**SECURITIES AND 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 JUNE 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.**

(Exactname of registrant as specified in its charter)

 

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

 

**9625 WEST 76TH STREET, SUITE 150**

**EDEN PRAIRIE, MINNESOTA 55344**

(Addressof principal executive offices)

 

**(952) 253-1234**

(Registrant’stelephone number, including area code)

 

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ýNo o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2) Yes ýNo o

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practical date.

 

| **COMMON STOCK, $0.01 PAR VALUE** | ** ** | **32,428,842 SHARES**            |
|-----------------------------------|------------|----------------------------------|
| (Class)                           |       | Outstanding  as of July 31, 2004 |

 

 

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DIGITALRIVER, INC.

 Form10-Q

Index

 
| PART I.       | FINANCIAL INFORMATION                                                                                       |   |
|---------------|-------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                        |   |
| Item 1.       | Financial Statements                                                                                        |   |
|          |                                                                                                        |   |
|          | Condensed  Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003                            |   |
|          |                                                                                                        |   |
|          | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2004 and 2003 |   |
|          |                                                                                                        |   |
|          | Condensed  Consolidated Statements of Cash Flows for the six months ended June 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.      | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                           |   |
|          |                                                                                                        |   |
| Item 4.       | Submission of  Matters to a Vote of Security Holders                                                        |   |
|          |                                                                                                        |   |
| Item 6.       | Exhibits and Reports  on Form 8-K                                                                           |   |
|          |                                                                                                        |
| SIGNATURES    |                                                                                                        |
|          |                                                                                                        |
| EXHIBIT INDEX |                                                                                                        |

 

2

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

 

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

 

**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 
| ** **                                                                                                           | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                           | ** ** | **(unaudited)**    | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                           |       |               |       |                   |       |
| CURRENT ASSETS:                                                                                                      |       |               |       |                   |       |
| Cash and cash equivalents                                                                                            |       | $                  | 176,180    |                   | $          | 101,878 |   |
| Short-term investments                                                                                               |       | 29,207             |       | 30,044                 |       |
| Accounts receivable, net of allowance of $693 and $319                                                               |       | 13,770             |       | 9,306                  |       |
| Prepaid expenses and other                                                                                           |       | 1,877              |       | 1,589                  |       |
| Total current assets                                                                                                 |       | 221,034            |       | 142,817                |       |
|                                                                                                                 |       |               |       |                   |       |
| PROPERTY AND EQUIPMENT:                                                                                              |       |               |       |                   |       |
| Property and equipment                                                                                               |       | 40,264             |       | 32,433                 |       |
| Less accumulated depreciation                                                                                        |       | (23,340            | )          | (17,799                | )          |
| Net property and equipment                                                                                           |       | 16,924             |       | 14,634                 |       |
| GOODWILL                                                                                                             |       | 140,260            |       | 23,921                 |       |
| INTANGIBLE ASSETS, net of accumulated amortization of $23,822 and  $19,976                                           |       | 20,097             |       | 8,172                  |       |
| OTHER ASSETS                                                                                                         |       | 5,918              |       | 114                    |       |
|                                                                                                                 |       | $                  | 404,233    |                   | $          | 189,658 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                       |       |               |       |                   |       |
| CURRENT LIABILITIES:                                                                                                 |       |               |       |                   |       |
| Accounts payable                                                                                                     |       | $                  | 56,299     |                   | $          | 41,814 |   |
| Accrued payroll                                                                                                      |       | 2,636              |       | 2,825                  |       |
| Deferred revenue                                                                                                     |       | 4,047              |       | 3,572                  |       |
| Other accrued liabilities                                                                                            |       | 11,672             |       | 9,595                  |       |
| Total current liabilities                                                                                            |       | 74,654             |       | 57,806                 |       |
|                                                                                                                 |       |               |       |                   |       |
| NON-CURRENT LIABILITIES:                                                                                             |       |               |       |                   |       |
| Convertible senior notes                                                                                             |       | 175,000            |       | —                 |       |
| Total non-current liabilities                                                                                        |       | 175,000            |       | —                 |       |
|                                                                                                                 |       |               |       |                   |       |
| 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;  32,394,116 and 31,497,719 shares issued and outstanding |       | 324                |       | 315                    |       |
| Additional paid-in capital                                                                                           |       | 226,405            |       | 217,981                |       |
| Accumulated deficit                                                                                                  |       | (72,118            | )          | (86,488                | )          |
| Accumulated other comprehensive income (loss)                                                                        |       | (32                | )          | 44                     |       |
| Total stockholders’ equity                                                                                      |       | 154,579            |       | 131,852                |       |
|                                                                                                                 |       | $                  | 404,233    |                   | $          | 189,658 |   |

 

See accompanying notes to condensed consolidated financialstatements.

 

3

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**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OFOPERATIONS

(in thousands, except per share data; unaudited)

 
| ** **                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                       |       |                             |       |                           |       |   |   |   |   |
| REVENUE                                    |       | $                                | 34,877     |                           | $          | 22,764 |   | $ | 66,732 |   | $ | 47,364 |   |
| COST OF REVENUE:                           |       |                             |       |                           |       |   |   |   |   |
| Direct cost of services                    |       | 1,449                            |       | 939                            |       | 2,067 |   | 1,881 |   |
| Network and infrastructure                 |       | 3,506                            |       | 2,857                          |       | 6,806 |   | 5,803 |   |
| GROSS MARGIN                               |       | 29,922                           |       | 18,968                         |       | 57,859 |   | 39,680 |   |
|                                       |       |                             |       |                           |       |   |   |   |   |
| OPERATING EXPENSES:                        |       |                             |       |                           |       |   |   |   |   |
| Sales and Marketing                        |       | 11,407                           |       | 8,978                          |       | 22,875 |   | 18,250 |   |
| Product Research and Development           |       | 3,645                            |       | 2,594                          |       | 6,569 |   | 4,982 |   |
| General and administrative                 |       | 3,856                            |       | 1,978                          |       | 6,693 |   | 4,269 |   |
| Depreciation and amortization              |       | 1,859                            |       | 1,652                          |       | 3,470 |   | 3,240 |   |
| Amortization of acquisition related costs  |       | 2,267                            |       | 1,246                          |       | 3,846 |   | 2,467 |   |
|                                       |       |                             |       |                           |       |   |   |   |   |
| Total operating expenses                   |       | 23,034                           |       | 16,448                         |       | 43,453 |   | 33,208 |   |
|                                       |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM OPERATIONS                     |       | 6,888                            |       | 2,520                          |       | 14,406 |   | 6,472 |   |
| OTHER INCOME/(EXPENSE), NET                |       | (132                             | )          | 247                            |       | (35 | ) | 317 |   |
| NET INCOME                                 |       | $                                | 6,756      |                           | $          | 2,767 |   | $ | 14,371 |   | $ | 6,789 |   |
|                                       |       |                             |       |                           |       |   |   |   |   |
| NET INCOME PER SHARE                       |       |                             |       |                           |       |   |   |   |   |
| BASIC                                      |       | $                                | 0.21       |                           | $          | 0.10 |   | $ | 0.45 |   | $ | 0.24 |   |
| DILUTED                                    |       | $                                | 0.19       |                           | $          | 0.09 |   | $ | 0.40 |   | $ | 0.22 |   |
|                                       |       |                             |       |                           |       |   |   |   |   |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING |       |                             |       |                           |       |   |   |   |   |
| BASIC                                      |       | 32,064                           |       | 28,195                         |       | 31,842 |   | 27,903 |   |
| DILUTED                                    |       | 35,981                           |       | 31,790                         |       | 35,515 |   | 31,101 |   |

 

See accompanying notes to condensed consolidated financialstatements.

 

4

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**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| OPERATING ACTIVITES:                                                               |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 14,371     |   | $ | 6,789 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                           |       |   |   |
| Amortization of acquisition related costs                                          |       | 3,846                          |       | 2,467 |   |
| Change in accounts receivable allowance                                            |       | 175                            |       | 1,074 |   |
| Depreciation and amortization                                                      |       | 3,453                          |       | 3,240 |   |
| Change in operating assets and liabilities:                                        |       |                           |       |   |   |
| Accounts receivable                                                                |       | (1,026                         | )          | 2,320 |   |
| Prepaid and other assets                                                           |       | 587                            |       | 69 |   |
| Accounts payable                                                                   |       | 4,934                          |       | (266 | ) |
| Deferred revenue                                                                   |       | 41                             |       | 179 |   |
| Accrued payroll and other accrued liabilities                                      |       | (1,423                         | )          | 1,664 |   |
| Net cash provided by operating activities                                          |       | 24,958                         |       | 17,536 |   |
|                                                                               |       |                           |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                           |       |   |   |
| Purchases of investments                                                           |       | (44,207                        | )          | — |   |
| Sales of investments                                                               |       | 44,982                         |       | — |   |
| Cash paid for acquisitions, net of cash received                                   |       | (124,714                       | )          | (2,442 | ) |
| Purchases of equipment                                                             |       | (4,409                         | )          | (3,127 | ) |
| Net cash used in investing activities                                              |       | (128,348                       | )          | (5,569 | ) |
|                                                                               |       |                           |       |   |   |
| 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           |       | 169,201                        |       | — |   |
| Exercise of stock options and warrants                                             |       | 8,007                          |       | 4,327 |   |
| Sales of common stock under employee stock purchase plan                           |       | 427                            |       | 800 |   |
| Net cash provided by financing activities                                          |       | 177,635                        |       | 5,127 |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH                                            |       | 57                             |       | — |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                          |       | 74,302                         |       | 17,094 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                     |       | 101,878                        |       | 40,801 |   |
| CASH AND CASH EQUIVALENTS, end of period                                           |       | $                              | 176,180    |   | $ | 57,895 |   |
| NONCASH INVESTING AND FINANCING ACTIVITIES:                                        |       |                           |       |   |   |
| Common stock issued in acquisitions and earn-outs                                  |       | $                              | —     |   | $ | 1,025 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

5

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**DIGITAL RIVER, INC.**

# **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Amountsin thousands, except per share data)

 

**1. BASIS OF PRESENTATION**

 

Theunaudited condensed consolidated financial statements included herein reflectall 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 operations for the three andsix months ended June 30, 2004 are not necessarily indicative of the results tobe expected for any subsequent quarter or for the entire fiscal year endingDecember 31, 2004.  The December 31, 2003 balance sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States.

 

*Summary of Significant AccountingPolicies.*  A detailed description of our significantaccounting policies can be found in our most recent Annual Report filed on Form10-K for the fiscal year ended December 31, 2003.

 

***ForeignCurrency Translation***

 

Thefinancial position and results of operations of certain foreign subsidiariesare measured using local currency as the functional currency.  Assets and liabilities are translated totheir U.S. dollar equivalents at rates in effect at the respective balancesheet dates and statements of operations are translated using average exchangerates for the fiscal period.  Theresulting translation adjustments are recorded as a component of stockholders’equity.

 

***Research andDevelopment and Software Development***

 

Researchand development expenses consist primarily of development personnel andexternal contractor costs related to the development of new products andservices, enhancement of existing products and services, quality assurance andtesting.  We follow AICPA Statement ofPosition No. 98-1, “Accounting for the Costs of Computer Software Developed orObtained for Internal Use,” in accounting for internally developedsoftware.  Prior to the second quarter of2004, capitalized software development costs were immaterial.  During the second quarter of 2004, we expanded andredeployed our R&D team to advance our new self-service, remote-controltechnology, as well as develop the international and e-marketing capabilitieson our next-generation e-commerce platform and, consistent with SOP 98-1,capitalized approximately $0.9 million of software development costs related tothose efforts.

 

**2. NET INCOME PER SHARE**

 

The table below setsforth the computation of basic and diluted net income per share:

 

 
| ** **                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                         | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                         |       |                             |       |                           |       |   |   |   |   |
| Net income                                         |       | $                                | 6,756      |                           | $          | 2,767 |   | $ | 14,371 |   | $ | 6,789 |   |
|                                               |       |                             |       |                           |       |   |   |   |   |
| Denominator:                                       |       |                             |       |                           |       |   |   |   |   |
| Basic — weighted average shares outstanding   |       | 32,064                           |       | 28,195                         |       | 31,842 |   | 27,903 |   |
| Effect of dilutive securities:                     |       |                             |       |                           |       |   |   |   |   |
| Employee stock options and warrants                |       | 3,917                            |       | 3,595                          |       | 3,673 |   | 3,198 |   |
| Diluted — weighted average shares outstanding |       | 35,981                           |       | 31,790                         |       | 35,515 |   | 31,101 |   |
|                                               |       |                             |       |                           |       |   |   |   |   |
| Basic — net income per share                  |       | $                                | 0.21       |                           | $          | 0.10 |   | $ | 0.45 |   | $ | 0.24 |   |
|                                               |       |                             |       |                           |       |   |   |   |   |
| Diluted — net income per share                |       | $                                | 0.19       |                           | $          | 0.09 |   | $ | 0.40 |   | $ | 0.22 |   |

 

6

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In the periodspresented, we did not include the potentially dilutive effect of the assumedconversion of the $175 million in principal of 1.25% convertible senior notesin the computation of dilutive earnings per share for the three and six monthperiods ended June 30, 2004, because the conditions for conversion had not beenmet. The notes are contingently convertible into approximately 4.0 millionshares of common stock at an initial conversion price of $44.063 per share.

 

**3. GOODWILL AND INTANGIBLE ASSETS**

 

We account for our goodwill in accordancewith SFAS No. 142, “Goodwill and Other Intangible Asset.”  SFAS No. 142 precludes the amortization ofgoodwill and intangible assets with indefinite lives, but these assets arereviewed annually (or more frequently if impairment indicators arise) forimpairment.

 

We complete our annual impairment test, inthe fourth quarter of each fiscal year, using a two-step approach and reassessany intangible assets, including goodwill, recorded in connection with earlier acquisitions.

 

Informationregarding our other intangible assets is as follows:

 
| ** **             | ** ** | **As of June 30, 2004**    | ** ** |
|------------------------|------------|----------------------------|------------|
| ** **             | ** ** | **Carrying Amount  Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **             | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer relationships |       | $                          | 16,488     |   | $ | 13,271 |   | $ | 3,217 |   |
| Non-compete agreements |       | 4,100                      |       | 3,312 |   | 788 |   |
| Technology/tradename   |       | 23,331                     |       | 7,239 |   | 16,092 |   |
| Total                  |       | $                          | 43,919     |   | $ | 23,822 |   | $ | 20,097 |   |

 
| ** **             | ** ** | **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 |   |

 

Amortizationexpense for the three months ended June 30, 2004 and 2003 was $2,267 and$1,246, respectively and $3,846 and $2,467 for the six months ended June 30,2004 and 2003, respectively.  Estimated amortization expense for theremaining life of the intangible assets, based on intangible assets as of June30, 2004, is as follows:

 

| **Year** | ** ** | ** ** | ** ** |
|----------|------------|------------|------------|
| 2004     |       | $          | 4,685      |   |
| 2005     |       | 7,421      |       |
| 2006     |       | 6,339      |       |
| 2007     |       | 1,652      |       |
| Total    |       | $          | 20,097     |   |

 

7

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**4. STOCK BASED COMPENSATION**

 

At June 30,2004, we had two stock-based employee compensation plans, which are describedmore fully in our 2003 Annual Report Note 7. We account for these plans under the recognition and measurementprinciples of Accounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations.  No stock-based employee compensation cost isreflected in net income, as all options granted under these plans had anexercise price equal to the market value of the underlying common stock on thedate of the grant.

 

We have elected to apply the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” asamended by SFAS No. 148. Accordingly, we account for stock-based compensationusing the intrinsic value method prescribed in APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations.Compensation cost for stock options is measured as the excess, if any, of thefair value of our common stock at the date of grant over the stock optionexercise price.

 

The following table illustrates the effect onnet income and net income per share if we had applied the fair valuerecognition provision of Financial Accounting Standards Board Statement No.123, “Accounting for Stock-Based Compensation,” to stock-based employeecompensation.

 
| ** **                                                                                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as reported                                                                         |       | $                               | 6,756      |                          | $          | 2,767 |   | $ | 14,371 |   | $ | 6,789 |   |
| Deduct: Total stock-based compensation determined under fair value  based method for all awards |       | (7,511                          | )          | (2,943                        | )          | (13,540 | ) | (5,705 | ) |
| Adjusted net income (loss), fair value method for all stock-based  awards                       |       | $                               | (755       | )                             | $          | (176 | ) | $ | 831 |   | $ | 1,084 |   |
|                                                                                            |       |                            |       |                          |       |   |   |   |   |
| Basic income per share — as reported                                                       |       | $                               | 0.21       |                          | $          | 0.10 |   | $ | 0.45 |   | $ | 0.24 |   |
| Diluted income per share — as reported                                                     |       | $                               | 0.19       |                          | $          | 0.09 |   | $ | 0.40 |   | $ | 0.22 |   |
|                                                                                            |       |                            |       |                          |       |   |   |   |   |
| Basic income (loss) per share – SFAS No. 123 adjusted                                      |       | $                               | (0.02      | )                             | $          | (0.01 | )  | $ | 0.03 |   | $ | 0.04 |   |
|                                                                                            |       |                            |       |                          |       |   |   |   |   |
| Diluted income (loss) per share – SFAS No. 123 adjusted                                    |       | $                               | (0.02      | )                             | $          | (0.01 | ) | $ | 0.02 |   | $ | 0.04 |   |

 

 

The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelusing the following weighted average assumptions:

 

| ** **              | ** ** | **Six Months Ended June 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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**5. ACQUISITIONS AND EARN-OUTARRANGEMENTS**

 

OnApril 19, 2004 we announced that we signed a definitive agreement to acquireelement 5 AG, a privately held company based in Germany.  Under the terms of the agreement, we paid$120 million in cash to acquire all of the outstanding shares of capital stockof element 5.  We also may pay up to anadditional $2.5 million in cash based on element 5’s operating performance overthe first 24 months subsequent to the acquisition.  Such earn-out amounts, if paid, will berecorded as goodwill as they are considered incremental to the purchase price.

 

In the second quarter of 2004,in connection with our acquisition of element 5, we began implementation of aplan intended to eliminate duplication of resources within the consolidatedcompany.  The plan includes theelimination of customer service positions at element 5’s Greenburg,Pennsylvania customer service center and the termination of the Greenburgfacility lease by the end of third quarter 2004.  As of June 30, 2004, we have included $0.9million towards the acquisition cost of element 5 related to this plan.

 

OnJune 1, 2004, we announced that we acquired substantially all of the assets andassumed certain liabilities of Fireclick, Inc., a leading provider ofWeb-analysis solutions for online retailers. Under the terms of the agreement, we paid $7.5 million in cash.  The agreement also provides Fireclick theopportunity for an earn-out based on our achieving certain revenue andprofitability targets attributable to Fireclick over the course of the threeyears following the closing of the acquisition. Such earn-out amounts, if paid, will be recorded as goodwill as they areconsidered incremental to the purchase price.

 

Duringthe six months ended June 30, 2003, we acquired certain assets and liabilitiesof Metatec International, Inc. and Hartsell Holdings, Inc., d/b/a/ InfoconAmerica Corporation.

 

TheCondensed Consolidated Financial Statements include the operating results ofeach business from the date of acquisition. The following unaudited pro forma condensed results of operations forthe three and six months ended June 30, 2004 and 2003 have been prepared as ifeach of the acquisitions from the six months ended June 30, 2004 and 2003 hadoccurred on January 1, 2003.

 
| ** **                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                   | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                         |       |                             |       |                           |       |   |   |   |   |
| Revenue                      |       | $                                | 37,159     |                           | $          | 26,888 |   | $ | 75,161 |   | 55,363 |   |
| Income from operations       |       | 5,662                            |       | 205                            |       | 12,510 |   | 1,814 |   |
| Net income                   |       | 5,477                            |       | 314                            |       | 12,103 |   | 1,860 |   |
|                         |       |                             |       |                           |       |   |   |   |   |
| Basic net income per share   |       | $                                | 0.17       |                           | $          | 0.01 |   | $ | 0.38 |   | $ | 0.07 |   |
| Diluted net income per share |       | $                                | 0.15       |                           | $          | 0.01 |   | $ | 0.34 |   | $ | 0.06 |   |

 

Thisfinancial information does not purport to represent results that would actuallyhave been obtained if the transactions had been completed on January 1, 2003 orany future results that may be realized.

 

**6. LONG-TERM DEBT**

 

OnApril 16, 2004, in connection with our acquisition of element 5, we established a $45 million securedrevolving credit facility with Harris Trust and Savings Bank.  This facility was repaid in full andterminated in connection with the sale and issuance of our convertible senior noteson June 1, 2004.

 

OnJune 1, 2004 we sold and issued $175 million in aggregate principal amount ofconvertible senior notes due January 1, 2024, in a private, unregisteredoffering. The notes were sold at 100 percent of their principal amount.  The initial purchasers exercised in fulltheir option to purchase up to an additional $20 million in aggregate principalamount of the notes on June 30, 2004, which purchase transaction closed on July6, 2004. 

 

Weare required to pay interest on January 1 and July 1 of each year beginningJanuary 1, 2005.  The notes bear interestat a rate of 1.25 percent and, if specified conditions are met, are convertibleinto Digital River common

 

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stockat a conversion price of $44.063 per share. The conversion price is subject to adjustments in certaincircumstances.  These conditions include the satisfactionof a market price condition, such that the price of our common stock reaches aspecified threshold; the satisfaction of a trading price condition, such thatthe trading price of the notes falls below a specified level; the redemption ofthe notes by us, in which event holders will have the option to convert theirnotes prior to redemption; the occurrence of specified corporate transactions,as defined in the related indenture; and the occurrence of a fundamentalchange, as defined in the related indenture. The initial conversion price is equivalent to aconversion rate of approximately 22.6948 shares per $1,000 of principal amountof 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. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeem thenotes, under certain circumstances, on or after July 1, 2007 and prior toJanuary 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

 

Aportion of the net proceeds of the offering was used to repay our seniorsecured revolving credit facility with Harris Trust and Savings Bank.  The balance will be used for generalcorporate purposes, including working capital, capital expenditures, potentialfuture acquisitions, investments, and the potential repurchase of shares of ourcommon stock.

 

**7. SUBSEQUENT EVENT**

 

Theinitial purchasers of our convertible senior notes due January 1, 2024exercised 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.

 

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*We note that, except for the historical informationcontained herein, the matters discussed below contain forward-lookingstatements that involve known and unknown risks, uncertainties and otherfactors that may cause our actual results, performance or achievements, orindustry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements.  We  expressly disclaimany obligation to update this information or publicly release any revision orreflect events or circumstances after the date of this report.  Suchfactors include, among others: our limited operating history andvariability of operating results, possibility of future losses, risksassociated with electronic software delivery, dependence on the Internet andgrowth in electronic commerce and Internet infrastructure development,dependence on software publishers, dependence on online retailers, systemdevelopment and electronic commerce security risks, rapid technological changes,competition in the electronic commerce industry, the importance of attractingand retaining personnel, management of our growth, integration of acquiredcompanies, dependence on key employees and other risk factors referenced in ourForm 10-K  for the year ended December31, 2003.*

 

**Overview**

 

Weare a provider of comprehensive electronic commerce outsourcing solutions. Wewere incorporated in February 1994 and commenced offering products forsale through our clients’ Web stores in August 1996. From inceptionthrough August 1996, we had no sales, and our activities related primarilyto the development of our proprietary technology platform, known as CNS. In1996, we began to focus our business development efforts on the softwareindustry, building our inventory of software products through contracts withsoftware publishers. In 1997, we began to develop software distributionrelationships through contracts with online retailers. As of June 30**,**2004, we had more than 23,000 softwarepublisher clients and online channel partners. In late 1998, we began to offerour comprehensive electronic commerce outsourcing services in the form of atransaction fee-based e-commerce service to clients outside of the softwareindustry. As of June 30, 2004, we were providing electronic commerce servicessuch as Web commerce development and hosting, transaction processing, fraudscreening, digital delivery, integration to physical fulfillment, merchandisingservices, analytical marketing and customer service to over 140 physical goodsclients, as well as operating nearly 12,000 small business physical goodssites.

 

Priorto January 1, 2004, we managed our physical goods clients through a division(formerly our E-Business Services Division) that was separate from our Softwareand Digital Commerce Services Division. Beginning January 1, 2004, this divisional structure was consolidated,and we announced that we will no longer report our activities as separatebusiness segments.  Nonetheless, weremain committed to serving existing and new clients in the important verticalmarket of physical goods.

 

Wehave approximately eight years of operating history upon which investors mayevaluate our business and prospects. Until 2003, we incurred significantoperating losses, and as of June 30, 2004, we had an accumulated deficit of$72.1 million. We intend to expend financial and management resources onthe development of additional services, sales and marketing, technology andoperations to support larger-scale operations and greater service offerings.Although we expect to generate positive cash flow from operations in 2004,there can be no assurance that our revenue will increase or even continue atits current level or that we will maintain profitability or generate cash fromoperations in future periods.

 

Ourprospects must be considered in light of the risks, expenses and difficultiesfrequently encountered by companies in new and rapidly evolving markets such aselectronic commerce. To address these risks, we must, among other things, attractand retain software publishers and online retailers as clients, attract andretain physical goods clients, introduce new Web sites, Web stores or services,continue to upgrade and develop our systems and infrastructure to meet emergingmarket needs and remain competitive in our service offerings, and retain andattract personnel commensurate with our business needs. There can be noassurance that we will be successful in addressing these risks, and any failureto do so could have a material adverse effect on our business, financialcondition and results of operations.

 

Ourcurrent and future expense levels are based largely on our planned operationsand estimates of future revenue. Revenue and operating results generally dependon the volume and timing of orders received, which are difficult to forecast.We may be unable to adjust spending in a timely manner to compensate for anyunexpected revenue shortfall. Accordingly, any significant shortfall in revenuecould have an immediate adverse effect on our business, financial condition andresults of operations. We are also likely to continue to see revenue fluctuateon a seasonal basis, which is typical for the software publishing market ingeneral and for our existing physical goods clients. We believe that our firstand fourth quarters tend to be seasonally stronger than our second and thirdquarters due to the

 

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timingof demand for tax preparation software and the holiday season selling period.In addition, we believe that software publishers avoid new product releases inthe summer months. In view of the rapidly evolving nature of our business, weare unable to accurately forecast our revenue and believe that period-to-periodcomparisons of our operating results are not necessarily meaningful and shouldnot be relied upon as an indication of future performance.

 

**Results of Operations**

 

Thefollowing table sets forth certain items from our condensed consolidatedstatements of operations as a percentage of total revenue for the periodsindicated.

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                   |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of Revenue:                          |       |                             |       |                           |       |   |   |   |   |
| Direct cost of services                   |       | 4.1                              |       | 4.1                            |       | 3.1 |   | 4.0 |   |
| Network and infrastructure                |       | 10.1                             |       | 12.6                           |       | 10.2 |   | 12.3 |   |
| Gross Margin                              |       | 85.8                             |       | 83.3                           |       | 86.7 |   | 83.7 |   |
| Operating Expenses:                       |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                       |       | 32.7                             |       | 39.4                           |       | 34.3 |   | 38.5 |   |
| Product research and development          |       | 10.5                             |       | 11.4                           |       | 9.8 |   | 10.5 |   |
| General and administrative                |       | 11.0                             |       | 8.7                            |       | 10.0 |   | 9.0 |   |
| Depreciation and amortization             |       | 5.3                              |       | 7.3                            |       | 5.2 |   | 6.8 |   |
| Amortization of acquisition related costs |       | 6.5                              |       | 5.4                            |       | 5.8 |   | 5.2 |   |
| Total operating expenses                  |       | 66.0                             |       | 72.2                           |       | 65.1 |   | 70.0 |   |
| Income from operations                    |       | 19.8                             |       | 11.1                           |       | 21.6 |   | 13.7 |   |
| Other income/(expense), net               |       | (0.4                             | )          | 1.1                            |       | — |   | 0.6 |   |
| Net income                                |       | 19.4                             | %          | 12.2                           | %          | 21.6 | % | 14.3 | % |

 

***REVENUE.***Revenue increased to $34.9 million for the three months ended June 30, 2004from $22.8 million for the same period in the prior year, an increase of $12.1million or 53.2%.  For the six months ended June 30, 2004 revenue totaled$66.7 million, an increase of $19.4 million or 40.9% from revenue of $47.4million recorded in the same period of the prior year.  The increase was primarily attributable tohigher online activity across our client base, growth in the number of softwarepublishers and online retailer clients, increased international sites, andaccretive acquisitions.

 

International salesrepresented approximately 31% and 24% of total revenue in the three-monthperiods ended June 30, 2004 and 2003, respectively, and approximately 29% and23% of total revenue for the six month period ended June 30, 2004 and 2003,respectively.  We expect that thispercentage will continue to increase.

 

***GROSS MARGIN.***Costof revenue, which consists of direct cost of services and network andinfrastructure costs (both shown in this paragraph and table above exclusive ofdepreciation and amortization expense), increased to $5.0 million and $8.9million, respectively, for the three and six months ended June 30, 2004 from$3.8 million and $7.7 million for the same periods in the prior year.  Thegross profit margin increased in the three months ended June 30, 2004 to 85.8%from 83.3% for the same period in the prior year, but decreased 191 basispoints sequentially from the first quarter of 2004’s profit margin of87.7%.  The higher margin in the firstquarter was driven by the network and infrastructure leverage we experiencedduring the higher virus and seasonal activity. For the six months ended June 30, 2004 gross profit margin increased to86.7% from 83.8% for the same period in the prior year.  The increase in gross margin was primarilydue to leveraging our infrastructure over significantly more revenue andclients.  We believe that electroniccommerce and related services are becoming more competitive.  Accordingly,we may have to reduce our pricing or alter our pricing structure and policiesin the future and any such change could reduce our gross margins.

 

***SALES AND MARKETING.***Sales and marketing expense consists primarily ofpersonnel and related expenses, advertising and promotional expenses, creditcard chargebacks and bad debt expense, and credit card transaction fees.

 

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Salesand marketing expense increased to $11.4 million and $22.9 million,respectively, for the three and six months ended June 30, 2004 from $9.0million and $18.3 million for the same periods in the prior year, an increaseof $2.4 million or 27.1% and $4.6 million or 25.3%, respectively.  Theincrease primarily resulted from credit card fees and chargeback costs directlyassociated with the increase in revenue and additional sales and marketingpersonnel and related expenses.  As a percentage of revenue, sales andmarketing expense were 32.7% and 34.3%, respectively, in the three and sixmonths ended June 30, 2004, compared to 39.4% and 38.5%, respectively, for thesame periods in the prior year, primarily reflecting our increasedrevenue.  We expect sales and marketing expenses to increase in absoluteterms and decline as a percentage of revenue over time.

 

***PRODUCT RESEARCH ANDDEVELOPMENT.*** Productresearch and development expense consists primarily of personnel and related expensesand consulting costs associated with developing and enhancing our CNS platformand related internal systems.  Productresearch and development expense increased to $3.6 million and $6.6 million,respectively, for the three and six months ended June 30, 2004 from $2.6million and $5.0 million for the same periods in the prior year, an increase of$1.0 million or 40.5%, and $1.6 million or 31.9%, respectively.   The increase was primarily driven byincreases in personnel-related expenses, partially offset by reductions inoutside consulting fees.  During thesecond quarter of 2004, we expanded and redeployed our R&D team to advanceour new self-service, remote-control technology, as well as the international ande-marketing capabilities on our next-generation e-commerce platform.  In accordance with GAAP, we capitalizedapproximately $0.9 million of software development costs related to theseefforts.  As a percentage of revenue,product research and development expense was 10.5% and 9.8% in the three andsix months ended June 30, 2004, compared to 11.4% and 10.5%, respectively, forthe same periods in the prior year.  We expect product research anddevelopment costs to increase in absolute dollars and range between 9 and 11percent of revenue on a quarterly basis.

 

***GENERAL AND ADMINISTRATIVE.***Generaland administrative expense consists primarily of executive, accounting andadministrative personnel and related expenses, including professional fees andinvestor relations expenses.  General and administrative expensesincreased to $3.9 million and $6.7 million, respectively, for the three and sixmonths ended June 30, 2004 from $2.0 million and $4.3 million for the sameperiods in the prior year, an increase of $1.9 million or 94.9%, and $2.4million or 56.8%, respectively.  Theincrease resulted primarily from professional and legal fees and audit and taxservices associated with compliance with the Sarbanes-Oxley Act and relatedrules and regulations, foreign governance compliance, and ongoing litigation expenses. As a percentage of revenue, general and administrative expense was 11.0% and10.0% for the three and six months ended June 30, 2004, compared to 8.7% and9.0%, respectively,  for the same periodsin the prior year.  We expect general and administrative expense willincrease in absolute dollars over time as we continue to build infrastructureto support our business and comply with new governmental regulations.  As apercentage of revenue, general and administrative expense is expected  to decline over time.

 

***AMORTIZATION OF ACQUISITION-RELATED COSTS.***Amortizationof acquisition related costs consists of amortization of other intangibleassets recorded from our acquisitions over the last three years.  Amortization of intangible assets was $2.3million and $3.8 million, respectively, for the three and six months ended June30, 2004 compared to $1.2 million and $2.5 million for the same periods in theprior year.  The increase was due toadditional amortizable assets acquired throughout 2003 and the second quarterof 2004.

 

***OTHERINCOME/(EXPENSE), NET.***  Other income/(expense), net consists ofinterest income on our cash and cash equivalents and short-term investments,interest expense on debt financing obligations, currency gain or loss fromremeasured foreign transactions or assets from their native currency to U.S.dollars, as well as gain or loss 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 losscarryforwards of approximately $94.7 million as of June 30, 2004. Included inthis amount is approximately $63.1 million of deductions resulting fromdisqualifying dispositions of stock options. When these deductions relating todisqualifying dispositions are realized for financial statement purposes theywill not result in a reduction in income tax expense, rather the benefit willbe recorded as additional paid-in-capital. These income tax net operating losscarryforwards expire beginning in the year 2009. Deductions from disqualifyingdispositions of stock options are included in net operating loss carryforwardswith a corresponding valuation allowance. Because of the uncertainty of future realization, a valuation allowanceequal to the deferred tax asset has been recorded.

 

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**Liquidity and Capital Resources**

 

As of June 30, 2004, wehad $176.2 million of cash and cash equivalents, $29.2 million of short-terminvestments and working capital of approximately $146.4 million. Ourprimary source of internal liquidity is our operating activities.  During the six months ended June 30, 2004,our operations generated $25.0 million of cash compared to $17.5 million forthe same period of the prior year.  The improvement was mainly due to anincrease in net income and an increase in accounts payable, offset by anincrease in accounts receivable and a decrease in non-acquisition relatedaccrued liabilities.  Net cash used in investing activities during the sixmonths ended June 30, 2004 totaled $128.3 million.  This was comprised ofnet investments in acquisitions of $124.7 million, investments in equipment of $4.4 million offset by thenet sale of investments of $0.8 million. On April 19, 2004, we announced adefinitive agreement to acquire element 5 AG, a privately held company based inGermany.  Under the terms of theagreement, we paid $120 million in cash to acquire all of the outstandingshares of capital stock of element 5.  OnJune 1, 2004, we announced that we acquired substantially all of the assets andassumed certain liabilities of Fireclick, Inc. Under the terms of the agreement, we paid $7.5 million in cash.  Net cash provided by financingactivities during the six months ended June 30, 2004 totaled $177.6million.  This was comprised of $169.2million from the sale of convertible senior notes and $8.4 million from the saleof stock through the exercise of stock options and purchases through theemployee stock purchase plan.

 

Our principalcommitments consist of interest and principal on our convertible senior notesand long-term obligations outstanding under operating leases.  Although we have no material commitments forcapital expenditures, we anticipate continued capital expenditures consistentwith our anticipated growth in operations, infrastructure, and personnel aswell as those which may arise in connection with our integration of element 5and Fireclick, Inc.    We furtheranticipate that our expenditures on product development will be consistent withour anticipated growth in operations as well as any requirements which may arisein connection with our integration of element 5 and Fireclick, Inc.  Wealso anticipate that we will continue to experience growth in our operatingexpenses for the foreseeable future and that our operating expenses will be amaterial use of our cash resources.

 

**Contractual  Commitments**

 
| ** **                  | ** ** | **Payment due by period (in thousands)** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total Amount  Committed**              | ** ** | **Jul-Dec  2004** | ** ** | **2005-2006** | ** ** | **2007-2008** | ** ** | **2009 and  Thereafter** | ** ** |
| Operating Lease Obligations |       | $                                        | 5,923      |   | $ | 1,008 |   | $ | 2,720 |   | $ | 1,322 |   | $ | 873 |   |
| Convertible Senior Notes    |       | $                                        | 242,714    |   | $ | 1,401 |   | $ | 4,875 |   | $ | 4,875 |   | $ | 231,563 |   |
| Total                       |       | $                                        | 248,637    |   | $ | 2,409 |   | $ | 7,595 |   | $ | 6,197 |   | $ | 232,436 |   |

 

We expect to continue toevaluate and consider a wide array of potential strategic transactions,including business combinations and acquisitions of businesses, products,services and other assets as well as licenses of technology related to ourcurrent business.  At any given time, wemay be engaged in discussions or negotiations with respect to one or more suchtransactions.  Any such transactions couldhave a material impact on our financial position, results of operations, orcash flows.  There is no assurance thatany such discussions or negotiations will result in the consummation of anytransaction.  The process of integratingany acquisition may create unforeseen challenges for our operational, financialand management information systems, as well as unforeseen expenditures andother risks, including diversion of management’s attention from other businessconcerns, the potential loss of key customers, employees and business partners,difficulties in managing facilities and employees in different geographicareas, and difficulties in entering markets in which we have no or limiteddirect prior experience and where competitors in such markets have strongermarket positions.  In addition, anacquisition may cause us to assume liabilities or become subject tolitigation.  Further, there can be noassurance that we will realize a positive return on any acquisition or thatfuture 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.

 

OnApril 16, 2004, in connection with our acquisition of element 5, we established a $45 million securedrevolving credit facility with Harris Trust and Savings Bank.  This facility was repaid in full andterminated in connection with the sale and issuance of our convertible seniornotes on June 1, 2004.

 

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OnJune 1, 2004 we sold and issued $175 million in aggregate principal amount ofconvertible senior notes due January 1, 2024, in a private, unregisteredoffering. The notes were sold at 100 percent of their principal amount.  The initial purchasers exercised in fulltheir option to purchase up to an additional $20 million in aggregate principalamount of the Notes on June 30, 2004, which purchase transaction closed on July6, 2004.

 

Weare required to pay interest on January 1 and July 1 of each year beginningJanuary 1, 2005.  The notes bear interestat a rate of 1.25 percent and, if specified conditions are met, are convertibleinto Digital River common stock at a conversion price of $44.063 pershare.  The conversion price is subjectto adjustments in certain circumstances. These conditions include the satisfaction of amarket price condition, such that the price of our common stock reaches aspecified threshold; the satisfaction of a trading price condition, such thatthe trading price of the notes falls below a specified level; the redemption ofthe notes by us, in which event holders will have the option to convert theirnotes prior to redemption; the occurrence of specified corporate transactions,as defined in the related indenture; and the occurrence of a fundamentalchange, as defined in the related indenture.  Theinitial conversion price is equivalent to a conversion rate of approximately22.6948 shares per $1,000 of principal amount of the notes.  We will adjust the conversion price if certainevents occur, as specified in the related indenture, such as the issuance ofour common stock as a dividend or distribution or the occurrence of a stocksubdivision or combination. In addition, contingent interest is required to bepaid to holders if certain conditions are met. If a fundamental change, such asa change in our control, as defined in the related indenture, occurs on orbefore January 1, 2009, we may also be required to purchase the notes for cashand pay an additional make whole premium payable in our common stock upon therepurchase or conversion of the notes in connection with the fundamentalchange. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeem thenotes, under certain circumstances, on or after July 1, 2007 and prior toJanuary 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

 

Aportion of the net proceeds of the offering was used to repay our seniorsecured revolving credit facility with Harris Trust and Savings Bank.  The balance will be used for generalcorporate purposes, including working capital, capital expenditures, potentialfuture acquisitions, investments, and the potential repurchase of shares of ourcommon stock.

 

We believe that existingsources of liquidity and the results of our operations will provide adequatecash to fund our operations, although we may seek to raise additional capital.In January 2002, we filed a universal shelf registration statement with the SECpursuant to which we could issue up to $100 million in common stock, preferredstock, debt securities and/or warrants.  Of this amount, approximately $45 million was utilized to issue commonstock in our July 2003 public offering leaving approximately $55 millionavailable for future use.   The sale ofadditional equity or convertible debt securities could result in additionaldilution to our stockholders. There can be no assurances that financing will beavailable in amounts or on terms acceptable to us, if at all.

 

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**Item 3.  Qualitative and QuantitativeDisclosure About Market Risk**

 

** Interest Rate Risk**

 

Wemaintain our portfolio of cash equivalents and short-term investments in avariety of securities, including governmentobligations and money market funds. Investments are classified asavailable for sale securities and carried at their market value with cumulativeunrealized gains or losses recorded as a component of accumulated othercomprehensive income/(loss) within stockholders’ equity.  As of June 30, 2004, all securities held hadmaturities of less than two 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 primarily in theUnited States currency and as such have not been subject to material foreigncurrency 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 average exchangerates in each applicable period. To the extent the U.S. dollar weakens againstforeign currencies, the translation of these foreign currency denominatedtransactions results in increased net revenues, operating expenses and netincome. Conversely, our net revenues, operating expenses and net income willdecrease when the U.S. dollar strengthens against foreign currencies. We do notcurrently have a currency hedging program to mitigate the effect of fluctuationsof currency prices on our financial results.

 

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**Item 4.  Controls and Procedures**

 

(a)           Based on their evaluation of ourdisclosure controls and procedures conducted as of June 30, 2004, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated underthe Securities Exchange Act of 1934) are effective.

 

(b)           This evaluation did not identify anychange in our internal controls over financial reporting that occurred duringthe quarter ended June 30, 2004 that has materially affected, or is reasonablylikely to materially affect, our internal controls over financial reporting.

 

**Limitations on the Effectiveness ofControls**

 

Ourmanagement, including the Chief Executive Officer and Chief Financial Officer,does not expect that our disclosure controls and procedures or our internalcontrols will prevent all error and fraud. A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. Further, the design of acontrol system must reflect the fact that there are resource constraints, andthe benefits of controls must be considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within our company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the control. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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**PART II.  OTHERINFORMATION**

 

**Item 1. Legal Proceedings**

 

Beginningin August 2001, we and certain of our officers and directors were named asdefendants in several class action shareholder complaints filed in the UnitedStates District Court for the Southern District of New York, now consolidatedas *In re Digital River, Inc. Initial Public OfferingSecurities Litigation,* Case No. 01-CV-7355.  Similar complaints, referred to here as theIPO Lawsuits, were filed in the same court against hundreds of other publiccompanies, referred to here as the Issuers. In the consolidated amended complaint against us, the plaintiffs allegethat we, certain of our officers and directors and the underwriters of ourinitial public offering, or IPO, violated Section 11 of the Securities Act of1933 based on allegations that our IPO registration statement and prospectusfailed to disclose material facts regarding the compensation to be received by,and the stock allocation practices of, the IPO underwriters.  The complaint also contains a claim forviolation of Section 10(b) of the Securities Exchange Act of 1934 based onallegations that this omission constituted a deceit on investors.  The plaintiffs seek unspecified monetarydamages and other relief.

 

In July 2002, we joinedin a global motion to dismiss the IPO Lawsuits filed by all of the Issuers(among others).  In October 2002, the parties agreed to toll the statuteof limitations with respect to certain of the named officers and directorsuntil September 30, 2003 and on the basis of this agreement, our officersand directors were dismissed from the lawsuit without prejudice.  InFebruary 2003, the court issued a decision denying the motion to dismiss theSection 11 claims against us and almost all of the other Issuers and denyingthe motion to dismiss the Section 10(b) claims against us and many ofthe Issuers.

 

During the summer of2003, we, along with a substantial majority of Issuers, indirectlyparticipated in discussions with the plaintiffs and the Issuers’ respectiveinsurers regarding a tentative settlement of the IPO Lawsuits. The termsof the tentative settlement would provide for, among other things, a release ofthe Issuers and their officers and directors from all further liabilityresulting from plaintiffs’ claims, and the assignment to plaintiffs of certainpotential claims that the Issuers may have against their IPO underwriters. Thetentative settlement also provides that, in the event that plaintiffsultimately recover less than a guaranteed sum of $1 billion from the IPOunderwriters, plaintiffs would be entitled to payment by each participating Issuer’sinsurer of 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.

 

InAugust 2001, an action was brought against us and other defendants in the U.S.District Court in the District of Columbia alleging infringement of UnitedStates Patent No. 6,014,651 owned by Christopher M. Crawford of Washington,D.C.  Crawford alleges that we directlyinfringe the patent by the provision of online software purchase and deliveryservices, that we actively induce infringement of the patent by supporting andotherwise promoting our electronic software delivery services to others andthat we contributorily infringed the patent by making, using, selling andoffering to sell components of our electronic software delivery services. No substantive actions have taken place in this case.  The court has delayed substantive discoveryin this case, pending a preliminary determination of the legal scope of Crawford’sclaim.  Discovery reopened in February2004, and is ongoing.  We have been inthe process of preparing materials regarding claim interpretation to present tothe court, and we expect to do so at an appropriate point in the case.  Although a number of co-defendants havesettled with plaintiff Crawford, at this time, Crawford has declined to make adefinitive demand for the resolution of this case.  We believe that this lawsuit is withoutmerit and intend to defend against it vigorously.

 

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**Item 2. Changes in Securities,Use of Proceeds and Issuer Purchases of Equity Securities**

 

In April 2001, the Boardof Directors authorized a share repurchase program of up to $5.0 million of ouroutstanding shares of common stock. Repurchases are at our discretion based onongoing assessments of the capital needs of the business and the market priceof our shares. No time limit was set for the completion of the repurchaseprogram.  In 2001, we expended $267,000 to repurchase our shares. Duringthe year ended December 31, 2003 and the six months ended June 30, 2004, noshares were repurchased under the repurchase program.

 

OnJune 1, 2004 we sold and issued $175 million in aggregate principal amount ofconvertible senior notes due January 1, 2024, in a private, unregisteredoffering. Theinitial purchasers of the notes were Credit Suisse First Boston, Harris Nesbittand RBC Capital Markets. The sale of the notes to the initial purchasers wasexempt from registration under the Securities Act of 1933, as amended, underSection 4(2) thereof, as a transaction not involving a public offering. Thenotes were reoffered in the United States to qualified institutional buyers inreliance on Rule 144A under the Securities Act.  Thenotes were sold at 100 percent of their principal amount.  The initial purchasers exercised in fulltheir option to purchase up to an additional $20 million in aggregate principalamount of the Notes on June 30, 2004, which purchase transaction closed on July6, 2004.  We received aggregate net proceeds ofapproximately $188 million from this offering.

 

Weare required to pay interest on January 1 and July 1 of each year beginningJanuary 1, 2005.  The notes bear interestat a rate of 1.25 percent and, if specified conditions are met, are convertibleinto Digital River common stock at a conversion price of $44.063 pershare.  The conversion price is subjectto adjustments in certain circumstances. These conditions include the satisfaction of amarket price condition, such that the price of our common stock reaches aspecified threshold; the satisfaction of a trading price condition, such thatthe trading price of the notes falls below a specified level; the redemption ofthe notes by us, in which event holders will have the option to convert theirnotes prior to redemption; the occurrence of specified corporate transactions,as defined in the related indenture; and the occurrence of a fundamentalchange, as defined in the related indenture.  Theinitial conversion price is equivalent to a conversion rate of approximately22.6948 shares per $1,000 of principal amount of the notes.  We will adjust the conversion price if certainevents occur, as specified in the related indenture, such as the issuance ofour common stock as a dividend or distribution or the occurrence of a stocksubdivision or combination. In addition, contingent interest is required to bepaid to holders if certain conditions are met. If a fundamental change, such asa change in our control, as defined in the related indenture, occurs on orbefore January 1, 2009, we may also be required to purchase the notes for cashand pay an additional make whole premium payable in our common stock upon therepurchase or conversion of the notes in connection with the fundamentalchange. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeem thenotes, under certain circumstances, on or after July 1, 2007 and prior toJanuary 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

 

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**Item 4. Submission of matters to a vote ofsecurity holders**

 

Ourannual meeting of stockholders was held on May  24, 2004 (the “AnnualMeeting”).  The following matters wereconsidered and voted upon at the Annual Meeting:

 

Thefirst matter was the election of three director nominees, Joel A. Ronning,Perry W. Steiner and J. Paul Thorin, as directors to serve until the 2007annual meeting of the stockholders.  Thevotes cast for and withheld for such nominees were as follows:

 
| **Name**         | ** ** | **For**    | ** ** | **Withhold** | ** ** |
|------------------|------------|------------|------------|--------------|------------|
|             |       |       |       |         |       |
| Joel A. Ronning  |       | 27,588,327 |       | 1,445,629    |       |
|             |       |       |       |         |       |
| Perry W. Steiner |       | 17,955,960 |       | 11,077,996   |       |
|             |       |       |       |         |       |
| J. Paul Thorin   |       | 27,487,095 |       | 1,546,861    |       |

 

Thesecond matter was to approve an amendment and restatement of our 1998 StockOption Plan (the “1998 Plan”) that would give us the flexibility to grant stockappreciation rights, restricted stock units, stock purchase rights and stockbonuses, in addition to incentive and non-statutory stock options, to ourdirectors, officers, employees and consultants and certain other eligiblerecipients, and would extend the term of the 1998 Plan from June 2008 to March2014.  There were 5,751,774 votes castfor the approval, and there were 14,659,148 votes cast against theapproval.  There were 168,957 abstentionsand 8,454,077 broker non-votes.

 

Thethird matter was to approve an amendment and restatement of our 1999 StockOption Plan (the “1999 Plan”) that would give us the flexibility to grantincentive stock options, stock appreciation rights, restricted stock units,stock purchase rights and stock bonuses, in addition to non-statutory stockoptions, to our directors, officers, employees and consultants and certain othereligible recipients, and would fix the term of the 1999 Plan from unspecifiedto March 2014.  There were 5,641,607votes cast for the approval, and there were 14,763,522 votes cast against theapproval.  There were 174,750 abstentionsand 8,454,077 broker non-votes.

 

Thefourth matter was to ratify the Audit Committee of the Board of  Director’s selection of Ernst & Young LLPas independent auditors of our financial statements for our fiscal year endingDecember 31, 2004.  There were 28,564,118votes cast for approval, and there were 453,186 cast against the approval.  There were 16,652 abstentions and no brokernon-votes.

 

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**Item 6.  Exhibits and Reports on Form 8-K**

 

(a)Exhibits

 
| **EXHIBIT  NUMBER** |   |   | **DESCRIPTION OF DOCUMENTS** |
|---------------------|--------|--------|------------------------------|
|                |   |   |                         |
| 2.1                 |   | (4)    |                         | Stock Purchase Agreement, dated as of April 17, 2004 by  and among Digital River, Inc., Blitz F03-1424 GmbH, a company organized under  the laws of Germany and a wholly owned subsidiary of Digital River, and the  selling shareholders of element 5 Informationstechnologien und  –dienstleistungen Aktiengesellschaft, a company organized under the laws of  Germany. |
| 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                 |   | (5)    |                         | Indenture dated as of June 1, 2004 between Digital  River, Inc. and Wells Fargo Bank, N.A. as trustee, including therein the form  of the Note. |
| 10.15               |   | (4)    |                         | Line of Credit Agreement, dated April 16, 2004, between  Digital River, Inc. and Harris Trust and Savings Bank. |
| 10.16               |   | (4)    |                         | Security Agreement Re: Receivables, dated April 16,  2004, between Digital River, Inc. and Harris Trust and Savings Bank. |
| 10.17               |   | (4)    |                         | First Amendment to Line of Credit Agreement and  Promissory Note, dated April 30, 2004, between Digital River, Inc. and Harris  Trust and Savings Bank. |
| 10.18               |   | (4)    |                         | First Amendment to Security Agreement Re: Receivables,  dated April 30, 2004, between Digital River, Inc. and Harris Trust and  Savings Bank. |
| 10.19               |   | (5)    |                         | Registration Rights Agreement dated as of June 1, 2004  between Digital River, Inc. and the initial purchasers of Senior Convertible  Notes due January 1, 2024. |
| 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 our Registration  Statement on Form S-3, File No. 333-81626, filed on January 29, 2002,  declared effective on February 12, 2002, and incorporated herein by  reference. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Filed as an exhibit to our Annual Report on Form 10-K  for the year ended December 31, 2000, filed on March 27, 2001, and  incorporated herein by reference.                                              |
| (3) |   | Filed as an exhibit to our Registration Statement on  Form S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                         |
| (4) |   | Filed as an exhibit to our Current Report on Form 8-K,  filed on May 4, 2004, and incorporated herein by reference.                                                                                       |
| (5) |   | Filed as an exhibit to our Current Report on Form 8-K,  filed on July 13, 2004, and incorporated herein by reference.                                                                                     |

 

(b)Reports on Form 8-K.

 

OnApril 19, 2004, we furnished a current report on Form 8-K announcing under Item12 the financial results for the quarter ended March 31, 2004.

 

OnApril 22, 2004, we furnished a current report on Form 8-K announcing under Item12 the financial results for the quarter ended March 31, 2004.

 

On May 4, 2004, we fileda current report on Form 8-K announcing under Item 2 and Item 7 the acquisitionof element 5 AG and a line of credit agreement with Harris Trust and SavingsBank.

 

On May 24, 2004, wefiled an amended current report on Form 8-K/A providing under Item 7 thefinancial results for element 5 AG for the years ended 2002 and 2003 andquarter ended March 31, 2004 along with pro forma financial results for DigitalRiver, Inc. and element 5 AG.

 

On May 26, 2004, wefiled a current report on Form 8-K announcing under Item 5 our intention tosell $175 million of Convertible Senior Notes due 2024 in a privateunregistered offering.

 

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On May 26, 2004, wefiled a current report on Form 8-K announcing under Item 5 our entrance into adefinitive  agreement for the sale of$175 million of Convertible Senior Notes due 2024 in a private unregisteredoffering.

 

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SIGNATURES

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date:  | August 6, 2004                                 | DIGITAL RIVER, INC.  |
|--------|------------------------------------------------|----------------------|
|   |                                           |
|   | By:                                            | /s/  CARTER D. HICKS |
|   |                                           |
|   | Carter  D. Hicks                               |
|   | *Chief Financial Officer*                      |
|   | *(Principal Financial and Accounting Officer)* |
|        |                                                |                      |  |

 

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EXHIBITINDEX

 
| **EXHIBIT  NUMBER** |   |   | **DESCRIPTION OF DOCUMENTS**                                              |
|---------------------|--------|--------|---------------------------------------------------------------------------|
|                |   |   |
| 2.1                 |   | (4)    |                                                                      | Stock Purchase Agreement, dated as of April 17, 2004 by  and among Digital River, Inc., Blitz F03-1424 GmbH, a company organized under  the laws of Germany and a wholly owned subsidiary of Digital River, and the  selling shareholders of element 5 Informationstechnologien und  –dienstleistungen Aktiengesellschaft, a company organized under the laws of  Germany. |
| 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                 |   | (5)    |                                                                      | Indenture dated as of June 1, 2004 between Digital  River, Inc. and Wells Fargo Bank, N.A. as trustee, including therein the form  of the Note. |
| 10.15               |   | (4)    |                                                                      | Line of Credit Agreement, dated April 16, 2004, between  Digital River, Inc. and Harris Trust and Savings Bank. |
| 10.16               |   | (4)    |                                                                      | Security Agreement Re: Receivables, dated April 16,  2004, between Digital River, Inc. and Harris Trust and Savings Bank. |
| 10.17               |   | (4)    |                                                                      | First Amendment to Line of Credit Agreement and  Promissory Note, dated April 30, 2004, between Digital River, Inc. and Harris  Trust and Savings Bank. |
| 10.18               |   | (4)    |                                                                      | First Amendment to Security Agreement Re: Receivables,  dated April 30, 2004, between Digital River, Inc. and Harris Trust and  Savings Bank. |
| 10.19               |   | (5)    |                                                                      | Registration Rights Agreement dated as of June 1, 2004  between Digital River, Inc. and the initial purchasers of Senior Convertible  Notes due January 1, 2024. |
| 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 our Registration  Statement on Form S-3, File No. 333-81626, filed on January 29, 2002,  declared effective on February 12, 2002, and incorporated herein by  reference. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Filed as an exhibit to our Annual Report on Form 10-K  for the year ended December 31, 2000, filed on March 27, 2001, and  incorporated herein by reference.                                              |
| (3) |   | Filed as an exhibit to our Registration Statement on  Form S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                         |
| (4) |   | Filed as an exhibit to our Current Report on Form 8-K,  filed on May 4, 2004, and incorporated herein by reference.                                                                                       |
| (5) |   | Filed as an exhibit to our Current Report on Form 8-K,  filed on July 13, 2004, and incorporated herein by reference.                                                                                     |

 

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