**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004**

 

**OR**

 

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

 

**FOR THE TRANSITION PERIOD FROM         TO**

 

**Commission file****number 000-24643**

 

**DIGITAL RIVER, INC.**

(Exact name of registrant asspecified in its charter)

 
| **DELAWARE**                                                                                                 | ** ** | **41-1901640**                            |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|
| (State or other jurisdiction  of  incorporation or organization)                                             |       | (I.R.S.  Employer  Identification Number) |
|                                                                                                         |       |                                      |
| **9625 WEST 76TH STREET, SUITE 150  EDEN PRAIRIE, MINNESOTA 55344**(Address of  principal executive offices) |
| ** **                                                                                                   |
| **(952) 253-1234**                                                                                           |
| (Registrant’s telephone number, including area code)                                                    |

 

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

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes ý No o

 

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

 
| **COMMON STOCK, $0.01 PAR VALUE** | ** ** | **33,005,616 SHARES**               |
|-----------------------------------|------------|-------------------------------------|
| (Class)                           |       | Outstanding as of October  29, 2004 |

 

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DIGITAL RIVER, INC.

Form 10-Q

Index

 
| PART I.       | FINANCIAL  INFORMATION |
|---------------|------------------------|
|          |                   |
|          | Item 1.                | Financial Statements |
|          |                   |   |
|          |                   | Condensed  Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003 |
|          |                   |   |
|          |                   | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2004 and 2003 |
|          |                   |   |
|          |                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003 |
|          |                   |   |
|          |                   | 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

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**PARTI.  FINANCIAL INFORMATION**

 

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

**DIGITALRIVER, INC.**

CONDENSED CONSOLIDATEDBALANCE SHEETS

(inthousands, except share data)

 
| ** **                                                                                                           | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                           | ** ** | **(unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                           |       |                    |       |                   |       |
| CURRENT ASSETS:                                                                                                      |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                            |       | $                       | 191,378    |                   | $          | 101,878 |   |
| Short-term investments                                                                                               |       | 66,134                  |       | 30,044                 |       |
| Accounts receivable, net of allowance of  $679 and $319                                                              |       | 15,348                  |       | 9,306                  |       |
| Prepaid expenses and other                                                                                           |       | 2,234                   |       | 1,589                  |       |
| Total current assets                                                                                                 |       | 275,094                 |       | 142,817                |       |
|                                                                                                                 |       |                    |       |                   |       |
| PROPERTY AND EQUIPMENT:                                                                                              |       |                    |       |                   |       |
| Property and equipment                                                                                               |       | 42,053                  |       | 32,433                 |       |
| Less accumulated depreciation                                                                                        |       | (25,275                 | )          | (17,799                | )          |
| Net property and equipment                                                                                           |       | 16,778                  |       | 14,634                 |       |
| GOODWILL                                                                                                             |       | 140,908                 |       | 23,921                 |       |
| INTANGIBLE ASSETS, net of accumulated  amortization of $26,255 and $19,976                                           |       | 17,663                  |       | 8,172                  |       |
| OTHER ASSETS                                                                                                         |       | 6,427                   |       | 114                    |       |
|                                                                                                                 |       | $                       | 456,870    |                   | $          | 189,658 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                       |       |                    |       |                   |       |
| CURRENT LIABILITIES:                                                                                                 |       |                    |       |                   |       |
| Accounts payable                                                                                                     |       | $                       | 74,836     |                   | $          | 41,814 |   |
| Accrued payroll                                                                                                      |       | 3,811                   |       | 2,825                  |       |
| Deferred revenue                                                                                                     |       | 3,854                   |       | 3,572                  |       |
| Other accrued liabilities                                                                                            |       | 13,978                  |       | 9,595                  |       |
| Total current liabilities                                                                                            |       | 96,479                  |       | 57,806                 |       |
|                                                                                                                 |       |                    |       |                   |       |
| NON-CURRENT LIABILITIES:                                                                                             |       |                    |       |                   |       |
| Convertible senior notes                                                                                             |       | 195,000                 |       | —                 |       |
| Total non-current liabilities                                                                                        |       | 195,000                 |       | —                 |       |
|                                                                                                                 |       |                    |       |                   |       |
| 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; 32,548,486 and 31,497,719 shares issued and outstanding |       | 325                     |       | 315                    |       |
| Additional paid-in capital                                                                                           |       | 228,979                 |       | 217,981                |       |
| Accumulated deficit                                                                                                  |       | (63,992                 | )          | (86,488                | )          |
| Accumulated other comprehensive income                                                                               |       | 79                      |       | 44                     |       |
| Total stockholders’ equity                                                                                      |       | 165,391                 |       | 131,852                |       |
|                                                                                                                 |       | $                       | 456,870    |                   | $          | 189,658 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**DIGITALRIVER, INC.**

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(inthousands, except per share data; unaudited)

 
| ** **                                   | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2004**                               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| REVENUE                                      |       | $                                      | 39,439     |                                  | $          | 26,748 |   | $ | 106,171 |   | $ | 74,112 |   |
| COST OF REVENUE:                             |       |                                   |       |                                  |       |   |   |   |   |
| Direct cost of  services                     |       | 1,621                                  |       | 861                                   |       | 3,688 |   | 2,742 |   |
| Network and  infrastructure                  |       | 4,253                                  |       | 3,286                                 |       | 11,059 |   | 9,089 |   |
| GROSS MARGIN                                 |       | 33,565                                 |       | 22,601                                |       | 91,424 |   | 62,281 |   |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| OPERATING  EXPENSES:                         |       |                                   |       |                                  |       |   |   |   |   |
| Sales and  Marketing                         |       | 13,338                                 |       | 9,895                                 |       | 36,213 |   | 28,145 |   |
| Product Research  and Development            |       | 3,732                                  |       | 2,447                                 |       | 10,301 |   | 7,429 |   |
| General and  administrative                  |       | 4,045                                  |       | 2,472                                 |       | 10,738 |   | 6,741 |   |
| Depreciation and  amortization               |       | 2,207                                  |       | 1,899                                 |       | 5,677 |   | 5,139 |   |
| Amortization of  acquisition related costs   |       | 2,434                                  |       | 1,411                                 |       | 6,280 |   | 3,878 |   |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| Total operating  expenses                    |       | 25,756                                 |       | 18,124                                |       | 69,209 |   | 51,332 |   |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| INCOME FROM  OPERATIONS                      |       | 7,809                                  |       | 4,477                                 |       | 22,215 |   | 10,949 |   |
| OTHER  INCOME/(EXPENSE), NET                 |       | 317                                    |       | 264                                   |       | 281 |   | 581 |   |
| NET INCOME                                   |       | $                                      | 8,126      |                                  | $          | 4,741 |   | $ | 22,496 |   | $ | 11,530 |   |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| NET INCOME PER  SHARE:                       |       |                                   |       |                                  |       |   |   |   |   |
| BASIC                                        |       | $                                      | 0.25       |                                  | $          | 0.16 |   | $ | 0.70 |   | $ | 0.40 |   |
| DILUTED                                      |       | $                                      | 0.23       |                                  | $          | 0.14 |   | $ | 0.63 |   | $ | 0.36 |   |
|                                         |       |                                   |       |                                  |       |   |   |   |   |
| WEIGHTED AVERAGE  COMMON SHARES OUTSTANDING: |       |                                   |       |                                  |       |   |   |   |   |
| BASIC                                        |       | 32,459                                 |       | 30,392                                |       | 32,049 |   | 28,742 |   |
| DILUTED                                      |       | 35,807                                 |       | 34,608                                |       | 35,614 |   | 32,279 |   |
|                                              |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**DIGITALRIVER, INC.**

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(inthousands; unaudited)

 
| ** **                                                                         | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| OPERATING ACTIVITES:                                                               |       |                                  |       |   |   |
| Net income                                                                         |       | $                                     | 22,496     |   | $ | 11,530 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                  |       |   |   |
| Amortization of  acquisition related costs                                         |       | 6,280                                 |       | 3,878 |   |
| Change in  accounts receivable allowance                                           |       | 360                                   |       | 1,516 |   |
| Depreciation and  amortization                                                     |       | 5,634                                 |       | 5,139 |   |
| Change in  operating assets and liabilities:                                       |       |                                  |       |   |   |
| Accounts  receivable                                                               |       | (2,685                                | )          | 1,969 |   |
| Prepaid and other  assets                                                          |       | 246                                   |       | (57 | ) |
| Accounts payable                                                                   |       | 23,134                                |       | 8,947 |   |
| Deferred revenue                                                                   |       | (164                                  | )          | 1,006 |   |
| Accrued payroll  and other accrued liabilities                                     |       | 2,506                                 |       | 4,290 |   |
| Net cash provided  by operating activities                                         |       | 57,807                                |       | 38,218 |   |
|                                                                               |       |                                  |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                  |       |   |   |
| Purchases of  investments                                                          |       | (95,389                               | )          | (15,000 | ) |
| Sales of  investments                                                              |       | 59,328                                |       | — |   |
| Cash paid for  acquisitions, net of cash received                                  |       | (125,856                              | )          | (3,873 | ) |
| Purchases of  equipment                                                            |       | (6,125                                | )          | (4,675 | ) |
| Net cash used in  investing activities                                             |       | (168,042                              | )          | (23,548 | ) |
|                                                                               |       |                                  |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                  |       |   |   |
| Principal amount  on line of credit                                                |       | 45,000                                |       | — |   |
| Repayment of  principal on line of credit                                          |       | (45,000                               | )          | — |   |
| Net proceeds on  issuance of 1.25% convertible senior notes due 1/1/2024           |       | 188,398                               |       | — |   |
| Proceeds from  sales of common stock                                               |       | —                                |       | 43,380 |   |
| Exercise of stock  options and warrants                                            |       | 10,104                                |       | 9,298 |   |
| Sales of common  stock under employee stock purchase plan                          |       | 904                                   |       | 800 |   |
| Net cash provided  by financing activities                                         |       | 199,406                               |       | 53,478 |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH                                           |       | 329                                   |       | — |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 89,500                                |       | 68,148 |   |
| CASH AND CASH  EQUIVALENTS, beginning of period                                    |       | 101,878                               |       | 40,801 |   |
| CASH AND CASH  EQUIVALENTS, end of period                                          |       | $                                     | 191,378    |   | $ | 108,949 |   |
| NONCASH INVESTING AND FINANCING ACTIVITIES:                                        |       |                                  |       |   |   |
| Common stock  issued in acquisitions and earn-outs                                 |       | $                                     | —     |   | $ | 1,025 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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**DIGITAL RIVER, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

 

**1. BASIS OF PRESENTATION**

 

The unaudited condensedconsolidated financial statements included herein reflect all adjustments,  including normalrecurring adjustments, 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, 2003 asfiled with the Securities and Exchange Commission. The results of operationsfor the three and nine months ended September 30, 2004 arenot necessarily indicative of the results to be expected for any subsequentquarter or for the entire fiscal year ending December 31, 2004.  TheDecember 31, 2003 balance sheet was derived from audited financial statements,but does not include all disclosures required by accounting principlesgenerally accepted in the United States.

 

*Summary ofSignificant Accounting Policies.*  Adetailed description of our significant accounting policies can be found in ourmost recent Annual Report filed on Form 10-K for the fiscal year ended December31, 2003.

 

***ForeignCurrency Translation***

 

The financial position and results ofoperations of certain foreign subsidiaries are measured using local currency asthe functional currency.  Assets andliabilities are translated to their U.S. dollar equivalents at rates in effectat the respective balance sheet dates and statements of operations aretranslated using average exchange rates for the fiscal period.  The resulting translation adjustments arerecorded as a component of stockholders’ equity.

 

***Researchand Development and Software Development***

 

Research and development expenses consistprimarily of development personnel and external contractor costs related to thedevelopment of new products and services, enhancement of existing products andservices, quality assurance and testing. We follow AICPA Statement of Position No.98-1, “Accounting for the Costs of Computer Software Developed or Obtained forInternal Use,” in accounting for internally developed software.  Prior to the second quarter of 2004,capitalized software development costs were immaterial.  During the second quarter of 2004, weexpanded and redeployed our R&D team to advance our new self-service,remote-control technology, as well as develop the international and e-marketingcapabilities on our next-generation e-commerce platform and, consistent withSOP 98-1, we have capitalized approximately $1.6 million of softwaredevelopment costs related to those efforts. These capitalized costs are included in purchases of equipment withininvesting activities on our Condensed Consolidated Statement of Cash Flows.

 

**2. NET INCOME PER SHARE**

 

The table below sets forth the computation of basicand diluted net income per share (in thousands, except per share amounts):

 
| ** **                                          | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2004**                               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                          |       |                                   |       |                                  |       |   |   |   |   |
| Net income                                          |       | $                                      | 8,126      |                                  | $          | 4,741 |   | $ | 22,496 |   | $ | 11,530 |   |
|                                                |       |                                   |       |                                  |       |   |   |   |   |
| Denominator:                                        |       |                                   |       |                                  |       |   |   |   |   |
| Basic — weighted  average shares outstanding   |       | 32,459                                 |       | 30,392                                |       | 32,049 |   | 28,742 |   |
| Effect of  dilutive securities:                     |       |                                   |       |                                  |       |   |   |   |   |
| Employee stock  options and warrants                |       | 3,348                                  |       | 4,216                                 |       | 3,565 |   | 3,537 |   |
| Diluted —  weighted average shares outstanding |       | 35,807                                 |       | 34,608                                |       | 35,614 |   | 32,279 |   |
|                                                |       |                                   |       |                                  |       |   |   |   |   |
| Basic — net  income per share                  |       | $                                      | 0.25       |                                  | $          | 0.16 |   | $ | 0.70 |   | $ | 0.40 |   |
|                                                |       |                                   |       |                                  |       |   |   |   |   |
| Diluted — net  income per share                |       | $                                      | 0.23       |                                  | $          | 0.14 |   | $ | 0.63 |   | $ | 0.36 |   |

 

6

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**DIGITAL RIVER, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

In the periods presented, we did not include thepotentially dilutive effect of the assumed conversion of the $195 million inprincipal of our 1.25% convertible senior notes in the computation of dilutiveearnings per share for the three and nine month periods ended September 30,2004, because the conditions for conversion had not been met. The notes arecontingently convertible into approximately 4.4 million shares of common stockat an initial conversion price of $44.063 per share.

 

Subsequent to our issuance of 1.25% convertiblesenior notes on June 1, 2004, the Emerging Issues Task Force (EITF), Issue No. 04-08, proposed that the unissued shares underlying contingent convertible notes betreated as if such shares were issued and outstanding for the purposes ofcalculating GAAP earnings per share.  On October 13, 2004, the Financial AccountingStandards Board (FASB) ratified this new accountingtreatment for periods ending after December 15, 2004.  Consequently, we will reflect the dilutiveeffect of our 1.25% convertible senior notes on earnings per share in thefourth quarter of 2004.

 

**3. GOODWILL AND INTANGIBLE ASSETS**

 

We account forour goodwill in accordance with SFAS No. 142, “Goodwilland Other Intangible Asset.”  SFAS No. 142 precludes the amortization of goodwill andintangible assets with indefinite lives, but these assets are reviewed annually(or more frequently if impairment indicators arise) for impairment.

 

We completeour annual impairment test, in the fourth quarter of each fiscal year, using atwo-step approach and reassess any intangible assets, including goodwill,recorded in connection with earlier acquisitions.

 

Information regarding our other intangible assets isas follows (in thousands):

 
| ** **             | ** ** | **As of  September 30, 2004** | ** ** |
|------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Carrying  Amount  Gross**   | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **             | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer relationships |       | $                             | 16,488     |   | $ | 14,064 |   | $ | 2,424 |   |
| Non-compete agreements |       | 4,100                         |       | 3,439 |   | 661 |   |
| Technology/tradename   |       | 23,330                        |       | 8,752 |   | 14,578 |   |
| Total                  |       | $                             | 43,918     |   | $ | 26,255 |   | $ | 17,663 |   |

 
| ** **             | ** ** | **As of December 31, 2003** | ** ** |
|------------------------|------------|-----------------------------|------------|
| ** **             | ** ** | **Carrying Amount  Gross**  | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Customer relationships |       | $                           | 16,488     |   | $ | 11,405 |   | $ | 5,083 |   |
| Non-compete agreements |       | 3,850                       |       | 2,992 |   | 858 |   |
| Technology/tradename   |       | 7,810                       |       | 5,579 |   | 2,231 |   |
| Total                  |       | $                           | 28,148     |   | $ | 19,976 |   | $ | 8,172 |   |

 

Amortization expense for the three months endedSeptember 30, 2004 and 2003 was $2.4 million and $1.4 million, respectively and$6.3 million and $3.9 million for the nine months ended September 30, 2004 and2003, respectively.  Estimated amortization expense for the remaining lifeof the intangible assets, based on intangible assets as of September 30, 2004,is as follows (in thousands):

 

| **Year** | ** ** | ** ** |
|----------|------------|------------|
| 2004     |       | $          | 2,251 |
| 2005     |       | 7,421      |
| 2006     |       | 6,339      |
| 2007     |       | 1,652      |
| Total    |       | $          | 17,663 |

 

7

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** **

**DIGITAL RIVER, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

** **

**4. STOCK BASED COMPENSATION**

 

At September30, 2004, we had two stock-based employee compensation plans, which aredescribed more fully in Note 7 of our 2003 Annual Report.  We account for these plans under therecognition 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 have electedto apply the disclosure-only provisions of SFASNo. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148. Accordingly, we account for stock-basedcompensation using the intrinsic value method prescribed in APB OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations. Compensation cost for stock options is measured as the excess,if any, of the fair value of our common stock at the date of grant over thestock option exercise price.

 

The followingtable illustrates the effect on net income and net income per share if we hadapplied the fair value recognition provision of Financial Accounting StandardsBoard Statement No. 123, “Accounting for Stock-Based Compensation,” tostock-based employee compensation (in thousands, except per share amounts):

 
| ** **                                                                                       | ** ** | **Three Months Ended****September  30,** | ** ** | **Nine Months Ended****September  30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                 | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** |   |
| Net income, as  reported                                                                         |       | $                                        | 8,126      |                                    | $          | 4,741 |   | $ | 22,496 |   | $ | 11,530 |   |
| Deduct: Total  stock-based compensation determined under fair value based method for all  awards |       | (6,369                                   | )          | (3,335                                  | )          | (19,909 | ) | (9,040 | ) |
| Adjusted net  income fair value method for all stock-based awards                                |       | $                                        | 1,757      |                                    | $          | 1,406 |   | $ | 2,587 |   | $ | 2,490 |   |
|                                                                                             |       |                                     |       |                                    |       |   |   |   |   |
| Basic income per  share – as reported                                                       |       | $                                        | 0.25       |                                    | $          | 0.16 |   | $ | 0.70 |   | $ | 0.40 |   |
|                                                                                             |       |                                     |       |                                    |       |   |   |   |   |
| Diluted income  per share – as reported                                                     |       | $                                        | 0.23       |                                    | $          | 0.14 |   | $ | 0.63 |   | $ | 0.36 |   |
|                                                                                             |       |                                     |       |                                    |       |   |   |   |   |
| Basic income per  share – SFAS No. 123 adjusted                                             |       | $                                        | 0.05       |                                    | $          | 0.05 |   | $ | 0.08 |   | $ | 0.09 |   |
|                                                                                             |       |                                     |       |                                    |       |   |   |   |   |
| Diluted income  per share – SFAS No. 123 adjusted                                           |       | $                                        | 0.05       |                                    | $          | 0.04 |   | $ | 0.07 |   | $ | 0.08 |   |

 

The fair valueof each option grant is estimated on the date of grant using the Black-Scholes option pricing model using the following weightedaverage assumptions:

 
| ** **              | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------|------------|-------------------------------------|------------|
| ** **              | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Risk-free interest rate |       | 4%                                  |       | 3% |   |
| Expected life (years)   |       | 1-3                                 |       | 5 |   |
| Volatility factor       |       | 1.3                                 |       | 1.4 |   |
| Expected dividends      |       | —                              |       | — |   |

 

8

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**DIGITAL RIVER, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

**5. ACQUISITIONS AND EARN-OUTARRANGEMENTS**

 

In April 2004 we acquired element 5 AG, a privatelyheld company based in Germany.  Under theterms of the acquisition, we paid $120 million in cash to acquire all of theoutstanding shares of capital stock of element 5.  We also may pay up to an additional $2.5million in cash based on element 5’s operating performance over the first 24months subsequent to the acquisition. Such earn-out amounts, if paid, will be recorded as goodwill as they areconsidered incremental to the purchase price.

 

The purchase price of $120million has been preliminarily allocated to $1.1 million of tangible net assetsacquired, with the remaining portion, including transaction costs incurred, tobe allocated between goodwill and certain separable intangible assets. Theallocation of the excess purchase price, over the fair value of the assetsacquired and liabilities assumed, to goodwill is based upon a preliminaryanalysis. Upon completion of a final purchase price allocation, an additionalportion of the excess purchase price may be allocated to certain intangiblesthat are separable from goodwill or arise from contractual or legal rights.

 

In the secondquarter of 2004, in connection with our acquisition of element 5, we beganimplementation of a plan intended to eliminate duplication of resources withinthe consolidated company.  The planincludes the elimination of customer service positions at element 5’sGreenburg, Pennsylvania customer service center and the termination of theGreenburg facility lease by the end of the third quarter of 2004.  As of September 30, 2004, we had included$1.0 million as part of the acquisition cost of element 5 related to this plan.  The following table provides detail on theactivity and our remaining accrual balance by category as of September 30, 2004(in thousands):

 
| ** **               | ** ** | **Accrual  June 30, 2004** | ** ** | **Net  Additions** | ** ** | **Charges** | ** ** | **Accrual  September 30, 2004** | ** ** |
|--------------------------|------------|----------------------------|------------|--------------------|------------|-------------|------------|---------------------------------|------------|
| Employee severance costs |       | $                          | 700        |               | $          | 0           |       | $                               | (400       | ) | $ | 300 |   |
| Facilities consolidation |       | 200                        |       | 100                |       | (200        | )          | 100                             |       |
| Total                    |       | $                          | 900        |               | $          | 100         |       | $                               | (600       | ) | $ | 400 |   |

 

On June 1, 2004, we announced that we acquiredsubstantially all of the assets and assumed certain liabilities of Fireclick, Inc., a leading provider of Web-analysissolutions for online retailers.  Underthe terms of the agreement, we paid $7.5 million in cash.  The agreement also provides Fireclick the opportunity for an earn-out based on ourachieving certain revenue and profitability targets attributable to Fireclick over the course of the three years following theclosing of the acquisition.  Suchearn-out amounts, if paid, will be recorded as goodwill as they are consideredincremental to the purchase price.

 

During the nine months ended September 30, 2003, weacquired certain assets and liabilities of MetatecInternational, Inc., Hartsell Holdings, Inc., d/b/a/ Infocon America Corporation, and The Registration Network, alsoknown as Reg.Net.

 

The Condensed Consolidated Financial Statementsinclude the operating results of each business from the date ofacquisition.  The following unaudited pro forma condensed results of operations for thethree and nine months ended September 30, 2004 and 2003 have been prepared asif each of the acquisitions from the nine months ended September 30, 2004 and2003 had occurred on January 1, 2003 (in thousands, except per share amounts):

 
| ** **                    | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **2004**                               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                    | ** ** | ** **                             | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                       |       | $                                      | 39,439     |                                  | $          | 30,851 |   | $ | 114,600 |   | 86,213 |   |
| Income from  operations       |       | 7,809                                  |       | 2,291                                 |       | 20,319 |   | 4,104 |   |
| Net income                    |       | 8,126                                  |       | 2,420                                 |       | 20,228 |   | 4,279 |   |
|                          |       |                                   |       |                                  |       |   |   |   |   |
| Basic net income  per share   |       | $                                      | 0.25       |                                  | $          | 0.08 |   | $ | 0.63 |   | $ | 0.15 |   |
| Diluted net  income per share |       | $                                      | 0.23       |                                  | $          | 0.07 |   | $ | 0.57 |   | $ | 0.13 |   |
|                               |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

This financial information does not purport torepresent results that would actually have been obtained if the transactionshad been completed on January 1, 2003 or any future results that may berealized.

 

9

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**DIGITAL RIVER, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

**6. LONG-TERM DEBT**

 

On April 16, 2004, in connection with our acquisitionof element 5, we established a $45 million secured revolving creditfacility with Harris Trust and Savings Bank. This facility was repaid in full and terminated in connection with thesale and issuance of our 1.25% convertible senior notes on June 1, 2004.

 

On June 1, 2004 we sold and issued $175 million inaggregate 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 inaggregate principal amount of the notes on June 30, 2004, which purchasetransaction closed 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. In addition, contingent interest isrequired to be paid to holders if certain conditions are met. If a fundamentalchange, such as a change in our control, as defined in the related indenture,occurs on or before January 1, 2009, we may also be required to purchase thenotes for cash and pay an additional make whole premium payable in our commonstock upon the repurchase or conversion of the notes in connection with thefundamental change. Holders of the noteshave the right to require us to repurchase their notes prior to maturity onJanuary 1, 2009, 2014 and 2019. We have the right to redeem the notes, undercertain circumstances, on or after July 1, 2007 and prior to January 1, 2009,and we may redeem the notes at anytime on or after January 1, 2009.

 

A portion of the net proceeds of the offering wasused to repay our senior secured revolving credit facility with Harris Trustand Savings Bank.  The balance will beused for general corporate purposes, including working capital, capital expenditures,potential future acquisitions, investments, and the potential repurchase ofshares of our common stock.

 

**7. SUBSEQUENT EVENT**

 

On November 1, 2004, we acquired all of theoutstanding stock of BlueHornet Networks, Inc., aleading e-mail marketing technology and service provider.  As considerationfor the acquisition, we issued a total of 160,185 shares of our common stock tothe BlueHornet shareholders and assumed debtobligations of BlueHornet totaling approximately$676,000.  In addition, the shareholders of BlueHornetmay receive additional payments of cash or our common stock, at our discretion,based on BlueHornet’s operating performance over thefirst 36 months subsequent to the acquisition.

 

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**Item 2.****  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*We note that, except for thehistorical information contained herein, the matters discussed below containforward-looking statements that involve known and unknown risks, uncertaintiesand other factors that may cause our actual results, performance orachievements, or industry results, to be materially different from any futureresults, performance or achievements expressed or implied by suchforward-looking statements.  We  expressly disclaim any obligation toupdate this information or publicly release any revision or reflect events orcircumstances after the date of this report.  Such factors include, amongothers: our limited operating history and variability of operatingresults, possibility of future losses, risks associated with electronicsoftware delivery, dependence on the Internet and growth in electronic commerceand Internet infrastructure development, dependence on software publishers,dependence on online retailers, system development and electronic commercesecurity risks, rapid technological changes, competition in the electroniccommerce industry, the importance of attracting and retaining personnel,management of our growth, integration of acquired companies, dependence on keyemployees and other risk factors referenced in our Form 10-K  for the year ended December 31, 2003.*

 

**Overview**

 

We are a provider of comprehensive electroniccommerce outsourcing solutions. We were incorporated in February 1994 andcommenced offering products for sale through our clients’ Web stores inAugust 1996. From inception through August 1996, we had no sales, andour activities related primarily to the development of our proprietarytechnology platform, known as CNS. In 1996, we began to focus our business developmentefforts on the software industry, building our inventory of software productsthrough contracts with software publishers. In 1997, we began to developsoftware distribution relationships through contracts with online retailers. Asof September 30**,**2004, we had morethan 36,000 software publisher clients and online channel partners. In late1998, we began to offer our comprehensive electronic commerce outsourcingservices in the form of a transaction fee-based e-commerce service to clientsoutside of the software industry. As of September 30, 2004, we were providingelectronic commerce services such as Web commerce development and hosting,transaction processing, fraud screening, digital delivery, integration tophysical fulfillment, merchandising services, analytical marketing and customerservice to over 230 physical goods clients, as well as operating more than 14,000small business physical goods sites.

 

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 September 30,2004, we had an accumulated deficit of $64.0 million. We intend to expendfinancial and management resources on the development of additional services,sales and marketing, technology and operations to support larger-scaleoperations and greater service offerings. Although we expect to generatepositive cash flow from operations in 2004, there can be no assurance that ourrevenue will increase or even continue at its current level or that we willmaintain profitability or generate 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 electronic commerce. To address theserisks, we must, among other things, attract and retain software publishers andonline retailers as clients, attract and retain physical goods clients,introduce new Web sites, Web stores or services, continue to upgrade anddevelop our systems and infrastructure to meet emerging market needs and remaincompetitive in our service offerings, and retain and attract personnelcommensurate with our business needs. There can be no assurance that we will besuccessful in addressing these risks, and any failure to do so could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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 shortfall in revenue could have an immediateadverse effect on our business, financial condition and results of operations.We are also likely to continue to see revenue fluctuate on a seasonal basis,which is typical for the software publishing market in general and for ourexisting physical goods clients.  We believethat our first and fourth quarters tend to be seasonally stronger than our

 

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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 items fromour condensed consolidated statements of operations as a percentage of totalrevenue for the periods indicated.

 
| ** **                                 | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                 | ** ** | **2004**                               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** |   |
| Revenue                                    |       | 100.0                                  | %          | 100.0                                 | %          | 100.0 | % | 100.0 | % |
| Cost of Revenue:                           |       |                                   |       |                                  |       |   |   |   |   |
| Direct cost of  services                   |       | 4.1                                    |       | 3.2                                   |       | 3.5 |   | 3.7 |   |
| Network and  infrastructure                |       | 10.8                                   |       | 12.3                                  |       | 10.4 |   | 12.3 |   |
| Gross Margin                               |       | 85.1                                   |       | 84.5                                  |       | 86.1 |   | 84.0 |   |
| Operating  Expenses:                       |       |                                   |       |                                  |       |   |   |   |   |
| Sales and  marketing                       |       | 33.8                                   |       | 37.0                                  |       | 34.1 |   | 38.0 |   |
| Product research  and development          |       | 9.5                                    |       | 9.2                                   |       | 9.7 |   | 10.0 |   |
| General and  administrative                |       | 10.2                                   |       | 9.2                                   |       | 10.1 |   | 9.1 |   |
| Depreciation and  amortization             |       | 5.6                                    |       | 7.1                                   |       | 5.4 |   | 6.9 |   |
| Amortization of  acquisition related costs |       | 6.2                                    |       | 5.3                                   |       | 5.9 |   | 5.2 |   |
| Total operating  expenses                  |       | 65.3                                   |       | 67.8                                  |       | 65.2 |   | 69.2 |   |
| Income from  operations                    |       | 19.8                                   |       | 16.7                                  |       | 20.9 |   | 14.8 |   |
| Other  income/(expense), net               |       | 0.8                                    |       | 1.0                                   |       | 0.3 |   | 0.8 |   |
| Net income                                 |       | 20.6                                   | %          | 17.7                                  | %          | 21.2 | % | 15.6 | % |

 

***REVENUE.*** Revenue increased to $39.4 million for the three months endedSeptember 30, 2004 from $26.7 million for the same period in the prior year, anincrease of $12.7 million, or 47.4%.  For the nine months ended September30, 2004 revenue totaled $106.2 million, an increase of $32.1 million, or43.3%, from revenue of $74.1 million recorded in the same period of the prioryear.  The increase was primarilyattributable to higher online activity across our client base, growth in thenumber of software publishers and online retailer clients, increasedinternational sites, and accretive acquisitions.

 

International sales represented approximately 29%and 24% of total revenue in the three month periods ended September 30, 2004and 2003, respectively, and approximately 29% and 23% of total revenue for thenine month periods ended September 30, 2004 and 2003, respectively.  We expect that this percentage will continueto increase on a year over year basis.

 

***GROSS MARGIN.*********Cost of revenue, which consists of directcost of services and network and infrastructure costs (both shown in thisparagraph and table above exclusive of depreciation and amortization expense),increased to $5.9 million and $14.7 million, respectively, for the three andnine months ended September 30, 2004 from $4.1 million and $11.8 million forthe same periods in the prior year.  The gross profit margin increased inthe three months ended September 30, 2004 to 85.1% from 84.5% for the sameperiod in the prior year, but decreased 69 basis points, a slight sequentialdecrease from the second quarter of 2004’s profit margin of 85.8%.  For the nine months ended September 30, 2004gross profit margin increased to 86.1% from 84.0% for the same period in theprior year.  The quarter over quarter andyear over year increases in gross margin were primarily due to leveraging ourinfrastructure over significantly more revenue and clients.  We believe that electronic commerce andrelated services are becoming more competitive.  Accordingly, we may haveto reduce our pricing or alter our pricing structure and policies in the futureand any such change could reduce our gross margins.

 

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***SALES AND MARKETING.*********Sales and marketing expense consistsprimarily of personnel and related expenses, advertising and promotional expenses,credit card chargebacks and bad debt expense, andcredit card transaction fees.  Sales and marketing expense increased to$13.3 million and $36.2 million, respectively, for the three and nine monthsended September 30, 2004 from $9.9 million and $28.1 million for the sameperiods in the prior year, an increase of $3.4 million, or 34.8%, and $8.1million, or 28.7%, respectively.  The increase primarily resulted fromcredit card fees and chargeback costs directly associated with the increase inrevenue and additional sales and marketing personnel and relatedexpenses.  As a percentage of revenue, sales and marketing expense was33.8% and 34.1%, respectively, in the three and nine months ended September 30,2004, compared to 37.0% and 38.0%, respectively, for the same periods in theprior year, primarily reflecting our increased revenue.  We expect salesand marketing expenses to increase in absolute terms and decline as apercentage of revenue over time.

 

***PRODUCT RESEARCH AND DEVELOPMENT.********* Product research and developmentexpense consists primarily of personnel and related expenses and consultingcosts associated with developing and enhancing our CNS platform and relatedinternal systems.  Product research anddevelopment expense increased to $3.7 million and $10.3 million, respectively,for the three and nine months ended September 30, 2004 from $2.4 million and$7.4 million for the same periods in the prior year, an increase of $1.3million, or 52.5%, and $2.9 million, or 38.7%, respectively.   The increase was primarily driven byincreases in personnel-related expenses, partially offset by reductions inoutside consulting fees.  During thethird quarter of 2004, we continued to advance our new self-service, remote-controltechnology, as well as the international and e-marketing capabilities on ournext-generation e-commerce platform.  Wecapitalized approximately $0.7 million and $1.6 million of software developmentcosts related to these efforts in the three and nine month periods endingSeptember 30, 2004.  As a percentage ofrevenue, product research and development expense was 9.5% and 9.7% in thethree and nine months ended September 30, 2004, compared to 9.2% and 10.0%,respectively, for the same periods in the prior year.  We expect productresearch and development costs to increase in absolute dollars but declineslightly on a percentage basis as revenues increase.

 

***GENERAL AND ADMINISTRATIVE.*********General and administrative expense consistsprimarily of executive, accounting and administrative personnel and relatedexpenses, including professional fees and investor relations expenses. General and administrative expenses increased to $4.0 million and $10.7million, respectively, for the three and nine months ended September 30, 2004from $2.5 million and $6.7 million for the same periods in the prior year, anincrease of $1.6 million, or 63.6%, and $4.0 million, or 59.3%,respectively.  The increase resultedprimarily from professional and legal fees and audit and tax servicesassociated with compliance with the Sarbanes-Oxley Act and related rules andregulations, foreign governance compliance, and ongoing litigationexpenses.  As a percentage of revenue, general and administrative expensewas 10.2% and 10.1% for the three and nine months ended September 30, 2004,compared to 9.2% and 9.1%, respectively, for the same periods in the prioryear.  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 andadministrative expense is expected  to decline over time.

 

***AMORTIZATION OF ACQUISITION-RELATED COSTS.*********Amortization of acquisition related costsconsists of amortization of other intangible assets recorded from ouracquisitions over the last three years. Amortization of intangible assets was $2.4 million and $6.3 million,respectively, for the three and nine months ended September 30, 2004 comparedto $1.4 million and $3.9 million for the same periods in the prior year.  The increase was due to additionalamortizable assets acquired throughout 2003 and the second quarter of 2004.

 

***OTHERINCOME/(EXPENSE), NET.***  Other income/(expense),net consists of interest income on our cash and cash equivalents and short-terminvestments, interest expense on debt financing obligations, currency gain orloss from remeasured foreign transactions or assetsfrom their native currency to their functional currency, as well as gain orloss on the sale of investments.

 

***INCOME TAXES.***** **We paid no income taxes in any reported period due to utilization ofnet operating losses and recognized no income tax expense because we have fullyreserved for deferred tax assets related to the net operating losses.  We had net operating loss carryforwards of approximately $88.0 million as ofSeptember 30, 2004. Included in this amount is approximately $64.5 million ofdeductions resulting from disqualifying dispositions of stock options. Whenthese deductions relating to disqualifying dispositions are realized forfinancial statement purposes they will not result in a reduction in income taxexpense, rather the benefit will be recorded as additional paid-in-capital.These income tax net operating loss carryforwards  expire beginning in the year 2009. Deductions fromdisqualifying dispositions of stock options are included in net operating loss carryforwards with a corresponding valuationallowance.  Because of the uncertainty offuture realization, a valuation allowance equal to the deferred tax asset hasbeen recorded.

 

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**Liquidity and Capital Resources**

 

As of September 30, 2004, we had $191.4 million ofcash and cash equivalents, $66.1 million of short-term investments and workingcapital of approximately $178.6 million. Our primary source of internalliquidity is our operating activities. During the nine months ended September 30, 2004, our operationsgenerated $57.8 million of cash compared to $38.2 million for the same period ofthe prior year.  The improvement was mainly due to an increase in netincome and an increase in accounts payable, offset by an increase in accountsreceivable.  Net cash used in investing activities during the nine monthsended September 30, 2004 totaled $168.0 million.  This was comprised ofnet investments in acquisitions of  $125.9 million, net purchases ofinvestments of $36.1 million and investments in equipment of $6.1 million.  In April 2004, we acquired element 5 AG, aprivately held company based in Germany. Under the terms of the acquisition, we paid $120 million in cash toacquire all of the outstanding shares of capital stock of element 5.  On June 1, 2004, we announced that weacquired substantially all of the assets and assumed certain liabilities of Fireclick, Inc. Under the terms of the agreement, we paid $7.5 million in cash.  Net cash provided by financing activitiesduring the nine months ended September 30, 2004 totaled $199.4 million.  This was comprised of $188.4 million from thesale of our 1.25% convertible senior notes and $11.0 million from the sale ofstock through the exercise of stock options and purchases through the employeestock purchase plan.

 

Our principal commitments consist of interest andprincipal on our convertible senior notes and long-term obligations outstandingunder operating leases.  Although we haveno material commitments for capital expenditures, we anticipate continuedcapital expenditures consistent with our anticipated growth in operations,infrastructure, and personnel as well as those which may arise in connectionwith our integration of element 5 and Fireclick,Inc.    We further anticipate thatour expenditures on product development will be consistent with our anticipatedgrowth in operations as well as any requirements which may arise in connectionwith our integration of element 5 and Fireclick,Inc.  We also anticipate that we will continue to experience growth in ouroperating expenses for the foreseeable future and that our operating expenseswill be a material use of our cash resources.

 

**Contractual  Commitments**

 
| ** **                   | ** ** | ** **                               | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **Payment due by period (in thousands)** | ** ** |
| **Contractual  Obligations** | ** ** | **Total Amount  Committed**              | ** ** | **Oct-Dec  2004** | ** ** | **2005-2006** | ** ** | **2007-2008** | ** ** | **2009 and  Thereafter** | ** ** |
| Operating Lease Obligations  |       | $                                        | 5,474      |   | $ | 508 |   | $ | 2,739 |   | $ | 1,342 |   | $ | 885 |   |
| Convertible Senior Notes     |       | $                                        | 242,714    |   | $ | 1,401 |   | $ | 4,875 |   | $ | 4,875 |   | $ | 231,563 |   |
| Total                        |       | $                                        | 248,188    |   | $ | 1,909 |   | $ | 7,614 |   | $ | 6,217 |   | $ | 232,448 |   |
|                              |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We expect tocontinue to evaluate and consider a wide array of potential strategictransactions, including business combinations and acquisitions of businesses,products, services and other assets as well as licenses of technology relatedto our current business.  At any giventime, we may be engaged in discussions or negotiations with respect to one ormore such transactions.  Any suchtransactions could have a material impact on our financial position, results ofoperations, or cash flows.  There is noassurance that any such discussions or negotiations will result in the consummationof any 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.

 

On April 16, 2004, in connection with our acquisitionof element 5, we established a $45 million secured revolving credit facilitywith Harris Trust and Savings Bank.  Thisfacility was repaid in full and terminated in connection with the sale andissuance of our 1.25% convertible senior notes on June 1, 2004.

 

On June 1, 2004 we sold and issued $175 million inaggregate 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

 

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** **

in full their option to purchase up to anadditional $20 million in aggregate principal amount of the notes on June 30,2004, which purchase transaction closed 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 initial conversion price is equivalent toa conversion rate of approximately 22.6948 shares per $1,000 of principalamount of the notes.  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. Holders of the notes have the right to require us to repurchase theirnotes prior to maturity on January 1, 2009, 2014 and 2019. We have the right toredeem the notes, under certain circumstances, on or after July 1, 2007 andprior to January 1, 2009, and we may redeem the notes at anytime on or afterJanuary 1, 2009.

 

A portion of the net proceeds of the offering wasused to repay our senior secured revolving credit facility with Harris Trustand Savings Bank.  The balance will beused for general corporate purposes, including working capital, capitalexpenditures, potential future acquisitions, investments, and the potentialrepurchase of shares of our common stock.

 

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.   The sale of additional equity or convertibledebt securities could result in additional dilution to our stockholders. Therecan be no assurances that financing will be available in amounts or on termsacceptable to us, if at all.

 

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** **

**Item 3.****  Qualitative andQuantitative Disclosure About Market Risk**

 

** Interest Rate 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 September 30, 2004, 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.

 

**Foreign Currency Risk**

 

Our operations have been conducted primarilyin the United States currency and as such have not been subject to materialforeign 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 onehalf of our recently acquired element 5’s revenue is in euros and currenciesother than U.S. dollars.  As a result, agreater proportion of our revenues and earnings will now be subject to currencyfluctuations.  We translate incomestatement amounts that are denominated in foreign currency  into U.S. dollars at the averageexchange rates in each applicable period. To the extent the U.S. dollar weakensagainst foreign currencies, the translation of these foreigncurrency denominated transactions results in increased net revenues,operating expenses and net income. Conversely, our net revenues, operatingexpenses and net income will decrease when the U.S. dollar strengthens againstforeign currencies. We do not currently have a currency hedging program tomitigate the effect of fluctuations of currency prices on our financialresults.

 

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

 

(a)                                  Basedon their evaluation of our disclosure controls and procedures conducted as ofSeptember 30, 2004, our Chief Executive Officer and Chief Financial Officerhave concluded that our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934)are effective at the reasonable assurance level.

 

(b)                                 Thisevaluation did not identify any change in our internal controls over financialreporting that occurred during the quarter ended September 30, 2004 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.

 

**Limitations on the Effectiveness ofControls**

 

Our management, including the Chief ExecutiveOfficer and Chief Financial Officer, does not expect that our disclosurecontrols and procedures or our internal controls 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 allcontrol systems, no evaluation of controls can provide absolute assurance thatall control 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 occurand not be detected.

 

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**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 seekunspecified monetary 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 were dismissedfrom the lawsuit without prejudice.  In February 2003, the court issued adecision denying the motion to dismiss the Section 11 claims against us andalmost all of the other Issuers and denying the motion to dismiss the Section10(b) claims against us and many of the Issuers.

 

During the summer of 2003, we, alongwith a substantial majority of Issuers, indirectly participated indiscussions with the plaintiffs and the Issuers’ respective insurers regardinga tentative settlement of the IPO Lawsuits. The terms of the tentativesettlement would provide for, among other things, a release of the Issuers andtheir officers and directors from all further liability resulting fromplaintiffs’ claims, and the assignment to plaintiffs of certain potentialclaims that the Issuers may have against their IPO underwriters. The tentativesettlement also provides that, in the event that plaintiffs ultimately recoverless than a guaranteed sum of $1 billion from the IPO underwriters,plaintiffs would be entitled to payment by each participating Issuer’s insurerof a pro rata share of any shortfall in the plaintiffs’ guaranteedrecovery.  In June 2003, pursuant to the authorization of a speciallitigation committee of our board of directors, we entered into anon-binding memorandum of understanding reflecting the settlement termsdescribed above. In September 2003, in connection with the possiblesettlement, 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. The settlement is still subject to a number of conditions, includingaction by the Court certifying a class action for settlement purposes andformally approving the settlement.  Theunderwriters have opposed both the certification of the class and the judicialapproval of the settlement.  Pendingdefinitive settlement, we continue to believe that the claims against us,our officers and directors are without merit and intend to defend against them vigorously.

 

In August 2001, an action was brought againstus and other defendants in the U.S. District Court in the District of Columbiaalleging infringement of United States Patent No. 6,014,651 owned byChristopher M. Crawford of Washington, D.C. Crawford alleges that we directly infringe the patent by the provisionof online software purchase and delivery services, that we actively induceinfringement of the patent by supporting and otherwise promoting our electronicsoftware delivery services to others and that we contributorilyinfringed the patent by making, using, selling and offering to sell componentsof our electronic software delivery services.

 

Discovery reopened in February 2004, and isongoing.  In September 2004, we filed amotion for summary judgment and a supporting brief.  This motion is not yet fully briefed.  Although a number of co-defendants havesettled with plaintiff Crawford, at this time, Crawford has not made adefinitive demand for the resolution of this case.  We believe that this lawsuit is without meritand intend to defend against it vigorously.

 

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

 

In April 2001, the Board of Directors authorized ashare repurchase program of up to $5.0 million of our outstanding shares ofcommon stock. Repurchases are at our discretion based on ongoing assessments ofthe capital needs of the business and the market price of our shares. No timelimit was set for the completion of the repurchase program.  In 2001, wespent $267,000 to repurchase our shares. During the year ended December 31,2003 and the nine months ended September 30, 2004, no shares were repurchasedunder the repurchase program.

 

On June 1, 2004 we sold and issued $175 million inaggregate principal amount of 1.25% convertible senior notes due January 1,2024, in a private, unregistered offering. The initial purchasers of thenotes were Credit Suisse First Boston, Harris Nesbitt and RBCCapital Markets. The sale of the notes to the initial purchasers was exemptfrom registration under the Securities Act of 1933, as amended, under Section4(2) thereof, as a transaction not involving a public offering. The notes werereoffered in the United States to qualified institutional buyers in reliance onRule 144A under the Securities Act.  The notes were sold at 100% of theirprincipal amount.  The initial purchasersexercised in full their option to purchase up to an additional $20 million inaggregate principal amount of the notes on June 30, 2004, which purchasetransaction closed on July 6, 2004.  Wereceived aggregate net proceeds of approximately $188 million from thisoffering.

 

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 initial conversion price is equivalent toa conversion rate of approximately 22.6948 shares per $1,000 of principalamount of the notes.  We will adjustthe conversion price if certain events occur, as specified in the relatedindenture, 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. Holders of the notes have the right to require us to repurchase theirnotes prior to maturity on January 1, 2009, 2014 and 2019. We have the right toredeem the notes, under certain circumstances, on or after July 1, 2007 andprior to January 1, 2009, and we may redeem the notes at anytime on or afterJanuary 1, 2009.

 

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

 

**(a) Exhibits**

 

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                 | (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. |
| 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. |

 

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(1)                    Filed as Exhibits 3.1 and 3.3 to ourRegistration Statement on Form S-3, File No. 333-81626, filed on January 29,2002, declared effective on February 12, 2002, and incorporated herein byreference.

(2)                    Filed as an exhibit to our Annual Report onForm 10-K for the year ended December 31, 2000, filed on March 27, 2001, andincorporated herein by reference.

(3)                    Filed as an exhibit to our RegistrationStatement 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 onForm 8-K, filed on July 13, 2004, and incorporated herein by reference.

 

 

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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:  | November 9, 2004 | DIGITAL RIVER, INC.                                                     |
|--------|------------------|-------------------------------------------------------------------------|
|   |             |                                                                    |
|   |             | By:                                                                     | /s/ CARTER D. HICKS |
|   |             |                                                                    |
|   |             | Carter D. Hicks                                                         |
|   |             | *Chief Financial Officer  (Principal Financial and Accounting Officer)* |
|        |                  |                                                                         |  |

 

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EXHIBIT INDEX

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION  OF DOCUMENTS** |
|---------------------|------------|-------------------------------|
|                |       |                          |
| 3.1                 | (1)        |                          | Amended and Restated Certificate of Incorporation,  as amended, as currently in effect. |
| 3.2                 | (2)        |                          | Amended and Restated Bylaws, as currently in  effect. |
| 4.1                 | (3)        |                          | Specimen of Common Stock Certificate. |
| 4.2                 | (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. |
| 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. |

 

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(1)                    Filed as Exhibits 3.1 and 3.3 to ourRegistration Statement on Form S-3, File No. 333-81626, filed on January 29,2002, declared effective on February 12, 2002, and incorporated herein byreference.

(2)                    Filed as an exhibit to our Annual Report onForm 10-K for the year ended December 31, 2000, filed on March 27, 2001, andincorporated herein by reference.

(3)                    Filed as an exhibit to our Registration Statementon Form S-1, File No. 333-56787, declared effective on August 11, 1998, andincorporated herein by reference.

(4)                    Filed as an exhibit to our Current Report onForm 8-K, filed on July 13, 2004, and incorporated herein by reference.

 

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