** **

**SECURITIESAND EXCHANGE COMMISSION********Washington, D.C. 20549**

 

----

** **

**FORM10-Q**

 

----

 

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED March 31, 2005**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**FOR THE TRANSITION PERIOD FROM        TO       **

** **

**Commission file number 000-24643**

 

**DIGITALRIVER, INC.**(Exact name of registrant as specified inits charter)

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

 

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

** **

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

 

----

 

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 ýNo o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes ýNo 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** | ** ** | **34,205,564 SHARES**             |
|-----------------------------------|------------|-----------------------------------|
| (Class)                           |       | Outstanding  as of April 29, 2005 |

 

 

----

 

DIGITALRIVER, INC.

 Form10-Q

Index

 
| PART I.       | FINANCIAL  INFORMATION                                                                               |   |
|---------------|------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                 |   |
| Item 1.       | Financial  Statements                                                                                |   |
|          |                                                                                                 |   |
|          | Condensed  Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004                    |   |
|          |                                                                                                 |   |
|          | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2005 and 2004 |   |
|          |                                                                                                 |   |
|          | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2005 and 2004 |   |
|          |                                                                                                 |   |
|          | 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 2.       | Unregistered Sales of  Equity Securities and Use of Proceeds                                         |   |
|          |                                                                                                 |   |
| Item 6.       | Exhibits                                                                                             |   |
|          |                                                                                                 |   |
| SIGNATURES    |                                                                                                 |   |
|          |                                                                                                 |   |
| EXHIBIT INDEX |                                                                                                 |

 

2

----

 

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

 

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

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(inthousands, except share data)

 
| ** **                                                                                                           | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                           |       |                |       |                   |       |
| CURRENT ASSETS:                                                                                                      |       |                |       |                   |       |
| Cash and cash equivalents                                                                                            |       | $                   | 142,786    |                   | $          | 127,734 |   |
| Short-term investments                                                                                               |       | 172,826             |       | 164,402                |       |
| Accounts receivable, net of allowance of  $843 and $1,146                                                            |       | 22,580              |       | 21,520                 |       |
| Prepaid expenses and other                                                                                           |       | 6,215               |       | 1,843                  |       |
| Total current assets                                                                                                 |       | 344,407             |       | 315,499                |       |
|                                                                                                                 |       |                |       |                   |       |
| PROPERTY AND EQUIPMENT, NET                                                                                          |       | 18,999              |       | 17,367                 |       |
| GOODWILL                                                                                                             |       | 154,330             |       | 148,086                |       |
| INTANGIBLE ASSETS, net of accumulated  amortization of $30,641 and $28,245                                           |       | 17,144              |       | 17,297                 |       |
| OTHER ASSETS                                                                                                         |       | 6,218               |       | 6,272                  |       |
|                                                                                                                 |       | $                   | 541,098    |                   | $          | 504,521 |   |
|                                                                                                                 |       |                |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                       |       |                |       |                   |       |
| CURRENT LIABILITIES:                                                                                                 |       |                |       |                   |       |
| Accounts payable                                                                                                     |       | $                   | 97,549     |                   | $          | 88,052 |   |
| Accrued payroll                                                                                                      |       | 3,842               |       | 5,332                  |       |
| Deferred revenue                                                                                                     |       | 4,702               |       | 3,901                  |       |
| Accrued acquisitions expenses                                                                                        |       | 3,643               |       | 6,720                  |       |
| Other accrued liabilities                                                                                            |       | 18,502              |       | 12,747                 |       |
| Total current liabilities                                                                                            |       | 128,238             |       | 116,752                |       |
|                                                                                                                 |       |                |       |                   |       |
| NON-CURRENT LIABILITIES:                                                                                             |       |                |       |                   |       |
| Convertible senior notes                                                                                             |       | 195,000             |       | 195,000                |       |
|                                                                                                                 |       |                |       |                   |       |
| COMMITMENTS AND CONTINGENCIES                                                                                        |       |                |       |                   |       |
|                                                                                                                 |       |                |       |                   |       |
| 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; 34,199,880 and 33,652,149 shares issued and outstanding |       | 342                 |       | 337                    |       |
| Additional paid-in capital                                                                                           |       | 256,091             |       | 243,926                |       |
| Accumulated deficit                                                                                                  |       | (37,127             | )          | (51,164                | )          |
| Accumulated other comprehensive loss                                                                                 |       | (1,446              | )          | (330                   | )          |
| Total stockholders’ equity                                                                                      |       | 217,860             |       | 192,769                |       |
|                                                                                                                 |       | $                   | 541,098    |                   | $          | 504,521 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

----

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(inthousands, except per share data; unaudited)

 
| ** **                                                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                                            |       |                              |       |   |   |
| REVENUE                                                                                         |       | $                                 | 54,529     |   | $ | 31,855 |   |
| COSTS AND EXPENSES (exclusive of  depreciation and amortization expense shown separately below) |       |                              |       |   |   |
| Direct cost of services                                                                         |       | 1,301                             |       | 618 |   |
| Network and infrastructure                                                                      |       | 4,479                             |       | 3,300 |   |
| Sales and marketing                                                                             |       | 16,376                            |       | 11,468 |   |
| Product research and development                                                                |       | 4,458                             |       | 2,924 |   |
| General and administrative                                                                      |       | 5,615                             |       | 2,837 |   |
| Depreciation and amortization                                                                   |       | 2,122                             |       | 1,611 |   |
| Amortization of acquisition related  intangibles                                                |       | 2,396                             |       | 1,579 |   |
| Total costs and expenses                                                                        |       | 36,747                            |       | 24,337 |   |
|                                                                                            |       |                              |       |   |   |
| INCOME FROM OPERATIONS                                                                          |       | 17,782                            |       | 7,518 |   |
| OTHER INCOME/(EXPENSE), NET                                                                     |       | 1,155                             |       | 97 |   |
| INCOME BEFORE INCOME TAX EXPENSE                                                                |       | $                                 | 18,937     |   | $ | 7,615 |   |
| Income tax expense                                                                              |       | 4,900                             |       | — |   |
| NET INCOME                                                                                      |       | $                                 | 14,037     |   | $ | 7,615 |   |
|                                                                                            |       |                              |       |   |   |
| NET INCOME PER SHARE:                                                                           |       |                              |       |   |   |
| BASIC                                                                                           |       | $                                 | 0.41       |   | $ | 0.24 |   |
| DILUTED                                                                                         |       | $                                 | 0.35       |   | $ | 0.22 |   |
|                                                                                            |       |                              |       |   |   |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:                                                     |       |                              |       |   |   |
| BASIC                                                                                           |       | 33,932                            |       | 31,620 |   |
| DILUTED                                                                                         |       | 41,454                            |       | 35,059 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

4

----

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(inthousands; unaudited)

 
| ** **                                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| OPERATING ACTIVITES:                                                               |       |                              |       |   |   |
| Net income                                                                         |       | $                                 | 14,037     |   | $ | 7,615 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                              |       |   |   |
| Amortization of acquisition related costs                                          |       | 2,396                             |       | 1,579 |   |
| Change in accounts receivable allowance                                            |       | 6                                 |       | 66 |   |
| Depreciation and amortization                                                      |       | 2,122                             |       | 1,611 |   |
| Tax benefit of stock based compensation                                            |       | 2,600                             |       | — |   |
| Change in operating assets and liabilities:                                        |       |                              |       |   |   |
| Accounts receivable                                                                |       | 831                               |       | 81 |   |
| Prepaid and other assets                                                           |       | (4,408                            | )          | (931 | ) |
| Accounts payable                                                                   |       | 4,086                             |       | 7,904 |   |
| Litigation reserve                                                                 |       | (620                              | )          | — |   |
| Deferred revenue                                                                   |       | 851                               |       | 8 |   |
| Accrued payroll and other accrued  liabilities                                     |       | 5,360                             |       | 1,213 |   |
| Net cash provided by operating activities                                          |       | 27,261                            |       | 19,146 |   |
|                                                                               |       |                              |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                              |       |   |   |
| Purchases of investments                                                           |       | (36,485                           | )          | (15,000 | ) |
| Sales of investments                                                               |       | 27,277                            |       | — |   |
| Cash paid for acquisitions, net of cash  received                                  |       | (7,306                            | )          | (294 | ) |
| Purchases of equipment                                                             |       | (3,680                            | )          | (2,124 | ) |
| Net cash used in investing activities                                              |       | (20,194                           | )          | (17,418 | ) |
|                                                                               |       |                              |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                              |       |   |   |
| Proceeds from sales of common stock                                                |       | —                            |       | — |   |
| Exercise of stock options                                                          |       | 8,801                             |       | 1,470 |   |
| Sales of common stock under employee stock  purchase plan                          |       | 771                               |       | 427 |   |
| Net cash provided by financing activities                                          |       | 9,572                             |       | 1,897 |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH                                            |       | (1,587                            | )          | — |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                          |       | 15,052                            |       | 3,625 |   |
| CASH AND CASH EQUIVALENTS, beginning of  period                                    |       | 127,734                           |       | 101,878 |   |
| CASH AND CASH EQUIVALENTS, end of period                                           |       | $                                 | 142,786    |   | $ | 105,503 |   |
| SUPPLEMENTAL DISCLOSURES:                                                          |       |                              |       |   |   |
| Cash paid for interest                                                             |       | $                                 | 1,401      |   | $ | — |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

----

 

**DIGITAL RIVER, INC.**

**NOTES T****O CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

 

 

**1. BASIS OF PRESENTATION**

 

The unaudited condensed consolidated financialstatements included herein reflect all adjustments, including normal recurringadjustments, which in our opinion are necessary to fairly state ourconsolidated financial position, results of operations and cash flows for theperiods presented.  These condensed consolidated financial statementsshould be read in conjunction with our audited consolidated financialstatements included in our Form 10-K for the year ended December 31, 2004 as filedwith the Securities and Exchange Commission. The results of operations for thethree months ended March 31, 2005 are not necessarily indicative of the resultsto be expected for any subsequent quarter or for the entire fiscal year endingDecember 31, 2005. The December 31, 2004 balance sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States.

 

***Summary ofSignificant Accounting Policies***

 

A detailed description of our significantaccounting policies can be found in our most recent Annual Report filed on Form10-K for the fiscal year ended December 31, 2004.

 

***ForeignCurrency Translation***

 

Foreign currency denominated revenue andexpense transactions are remeasured to our functional currency using averageexchange rates for the fiscal period. Foreign currency denominated assets and liabilities are remeasured toour functional currency using exchange rate in effect at the respective balancesheet dates.  Any gains or losses areincluded in the consolidated statement of operations within “other income(expense), net.”  The financial positionand results of operations of our foreign subsidiaries are measured using localcurrency as the functional currency. Assets and liabilities are translated to their U.S. dollar equivalentsat rates in effect at the respective balance sheet dates and statements ofoperations and cash flows are translated using average exchange rates for thefiscal period.  The resulting translationadjustments are recorded as a component of stockholders’ equity.

 

***Researchand Development and Software Development***

 

Research and development expenses consist primarily of developmentpersonnel and external contractor costs related to the development of newproducts and services, enhancement of existing products and services, qualityassurance and testing.  We follow AICPAStatement of Position No. 98-1, “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use,” in accounting for internally developedsoftware.  Consistent with SOP98-1, we capitalized approximately $2.7 million and $0.4 million of softwaredevelopment costs related to those efforts for the year 2004 and the threemonths ended March 31, 2005, respectively. These capitalized costs are includedin purchases of equipment within investing activities on our ConsolidatedStatement of Cash Flows.

 

**2. NET INCOME PER SHARE**

 

The table below sets forth the computation ofbasic and diluted net income per share (in thousands, except per shareamounts):

 

6

----

 
| ** **                                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Earnings per share - basic                                                                              |       |                                   |       |   |   |
| Net income - basic                                                                                      |       | $                                      | 14,037     |   | $ | 7,615 |   |
| Weighted average shares outstanding - basic                                                             |       | 33,932                                 |       | 31,620 |   |
| Earning per share - basic                                                                               |       | $                                      | 0.41       |   | $ | 0.24 |   |
| Earnings per share - diluted                                                                            |       |                                   |       |   |   |
| Net income - basic                                                                                      |       | 14,037                                 |       | 7,615 |   |
| Exclude: Interest expense and amortized  financing cost of convertible senior notes, net of tax benefit |       | 511                                    |       | — |   |
| Net income - diluted                                                                                    |       | $                                      | 14,548     |   | $ | 7,615 |   |
| Weighted average shares outstanding - basic                                                             |       | 33,932                                 |       | 31,620 |   |
| Dilutive impact of options outstanding                                                                  |       | 3,097                                  |       | 3,439 |   |
| Dilutive impact of convertible senior notes                                                             |       | 4,425                                  |       | — |   |
| Diluted — weighted average shares  outstanding                                                     |       | 41,454                                 |       | 35,059 |   |
| Diluted — net income per share                                                                     |       | $                                      | 0.35       |   | $ | 0.22 |   |

 

Subsequent to our issuanceof 1.25% convertible senior notes on June 1, 2004, the Emerging Issues TaskForce (EITF), Issue No. 04-08, proposed that the unissued shares underlyingcontingent convertible notes be treated as if such shares were issued andoutstanding for the purposes of calculating GAAP diluted earnings pershare.  The notes are contingentlyconvertible into approximately 4.4 million shares of common stock at an initialconversion price of $44.063 per share, which have been included in our weightedaverage shares outstanding calculation since the date of issuance.

 

**3. GOODWILL ANDINTANGIBLE ASSETS**

 

We accountfor our goodwill in accordance with SFAS No. 142, “Goodwill and OtherIntangible Asset.”  SFAS No. 142precludes the amortization of goodwill and intangible assets with indefinitelives, but these assets are reviewed annually (or more frequently if impairmentindicators arise) for impairment.

 

We completeour annual impairment test in the fourth quarter of each fiscal year, andreassess any intangible assets, including goodwill, recorded in connection withearlier acquisitions.  There was noimpairment of goodwill in the three months ended March 31, 2005 and 2004.

 

Information regarding our other intangibleassets is as follows (in thousands):

 

7

----

 
| ** **             | ** ** | **As of March 31, 2005**   | ** ** |
|------------------------|------------|----------------------------|------------|
| ** **             | ** ** | **Carrying Amount  Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|                   |       |                       |       |   |   |   |   |
| Customer relationships |       | $                          | 27,154     |   | $ | 15,511 |   | $ | 11,643 |   |
| Non-compete agreements |       | 5,134                      |       | 3,657 |   | 1,477 |   |
| Technology/tradename   |       | 15,497                     |       | 11,473 |   | 4,024 |   |
| Total                  |       | $                          | 47,785     |   | $ | 30,641 |   | $ | 17,144 |   |

 
| ** **             | ** ** | **As of December 31, 2004** | ** ** |
|------------------------|------------|-----------------------------|------------|
| ** **             | ** ** | **Carrying Amount  Gross**  | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|                   |       |                        |       |   |   |   |   |
| Customer relationships |       | $                           | 25,406     |   | $ | 14,784 |   | $ | 10,622 |   |
| Non-compete agreements |       | 5,134                       |       | 3,549 |   | 1,585 |   |
| Technology/tradename   |       | 15,002                      |       | 9,912 |   | 5,090 |   |
| Total                  |       | $                           | 45,542     |   | $ | 28,245 |   | $ | 17,297 |   |

 

Amortization expense for the three months endedMarch 31, 2005 and 2004 was $ 2.4 million and $1.6 million, respectively. Estimated amortization expense for the remaining life of the intangible assets,based on intangible assets as of March 31, 2005, is as follows (in thousands):

 
| **Year** | ** ** | ** ** | ** ** |
|----------|------------|------------|------------|
| 2005     |       | 4,229      |       |
| 2006     |       | 5,644      |       |
| 2007     |       | 3,857      |       |
| 2008     |       | 2,751      |       |
| 2009     |       | 660        |       |
| 2010     |       | 3          |       |
| Total    |       | $          | 17,144     |   |
|          |            |            |            |  |

 

**4.  STOCK BASED COMPENSATION**

 

At March 31, 2005, we had two stock-based employee compensation plans,which are described more fully in Note 11 of our 2004 Annual Report on Form10-K.  We account for these plans underthe recognition and measurement principles of Accounting Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations.  No stock-based employeecompensation cost is reflected in net income, as all options granted underthese plans had an exercise price equal to the market value of the underlyingcommon stock on the date of the grant.

 

We haveelected to apply the disclosure-only provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation” as amended by SFAS No. 148. Accordingly, weaccount 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 our common stock at thedate of grant over the stock option exercise price.

 

Thefollowing table illustrates the effect on net income and net income per shareif we had applied the fair value recognition provision of Financial AccountingStandards Board Statement No. 123, “Accounting for Stock-Based Compensation,”to stock-based employee compensation (in thousands, except per share amounts):

 

8

----

 
| ** **                                                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net income, as reported                                                                         |       | $                                 | 14,037     |   | $ | 7,615 |   |
| Deduct: Total stock-based compensation  determined under fair value based method for all awards |       | (3,234                            | )          | (5,974 | ) |
| Adjusted net income, fair value method for  all stock-based awards                              |       | $                                 | 10,803     |   | $ | 1,641 |   |
|                                                                                            |       |                              |       |   |   |
| Basic income per share — as reported                                                       |       | $                                 | 0.41       |   | $ | 0.24 |   |
| Diluted income per share — as reported                                                     |       | $                                 | 0.35       |   | $ | 0.22 |   |
| Basic income per share – SFAS No. 123 adjusted                                             |       | $                                 | 0.32       |   | $ | 0.05 |   |
| Diluted income per share – SFAS No. 123  adjusted                                          |       | $                                 | 0.27       |   | $ | 0.05 |   |

 

The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model using the following weighted averageassumptions:

 
| ** **              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Risk-free interest rate |       | 4                                | %          | 4 | % |
| Expected life (years)   |       | 4                                |       | 1-3 |   |
| Volatility factor       |       | 0.93                             |       | 1.3 |   |
| Expected dividends      |       | —                           |       | — |   |

 

In December2004, the Financial Accounting Standards Board issued SFAS 123 (R), “Share-BasedPayment.”  This Statement is a revisionto SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees.”  SFAS 123(R) requires the measurement of thecost of employee services received in exchange for an award of equityinstruments based on the grant-date fair value of the award.  No compensation cost is recognized for equityinstruments for which employees do not render service.  We will adopt SFAS 123(R) effective on January1, 2006, requiring compensation cost to be recognized as expense for theportion of outstanding unvested awards, and any new awards made thereafter,based on the grant-date fair value of those awards.

 

**5. ACQUISITIONS ANDEARN-OUT ARRANGEMENTS**

 

In March 2005, we acquired certain assets andassumed certain liabilities, vendor contracts and intellectual property of

SWReg, an operating business of Atlantic Coastplc, a private limited UK company for $8.8 million in cash. SWReg is

a provider of e-commerce services for softwareauthors. We may also make additional earn-out payments in cash based onachieving specific revenue and development goals over the first 12 monthsfollowing the closing of the acquisition. Such earn-out amounts, if paid, will be recorded as goodwill as they areconsidered incremental to the purchase price.

 

In November 2004, we acquired all of theoutstanding capital stock of BlueHornet Networks, Inc.  BlueHornet is a leading provider of e-mailmarketing campaign management services and related customer relationshipmanagement (CRM) tools.  As considerationfor the acquisition, we issued a total of 160 thousand shares of our commonstock to the BlueHornet stockholders, valued at approximately $5.3 million,paid off $0.7 million of BlueHornet debt obligations at closing and agreed topay an additional $0.5 million in cash to the former BlueHornet stockholdersfollowing the transition of certain BlueHornet assets to our facilities in EdenPrairie, Minnesota.  Goodwill of $4.3million was recorded as a result of this acquisition. We are amortizing otherintangible assets acquired, consisting of technology/tradename, customerrelationships and non-compete agreements, over a three-year period.  In addition, the former BlueHornet stockholdersmay receive additional earn-out payments in cash or our common stock, at our 

 

9

----

 

discretion, based on BlueHornet’s operatingperformance over the first 36 months following the closing of the acquisition.  These earn-out amounts, if paid, will berecorded as goodwill as they are considered incremental to the purchase price.

 

In June 2004, we acquired substantially all ofthe assets and assumed certain liabilities of Fireclick, Inc., a leadingprovider of Web-analysis solutions for online retailers, providing web siteowners with the tools necessary to measure campaign ROI, track user pathanalysis and enhance web site user experience. Under the terms of the agreement, we paid $7.5 million in cash and anadditional $0.3 million in cash upon the completion of certain integrationmilestones.  Goodwill of$7.5 million has been recorded as a result of this acquisition. We areamortizing other intangible assets acquired, consisting of non-competeagreements and technology/tradename, over a three-year period.The agreement also provides Fireclick the opportunity for an earn-out based onour achieving certain revenue and profitability targets attributable toFireclick over the first 36 months following the closing of theacquisition.  These earn-out amounts, ifpaid, will be recorded as goodwill as they are considered incremental to thepurchase price.

 

In April 2004 we acquired element 5 AG, aprivately held company based in Germany and a leading European e-commerce solutionprovider for software publishers.  Underthe terms of the acquisition, we paid $120 million in cash to acquire all ofthe outstanding shares of capital stock of element 5.  We also agreed to pay up to an additional$2.5 million in cash based on element 5’s operating performance over the first24 months following the closing of the acquisition.

 

In the second quarter of 2004, in connectionwith our acquisition of element 5, we began implementation of a plan intendedto eliminate duplication of resources within the consolidated company.  The plan included the elimination of customerservice positions at element 5’s Greenburg, Pennsylvania customer servicecenter and the termination of the Greenburg facility lease by the end of thethird quarter of 2004.

 

On January 18, 2005, we entered into anagreement with senior employees of element 5 AG, pursuant to which theseemployees agreed to cease providing services to element 5 sixty days after thedate of the agreement. Pursuant to the agreement, we also agreed to resolve a$12 million escrow associated with our acquisition of element 5 by distributing$10 million to the former element 5 shareholders, and $2 million to us. Certain adjustments were also made to our earn-out obligations under the April2004 acquisition agreement.  Under the restructured earn-out, the formerelement 5 shareholders were paid $1.25 million on March 1, 2005 and will bepaid an additional $1.25 million on March 1, 2006.  These earn-out amounts have been recorded asadditional goodwill as they were incremental to the purchase price.  Goodwill of $110.8 million was recorded as aresult of this acquisition. We are amortizing other intangible assets acquired,consisting of technology/tradename, customer relationships and non-compete agreements,over a three-year period.

 

As of March 31, 2005, we had included $4.9 million as part of theacquisition cost of element 5 related to these acquisition restructuringplans.  The following table providesdetail on the activity and our remaining accrual balance by category as ofMarch 31, 2005 (in thousands):

 
| ** **               | ** ** | **Accrual  December 31, 2004** | ** ** | **Net Additions** | ** ** | **Payments** | ** ** | **Accrual  March 31, 2005** | ** ** |
|--------------------------|------------|--------------------------------|------------|-------------------|------------|--------------|------------|-----------------------------|------------|
| Employee severance costs |       | $                              | 4,900      |              | $          | 0            |       | $                           | (1,600     | ) | $ | 3,300 |   |
| Facilities consolidation |       | 0                              |       | 0                 |       | $            | 0          |                        | $          | 0 |   |
| Total                    |       | $                              | 4,900      |              | $          | 0            |       | $                           | (1,600     | ) | $ | 3,300 |   |

 

As of March 31, 2005, we believe that the maximumpotential for future earn-out payments for all prior acquisitions isapproximately $3.0 million.

 

The Condensed Consolidated Financial Statementsinclude the operating results of each business from the date ofacquisition.  The following unaudited proforma condensed results of operations for the three months ended March 31, 2005and 2004 have been prepared as if each of the acquisitions from the threemonths ended March 31, 2005 and 2004 had occurred on January 1, 2004 (inthousands, except per share amounts):

 

10

----

 
| ** **                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                         |       |                              |       |   |   |
| Revenue                      |       | $                                 | 55,130     |   | $ | 39,973 |   |
| Income from operations       |       | 18,076                            |       | 6,804 |   |
| Net income                   |       | 14,395                            |       | 6,693 |   |
|                         |       |                              |       |   |   |
| Basic net income per share   |       | $                                 | 0.42       |   | $ | 0.21 |   |
| Diluted net income per share |       | $                                 | 0.36       |   | $ | 0.19 |   |

 

This financial information does not purport torepresent results that would actually have been obtained if the transactionshad been completed on January 1, 2004 or any future results that may berealized.

 

11

----

 

**6. LONG-TERM DEBT**

 

On June 1, 2004 we sold and issued $175 millionin aggregate principal amount of 1.25% convertible senior notes due January 1,2024, in a private, unregistered offering. The notes were sold at 100% of theirprincipal amount.  The initial purchasersexercised in full their option to purchase up to an additional $20 million in aggregateprincipal amount of the notes on June 30, 2004, which purchase transactionclosed on July 6, 2004. 

We are required to pay interest on the notes onJanuary 1 and July 1 of each year beginning January 1, 2005.  The notes bear interest at a rate of 1.25%and, if specified conditions are met, are convertible into our common stock ata conversion price of $44.063 per share. The notes may be surrendered for conversion under certaincircumstances, including the satisfaction of a market price condition, suchthat the price of our common stock reaches a specified threshold; thesatisfaction of a trading price condition, such that the trading price of thenotes falls below a specified level; the redemption of the notes by us, theoccurrence of specified corporate transactions, as defined in the relatedindenture; and the occurrence of a fundamental change, as defined in therelated indenture. The initialconversion price is equivalent to a conversion rate of approximately 22.6948shares per $1,000 of principal amount of the notes.  We will adjust the conversion price ifcertain events occur, as specified in the related indenture, such as theissuance of our common stock as a dividend or distribution or the occurrence ofa stock subdivision or combination. If a fundamental change, such as a changein our control, as defined in the related indenture, occurs on or beforeJanuary 1, 2009, we may also be required to purchase the notes for cash and payan additional make whole premium payable in our common stock upon therepurchase or conversion of the notes in connection with the fundamentalchange. Holders of the notes have the right torequire us to repurchase their notes prior to maturity on January 1, 2009, 2014and 2019. We have the right to redeem the notes, under certain circumstances,on or after July 1, 2007 and prior to January 1, 2009, and we may redeem thenotes at anytime on or after January 1, 2009.

 

A portion of the net proceeds of the offeringwas used to repay our senior secured revolving credit facility with HarrisTrust and Savings Bank.  The balance willbe used for general corporate purposes, including working capital, capitalexpenditures, potential future acquisitions, investments, and the potentialrepurchase of shares of our common stock.

 

We incurred interest expense of $0.6 million andmade interest payments of $1.4 million in the first quarter of 2005.

 

**7. SUBSEQUENT EVENT**

 

On April 19, 2005, we authorized a newshare repurchase program of up to $50.0 million of our outstanding common sharesthat superseded and replaced the $5.0 million share repurchase program that wasadopted in 2001. The shares may be repurchased in open market or in privatelynegotiated transactions. Repurchases would be from time to time at ourdiscretion, based on ongoing assessments of the capital needs of the business,the market price of our common stock and general market conditions. No timelimit has been set for the completion of this program.

 

12

----

 

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

 

*We note that, exceptfor the historical information contained herein, the matters discussed belowcontain forward-looking statements that involve known and unknown risks,uncertainties and other factors that may cause our actual results, performanceor achievements, or industry results, to be materially different from anyfuture results, performance or achievements expressed or implied by suchforward-looking statements.  We expressly disclaim 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: our limited operatinghistory and variability of operating results, possibility of future losses,risks associated with electronic software delivery, dependence on the Internetand growth in electronic commerce and Internet infrastructure development,dependence on software publishers, dependence on online retailers, systemdevelopment and electronic commerce security risks, rapid technologicalchanges, competition in the electronic commerce industry, the importance ofattracting and retaining personnel, management of our growth, integration ofacquired companies, dependence on key employees and other risk factorsreferenced in our Form 10-K  for the yearended December 31, 2004.*

 

**Overview**

 

We are a provider of comprehensive e-commerceoutsourcing solutions. We were incorporated in February 1994 and commencedoffering products for sale through our clients’ e-commerce stores inAugust 1996. From inception through August 1996, we had no sales, andour activities related primarily to the development of our proprietarytechnology platform.  In 1996, we beganto focus our business development efforts on the software industry, buildingour catalog of software products through contracts with software publishers.  In 1997, we began to develop softwaredistribution relationships through contracts with online retailers. In late 1998,we began to offer our comprehensive e-commerce outsourcing services in the formof a transaction fee-based e-commerce service to clients outside of thesoftware industry.  As of March 31**,**2005, we were providing e-commerceservices for more than 40,000 software and digital products publishers,manufacturers, online retailers and online channel partners.

 

Prior to January 1, 2004, we managed ourphysical goods clients through a division (formerly our E-Business ServicesDivision) that was separate from our Software and Digital Commerce ServicesDivision.  Beginning January 1, 2004,this divisional structure was consolidated, and we announced that we will nolonger report our activities as separate business segments.  Nonetheless, we remain committed to servingexisting and new clients in the important vertical market of physical goods.

 

We have approximately eight years ofoperating history upon which investors may evaluate our business and prospects.Until 2003, we incurred significant operating losses, and as of March 31, 2005,we had an accumulated deficit of $37.1 million. We intend to expend financialand management resources on the development of additional services, sales andmarketing, technology and operations to support larger-scale operations and greaterservice offerings. Although we expect to generate positive cash flow fromoperations in 2005, there can be no assurance that our revenue will increase oreven continue at its current level or that we will maintain profitability orgenerate cash from operations in future periods.

 

Our prospects must be considered in light ofthe risks, expenses and difficulties frequently encountered by companies in newand rapidly evolving markets such as e-commerce. To address these risks, wemust, among other things, attract and retain software publishers and onlineretailers as clients, attract and retain physical goods clients, introduce newWeb sites, online stores or services, continue to upgrade and develop oursystems and infrastructure to meet emerging market needs and remain competitivein our service offerings, and retain and attract personnel commensurate withour business needs. There can be no assurance that we will be successful inaddressing these risks, and any failure to do so could have a material adverseeffect on our business, financial condition and results of operations.

 

Our current and future expense levels arebased largely on our planned operations and estimates of future revenue.Revenue and operating results generally depend on the volume and timing oforders received, which are difficult to forecast. We may be unable to adjustspending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfallin revenue could have an immediate adverse effect on our business, financialcondition and results of operations. Our quarterly and annual operating resultsare subject to fluctuations in demand for the products or services offered byus or our clients, such as anti-virus software and tax preparation software,among others.  In particular, sales ofanti-virus software represented a significant portion of our revenues in recentyears, and continue to be very important to our business.  To the extent that our competitorssuccessfully introduce products or services not sold through our platform thatare competitive with products and services sold by current Digital Riverclients (including anti-virus products and services), our revenues will beadversely affected.

 

13

----

 

We are also likely to continue to see revenuefluctuate on a seasonal basis, which is typical for the software publishingmarket in general and for our existing physical goods clients. We believe thatour first and fourth quarters tend to be seasonally stronger than our secondand third quarters due to the timing of demand for tax preparation software andthe holiday season selling period. In addition, we believe that softwarepublishers avoid new product releases in the summer months. In view of therapidly evolving nature of our business, we are unable to accurately forecastour revenue and believe that period-to-period comparisons of our operatingresults are not necessarily meaningful and should not be relied upon as anindication of future performance.

 

**Results of Operations**

 

The following table sets forth certain itemsfrom our condensed consolidated statements of operations as a percentage oftotal revenue for the periods indicated.

 
| ** **                                                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                    | ** ** | **2005**                          | ** ** | **2004** |   |
| Revenue                                                                                       |       | 100.0                             | %          | 100.0 | % |
| Cost of Revenue (exclusive of depreciation  and amortization expense shown separately below): |       |                              |       |   |   |
| Direct cost of services                                                                       |       | 2.4                               |       | 1.9 |   |
| Network and infrastructure                                                                    |       | 8.2                               |       | 10.4 |   |
| Sales and marketing                                                                           |       | 30.0                              |       | 36.0 |   |
| Product research and development                                                              |       | 8.2                               |       | 9.2 |   |
| General and administrative                                                                    |       | 10.3                              |       | 8.9 |   |
| Depreciation and amortization                                                                 |       | 3.9                               |       | 5.0 |   |
| Amortization of acquisition related costs                                                     |       | 4.4                               |       | 5.0 |   |
| Total costs and expenses                                                                      |       | 67.4                              |       | 76.4 |   |
| Income from operations                                                                        |       | 32.6                              |       | 23.6 |   |
| Other income/(expense), net                                                                   |       | 2.1                               |       | 0.3 |   |
| Income before income tax expense                                                              |       | 34.7                              |       | 23.9 |   |
| Income tax expense                                                                            |       | (9.0                              | )          | — |   |
| Net income                                                                                    |       | 25.7                              | %          | 23.9 | % |

 

During 2004, we acquired element 5 AG in April;Fireclick, Inc. in June; and BlueHornet Networks, Inc. in November.  Accordingly, our operations in the firstquarter of 2005 include the revenue and expenses of these acquired operations, withno corresponding expenses in the first quarter of 2004.  As a result, while absolute dollars haveincreased in the first quarter of 2005 compared to 2004, our total costs andexpenses declined as a percent of revenue from 76.4% in the first quarter of2004 to 67.4% in the first quarter of 2005.

 

***REVENUE.***Revenue increased to $54.5 million for the three months ended March 31, 2005 from$31.9 million for the same period in the prior year, an increase of $22.7million or 71.2%. The increase was primarily attributable to higher online activityacross our client base and growth in the number of software publishers, onlineretailers and international sites.

 

International sales represented approximately 36% and 27 % of total revenue in the three month period ended March 31, 2005 and2004, respectively.  We expect that thispercentage will continue to increase on a year over year basis.

 

***GROSS MARGIN (Exclusive ofdepreciation and amortization, consistent with our Consolidated Statement ofoperations.)***  Cost of revenue consists of direct cost ofservices and network and infrastructure costs and is composed of direct laborcosts related to revenue and the costs to operate and maintain our technologyplatform, as well as customer service and operations functions.  Such amounts are shown exclusive of anyrelated depreciation and amortization expenses. Gross margin was $48.7 million for the three months ended March 31, 2005,up from $27.9 million for the same period in the prior year.  Gross profit margins were 89.4% for the threemonths ended March 31, 2005 versus 87.7% for the same period in the prior yeardue to greater leveraging of our infrastructure over more revenue andclients.  We continue to believe thate-commerce and related services may become more competitive in the future.  Accordingly, we may have to reduce ourpricing or alter our pricing structure and policies 

 

14

----

 

in the future and any such change couldnegatively impact gross margins.  Weexpect direct cost of services and network and infrastructure to increase inabsolute dollars and remain relatively flat as a percent of revenue.

 

***GROSS MARGIN (Inclusive ofdepreciation and amortization, an alternative to our Consolidated Statement ofoperations.)***  Gross margin, inclusive of depreciation andamortization was $47.1 million for the three months ended March 31, 2005, upfrom $26.7 million for the same period in the prior year.  Gross profit margins, inclusive ofdepreciation and amortization were 86.3% and 83.7% for the three months endedMarch 31, 2005 and 2004, respectively.  Thisinclusive presentation is an allocation of depreciation and amortization costsfrom that line item in our Consolidated Statement of Operations.  This inclusive allocation presentation impactsneither net income, nor net income per share as reported.

 

***SALESAND MARKETING.***Sales andmarketing expense consists primarily of personnel and related expenses,advertising and promotional expenses, credit card chargebacks and bad debtexpense, and credit card transaction fees.  Sales and marketing expenseincreased to $16.4 million, for the three months ended March 31, 2005 from$11.5 million for the same period in the prior year, an increase of $4.9million, or 42.8%. The increase primarily resulted from credit card fees andchargeback costs directly associated with the increase in revenue andadditional sales and marketing personnel and related expenses, partially offsetby lower bad debt expense and lower advertising expenses.  As a percentageof revenue, sales and marketing expense was 30% in the three months ended March31, 2005, compared to 36% for the same period in the prior year, primarilyreflecting our increased revenue.  We expect sales and marketing expensesto increase in absolute terms and decline slightly as a percentage of revenueover time.

 

***PRODUCTRESEARCH AND DEVELOPMENT.*** Productresearch and development expense consists primarily of personnel and relatedexpenses and consulting costs associated with developing and enhancing our technologyplatform and related internal systems. Product research and development expense increased to $4.5 million forthe three months ended March 31, 2005 from $2.9 million for the same period inthe prior year, an increase of $1.5 million, or 52.5 %.   The increase was primarily driven byincreases in personnel-related expenses and outside consulting fees.  During the first quarter of 2005, wecontinued to advance our new self-service, remote-control technology, as wellas the international and e-marketing capabilities on our next-generatione-commerce platform.  We capitalized approximately$0.4 million of software development costs related to these efforts in thethree months ended March 31, 2005.  As apercentage of revenue, product research and development expense was 8.2% in thethree month ended March 31, 2005, compared to 9.2% for the same period in theprior year.  We expect product research and development costs to increasein absolute dollars but decline slightly on a percentage basis as revenuesincrease.

 

***GENERALAND ADMINISTRATIVE.***General andadministrative expense consists primarily of executive, accounting andadministrative personnel and related expenses, including professional fees andinvestor relations expenses.  General and administrative expensesincreased to $5.6 million for the three months ended March 31, 2005 from $2.8million for the same period in the prior year, an increase of $2.8 million, or 97.9%.  The increase resulted primarily fromprofessional and legal fees and audit and tax services associated withcompliance with the Sarbanes-Oxley Act and related rules and regulations,foreign governance compliance, and ongoing litigation expenses.  As apercentage of revenue, general and administrative expense was 10.3% for thethree months ended March 31, 2005, compared to 8.9% for the same period in theprior year.  We expect general and administrative expense will increase inabsolute dollars over time as we continue to build infrastructure to supportour business and comply with new governmental regulations.  As a percentage of revenue, general and administrativeexpense is expected to decline slightly over time.

 

***AMORTIZATIONOF ACQUISITION-RELATED INTANGIBLES.***Amortizationof acquisition related intangibles consists of amortization of other intangibleassets recorded from our acquisitions over the last three years.  Amortization of intangible assets was $2.4 millionfor the three months ended March 31, 2005 compared to $1.6 million for the sameperiod in the prior year.  The increasewas due to additional amortizable assets acquired throughout 2004 and the firstquarter of 2005.

 

***OTHERINCOME/(EXPENSE), NET.*** Other income/(expense), net consists of interest income on our cash andcash equivalents and short-term investments, interest expense on debt financingobligations, currency gain or loss from remeasured foreign transactions orassets from their native currency to their functional currency, as well as gainor loss on the sale of investments. Interest income was $1.8 million and $0.4 million for the three monthsended March 31, 2005 and 2004, respectively. Interest expense was $0.6 million for the three months ended March 31,2005 with no corresponding interest expense for the three months ended March31, 2004.  Gains or losses from currencyremeasurement and the sale of investments were immaterial.

 

***INCOME TAXES.***** **Forthe three months ended March 31, 2005, we had tax expense of $4.9 million ofwhich $3.7 

 

15

----

 

millionrelated to domestic and $1.2 million to foreign operations.  U.S. net income was almost fully offset bynet operating loss carryforwards of approximately $8.4 million resulting in a25.9% effective income tax rate for the quarter and an anticipated annualeffective rate of 40% for the remainder of the year.  As of March 31, 2005, we had net U.S.operating loss carryforwards of approximately $100 million resulting fromdisqualifying dispositions of stock options and foreign tax loss carryforwardsof $8 million related to preacquisition losses.  When these disqualifying dispositiondeductions and preacquisition loss deductions are realized for financialstatement purposes, they will not result in a reduction in income tax expense,rather the benefit will be recorded as additional paid-in-capital or areduction of goodwill. These income tax net operating loss carryforwards expirebeginning in the year 2012. No income tax expense was recorded for the threemonth period ended March 31, 2004, as we utilized prior operating losscarryforwards and related valuation allowance resulting in a full offset ofincome tax expense for the quarter.  Deductionsfrom disqualifying dispositions of stock options are included in net operatingloss carryforwards with a corresponding valuation allowance.  Because of the uncertainty of futurerealization, a valuation allowance equal to the deferred tax asset has beenrecorded.  Ownership changes resultingfrom the issuance of additional equity may limit future annual realization ofthe tax net operating loss carryforwards to a specified percentage of our valueunder Section 382 of the Internal Revenue Code.

 

16

----

 

**Liquidity and CapitalResources**

 

As of March 31, 2005, we had $142.8 million ofcash and cash equivalents, $172.8 million of short-term investments and workingcapital of approximately $216.2 million. Significant components of ourworking capital are cash and cash equivalents, short term investments and shortterm receivables net of client and merchant payables. Our primary source ofinternal liquidity is our operating activities. During the three months ended March 31, 2005, our operations generated $27.3million of cash compared to $19.1 million for the same period of the prioryear.  The improvement was mainly due to an increase in net income and anincrease in accounts payable.  Net cash used in investing activitiesduring the three months ended March 31, 2005 totaled $20.2 million.  Thiswas comprised of cash paid for acquisitions, net of cash received of $7.3million, net purchases of investments of $9.2 million and investments inequipment of $3.7 million.  In March2005, we acquired SWReg, an operating business of Atlantic Coast plc, a privatelimited UK company, for $8.8 million in cash. Net cash provided by financing activities during the three months endedMarch 31, 2005 totaled $9.6 million. This was comprised of the sale of stock through the exercise of stockoptions and purchases through the employee stock purchase plan.

 

Our principal commitments consist of interestand principal on our convertible senior notes and long-term obligationsoutstanding under operating leases. Although we have no material commitments for capital expenditures, weanticipate continued capital expenditures consistent with our anticipatedgrowth in operations, infrastructure, and personnel.  We further anticipatethat our expenditures on product development will be consistent with ouranticipated growth in operations. We also anticipate that we will continue toexperience growth in our operating expenses for the foreseeable future and thatour operating expenses will be a material use of our cash resources.

 

**Contractual Commitments**

 
| ** **                   | ** ** | **Payment due by period (in thousands)** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total Amount  Committed**              | ** ** | **Apr-Dec  2005** | ** ** | **2006-2007** | ** ** | **2008-2009** | ** ** | **2010 and  Thereafter** | ** ** |
| Operating Lease Obligations  |       | $                                        | 4,925      |   | $ | 1,381 |   | $ | 1,896 |   | $ | 1,405 |   | $ | 243 |   |
| Convertible Senior Notes     |       | $                                        | 240,703    |   | $ | 1,828 |   | $ | 4,875 |   | $ | 4,875 |   | $ | 229,125 |   |
| Total                        |       | $                                        | 245,628    |   | $ | 3,209 |   | $ | 6,771 |   | $ | 6,280 |   | $ | 229,368 |   |
|                              |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We expect tocontinue to evaluate and consider a wide array of potential strategic transactions,including business combinations and acquisitions of businesses, products,services and other assets as well as licenses of technology related to ourcurrent business.  At any given time, wemay be engaged in discussions or negotiations with respect to one or more suchtransactions.  Any such transactionscould have a material impact on our financial position, results of operations,or cash flows.  There is no assurancethat any such discussions or negotiations will result in the consummation ofany transaction.  The process ofintegrating any acquisition may create unforeseen challenges for ouroperational, financial and management information systems, as well asunforeseen expenditures and other risks, including diversion of management’sattention from other business concerns, the potential loss of key customers,employees and business partners, difficulties in managing facilities andemployees in different geographic areas, and difficulties in entering marketsin which we have no or limited direct prior experience and where competitors insuch markets have stronger market positions. In addition, an acquisition may cause us to assume liabilities or becomesubject to litigation.  Further, therecan be no assurance that we will realize a positive return on any acquisitionor that future acquisitions will not be dilutive to our current shareholders’percentage ownership or to earnings.  Wehave allocated significant valuation in the form of goodwill and intangiblesfor the companies we acquired in the past, which is subject to impairmenttesting on a regular basis.  If theindividual businesses do not perform as expected at the acquisition dates, wemay incur impairment charges for goodwill, accelerated amortization ofdefinite-lived intangible assets due to shortened expected lives of thoseassets, immediate write-offs and restructuring or other related expenses.

 

With respect to our convertible senior notes, weare required to pay interest on the notes on January 1 and July 1 of each yearbeginning January 1, 2005.  On January 3,2005 we paid $1.4 million in interest for the period June 1 through December31, 2004.  The notes bear interest at arate of 1.25% and, if specified conditions are met, are convertible into ourcommon stock at a conversion price of $44.063 per share.  The notes may be surrendered forconversion under certain circumstances, including the satisfaction of a marketprice condition, such that the price of our common stock reaches a specifiedthreshold; the satisfaction of a trading price condition, such that the tradingprice of the notes falls below a specified level; the redemption of the notesby us, the occurrence of specified corporate transactions, as defined in therelated indenture; and the occurrence of a fundamental change, as defined inthe related indenture.  The initial conversion price is equivalent toa conversion rate of approximately 22.6948 shares 

 

17

----

 

per $1,000 of principal amount of thenotes.  We willadjust the conversion price if certain events occur, as specified in therelated indenture, such as the issuance of our common stock as a dividend ordistribution or the occurrence of a stock subdivision or combination. Inaddition, contingent interest is required to be paid to holders if certainconditions are met. If a fundamental change, such as a change in our control,as defined in the related indenture, occurs on or before January 1, 2009, wemay also be required to purchase the notes for cash and pay an additional makewhole premium payable in our common stock upon the repurchase or conversion ofthe notes in connection with the fundamental change. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeem thenotes, under certain circumstances, on or after July 1, 2007 and prior toJanuary 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

 

We believethat existing sources of liquidity and the results of our operations willprovide adequate cash to fund our operations, although we may seek to raiseadditional capital. In January 2002, we filed a universal shelf registrationstatement with the SEC pursuant to which we could issue up to $100 million incommon stock, preferred stock, debt securities and/or warrants.   Of this amount, approximately $45 millionwas utilized to issue common stock in our July 2003 public offering leavingapproximately $55 million available for future use.   In January 2005, we filed a registrationstatement to increase our available shelf registration amount fromapproximately $55 million to $255 million. In addition, we filed an acquisition shelf registration statement for upto approximately 1.5 million shares. Both registration statements were declaredeffective by the SEC in April 2005.  Thesefilings were made to provide future flexibility for acquisition and financingpurposes.  The sale of additional equityor convertible debt securities could result in additional dilution to ourstockholders. There can be no assurances that financing will be available inamounts or on terms acceptable to us, if at all.

 

18

----

 

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

 

**InterestRate Risk**

 

We maintain our portfolio of cash equivalentsand short-term investments in a variety of securities, including government obligations and money market funds.Investments are classified as available-for-sale securities and carried attheir market value with cumulative unrealized gains or losses recorded as acomponent of accumulated other comprehensive income/(loss) within stockholders’equity.  As of March 31, 2005, allsecurities held had maturities of less than three years.  A sharp rise in interest rates could have anadverse impact on the market value of certain securities in our portfolio.  We do not currently hedge our interest rateexposure and do not enter into financial instruments for trading or speculativepurposes or utilize derivative financial instruments.  There have been no significant changes to ourinvestment portfolio that would alter our interest rate risk for the threemonths ended March 31, 2005.

 

**ForeignCurrency Risk**

 

Our operations have historically beenconducted primarily in the United States currency and as such have not beensubject to material foreign currency exchange rate risk.   However, the growth in our internationaloperations is increasing our exposure to foreign currency fluctuations as wellas other risks typical of international operations, including, but not limitedto differing economic conditions, changes in political climate, differing taxstructures and other regulations and restrictions. Accordingly, our futureresults could be materially adversely impacted by changes in these or otherfactors.  For example, approximately halfof our subsidiary element 5’s revenue is denominated in euros or currenciesother than the U.S. dollar.  As a result,a greater proportion of our revenues and earnings are now subject to currencyfluctuations.  We translate statement ofoperations amounts that are denominated in foreign currency into U.S. dollarsat the average exchange rates in each applicable period. To the extent the U.S.dollar weakens against foreign currencies, the translation of these foreigncurrency denominated transactions results in increased net revenues, operatingexpenses and net income. Conversely, our net revenues, operating expenses andnet income will decrease when the U.S. dollar strengthens against foreigncurrencies. We do not currently have a currency hedging program to mitigate theeffect of fluctuations of currency prices on our financial results.

 

19

----

 

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

 

(a)           Based on theirevaluation of our disclosure controls and procedures conducted as of March 31,2005, our Chief Executive Officer and Chief Financial Officer have concludedthat our disclosure controls and procedures (as defined in Rules 13a-15(e) or15d-15(e) promulgated under the Securities Exchange Act of 1934) are effectiveat the reasonable assurance level.

 

(b)           This evaluation didnot identify any change in our internal control over financial reporting thatoccurred during the quarter ended March 31, 2005 that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

 

**Limitations on theEffectiveness of Controls**

 

Our management, including the Chief ExecutiveOfficer and Chief Financial Officer, does not expect that our disclosurecontrols and procedures or our internal control will prevent all error andfraud. A control system, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. Further, the design of a control system must reflect the factthat there are resource constraints, and the benefits of controls must beconsidered relative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within our company have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerror or mistake. Additionally, controls can be circumvented by the individualacts of some persons, by collusion of two or more people, or by managementoverride of the control. The design of any system of controls also is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions; over time, control may become inadequatebecause of changes in conditions, or the degree of compliance with the policiesor procedures may deteriorate.  Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occur andnot be detected.

 

20

----

 

**PART II.****  OTHER INFORMATION**

 

**Item 1. ****Legal Proceedings**

 

Beginning in August 2001, we and certainof our officers and directors were named as defendants in several classaction shareholder complaints filed in the United States District Court for theSouthern District of New York, now consolidated as *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355.  Similar complaints,referred to here as the IPO Lawsuits, were filed in the same court againsthundreds of other public companies, referred to here as the Issuers.  In the consolidated amended complaint againstus, the plaintiffs allege that we, certain of our officers and directors andthe underwriters of our initial public offering, or IPO, violated Section 11 ofthe Securities Act of 1933 based on allegations that our IPO registrationstatement and prospectus failed to disclose material facts regarding thecompensation to be received by, and the stock allocation practices of, the IPOunderwriters.  The complaint alsocontains a claim for violation of Section 10(b) of the Securities Exchange Actof 1934 based on allegations that this omission constituted a deceit oninvestors.  The plaintiffs seek unspecifiedmonetary damages and other relief.

 

In July 2002, we joined in a global motion todismiss the IPO Lawsuits filed by all of the Issuers (among others). In October 2002, the parties agreed to toll the statute of limitations withrespect to certain of the named officers and directors until September 30, 2003and on the basis of this agreement, our officers and directors weredismissed from the lawsuit without prejudice.  In February 2003, the courtissued a decision denying the motion to dismiss the Section 11 claims againstus and almost all of the other Issuers and denying the motion to dismiss theSection 10(b) claims against us and many of the Issuers.

 

In June 2003, pursuant to the authorizationof a special litigation committee of our board of directors, we and asubstantial majority of Issuers entered into a non-binding memorandum ofunderstanding reflecting a tentative settlement of the IPO Lawsuits. Theterms of the tentative settlement provide for, among other things, a release ofthe Issuers and their officers and directors from all further liabilityresulting from plaintiffs’ claims, and the assignment to plaintiffs of certainpotential claims that the Issuers may have against their IPO underwriters. Thetentative settlement also provides that, in the event that plaintiffsultimately recover less than a guaranteed sum of $1 billion from the IPOunderwriters, plaintiffs would be entitled to payment by each participatingIssuer’s insurer of a pro rata share of any shortfall in the plaintiffs’ guaranteedrecovery.  In September 2003, in connection with the tentativesettlement, our officers and directors who had entered tolling agreementswith plaintiffs (described above) agreed to extend those agreements so thatthey would not expire prior to any settlement being finalized. In June 2004, weexecuted a final settlement agreement with the plaintiffs consistent with theterms of the memorandum of understanding. On February 15, 2005, the Court issued a decision certifying a classaction for settlement purposes and granting preliminary approval of thesettlement, subject to modification of certain bar orders contemplated by thesettlement.  In addition, the settlementis still subject to statutory notice requirements as well as final judicialapproval. Pending final approval of the settlement, we continue to believethat the claims against us, our officers and directors are without merit andintend to defend against them vigorously.

 

In addition, we are subject to legalproceedings, claims, and litigation arising in the ordinary course ofbusiness.  While the final outcome ofthese matters is currently not determinable, we believe there is no litigationpending against us that could have, individually or in the aggregate, amaterial adverse effect on our consolidated financial position, results ofoperation or cash flows.  As of March 31,2005, we had $470 thousand accrued for various legal matters where it wasestimable and probable that an unfavorable outcome will occur.

 

21

----

 

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

 

In April 2005, the Board of Directors authorizeda new share repurchase program of up to $50.0 million of our outstanding sharesof common stock. This new program superseded and replaced the $5.0 millionshare repurchase program adopted in 2001. In 2001, we spent $267,000 torepurchase our shares.  Under the newprogram, the shares may be repurchased in the open market or in privatelynegotiated transactions. Repurchases are at our discretion based on ongoingassessments of the capital needs of the business, the market price of ourcommon stock and general market conditions. No time limit was set for thecompletion of the repurchase program.

 

During the three months ended March 31, 2005, noshares were repurchased under the 2001 repurchase program.

 

22

----

 

**Item 6. ****Exhibits**

 

(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. |
| 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. |
| 10.16               | (5)        |                          | Supplemental Agreement and Settlement Agreement,  by and among Digital River, Inc., Digital River GmbH, element 5 AG, Messrs.  Clemens Roth, Christopher Reimold, Gerrit Schumann, Stephan Naujoks and  various other former element 5 shareholders, dated as of January 18, 2005. |
| 10.17               | (6)        |                          | Summary of Compensation Program for  Non-Employee Directors. |
| 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 an exhibit to our Current Report on  Form 8-K, filed on July 13, 2004, and incorporated herein by reference.                                                                                                              |
| (5) |   | Filed as an exhibit to our Current Report on  Form 8-K, filed on January 20, 2005, and incorporated herein by reference.                                                                                                           |
| (6) |   | Filed as an exhibit to our Current Report on  Form 8-K, filed on February 15, 2005, and incorporated herein by reference.                                                                                                          |

 

23

----

 

SIGNATURES

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Date:  | May 9, 2005 |   | DIGITAL  RIVER, INC.                           |
|--------|-------------|--------|------------------------------------------------|
|   |        |   |                                           |
|   |        |   |                                           |
|   |        | By:    | /s/  CARTER D. HICKS                           |
|   |        |   |                                           |
|   |        |   |                                           |
|   |        |   | Carter  D. Hicks                               |
|   |        |   | *Chief Financial Officer*                      |
|   |        |   | *(Principal Financial and Accounting Officer)* |

 

24

----

 

EXHIBITINDEX

 
| **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. |
| 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. |
| 10.16              | (5)        |                          | Supplemental Agreement and Settlement  Agreement, by and among Digital River, Inc., Digital River GmbH, element 5  AG, Messrs. Clemens Roth, Christopher Reimold, Gerrit Schumann, Stephan  Naujoks and various other former element 5 shareholders, dated as of January  18, 2005. |
| 10.17              | (6)        |                          | Summary of Compensation Program for  Non-Employee Directors. |
| 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 an exhibit  to our Current Report on Form 8-K, filed on July 13, 2004, and incorporated  herein by reference.                                                                                                             |
| (5) |   | Filed as an exhibit  to our Current Report on Form 8-K, filed on January 20, 2005, and  incorporated herein by reference.                                                                                                          |
| (6) |   | Filed as an exhibit  to our Current Report on Form 8-K, filed on February 15, 2005, and  incorporated herein by reference.                                                                                                         |

 

25

----