
    
    
    
    
   13




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  5. INCOME TAXES
       6. LONG-TERM DEBT
   14




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DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  15




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 The discussion in this Quarterly Report contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from those discussed below. Additional
factors that could cause or contribute to such differences include, but are not limited to, those
identified below, and those discussed in the section entitled Risk Factors, included in Item 1A
of Part II of this Quarterly Report. When used in this document, the words believes, expects,
anticipates, intends, plans, and similar expressions, are intended to identify certain of
these forward-looking statements. However, these words are not the exclusive means of identifying
such statements. In addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking statements. The cautionary
statements made in this document should be read as being applicable to all related forward-looking
statements wherever they appear in this document.
 Overview
      Critical Accounting Policies
  16




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Results of Operations
  17




---



##### Table of Contents



Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of Revenue (exclusive of depreciation
and amortization expense shown separately
below):Direct cost of services
    
    
    2.7
    
    
    
    2.3
    
    
    
    2.5
    
    
    
    2.3Network and infrastructure
    
    
    8.8
    
    
    
    9.3
    
    
    
    9.2
    
    
    
    8.7Sales and marketing
    
    
    38.7
    
    
    
    30.8
    
    
    
    36.5
    
    
    
    30.4Product research and development
    
    
    10.5
    
    
    
    10.0
    
    
    
    10.1
    
    
    
    9.1General and administrative
    
    
    11.6
    
    
    
    10.4
    
    
    
    11.1
    
    
    
    10.3Depreciation and amortization
    
    
    3.5
    
    
    
    4.6
    
    
    
    3.2
    
    
    
    4.3Amortization of acquisition related costs
    
    
    4.3
    
    
    
    4.1
    
    
    
    3.9
    
    
    
    4.3Total costs and expenses
    
    
    80.1
    
    
    
    71.5
    
    
    
    76.5
    
    
    
    69.4Income from operations
    
    
    19.9
    
    
    
    28.5
    
    
    
    23.5
    
    
    
    30.6Other income/(expense), net
    
    
    8.9
    
    
    
    1.7
    
    
    
    6.2
    
    
    
    2.0Income before income tax expense
    
    
    28.8
    
    
    
    30.2
    
    
    
    29.7
    
    
    
    32.6Income tax expense
    
    
    10.2
    
    
    
    10.2
    
    
    
    9.8
    
    
    
    9.6Net income
    
    
    18.6
    %
    
    
    20.0
    %
    
    
    19.9
    %
    
    
    23.0
    %
  REVENUE.
  DIRECT COST OF SERVICES.
 18




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##### Table of Contents



NETWORK AND INFRASTRUCTURE.
 SALES AND MARKETING.
 PRODUCT RESEARCH AND DEVELOPMENT.
 GENERAL AND ADMINISTRATIVE.
 19




---



##### Table of Contents



AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES.
 OTHER INCOME, NET.
 INCOME TAXES.
     Off Balance Sheet Arrangements
  20




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##### Table of Contents



Liquidity and Capital Resources
      Payment due by period (in thousands)Total Amount
    
    Jul-Dec
    
    
    
    
    
    
    
    
    
    2011 andContractual Obligations
    
    Committed
    
    2006
    
    2007-2008
    
    2009-2010
    
    ThereafterOperating Lease Obligations
    
    $
    7,677
    
    
    $
    1,671
    
    
    $
    4,755
    
    
    $
    1,251
    
    
    $
    0Convertible Senior Notes
    
    $
    237,656
    
    
    $
    1,219
    
    
    $
    4,875
    
    
    $
    4,875
    
    
    $
    226,687Total
    
    $
    245,333
    
    
    $
    2,890
    
    
    $
    9,630
    
    
    $
    6,126
    
    
    $
    226,687
  21




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22




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##### Table of Contents



Item 3. Qualitative and Quantitative Disclosure About Market Risk
 Interest Rate Risk
   Foreign Currency Risk
  Transaction Exposure
  Translation Exposure
  23




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##### Table of Contents



Item 4. Controls and Procedures
 (a)
    
    Our management, under the supervision and with the participation of our Chief Executive
Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the
design and operation of our disclosure controls and procedures as of June 30, 2006. Based upon
this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that
our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) promulgated
under the Securities Exchange Act of 1934) were effective in providing reasonable assurance
that material information required to be disclosed by us in this Form 10-Q was recorded,
processed, summarized and reported in a timely manner.(b)
    
    During the quarter ended June 30, 2006, there was no change in our internal control over
financial reporting that materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting.
 Limitations on the Effectiveness of Controls
  24




---



##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
    
 Item 1A. Risk Factors
 The risks described below are not the only ones facing our company. Additional risks not presently
known to us or that we currently deem immaterial also may impair our business operations. Our
business ,financial condition or results of operations could be materially adversely affected by
any of these risks and the value of our common stock could decline due to any of these risks. This
quarterly report also contains forward-looking statements that involve risks and uncertainties. Our
actual results could differ materially from those anticipated in these forward-looking statements
as a result of certain factors, including the risks faced by us described below and elsewhere in
this report.
 A loss of any client that accounts for a large portion of our revenue would cause our revenue to
decline.
  We have a limited profitable operating history.
  25




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##### Table of Contents



Failure to properly manage and sustain our expansion efforts could strain our management and other
resources.
  We intend to continue to expand our international operations and these efforts may not be
successful in generating additional revenue.
  §
    
    Changes in regulatory requirements and tariffs;§
    
    Uncertainty of application of local commercial, tax, privacy and other laws and regulations;§
    
    Reduced protection of intellectual property rights;§
    
    Difficulties in physical distribution for international sales;§
    
    Higher incidences of credit card fraud and difficulties in accounts receivable collection;§
    
    The burden and cost of complying with a variety of foreign laws;§
    
    The possibility of unionization of our workforce outside the United States, particularly in Europe; and§
    
    Political or economic constraints on international trade or instability.
   Our operating results are subject to fluctuations in demand for products and services offered by us
or our clients.
  26




---



##### Table of Contents



New obligations to collect or pay transaction taxes could substantially increase the cost to us of
doing business.
  We could be liable for fraudulent, improper or illegal uses of our platforms.
  Loss of our credit card acceptance privileges would seriously hamper our ability to process the
sale of merchandise.
  Our failure to attract and retain software and digital products publishers, manufacturers, online
retailers and online channel partners as clients would cause our revenue and operating profits to
decline.
  27




---



##### Table of Contents



Implementing our acquisition strategy could result in dilution and operating difficulties leading
to a decline in revenue and operating profit.
  We may need to raise additional capital to achieve our business objectives, which could result in
dilution to existing investors or increase our debt obligations.
  Our operating results have fluctuated in the past and are likely to continue to do so, which could
cause the price of our common stock to be volatile.
  §
    
    The addition of new clients or loss of current clients;§
    
    The introduction by us of new websites, web stores or services that may require a substantial
investment of our resources;§
    
    The introduction by others of competitive websites, web stores or services or products;§
    
    Our ability to continue to upgrade and develop our systems and infrastructure to meet emerging
market needs and remain competitive in our service offerings;
 28




---



##### Table of Contents



§
    
    Economic conditions, particularly those affecting e-commerce;§
    
    Client decisions to delay new product launches or to invest in e-commerce initiatives;§
    
    The performance of our newly acquired assets or companies;§
    
    Slower than anticipated growth of the online market as a vehicle for the purchase of software
products;§
    
    The cost of compliance with U.S. and foreign regulations relating to our business; and§
    
    Our ability to retain and attract personnel commensurate with our business needs.
   Security breaches could hinder our ability to securely transmit confidential information.
   Claims of infringement of other parties intellectual property rights could require us to expend
significant resources, enter into unfavorable licenses or require us to change our business plans.
  29




---



##### Table of Contents



Claims against us related to the software products that we deliver electronically and the tangible
goods that we deliver physically could require us to expend significant resources.
  The growth of the market for our services depends on the development and maintenance of the
Internet infrastructure.
  Because the e-commerce industry is highly competitive and has low barriers to entry, we may be
unable to compete effectively.
  §
    
    In-house development of e-commerce capabilities using tools or applications from
companies, such as Art Technology Group, Inc. and IBM Corporation;§
    
    E-Commerce capabilities custom-developed by companies, such as IBM Global Services and
Accenture, Inc.;§
    
    Other providers of outsourced e-commerce solutions, such as GSI Commerce, Inc.,
Macrovision Corporation, and asknet Inc.;§
    
    Companies that provide technologies, services or products that support a portion of the
e-commerce process, such as payment processing, including CyberSource Corporation and
PayPal Corp.;§
    
    Companies that offer various online marketing services, technologies and products,
including ValueClick, Inc. and aQuantive, Inc.;§
    
    High-traffic, branded websites that generate a substantial portion of their revenue from
e-commerce and may offer or provide to others the means to offer their products for sale,
such as Amazon.com, Inc.; and§
    
    Web hosting, web services and infrastructure companies that offer portions of our
solution and are seeking to expand the range of their offering, such as Network Solutions,
LLC, Akamai Technologies, Inc., Yahoo! Inc., eBay Inc. and Hostopia.com Inc.
   30




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##### Table of Contents



Changes in government regulation could limit our Internet activities or result in additional costs
of doing business over the Internet.
  §
    
    User privacy with respect to adults and minors;§
    
    Our ability to collect and/or share necessary information that allows us to conduct
business on the Internet;§
    
    Export compliance;§
    
    Pricing and taxation;§
    
    Fraud;§
    
    Advertising;§
    
    Intellectual property rights;§
    
    Information security; and§
    
    Quality of products and services.
  Failure to develop our technology to accommodate increased traffic could reduce demand for our
services and impair the growth of our business.
   31




---



##### Table of Contents



System failures could reduce the attractiveness of our service offerings.
   §
    
    Fire, flood and other natural disasters;§
    
    Operator negligence, improper operation by, or supervision of, employees, physical and
electronic break-ins, misappropriation, computer viruses and similar events; and§
    
    Power loss, computer systems failures, and Internet and telecommunications failure.
  We may become liable to clients who are dissatisfied with our services.
  We depend on key personnel.
   32




---



##### Table of Contents



Protecting our intellectual property is critical to our success.
   Our clients sales cycles are lengthy, which may cause us to incur substantial expenses and expend
management time without generating corresponding consumer revenue, which would impair our cash
flow.
  The listing of our network addresses on anti-SPAM lists could harm our ability to service our
clients and deliver goods over the Internet.
  We are subject to regulations relating to consumer privacy.
   33




---



##### Table of Contents



Compliance with future laws imposed on e-commerce may substantially increase our costs of doing
business or otherwise adversely affect our ability to offer our services.
    We are exposed to foreign currency exchange risk.
  Changes in our tax rates could affect our future results.
  34




---



##### Table of Contents



Developments in accounting standards may cause us to increase our recorded expenses, which in turn
would jeopardize our ability to demonstrate sustained profitability.
  Compliance with changing regulation of corporate governance and public disclosure may result in
additional expenses.
  Internet-related stock prices are especially volatile and this volatility may depress our stock
price or cause it to fluctuate significantly.
  §
    
    Actual or anticipated variations in quarterly operating results;§
    
    Announcements of technological innovations;§
    
    The ability to sign new clients and the retention of existing clients;§
    
    New products or services that we offer;§
    
    Competitive developments, including new products or services, or new relationships by our competitors;§
    
    Changes that affect our clients or the viability of their product lines;§
    
    Changes in financial estimates by securities analysts;§
    
    Conditions or trends in the Internet and online commerce industries;§
    
    Global unrest and terrorist activities;§
    
    Changes in the economic performance and/or market valuations of other Internet or online
e-commerce companies;§
    
    Required changes in generally accepted accounting principles and disclosures;§
    
    Our announcement of significant acquisitions, strategic partnerships, joint ventures or
capital commitments or results of operations or other developments related to those
acquisitions;§
    
    Additions or departures of key personnel; and§
    
    Sales or other transactions involving our common stock or our convertible notes.
  Provisions of our charter documents, other agreements and Delaware law may inhibit potential
acquisition bids for us.
  35




---



##### Table of Contents



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
   Approximate dollarTotal number of
    
    value of sharesshares purchased as
    
    that may yet beTotal number of
    
    Average price paid
    
    part of publicly
    
    purchased under thePeriod
    
    shares purchased
    
    per share
    
    announced plan
    
    plan (in millions)April 1, 2006 - April 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6May 1, 2006 - May 31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6June 1, 2006 - June 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6Total
    
    
    
    
    
    
    
    
    
    
    
 36




---



##### Table of Contents



Item 4. Submission of Matters to a Vote of Security Holders
   For
    
    Authority WithheldWilliam J. Lansing
    
    
    21,937,603
    
    
    
    7,922,747Frederic M. Seegal
    
    
    28,650,149
    
    
    
    1,210,201
   For
    
    Against
    
    Abstained26,395,680
    
    3,410,249
    
    54,421
  For
    
    Against
    
    Abstained28,303,009
    
    1,543,358
    
    13,982
 37




---



##### Table of Contents



Item 6. Exhibits
  EXHIBITNUMBER
    
    DESCRIPTION OF DOCUMENTS3.1
    (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.4.2
    (1)
    
    Form of Senior Debt Indenture.4.3
    (1)
    
    Form of Subordinated Debt Indenture.4.4
    
    
    References are made to Exhibits 3.1 and 3.2.4.5
    (4)
    
    Indenture dated as of June 1, 2004 between Digital River, Inc. and Wells Fargo Bank, N.A.
as trustee, including therein the form of the Note.12.1
    
    
    Computation of Ratio of Earnings to Fixed Charges.31.1
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Filed as exhibits 3.1 and 3.3 and exhibits 4.5 and 4.6
to our Registration Statement on Form S-3, File No.
333-81626, filed on January 29, 2002, declared effective on
February 12, 2002, and incorporated herein by reference.(2)
    
    Filed as an exhibit to our Annual Report on Form 10-K
for the year ended December 31, 2000, filed on March 27,
2001, and incorporated herein by reference.(3)
    
    Filed as an exhibit to our Registration Statement on
Form S-1, File No. 333-56787, declared effective on August
11, 1998, and incorporated herein by reference.(4)
    
    Filed as exhibit 99.1 to our Current Report on Form 8-K,
filed on July 13, 2004 and incorporated herein by reference. 38




---



##### Table of Contents



Date: August 9, 2006
    
    
    
    
    
    DIGITAL RIVER, INC.By:
    
    /s/ THOMAS M. DONNELLYThomas M. DonnellyChief Financial Officer(Principal Financial and Accounting Officer)
 39




---



##### Table of Contents



EXHIBITNUMBER
    
    DESCRIPTION OF DOCUMENTS3.1
    (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.4.2
    (1)
    
    Form of Senior Debt Indenture.4.3
    (1)
    
    Form of Subordinated Debt Indenture.4.4
    
    
    References are made to Exhibits 3.1 and 3.2.4.5
    (4)
    
    Indenture dated as of June 1, 2004 between Digital River, Inc. and Wells Fargo Bank, N.A.
as trustee, including therein the form of the Note.12.1
    
    
    Computation of Ratio of Earnings to Fixed Charges.31.1
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Filed as Exhibits 3.1 and 3.3 and Exhibits 4.5 and 4.6
to our Registration Statement on Form S-3, File No.
333-81626, filed on January 29, 2002, declared effective on
February 12, 2002, and incorporated herein by reference.(2)
    
    Filed as an exhibit to our Annual Report on Form 10-K
for the year ended December 31, 2000, filed on March 27,
2001, and incorporated herein by reference.(3)
    
    Filed as an exhibit to our Registration Statement on
Form S-1, File No. 333-56787, declared effective on August
11, 1998, and incorporated herein by reference.(4)
    
    Filed as exhibit 99.1 to our Current Report on Form 8-K,
filed on July 13, 2004 and incorporated herein by reference. 40