##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED September 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE TRANSITION PERIOD FROM            TO
 Commission file number 000-24643
 DIGITAL RIVER, INC.
  DELAWARE
    
    41-1901640(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)
 9625 WEST 76TH STREET
EDEN PRAIRIE, MINNESOTA 55344
 (952) 253-1234
 
 þ o
  þ o o
 o þ




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##### 



PART I.
    
    FINANCIAL INFORMATION
    
    
    3Item 1.
    
    Financial Statements
    
    
    3Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3.
    
    Qualitative and Quantitative Disclosure about Market Risk
    
    
    22Item 4.
    
    Controls and Procedures
    
    
    23PART II.
    
    OTHER INFORMATION
    
    
    24Item 1.
    
    Legal Proceedings
    
    
    24Item 1A.
    
    Risk Factors
    
    
    24Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 6.
    
    Exhibits
    
    
    37SIGNATURES
    
    
    
    
    38EXHIBIT INDEX
    
    
    39Computation of Ratio of Earnings to Fixed ChargesSection 302 CertificationSection 302 CertificationSection 906 CertificationSection 906 Certification
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 DIGITAL RIVER, INC.
 
   (Unaudited)September 30,
    
    
    December 31,2006
    
    
    2005ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    335,676
    
    
    $
    131,770Short-term investments
    
    
    240,643
    
    
    
    220,569Accounts receivable, net of allowance of $1,522 and $1,023
    
    
    39,698
    
    
    
    34,883Deferred income taxes
    
    
    13,068
    
    
    
    22,251Prepaid expenses and other
    
    
    5,380
    
    
    
    3,741Total current assets
    
    
    634,465
    
    
    
    413,214Property and equipment, net
    
    
    24,127
    
    
    
    17,955Goodwill
    
    
    238,305
    
    
    
    195,299Intangible assets, net of accumulated amortization of $46,627 and $36,798
    
    
    23,222
    
    
    
    20,054Deferred income taxes
    
    
    4,132
    
    
    
    10,444Other assets
    
    
    11,912
    
    
    
    12,174TOTAL ASSETS
    
    $
    936,163
    
    
    $
    669,140LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    128,082
    
    
    $
    127,846Accrued payroll
    
    
    12,848
    
    
    
    8,866Deferred revenue
    
    
    7,012
    
    
    
    5,403Accrued acquisition costs
    
    
    6,004
    
    
    
    5,651Other accrued liabilities
    
    
    28,097
    
    
    
    21,210Total current liabilities
    
    
    182,043
    
    
    
    168,976NON-CURRENT LIABILITIES:Convertible senior notes
    
    
    195,000
    
    
    
    195,000Deferred income taxes
    
    
    
    
    
    
    22Total non-current liabilities
    
    
    195,000
    
    
    
    195,022TOTAL LIABILITIES
    
    
    377,043
    
    
    
    363,998COMMITMENTS AND CONTINGENCIESSTOCKHOLDERS EQUITY:Preferred Stock, $.01 par value; 5,000,000 shares authorized; no shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 120,000,000 shares authorized; 39,831,844 and 35,033,741 shares issued and outstanding
    
    
    398
    
    
    
    350Additional paid-in capital
    
    
    513,718
    
    
    
    315,489Deferred compensation
    
    
    
    
    
    
    (1,942
    )Retained earnings/(accumulated deficit)
    
    
    38,128
    
    
    
    (6,324
    )Accumulated other comprehensive income (loss)
    
    
    6,876
    
    
    
    (2,431
    )Total stockholders equity
    
    
    559,120
    
    
    
    305,142TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    936,163
    
    
    $
    669,140
  3




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##### Table of Contents



DIGITAL RIVER, INC.
 
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenue
    
    $
    75,337
    
    
    $
    53,179
    
    
    $
    224,628
    
    
    $
    158,851Costs and expenses:Direct cost of services
    
    
    1,912
    
    
    
    1,050
    
    
    
    5,689
    
    
    
    3,538Network and infrastructure
    
    
    7,761
    
    
    
    4,983
    
    
    
    21,502
    
    
    
    14,199Sales and marketing
    
    
    28,451
    
    
    
    16,713
    
    
    
    83,018
    
    
    
    48,829Product research and development
    
    
    8,338
    
    
    
    5,210
    
    
    
    23,428
    
    
    
    14,796General and administrative
    
    
    8,054
    
    
    
    5,294
    
    
    
    24,551
    
    
    
    16,210Depreciation and amortization
    
    
    2,943
    
    
    
    2,308
    
    
    
    7,671
    
    
    
    6,805Amortization of acquisition-related intangibles
    
    
    3,313
    
    
    
    2,089
    
    
    
    9,191
    
    
    
    6,595Total costs and expenses
    
    
    60,772
    
    
    
    37,647
    
    
    
    175,050
    
    
    
    110,972Income from operations
    
    
    14,565
    
    
    
    15,532
    
    
    
    49,578
    
    
    
    47,879Other income, net
    
    
    5,804
    
    
    
    1,526
    
    
    
    15,131
    
    
    
    3,572Income before income tax expense
    
    
    20,369
    
    
    
    17,058
    
    
    
    64,709
    
    
    
    51,451Income tax expense
    
    
    5,581
    
    
    
    4,700
    
    
    
    20,255
    
    
    
    14,830Net income
    
    $
    14,788
    
    
    $
    12,358
    
    
    $
    44,454
    
    
    $
    36,621Net income per share  basic
    
    $
    0.37
    
    
    $
    0.35
    
    
    $
    1.17
    
    
    $
    1.07Net income per share  diluted
    
    $
    0.33
    
    
    $
    0.31
    
    
    $
    1.04
    
    
    $
    0.92Shares used in per-share calculation  basic
    
    
    39,619
    
    
    
    34,824
    
    
    
    38,126
    
    
    
    34,342Shares used in per-share calculation  diluted
    
    
    45,666
    
    
    
    41,972
    
    
    
    44,107
    
    
    
    41,558
  4




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##### Table of Contents



DIGITAL RIVER, INC.
 
   Nine Months EndedSeptember 30,2006
    
    
    2005OPERATING ACTIVITES:Net income
    
    $
    44,454
    
    
    $
    36,621Adjustments to reconcile net income to net cash provided by operating activities:Amortization of acquisition-related intangibles
    
    
    9,191
    
    
    
    6,595Change in accounts receivable allowance, net of acquisitions
    
    
    426
    
    
    
    (257
    )Depreciation and amortization
    
    
    7,671
    
    
    
    6,715Stock-based compensation expense related to stock options and employee
stock purchase plans
    
    
    10,388
    
    
    
    Tax benefit of stock-based compensation
    
    
    
    
    
    
    10,496Excess tax benefits from stock-based compensation
    
    
    (3,032
    )
    
    
    Deferred and other income taxes
    
    
    17,676
    
    
    
    3,030Change in operating assets and liabilities (net of acquisitions):Accounts receivable
    
    
    (2,351
    )
    
    
    (2,431
    )Prepaid and other assets
    
    
    (291
    )
    
    
    (987
    )Accounts payable
    
    
    (7,028
    )
    
    
    499Deferred revenue
    
    
    881
    
    
    
    527Income tax payable
    
    
    1,022
    
    
    
    4,064Accrued payroll and other accrued liabilities
    
    
    5,680
    
    
    
    (569
    )Net cash provided by operating activities
    
    
    84,687
    
    
    
    64,303INVESTING ACTIVITIES:Purchases of investments
    
    
    (135,911
    )
    
    
    (144,509
    )Sales of investments
    
    
    116,446
    
    
    
    97,427Cash paid for acquisitions, net of cash received
    
    
    (37,998
    )
    
    
    (9,482
    )Purchases of equipment and capitalized software
    
    
    (12,825
    )
    
    
    (7,318
    )Net cash used in investing activities
    
    
    (70,288
    )
    
    
    (63,882
    )FINANCING ACTIVITIES:Proceeds from sales of common stock
    
    
    172,700
    
    
    
    Exercise of stock options
    
    
    10,579
    
    
    
    22,154Sales of common stock under employee stock purchase plan
    
    
    933
    
    
    
    1,488Repurchase of common stock
    
    
    
    
    
    
    (3,205
    )Excess tax benefits from stock-based compensation
    
    
    3,032
    
    
    
    Net cash provided by financing activities
    
    
    187,244
    
    
    
    20,437EFFECT OF EXCHANGE RATE CHANGES ON CASH
    
    
    2,263
    
    
    
    (3,524
    )NET INCREASE IN CASH AND CASH EQUIVALENTS
    
    
    203,906
    
    
    
    17,334CASH AND CASH EQUIVALENTS, beginning of period
    
    
    131,770
    
    
    
    127,734CASH AND CASH EQUIVALENTS, end of period
    
    $
    335,676
    
    
    $
    145,068SUPPLEMENTAL DISCLOSURES:Cash paid for interest on Convertible Senior Notes
    
    $
    2,438
    
    
    $
    2,641Cash paid for income taxes
    
    $
    1,424
    
    
    $
    Noncash investing and financing activities:Common stock issued in acquisitions and earn-outs
    
    $
    488
    
    
    $
    
  5




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##### Table of Contents



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




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##### Table of Contents



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




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Earnings per share  basicNet income  basic
    
    $
    14,788
    
    
    $
    12,358
    
    
    $
    44,454
    
    
    $
    36,621Weighted average shares outstanding  basic
    
    
    39,619
    
    
    
    34,824
    
    
    
    38,126
    
    
    
    34,342Earnings per share  basic
    
    $
    0.37
    
    
    $
    0.35
    
    
    $
    1.17
    
    
    $
    1.07Earnings per share  dilutedNet income  basic
    
    
    14,788
    
    
    
    12,358
    
    
    
    44,454
    
    
    
    36,621Exclude: Interest expense and amortized financing cost of
convertible senior notes, net of tax benefit
    
    
    435
    
    
    
    501
    
    
    
    1,305
    
    
    
    1,470Net income  diluted
    
    $
    15,223
    
    
    $
    12,859
    
    
    $
    45,759
    
    
    $
    38,091Weighted average shares outstanding  basic
    
    
    39,619
    
    
    
    34,824
    
    
    
    38,126
    
    
    
    34,342Dilutive impact of non-vested stock and options outstanding
    
    
    1,622
    
    
    
    2,723
    
    
    
    1,556
    
    
    
    2,791Dilutive impact of convertible senior notes
    
    
    4,425
    
    
    
    4,425
    
    
    
    4,425
    
    
    
    4,425Weighted average shares outstanding  diluted
    
    
    45,666
    
    
    
    41,972
    
    
    
    44,107
    
    
    
    41,558Net income per share  diluted
    
    $
    0.33
    
    
    $
    0.31
    
    
    $
    1.04
    
    
    $
    0.92
 3. BUSINESS COMBINATIONS, GOODWILL AND INTANGIBLE ASSETS
     8




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    Accrual
    
    
    
    
    
    
    
    
    
    Accrual
    
    
    
    
    
    
    
    
    
    Accrual
    
    
    
    
    
    AccrualApril 16,
    
    Net
    
    
    
    
    
    December
    
    Adjust-
    
    
    
    
    
    December
    
    
    
    
    
    September2004
    
    Additions
    
    Charges
    
    31, 2004
    
    ments
    
    Charges
    
    31, 2005
    
    Charges
    
    30, 2006Shareholder escrow
    
    $
    
    
    
    $
    2,500
    
    
    $
    
    
    
    $
    2,500
    
    
    $
    
    
    
    $
    (1,250
    )
    
    $
    1,250
    
    
    $
    (1,250
    )
    
    $
    Employee severance costs
    
    
    700
    
    
    
    2,100
    
    
    
    (400
    )
    
    
    2,400
    
    
    
    (200
    )
    
    
    (1,250
    )
    
    
    950
    
    
    
    (420
    )
    
    
    530Facilities consolidation
    
    
    200
    
    
    
    100
    
    
    
    (300
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    900
    
    
    $
    4,700
    
    
    $
    (700
    )
    
    $
    4,900
    
    
    $
    (200
    )
    
    $
    (2,500
    )
    
    $
    2,200
    
    
    $
    (1,670
    )
    
    $
    530
   Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Revenue
    
    $
    75,337
    
    
    $
    58,712
    
    
    $
    228,086
    
    
    $
    174,839Income from operations
    
    
    14,565
    
    
    
    14,963
    
    
    
    49,196
    
    
    
    45,260Net income
    
    
    14,788
    
    
    
    11,214
    
    
    
    43,852
    
    
    
    33,911Basic net income per share
    
    $
    0.37
    
    
    $
    0.32
    
    
    $
    1.15
    
    
    $
    0.99Diluted net income per share
    
    $
    0.33
    
    
    $
    0.28
    
    
    $
    1.02
    
    
    $
    0.84
  Goodwill and Other Intangible Assets
  9




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   As of September 30, 2006Carrying Amount
    
    
    Accumulated
    
    
    Carrying AmountGross
    
    
    Amortization
    
    
    NetCustomer relationships
    
    $
    41,752
    
    
    $
    27,842
    
    
    $
    13,910Non-compete agreements
    
    
    5,868
    
    
    
    4,935
    
    
    
    933Technology/tradename
    
    
    22,229
    
    
    
    13,850
    
    
    
    8,379Total
    
    $
    69,849
    
    
    $
    46,627
    
    
    $
    23,222
 As
of December 31, 2005Carrying Amount
    
    
    Accumulated
    
    
    Carrying AmountGross
    
    
    Amortization
    
    
    NetCustomer relationships
    
    $
    34,666
    
    
    $
    21,103
    
    
    $
    13,563Non-compete agreements
    
    
    5,121
    
    
    
    4,300
    
    
    
    821Technology/tradename
    
    
    17,065
    
    
    
    11,395
    
    
    
    5,670Total
    
    $
    56,852
    
    
    $
    36,798
    
    
    $
    20,054
  Year2006
    
    
    3,1212007
    
    
    8,2332008
    
    
    5,7082009
    
    
    4,7622010
    
    
    1,0022011
    
    
    396Total
    
    $
    23,222
 4. STOCK-BASED COMPENSATION PLANS
 Option and Restricted Stock Awards
    10




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   WeightedShares
    
    
    
    
    
    
    Options
    
    
    AverageAvailable
    
    
    Options
    
    
    Price
    
    
    Pricefor Grant
    
    
    Outstanding
    
    
    Per Share
    
    
    Per ShareBalance, December 31, 2004
    
    
    2,456,343
    
    
    
    5,714,740
    
    
    $
    1.69 - $31.13
    
    
    $
    13.94Granted
    
    
    (846,678
    )
    
    
    846,678
    
    
    
    23.90 - 30.69
    
    
    
    28.15Exercised
    
    
    
    
    
    
    (1,719,114
    )
    
    
    1.69 - 30.69
    
    
    
    13.50Canceled/expired
    
    
    318,919
    
    
    
    (318,919
    )
    
    
    3.88 - 27.40
    
    
    
    15.15Balance, December 31, 2005
    
    
    1,928,584
    
    
    
    4,523,385
    
    
    
    2.59 - 31.13
    
    
    
    16.69Granted
    
    
    (359,000
    )
    
    
    359,000
    
    
    
    29.75 - 48.39
    
    
    
    37.05Restricted stock effect on shares available for grant
    
    
    (128,250
    )
    
    
    N/A
    
    
    
    N/A
    
    
    
    N/AExercised
    
    
    
    
    
    
    (624,155
    )
    
    
    2.59 - 31.13
    
    
    
    16.95Canceled/expired
    
    
    113,034
    
    
    
    (113,034
    )
    
    
    2.59 - 27.40
    
    
    
    22.06Balance, September 30, 2006
    
    
    1,554,368
    
    
    
    4,145,196
    
    
    $
    2.59 - $48.39
    
    
    $
    18.27
   Options Outstanding
    
    
    Options ExercisableWeighted
    
    Weighted
    
    
    Aggregate
    
    
    
    
    
    
    Weighted
    
    
    AggregateNumber
    
    
    Average
    
    Average
    
    
    Intrinsic
    
    
    Number
    
    
    Average
    
    
    IntrinsicExercise Price
    
    Outstanding
    
    
    Life Remaining
    
    Price
    
    
    Value
    
    
    Exercisable
    
    
    Price
    
    
    Value$1.69 - $3.88
    
    
    134,746
    
    
    2.2 years
    
    $
    3.04
    
    
    $
    6,479,162
    
    
    
    134,746
    
    
    $
    3.04
    
    
    $
    6,479,1624.56 - 7.55
    
    
    924,144
    
    
    4.6 years
    
    
    5.37
    
    
    
    42,279,200
    
    
    
    922,491
    
    
    
    5.37
    
    
    
    42,207,0969.12 - 13.92
    
    
    826,554
    
    
    6.1 years
    
    
    11.55
    
    
    
    32,706,148
    
    
    
    631,627
    
    
    
    11.78
    
    
    
    24,845,84016.72 - 22.98
    
    
    812,171
    
    
    6.9 years
    
    
    22.05
    
    
    
    23,612,651
    
    
    
    556,752
    
    
    
    22.26
    
    
    
    16,066,92223.01 - 31.13
    
    
    1,140,581
    
    
    8.3 years
    
    
    27.30
    
    
    
    27,172,907
    
    
    
    324,011
    
    
    
    26.80
    
    
    
    7,879,26831.14 - 48.40
    
    
    307,000
    
    
    9.5 years
    
    
    38.29
    
    
    
    3,938,970
    
    
    
    27,811
    
    
    
    35.49
    
    
    
    434,618$1.69 - $48.40
    
    
    4,145,196
    
    
    6.6 years
    
    $
    18.27
    
    
    $
    136,189,037
    
    
    
    2,597,438
    
    
    $
    13.42
    
    
    $
    97,912,907
   WeightedRestricted
    
    
    AverageStock
    
    
    Intrinsic ValueNon-Vested Balance, December 31, 2005
    
    
    
    
    
    $
    Granted
    
    
    85,500
    
    
    
    39.45Vested
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Non-Vested Balance, September 30, 2006
    
    
    85,500
    
    
    $
    39.45
 11




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 Employee Stock Purchase Plan
  Inducement Equity Incentive Plan
  Expense Information under SFAS 123(R)
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Costs and expensesDirect cost of services
    
    $
    197
    
    
    $
    
    
    
    $
    629
    
    
    $
    Network and infrastructure
    
    
    78
    
    
    
    
    
    
    
    248
    
    
    
    Sales and marketing
    
    
    1,268
    
    
    
    
    
    
    
    3,880
    
    
    
    Product research and development
    
    
    556
    
    
    
    
    
    
    
    1,732
    
    
    
    General and administrative
    
    
    1,357
    
    
    
    
    
    
    
    3,899
    
    
    
    Stock-based compensation included in costs and expenses
    
    
    3,456
    
    
    
    
    
    
    
    10,388
    
    
    
    Tax benefit
    
    
    (1,286
    )
    
    
    
    
    
    
    (3,864
    )
    
    
    Stock-based compensation expense, net of tax
    
    $
    2,170
    
    
    $
    
    
    
    $
    6,524
    
    
    $
    
  12




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##### Table of Contents



DIGITAL RIVER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Pro forma
    
    
    
    
    
    
    Pro forma2006
    
    
    2005
    
    
    2006
    
    
    2005Net income, as reported for prior periods (1)
    
    
    N/A
    
    
    $
    12,358
    
    
    
    N/A
    
    
    $
    36,621Stock-based compensation expense
    
    $
    (3,456
    )
    
    
    (3,347
    )
    
    $
    (10,388
    )
    
    
    (6,581
    )Tax benefit (2)
    
    
    1,286
    
    
    
    
    
    
    
    3,864
    
    
    
    Stock-based compensation expense, net of tax (3)
    
    
    (2,170
    )
    
    
    (3,347
    )
    
    
    (6,524
    )
    
    
    (6,581
    )Net income, including the effect of stock-based compensation expense (4)
    
    $
    14,788
    
    
    
    9,011
    
    
    $
    44,454
    
    
    
    30,040Basic net income per share  as reported for prior periods (1)
    
    
    N/A
    
    
    $
    0.30
    
    
    
    N/A
    
    
    $
    0.71Diluted net income per share  as reported for prior periods (1)
    
    
    N/A
    
    
    $
    0.26
    
    
    
    N/A
    
    
    $
    0.61Basic net income per share, including the effect of stock-based compensation expense (4)
    
    $
    0.37
    
    
    $
    0.20
    
    
    $
    1.17
    
    
    $
    0.52Diluted net income per share, including the effect of stock-based compensation expense (4)
    
    $
    0.33
    
    
    $
    0.18
    
    
    $
    1.04
    
    
    $
    0.45
 
 (1)
    
    Net income and net income per share prior to 2006 did not include stock-based compensation expense under SFAS 123 because we did not adopt the recognition provisions of SFAS 123.(2)
    
    No tax benefit was recorded prior to the removal of the valuation allowance on certain deferred tax assets in the fourth quarter of 2005.(3)
    
    Stock-based compensation expense prior to 2006 is calculated based on the pro forma application of SFAS 123.(4)
    
    Net income and net income per share prior to 2006 represents pro forma information based on SFAS 123. Valuation Information under SFAS 123(R)
  Nine Months EndedSeptember 30,2006
    
    2005Risk-free interest rate
    
    
    4.7
    %
    
    
    4.0
    %Expected life (years)
    
    
    4.2
    
    
    
    4.0Volatility factor
    
    
    0.60
    
    
    
    0.93Expected dividends
    
    
    
    
    
    
    
    13




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




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 The discussion in this Quarterly Report contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from those discussed below. Additional
factors that could cause or contribute to such differences include, but are not limited to, those
identified below, and those discussed in the section entitled Risk Factors, included in Item 1A
of Part II of this Quarterly Report. When used in this document, the words believes, expects,
anticipates, intends, plans, and similar expressions, are intended to identify certain of
these forward-looking statements. However, these words are not the exclusive means of identifying
such statements. In addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking statements. The cautionary
statements made in this document should be read as being applicable to all related forward-looking
statements wherever they appear in this document.
 Overview
      Critical Accounting Policies
   15




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##### Table of Contents



Results of Operations
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of Revenue (exclusive of depreciation
and amortization expense shown
separately below):Direct cost of services
    
    
    2.5
    
    
    
    2.0
    
    
    
    2.5
    
    
    
    2.2Network and infrastructure
    
    
    10.3
    
    
    
    9.4
    
    
    
    9.6
    
    
    
    8.9Sales and marketing
    
    
    37.8
    
    
    
    31.4
    
    
    
    37.0
    
    
    
    30.7Product research and development
    
    
    11.1
    
    
    
    9.8
    
    
    
    10.4
    
    
    
    9.3General and administrative
    
    
    10.7
    
    
    
    10.0
    
    
    
    10.9
    
    
    
    10.3Depreciation and amortization
    
    
    3.9
    
    
    
    4.3
    
    
    
    3.4
    
    
    
    4.3Amortization of acquisition-related costs
    
    
    4.4
    
    
    
    3.9
    
    
    
    4.1
    
    
    
    4.2Total costs and expenses
    
    
    80.7
    
    
    
    70.8
    
    
    
    77.9
    
    
    
    69.9Income from operations
    
    
    19.3
    
    
    
    29.2
    
    
    
    22.1
    
    
    
    30.1Other income/(expense), net
    
    
    7.7
    
    
    
    2.9
    
    
    
    6.7
    
    
    
    2.3Income before income tax expense
    
    
    27.0
    
    
    
    32.1
    
    
    
    28.8
    
    
    
    32.4Income tax expense
    
    
    7.4
    
    
    
    8.9
    
    
    
    9.0
    
    
    
    9.3Net income
    
    
    19.6
    %
    
    
    23.2
    %
    
    
    19.8
    %
    
    
    23.1
    %
 16




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##### Table of Contents



REVENUE.
  DIRECT COST OF SERVICES.
 NETWORK AND INFRASTRUCTURE.
 SALES AND MARKETING.
 17




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PRODUCT RESEARCH AND DEVELOPMENT.
 GENERAL AND ADMINISTRATIVE.
 AMORTIZATION OF ACQUISITION-RELATED INTANGIBLES.
 OTHER INCOME, NET.
 18




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INCOME TAXES.
      Off Balance Sheet Arrangements
  19




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##### Table of Contents



Liquidity and Capital Resources
      Payment due by period (in thousands)Total Amount
    
    Oct-Dec
    
    
    
    
    
    
    
    
    
    2011 andContractual Obligations
    
    Committed
    
    2006
    
    2007-2008
    
    2009-2010
    
    ThereafterOperating Lease Obligations
    
    $
    7,300
    
    
    $
    907
    
    
    $
    5,174
    
    
    $
    1,219
    
    
    $
    0Convertible Senior Notes
    
    $
    237,656
    
    
    $
    0
    
    
    $
    4,875
    
    
    $
    4,875
    
    
    $
    227,906Total
    
    $
    244,956
    
    
    $
    907
    
    
    $
    10,049
    
    
    $
    6,094
    
    
    $
    227,906
  20




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21




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Item 3. Qualitative and Quantitative Disclosure About Market Risk
 Interest Rate Risk
   Foreign Currency Risk
  Transaction Exposure
  Translation Exposure
  22




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##### Table of Contents



Item 4. Controls and Procedures
 (a)
    
    Our management, under the supervision and with the participation of our Chief Executive
Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the
design and operation of our disclosure controls and procedures as of September 30, 2006. Based
upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded
that our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e)
promulgated under the Securities Exchange Act of 1934) were effective in providing reasonable
assurance that material information required to be disclosed by us in this Form 10-Q was
recorded, processed, summarized and reported in a timely manner.
 (b)
    
    During the quarter ended September 30, 2006, there was no change in our internal control over
financial reporting that materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting.
 Limitations on the Effectiveness of Controls
  23




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##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
      
 Item 1A. Risk Factors
 The risks described below are not the only ones facing our company. Additional risks not presently
known to us or that we currently deem immaterial also may impair our business operations. Our
business ,financial condition or results of operations could be materially adversely affected by
any of these risks and the value of our common stock could decline due to any of these risks. This
quarterly report also contains forward-looking statements that involve risks and uncertainties. Our
actual results could differ materially from those anticipated in these forward-looking statements
as a result of certain factors, including the risks faced by us described below and elsewhere in
this report.
 A loss of any client that accounts for a large portion of our revenue would cause our revenue to
decline.
  24




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##### Table of Contents



We have a limited profitable operating history.
  Failure to properly manage and sustain our expansion efforts could strain our management and other
resources.
  We intend to continue to expand our international operations and these efforts may not be
successful in generating additional revenue.
  §
    
    Changes in regulatory requirements and tariffs;§
    
    Uncertainty of application of local commercial, tax, privacy and other laws and regulations;§
    
    Reduced protection of intellectual property rights;§
    
    Difficulties in physical distribution for international sales;§
    
    Higher incidences of credit card fraud and difficulties in accounts receivable collection;§
    
    The burden and cost of complying with a variety of foreign laws;§
    
    The possibility of unionization of our workforce outside the United States, particularly in Europe; and§
    
    Political or economic constraints on international trade or instability.
   25




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##### Table of Contents



Our operating results are subject to fluctuations in demand for products and services offered by us
or our clients.
  New obligations to collect or pay transaction taxes could substantially increase the cost to us of
doing business.
  We could be liable for fraudulent, improper or illegal uses of our platforms.
  Loss of our credit card acceptance privileges would seriously hamper our ability to process the
sale of merchandise.
  26




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##### Table of Contents



Our failure to attract and retain software and digital products publishers, manufacturers, online
retailers and online channel partners as clients would cause our revenue and operating profits to
decline.
  Implementing our acquisition strategy could result in dilution and operating difficulties leading
to a decline in revenue and operating profit.
  We may need to raise additional capital to achieve our business objectives, which could result in
dilution to existing investors or increase our debt obligations.
  Our operating results have fluctuated in the past and are likely to continue to do so, which could
cause the price of our common stock to be volatile.
  27




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##### Table of Contents



§
    
    The addition of new clients or loss of current clients;§
    
    The introduction by us of new websites, web stores or services that may require a substantial
investment of our resources;§
    
    The introduction by others of competitive websites, web stores or services or products;§
    
    Our ability to continue to upgrade and develop our systems and infrastructure to meet emerging
market needs and remain competitive in our service offerings;§
    
    Economic conditions, particularly those affecting e-commerce;§
    
    Client decisions to delay new product launches or to invest in e-commerce initiatives;§
    
    The performance of our newly acquired assets or companies;§
    
    Slower than anticipated growth of the online market as a vehicle for the purchase of software
products;§
    
    The cost of compliance with U.S. and foreign regulations relating to our business; and§
    
    Our ability to retain and attract personnel commensurate with our business needs.
   Security breaches could hinder our ability to securely transmit confidential information.
   Claims of infringement of other parties intellectual property rights could require us to expend
significant resources, enter into unfavorable licenses or require us to change our business plans.
  28




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##### Table of Contents



Claims against us related to the software products that we deliver electronically and the tangible
goods that we deliver physically could require us to expend significant resources.
  The growth of the market for our services depends on the development and maintenance of the
Internet infrastructure.
  Because the e-commerce industry is highly competitive and has low barriers to entry, we may be
unable to compete effectively.
  §
    
    In-house development of e-commerce capabilities using tools or applications from
companies, such as Art Technology Group, Inc. and IBM Corporation;§
    
    E-Commerce capabilities custom-developed by companies, such as IBM Global Services and
Accenture, Inc.;§
    
    Other providers of outsourced e-commerce solutions, such as GSI Commerce, Inc.,
Macrovision Corporation, and asknet Inc.;§
    
    Companies that provide technologies, services or products that support a portion of the
e-commerce process, such as payment processing, including CyberSource Corporation and
PayPal Corp.;§
    
    Companies that offer various online marketing services, technologies and products,
including ValueClick, Inc. and aQuantive, Inc.;§
    
    High-traffic, branded websites that generate a substantial portion of their revenue from
e-commerce and may offer or provide to others the means to offer their products for sale,
such as Amazon.com, Inc.; and§
    
    Web hosting, web services and infrastructure companies that offer portions of our
solution and are seeking to expand the range of their offering, such as Network Solutions,
LLC, Akamai Technologies, Inc., Yahoo! Inc., eBay Inc. and Hostopia.com Inc.
  29




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##### Table of Contents



Changes in government regulation could limit our Internet activities or result in additional costs
of doing business over the Internet.
  §
    
    User privacy with respect to adults and minors;§
    
    Our ability to collect and/or share necessary information that allows us to conduct
business on the Internet;§
    
    Export compliance;§
    
    Pricing and taxation;§
    
    Fraud;§
    
    Advertising;§
    
    Intellectual property rights;§
    
    Information security; and§
    
    Quality of products and services.
  Failure to develop our technology to accommodate increased traffic could reduce demand for our
services and impair the growth of our business.
  30




---



##### Table of Contents



System failures could reduce the attractiveness of our service offerings.
   §
    
    Fire, flood and other natural disasters;§
    
    Operator negligence, improper operation by, or supervision of, employees, physical and
electronic break-ins, misappropriation, computer viruses and similar events; and§
    
    Power loss, computer systems failures, and Internet and telecommunications failure.
  We may become liable to clients who are dissatisfied with our services.
  We depend on key personnel.
   31




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##### Table of Contents



Protecting our intellectual property is critical to our success.
   Our clients sales cycles are lengthy, which may cause us to incur substantial expenses and expend
management time without generating corresponding consumer revenue, which would impair our cash
flow.
  The listing of our network addresses on anti-SPAM lists could harm our ability to service our
clients and deliver goods over the Internet.
  We are subject to regulations relating to consumer privacy.
  32




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##### Table of Contents



Compliance with future laws imposed on e-commerce may substantially increase our costs of doing
business or otherwise adversely affect our ability to offer our services.
    We are exposed to foreign currency exchange risk.
  33




---



##### Table of Contents



Changes in our tax rates could affect our future results.
  Developments in accounting standards may cause us to increase our recorded expenses, which in turn
would jeopardize our ability to demonstrate sustained profitability.
  Compliance with changing regulation of corporate governance and public disclosure may result in
additional expenses.
  Internet-related stock prices are especially volatile and this volatility may depress our stock
price or cause it to fluctuate significantly.
  §
    
    Actual or anticipated variations in quarterly operating results;§
    
    Announcements of technological innovations;§
    
    The ability to sign new clients and the retention of existing clients;§
    
    New products or services that we offer;§
    
    Competitive developments, including new products or services, or new relationships by our competitors;§
    
    Changes that affect our clients or the viability of their product lines;§
    
    Changes in financial estimates by securities analysts;§
    
    Conditions or trends in the Internet and online commerce industries;§
    
    Global unrest and terrorist activities;§
    
    Changes in the economic performance and/or market valuations of other Internet or online
e-commerce companies;§
    
    Required changes in generally accepted accounting principles and disclosures;§
    
    Our announcement of significant acquisitions, strategic partnerships, joint ventures or
capital commitments or results of operations or other developments related to those
acquisitions;§
    
    Additions or departures of key personnel; and
 34




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##### Table of Contents



§
    
    Sales or other transactions involving our common stock or our convertible notes.
  Provisions of our charter documents, other agreements and Delaware law may inhibit potential
acquisition bids for us.
  35




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##### Table of Contents



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
   Total number of
    
    Approximate dollar valueTotal number
    
    
    
    
    
    shares purchased as
    
    of shares that may yet beof shares
    
    Average price paid
    
    part of publicly
    
    purchased under the planPeriod
    
    purchased
    
    per share
    
    announced plan
    
    (in millions)July 1, 2006 - July 31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6August 1, 2006 - August 31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6September 1, 2006 - September 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36.6Total
    
    
    
    
    
    
    
    
    
    
    
 36




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##### Table of Contents



Item 6. Exhibits
  EXHIBITNUMBER
    
    DESCRIPTION OF DOCUMENTS3.1
    (1)
    
    Amended and Restated Certificate of Incorporation, as amended, as currently in effect.3.2
    (2)
    
    Amended and Restated Bylaws, as currently in effect.4.1
    (3)
    
    Specimen of Common Stock Certificate.4.2
    (1)
    
    Form of Senior Debt Indenture.4.3
    (1)
    
    Form of Subordinated Debt Indenture.4.4
    
    
    References are made to Exhibits 3.1 and 3.2.4.5
    (4)
    
    Indenture dated as of June 1, 2004 between Digital River, Inc. and Wells Fargo Bank, N.A.
as trustee, including therein the form of the Note.12.1
    
    
    Computation of Ratio of Earnings to Fixed Charges.31.1
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Filed as exhibits 3.1 and 3.3 and exhibits 4.5 and 4.6
to our Registration Statement on Form S-3, File No.
333-81626, filed on January 29, 2002, declared effective on
February 12, 2002, and incorporated herein by reference.(2)
    
    Filed as an exhibit to our Annual Report on Form 10-K
for the year ended December 31, 2000, filed on March 27,
2001, and incorporated herein by reference.(3)
    
    Filed as an exhibit to our Registration Statement on
Form S-1, File No. 333-56787, declared effective on August
11, 1998, and incorporated herein by reference.(4)
    
    Filed as exhibit 99.1 to our Current Report on Form 8-K,
filed on July 13, 2004 and incorporated herein by reference. 37




---



##### Table of Contents



Date: November 9, 2006
    DIGITAL RIVER, INC.By:
    /s/ THOMAS M. DONNELLYThomas M. Donnelly     Chief Financial Officer  
(Principal Financial and Accounting Officer) 38




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##### Table of Contents



EXHIBITNUMBER
    
    DESCRIPTION OF DOCUMENTS3.1
    (1)
    
    Amended and Restated Certificate of Incorporation, as amended, as currently in effect.3.2
    (2)
    
    Amended and Restated Bylaws, as currently in effect.4.1
    (3)
    
    Specimen of Common Stock Certificate.4.2
    (1)
    
    Form of Senior Debt Indenture.4.3
    (1)
    
    Form of Subordinated Debt Indenture.4.4
    
    
    References are made to Exhibits 3.1 and 3.2.4.5
    (4)
    
    Indenture dated as of June 1, 2004 between Digital River, Inc. and Wells Fargo Bank, N.A.
as trustee, including therein the form of the Note.12.1
    
    
    Computation of Ratio of Earnings to Fixed Charges.31.1
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Filed as Exhibits 3.1 and 3.3 and Exhibits 4.5 and 4.6
to our Registration Statement on Form S-3, File No.
333-81626, filed on January 29, 2002, declared effective on
February 12, 2002, and incorporated herein by reference.(2)
    
    Filed as an exhibit to our Annual Report on Form 10-K
for the year ended December 31, 2000, filed on March 27,
2001, and incorporated herein by reference.(3)
    
    Filed as an exhibit to our Registration Statement on
Form S-1, File No. 333-56787, declared effective on August
11, 1998, and incorporated herein by reference.(4)
    
    Filed as exhibit 99.1 to our Current Report on Form 8-K,
filed on July 13, 2004 and incorporated herein by reference. 39