**SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

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**FORM 10-Q**

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**ý****                                 QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002**

**OR**

**o****                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE TRANSITION PERIOD FROM         TO      **

**Commissionfile number 000-24643**

**DIGITAL RIVER, INC.******(Exact name ofregistrant as specified in its charter)

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

 

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

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

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Indicate by checkmark whether 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 ý No o

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

 

| **COMMON  STOCK, $0.01 PAR VALUE** |   | **27,198,466  SHARES**              |
|------------------------------------|--------|-------------------------------------|
| (Class)                            |   | Outstanding as of  November 8, 2002 |

 

 

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DIGITAL RIVER, INC.

 

Form 10-Q

 

Index

 

 

 
| PART I.        | FINANCIAL INFORMATION                                                                                             |   |   |
|----------------|-------------------------------------------------------------------------------------------------------------------|--------|--------|
|           |                                                                                                              |   |   |
| Item 1.        | Financial Statements                                                                                              |   |   |
|           |                                                                                                              |   |   |
|           | Condensed  Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001                             |   |   |
|           |                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2002 and 2001 |   |   |
|           |                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2002 and 2001           |   |   |
|           |                                                                                                              |   |   |
|           | 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 6.        | Exhibits and  Reports on Form 8-K                                                                                 |   |   |
|           |                                                                                                              |   |   |
| SIGNATURES     |                                                                                                              |   |
|           |                                                                                                              |   |   |
| CERTIFICATIONS |                                                                                                              |   |
|           |                                                                                                              |   |   |
| EXHIBIT INDEX  |                                                                                                              |   |

 

 

2

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**PARTI.  FINANCIAL INFORMATION**

** **

**Item1.  Financial Statements**

 

 

**DIGITAL RIVER, INC.**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 
| ** **                                                                                                                          |   | **September  30,  2002** |   | **December  31,  2001** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
|                                                                                                                                |   | **(unaudited)**          |   |                    |   |
| **ASSETS**                                                                                                                          |
| CURRENT ASSETS:                                                                                                                     |   |                     |   |                    |   |
| Cash and cash  equivalents                                                                                                          |   | $                        | 28,762 |                    | $      | 21,677 |   |
| Short-term investments                                                                                                              |   | 6,491                    |   | 9,978                   |   |
| Accounts  receivable, net                                                                                                           |   | 11,944                   |   | 8,719                   |   |
| Prepaid expenses  and other                                                                                                         |   | 2,134                    |   | 1,455                   |   |
|                                                                                                                                |   |                     |   |                    |   |
| Total current  assets                                                                                                               |   | 49,331                   |   | 41,829                  |   |
|                                                                                                                                |   |                     |   |                    |   |
| PROPERTY AND  EQUIPMENT, net                                                                                                        |   | 16,196                   |   | 16,146                  |   |
| GOODWILL                                                                                                                            |   | 16,351                   |   | 11,273                  |   |
| CUSTOMER BASE,  NONCOMPETE AGREEMENTS, TECHNOLOGY/TRADENAME, and OTHER, net                                                         |   | 9,542                    |   | 8,979                   |   |
|                                                                                                                                |   |                     |   |                    |   |
|                                                                                                                                |   | $                        | 91,420 |                    | $      | 78,227 |   |
|                                                                                                                                |   |                     |   |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      |
| CURRENT  LIABILITIES:                                                                                                               |   |                     |   |                    |   |
| Notes payable                                                                                                                       |   | $                        | — |                    | $      | 2,500 |   |
| Accounts payable                                                                                                                    |   | 31,812                   |   | 19,360                  |   |
| Accrued payroll                                                                                                                     |   | 2,674                    |   | 2,803                   |   |
| Deferred revenue                                                                                                                    |   | 1,034                    |   | 1,106                   |   |
| Other accrued  liabilities                                                                                                          |   | 4,445                    |   | 2,036                   |   |
|                                                                                                                                |   |                     |   |                    |   |
| Total current  liabilities                                                                                                          |   | 39,965                   |   | 27,805                  |   |
|                                                                                                                                |   |                     |   |                    |   |
| 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; 27,027,894 and 26,462,905  shares issued and outstanding, respectively |   | 270                      |   | 265                     |   |
| Additional  paid-in capital                                                                                                         |   | 158,079                  |   | 153,308                 |   |
| Deferred  compensation                                                                                                              |   | —                   |   | (37                     | )      |
| Accumulated  deficit                                                                                                                |   | (106,894                 | )      | (103,114                | )      |
|                                                                                                                                |   |                     |   |                    |   |
| Total  stockholders’ equity                                                                                                    |   | 51,455                   |   | 50,422                  |   |
|                                                                                                                                |   |                     |   |                    |   |
|                                                                                                                                |   | $                        | 91,420 |                    | $      | 78,227 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

 

3

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS

(in thousands, except per share data; unaudited)

 
| ** **                                                                                       |   | **Three  months ended****September 30,** |   | **Nine  months ended****September 30,** |   |
|--------------------------------------------------------------------------------------------------|--------|------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                             |   | **2002**                                 |   | **2001**                                |   | **2002** |   | **2001** |   |
|                                                                                             |   |                                     |   |                                    |   |   |   |   |   |
| REVENUE                                                                                          |   | $                                        | 18,872 |                                    | $      | 13,991 |   | $ | 56,289 |   | $ | 40,092 |   |
| COSTS AND EXPENSES (exclusive of depreciation and amortization expense  shown separately below): |   |                                     |   |                                    |   |   |   |   |   |
| Direct cost of services                                                                          |   | 559                                      |   | 778                                     |   | 1,730 |   | 1,990 |   |
| Network and infrastructure                                                                       |   | 2,998                                    |   | 2,144                                   |   | 8,520 |   | 7,602 |   |
| Sales and marketing                                                                              |   | 7,854                                    |   | 6,599                                   |   | 24,269 |   | 19,863 |   |
| Product research and development                                                                 |   | 2,764                                    |   | 2,764                                   |   | 9,327 |   | 7,962 |   |
| General and administrative                                                                       |   | 1,807                                    |   | 1,116                                   |   | 5,130 |   | 3,218 |   |
| Litigation and other charges                                                                     |   | —                                   |   | —                                  |   | 2,500 |   | — |   |
| Depreciation and amortization                                                                    |   | 1,486                                    |   | 1,226                                   |   | 4,296 |   | 3,522 |   |
| Amortization of goodwill and other intangibles and acquisition related  costs                    |   | 1,356                                    |   | 3,912                                   |   | 4,556 |   | 12,396 |   |
|                                                                                             |   |                                     |   |                                    |   |   |   |   |   |
| Total costs and expenses                                                                         |   | 18,824                                   |   | 18,539                                  |   | 60,328 |   | 56,553 |   |
|                                                                                             |   |                                     |   |                                    |   |   |   |   |   |
| INCOME (LOSS) FROM OPERATIONS                                                                    |   | 48                                       |   | (4,548                                  | )      | (4,039 | ) | (16,461 | ) |
| INTEREST INCOME                                                                                  |   | 50                                       |   | 174                                     |   | 259 |   | 784 |   |
|                                                                                             |   |                                     |   |                                    |   |   |   |   |   |
| NET INCOME (LOSS)                                                                                |   | $                                        | 98     |                                    | $      | (4,374 | ) | $ | (3,780 | ) | $ | (15,677 | ) |
|                                                                                             |   |                                     |   |                                    |   |   |   |   |   |
| NET INCOME (LOSS) PER SHARE:                                                                     |   |                                     |   |                                    |   |   |   |   |   |
| BASIC                                                                                            |   | $                                        | 0.00   |                                    | $      | (0.18 | ) | $ | (0.14 | ) | $ | (0.66 | ) |
| DILUTED                                                                                          |   | $                                        | 0.00   |                                    | $      | (0.18 | ) | $ | (0.14 | ) | $ | (0.66 | ) |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:                                                      |   |                                     |   |                                    |   |   |   |   |   |
| BASIC                                                                                            |   | 26,823                                   |   | 24,585                                  |   | 26,655 |   | 23,832 |   |
| DILUTED                                                                                          |   | 29,054                                   |   | 24,585                                  |   | 26,655 |   | 23,832 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

 

4

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS

(in thousands; unaudited)

 
|                                                                                       |   | **Nine  months ended****September 30,** |   |
|--------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                       |   | **2002**                                |   | **2001** |   |
|                                                                                       |   |                                    |   |   |   |
| OPERATING ACTIVITIES:                                                                      |   |                                    |   |   |   |
| Net loss                                                                                   |   | $                                       | (3,780 | ) | $ | (15,677 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |   |                                    |   |   |   |
| Amortization of goodwill and other intangibles and acquisition related  costs              |   | 4,556                                   |   | 12,396 |   |
| Depreciation and amortization                                                              |   | 4,296                                   |   | 3,522 |   |
| Deferred compensation expense                                                              |   | 37                                      |   | 129 |   |
| Litigation and other charges                                                               |   | 2,500                                   |   | — |   |
| Change in operating assets and liabilities:                                                |   |                                    |   |   |   |
| Accounts receivable and prepaid expenses                                                   |   | (4,064                                  | )      | (3,728 | ) |
| Accounts payable                                                                           |   | 8,711                                   |   | 2,298 |   |
| Other current liabilities and deferred revenue                                             |   | (1,157                                  | )      | 224 |   |
|                                                                                       |   |                                    |   |   |   |
| Net cash provided by (used in) operating activities                                        |   | 11,099                                  |   | (836 | ) |
|                                                                                       |   |                                    |   |   |   |
| INVESTING ACTIVITIES:                                                                      |   |                                    |   |   |   |
| Sales of investments, net                                                                  |   | 3,487                                   |   | 7,042 |   |
| Cash paid for acquisitions, net of cash received                                           |   | (2,778                                  | )      | (1,119 | ) |
| Purchases of equipment                                                                     |   | (4,089                                  | )      | (4,833 | ) |
| Patent acquisition costs                                                                   |   | —                                  |   | (8 | ) |
|                                                                                       |   |                                    |   |   |   |
| Net cash provided by (used in) investing activities                                        |   | (3,380                                  | )      | 1,082 |   |
|                                                                                       |   |                                    |   |   |   |
| FINANCING ACTIVITIES:                                                                      |   |                                    |   |   |   |
| Exercise of stock options and warrants                                                     |   | 1,486                                   |   | 332 |   |
| Sales of Common Stock under Employee Stock Purchase Plan                                   |   | 380                                     |   | 175 |   |
| Repurchase of Common Stock                                                                 |   | —                                  |   | (267 | ) |
| Repayment of notes payable                                                                 |   | (2,500                                  | )      | — |   |
|                                                                                       |   |                                    |   |   |   |
| Net cash provided by (used in) financing activities                                        |   | (634                                    | )      | 240 |   |
|                                                                                       |   |                                    |   |   |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                                  |   | 7,085                                   |   | 486 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                             |   | 21,677                                  |   | 16,920 |   |
|                                                                                       |   |                                    |   |   |   |
| CASH AND CASH EQUIVALENTS, end of period                                                   |   | $                                       | 28,762 |   | $ | 17,406 |   |
|                                                                                       |   |                                    |   |   |   |
| SUPPLEMENTAL CASH FLOW DISCLOSURE:                                                         |   |                                    |   |   |   |
| Common Stock issued in acquisitions and earn-outs                                          |   | $                                       | 2,910  |   | $ | 14,066 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

 

5

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**DIGITALRIVER, INC.**

# **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. BASIS OF PRESENTATION**

 

The unaudited condensed consolidated financial statements includedherein reflect all adjustments, consisting only of normal recurring adjustments,which in the opinion of management are necessary to fairly state the Company’sconsolidated financial position, results of operations and cash flows for theperiods presented.  These condensedconsolidated financial statements should be read in conjunction with theCompany’s audited consolidated financial statements included in the Company’sForm 10-K for the year ended December 31, 2001 as filed with the Securities andExchange Commission.  The results ofoperations for the three and nine months ended September 30, 2002 are notnecessarily indicative of the results to be expected for any subsequent quarteror for the entire fiscal year ending December 31, 2002.  The December 31, 2001 balance sheet wasderived from audited financial statements, but does not include all disclosuresrequired by generally accepted accounting principles.

 

**2. PRINCIPLES OFCONSOLIDATION**

 

The condensed consolidated financial statements include the accounts ofDigital River, Inc. and its wholly owned subsidiaries. All intercompanybalances and transactions have been eliminated in consolidation.

 

**3. NET INCOME(LOSS) PER SHARE**

 

The table below sets forth the computation of basic and diluted netincome (loss) per share:

 
|                                               |   | **Three  months ended****September 30,** |       | **Nine months ended  September 30,** |       |
|----------------------------------------------------|--------|------------------------------------------|------------|--------------------------------------|------------|
|                                               |   | **2002**                                 |       | **2001**                             |       | **2002** |   | **2001** |   |
| Numerator:                                         |   |                                     | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Net income (loss)                                  |   | $                                        | 98,000     |                                 | $          | (4,374,000 | ) | $ | (3,780,000 | ) | $ | (15,677,000 | ) |
|                                               |   |                                     |       |                                 |       |   |   |   |   |
| Denominator:                                       |   |                                     | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Basic — weighted average shares outstanding   |   | 26,823,000                               |       | 24,585,000                           |       | 26,655,000 |   | 23,832,000 |   |
| Effect of dilutive securities:                     |   |                                     |       |                                 |       |   |   |   |   |
| Employee stock options and warrants                |   | 2,231,000                                |       | —                               |       | — |   | — |   |
| Diluted — weighted average shares outstanding |   | 29,054,000                               |       | 24,585,000                           |       | 26,655,000 |   | 23,832,000 |   |
|                                               |   |                                     |       |                                 |       |   |   |   |   |
| Basic — net income (loss) per share           |   | $                                        | 0.00       |                                 | $          | (0.18 | ) | $ | (0.14 | ) | $ | (0.66 | ) |
|                                               |   |                                     |       |                                 |       |   |   |   |   |
| Diluted — net income (loss) per share         |   | $                                        | 0.00       |                                 | $          | (0.18 | ) | $ | (0.14 | ) | $ | (0.66 | ) |

 

Diluted — weighted average shares outstanding have not been adjustedfor employee stock options and warrants where the effect of those securitieswould have been anti-dilutive.

 

**4. GOODWILL AND INTANGIBLE ASSETS**

 

In July 2001, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 141, “Business Combinations” andNo. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires allbusiness combinations initiated after June 30, 2001 to be accounted for usingthe purchase method.  Under SFAS No.142, goodwill and intangible assets with indefinite lives will no longer beamortized but are reviewed annually (or more frequently if impairmentindicators arise) for impairment.  Foracquisitions consummated by the Company subsequent to July 1, 2001, the Companyadopted the provisions of SFAS No. 141 and 142 effective July 1, 2001.  The Company adopted the full provisions ofSFAS No. 141 and 142 during the first quarter of 2002.

 

 

6

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The Company has assessed goodwill impairment using a two-step approachbased on reportable segments and reassessed any intangible assets, includinggoodwill, recorded in connection with earlier acquisitions. The Companycompleted its initial required goodwill impairment test under SFAS No. 142 inthe first quarter of 2002, which indicated that there was no impairment ofgoodwill or other intangibles.

 

Upon adoption of SFAS No. 142, the Company discontinued theamortization of goodwill.  The followingtable presents a reconciliation of net income (loss) and net income (loss) pershare adjusted for the exclusion of goodwill amortization:

 
|                                 |   | **Three  months ended****September 30,** |       | **Nine months ended  September 30,** |       |
|--------------------------------------|--------|------------------------------------------|------------|--------------------------------------|------------|
|                                 |   | **2002**                                 |       | **2001**                             |       | **2002** |   | **2001** |   |
|                                 |   |                                     | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Reported net income (loss)           |   | $                                        | 98,000     |                                 | $          | (4,374,000 | ) | $ | (3,780,000 | ) | $ | (15,677,000 | ) |
| Add goodwill amortization            |   | —                                   |       | 2,671,000                            |       | — |   | 7,627,000 |   |
| Adjusted net income (loss)           |   | $                                        | 98,000     |                                 | $          | (1,703,000 | ) | $ | (3,780,000 | ) | $ | (8,050,000 | ) |
|                                 |   |                                     | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Reported net income (loss) per share |   | $                                        | 0.00       |                                 | $          | (0.18 | ) | $ | (0.14 | ) | $ | (0.66 | ) |
| Add goodwill amortization            |   | —                                   |       | 0.11                                 |       | — |   | 0.32 |   |
| Adjusted net income (loss) per share |   | $                                        | 0.00       |                                 | $          | (0.07 | ) | $ | (0.14 | ) | $ | (0.34 | ) |

 

The changes in the carrying amount of goodwill for the nine monthsended September 30, 2002, by operating segment, are as follows:

 
|                                 |   | **Software  and  Digital Commerce  Services Division** |      | **E-Business  Services Division** |   | **Total** |   |
|--------------------------------------|--------|--------------------------------------------------------|-----------|-----------------------------------|--------|-----------|--------|
|                                 |   |                                                   |      |                              |   |      |   |
| Balance as of  December 31, 2001     |   | $                                                      | 8,280,000 |                              | $      | 2,993,000 |   | $ | 11,273,000 |   |
| Goodwill  acquired during the period |   | 298,000                                                |      | 4,780,000                         |   | 5,078,000 |   |
| Balance as of  September 30, 2002    |   | $                                                      | 8,578,000 |                              | $      | 7,773,000 |   | $ | 16,351,000 |   |

 

Information regarding the Company’s other intangible assets is asfollows:

 
|                    |   | **As of  September 30, 2002** |       |
|-------------------------|--------|-------------------------------|------------|
|                    |   | **Carrying  amount**          |       | **Accumulated  amortization** |   | **Net** |   |
|                    |   |                          |       |   |   |   |   |
| Customer base           |   | $                             | 14,117,000 |   | $ | 7,416,000 |   | $ | 6,701,000 |   |
| Non-compete  agreements |   | 3,150,000                     |       | 2,278,000 |   | 872,000 |   |
| Technology/tradename    |   | 5,675,000                     |       | 3,720,000 |   | 1,955,000 |   |
| Total                   |   | $                             | 22,942,000 |   | $ | 13,414,000 |   | $ | 9,528,000 |   |

 
|                    |   | **As of  December 31, 2001** |       |
|-------------------------|--------|------------------------------|------------|
|                    |   | **Carrying  amount**         |       | **Accumulated  amortization** |   | **Net** |   |
|                    |   |                         |       |   |   |   |   |
| Customer base           |   | $                            | 9,317,000  |   | $ | 4,728,000 |   | $ | 4,589,000 |   |
| Non-compete  agreements |   | 3,050,000                    |       | 1,610,000 |   | 1,440,000 |   |
| Technology/tradename    |   | 5,425,000                    |       | 2,520,000 |   | 2,905,000 |   |
| Total                   |   | $                            | 17,792,000 |   | $ | 8,858,000 |   | $ | 8,934,000 |   |

 

 

7

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Amortization expense for the nine months ended September 30, 2002 was$4,556,000.  Estimated amortizationexpense for the remaining life of the intangible assets, based on intangibleassets as of September 30, 2002, is as follows:

 

Year endingDecember 31,

 

| 2002 |   | $         | 5,738,000 |   |
|------|--------|-----------|-----------|--------|
| 2003 |   | 4,727,000 |      |
| 2004 |   | 3,190,000 |      |
| 2005 |   | 429,000   |      |

 

**5. ACQUISITIONS AND EARN-OUT ARRANGEMENTS**

 

In March 2002, pursuant to an Asset Purchase Agreement between theCompany and Innuity Acquisition Corp. (“IAC”), the Company purchased certainassets for approximately $2,400,000 in cash and assumed approximately$3,600,000 in merchant liabilities.  TheCompany will amortize intangible assets acquired, consisting of customer base,non-compete agreements and technology/tradename over a three-year period.  The agreement includes an opportunity for acash earn-out based on revenue generated from the IAC assets during the12-month period following the close of the transaction.  Such earn-out amount, if any, will berecorded as additional goodwill.

 

In March 2002, pursuant to an Amended and Restated Asset PurchaseAgreement (the “Agreement”) between the Company and Beyond.com Corporation(“Beyond.com”), in exchange for 179,096 shares of the Company’s Common Stock,the Company purchased those assets and assumed those liabilities of Beyond.comrelated to its eStores business, which manages online stores for clients.  The Company will amortize intangible assetsacquired, consisting of customer base and non-compete agreements, over athree-year period.  The purchase wasapproved by the U.S. Bankruptcy Court following Beyond.com’s filing for Chapter11 bankruptcy protection.  Immediatelyfollowing the closing of the Agreement, the Company entered into a Post-ClosingAmendment to the Agreement with Beyond.com (the “Post-Closing Amendment”),pursuant to which, among other things, the Company agreed to increase thenumber of shares to be delivered to Beyond.com under the Agreement to 222,842, inexchange for a release of certain potential claims by Beyond.com against theCompany.  The Post-Closing Amendment issubject to approval by the U.S. Bankruptcy Court.  The Official Committee of Unsecured Creditors of Beyond.com'sbankruptcy estate has objected to the Post-Closing Amendment, asserting thatthe increase in shares to be delivered to Beyond.com under the Post-ClosingAmendment is inadequate.  The hearing onBeyond.com's motion to approve the Post-Closing Amendment was originally setfor June 7, 2002.  The parties, with theapproval of the U.S. Bankruptcy Court, have agreed to continue the hearing onseveral occasions.  The U.S. BankruptcyCourt is currently scheduled to consider the Post-Closing Amendment on February14, 2003.  Beyond.com is also assertingthat it is entitled to additional shares with a value of $650,000 under theAgreement pursuant to provisions of the Agreement under which Beyond.com couldearn additional consideration post-closing if certain clients of Beyond.comimmediately prior to the closing maintain or establish client relationshipswith the Company following the closing. The Company disagrees that any of such shares are due to Beyond.comunder the Agreement. Of the 179,096 shares issued at closing, 70,000 shareswere placed in escrow to secure certain indemnification obligations containedin the Agreement.  The parties haveagreed that 8,277 of these shares are to be returned to the Company to satisfyoutstanding claims under the escrow.  Anadditional 13,792 of these shares are subject to additional outstanding claimsand will remain in escrow pending resolution of such claims; the remaining47,931 shares will be released to Beyond.com.

 

In connection with the Company's purchase of the Free Merchant.comassets of Network Commerce in December 2001, the former owners of NetworkCommerce received earn-out payments totaling $420,000 during the nine monthsended September 30, 2002.  The Companyrecorded such amounts as additional goodwill.

 

Following is an allocation of the purchase price for the acquisitionsconsummated in the nine months ended September 30, 2002:

 

| Tangible assets         |   | $          | 231,000   |   |
|-------------------------|--------|------------|-----------|--------|
| Liabilities  assumed    |   | (3,717,000 | )         |
| Customer base           |   | 4,800,000  |      |
| Non-compete  agreements |   | 100,000    |      |
| Technology/tradename    |   | 250,000    |      |
| Goodwill                |   | 4,513,000  |      |
| Total purchase  price   |   | $          | 6,177,000 |   |

 

 

8

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The following unaudited pro forma condensed results of operations forthe nine months ended September 30, 2002 and 2001 has been prepared as if eachof the acquisitions had occurred on January 1, 2001:

 

|                                 |   | **Nine  months ended  September 30,** |       |
|--------------------------------------|--------|---------------------------------------|------------|
|                                 |   | **2002**                              |       | **2001** |   |
|                                 |   |                                  | ** ** |   | ** ** |
| Revenue                              |   | $                                     | 58,278,000 |   | $ | 45,888,000 |   |
| Loss from operations                 |   | (6,548,000                            | )          | (23,105,000 | ) |
| Net loss                             |   | (7,124,000                            | )          | (22,402,000 | ) |
| Basic and diluted net loss per share |   | $                                     | (0.27      | ) | $ | (0.93 | ) |

 

This financial information does not purport to represent results thatwould actually have been obtained if the transactions had been in effect onJanuary 1, 2001 or any future results that may in fact be realized.

 

**6. SEGMENT INFORMATION**

 

The Company has two operating segments, Software and Digital CommerceServices and E-Business Services, which have been identified as components ofthe Company that are reviewed regularly by management to determine resourceallocation and assess performance. Unallocated corporate items consist of pending litigation and othercharges, depreciation, amortization of goodwill and other intangibles andacquisition related costs, and interest income for operational results, andconsist of certain cash, investments and goodwill and other intangibles fortotal assets.  Segment information is asfollows:

 

|                                        |   | **Software  and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Unallocated  Corporate  Items** |   | **Consolidated** |       |
|---------------------------------------------|--------|--------------------------------------------------------|------------|-----------------------------------|--------|-----------------------------------|--------|------------------|------------|
| **Three  months ended  September 30, 2002** |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                                     |   | $                                                      | 15,430,000 |                              | $      | 3,442,000                         |   | $                | —     |   | $ | 18,872,000 |   |
| Gross profit                                |   | 12,895,000                                             |       | 2,420,000                         |   | —                            |   | 15,315,000       |       |
| Income (loss)  from operations              |   | 5,131,000                                              |       | (2,242,000                        | )      | (2,841,000                        | )      | 48,000           |       |
| Net income (loss)                           |   | 5,131,000                                              |       | (2,242,000                        | )      | (2,791,000                        | )      | 98,000           |       |
| Total assets at  September 30, 2002         |   | $                                                      | 32,975,000 |                              | $      | 15,267,000                        |   | $                | 43,178,000 |   | $ | 91,420,000 |   |
|                                        |   |                                                   |       |                              |   |                              |   |             |       |
| **Three  months ended  September 30, 2001** |   |                                                   |       |                              |   |                              |   |             |       |
| Revenue                                     |   | $                                                      | 10,629,000 |                              | $      | 3,362,000                         |   | $                | —     |   | $ | 13,991,000 |   |
| Gross profit                                |   | 8,855,000                                              |       | 2,214,000                         |   | —                            |   | 11,069,000       |       |
| Income (loss)  from operations              |   | 2,700,000                                              |       | (2,110,000                        | )      | (5,138,000                        | )      | (4,548,000       | )          |
| Net income  (loss)                          |   | 2,700,000                                              |       | (2,110,000                        | )      | (4,964,000                        | )      | (4,374,000       | )          |
| Total assets at  September 30, 2001         |   | $                                                      | 23,353,000 |                              | $      | 9,903,000                         |   | $                | 42,376,000 |   | $ | 75,632,000 |   |

 

 

9

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|                                       |   | **Software  and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Unallocated  Corporate Items** |   | **Consolidated** |   |
|--------------------------------------------|--------|--------------------------------------------------------|------------|-----------------------------------|--------|----------------------------------|--------|------------------|--------|
| **Nine  months ended  September 30, 2002** |   |                                                   |       |                              |   |                             |   |             |   |
| Revenue                                    |   | $                                                      | 45,231,000 |                              | $      | 11,058,000                       |   | $                | — |   | $ | 56,289,000 |   |
| Gross profit                               |   | 38,066,000                                             |       | 7,973,000                         |   | —                           |   | 46,039,000       |   |
| Income (loss)  from operations             |   | 14,116,000                                             |       | (6,804,000                        | )      | (11,351,000                      | )      | (4,039,000       | )      |
| Net income  (loss)                         |   | 14,116,000                                             |       | (6,804,000                        | )      | (11,092,000                      | )      | (3,780,000       | )      |
|                                       |   |                                                   |       |                              |   |                             |   |             |   |
| **Nine  months ended  September 30, 2001** |   |                                                   |       |                              |   |                             |   |             |   |
| Revenue                                    |   | $                                                      | 30,601,000 |                              | $      | 9,491,000                        |   | $                | — |   | $ | 40,092,000 |   |
| Gross profit                               |   | 24,026,000                                             |       | 6,474,000                         |   | —                           |   | 30,500,000       |   |
| Income (loss)  from operations             |   | 5,900,000                                              |       | (6,443,000                        | )      | (15,918,000                      | )      | (16,461,000      | )      |
| Net income  (loss)                         |   | 5,900,000                                              |       | (6,443,000                        | )      | (15,134,000                      | )      | (15,677,000      | )      |

 

**7. RECENT ACCOUNTING PRONOUNCEMENTS**

 

In June 2002, the Financial Accounting Standards Board issued SFAS No.146, “Accounting for Costs Associated with Exit or Disposal Activities”.  SFAS No. 146 addresses financial accountingand reporting for costs associated with exit or disposal activities.  It nullifies Emerging Issues Task ForceIssue No. 94-3, “Liability Recognition for Certain Employee TerminationBenefits and Other Costs to Exit an Activity”. SFAS No. 146 requires that a liability be recognized for costsassociated with an exit or disposal activity only when the liability isincurred.  SFAS No. 146 also establishesfair value as the objective for initial measurement of liabilities related toexit or disposal activities.  SFAS No.146 is effective for exit or disposal activities that are initiated afterDecember 31, 2002.  The Company does notbelieve that this statement will have a material impact on its consolidatedfinancial statements.

 

In July 2001, the Financial Accounting Standards Board issued SFAS No.144, “Impairment or Disposal of Long-Lived Assets”, which is effective forfiscal years beginning after December 15, 2001. The provisions of thisstatement provide a single accounting model for impairment of long-livedassets. The Company adopted SFAS No. 144 effective January 1, 2002.  The adoption of this statement did not havea material impact on the Company’s financial position or results of operations.

 

**8. LITIGATION AND OTHER CHARGES**

 

During March 2002, the Company recorded a charge for pending litigationof $2,300,000.  This reserve wasestablished based upon developments in new and existing litigation for whichmanagement determined, in the first quarter of 2002, that payment is bothprobable and estimable.  Additionally,the Company recorded a charge of $200,000 during March 2002 in connection withits decision during the period to consolidate one of its offices.

 

Subsequent to September 30, 2002, the Company’s ongoing contractualdispute with ePedas Sdn Bhd was settled with no admission of liability byeither party and the Company’s agreement to pay $625,000 to ePedas.  Such amount will be charged against thepending litigation reserve.  Each partyreleased the other from all claims related to the dispute and dismissed theirrespective claims with prejudice.

 

 

10

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

** **

*The Company notes that, except forthe historical information contained herein, the matters discussed belowcontain forward-looking statements that involve known and unknown risks, uncertaintiesand other factors that may cause the actual results, performance orachievements of the Company, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements.  TheCompany expressly disclaims any obligation to update this information orpublicly release any revision or reflect events or circumstances after the dateof this report.  Such factors include,among others:  the Company’s limitedoperating history and variability of operating results, possibility of futurelosses, risks associated with electronic software delivery, dependence on theInternet and growth in electronic commerce and Internet infrastructuredevelopment, dependence on software publishers, dependence on online retailers,system development and electronic commerce security risks, rapid technologicalchanges, competition in the electronic commerce industry, the importance ofattracting and retaining personnel, management of the Company’s growth,integration of acquired companies, dependence on key employees and other riskfactors referenced in the Company’s Form 10-K for the year ended December 31,2001.*

 

**Overview**

 

The Company is a leading provider of comprehensiveelectronic commerce outsourcing solutions. The Company was incorporated in February 1994 and commenced offeringproducts for sale through its clients’ Web stores in August 1996.  From inception through August 1996, theCompany had no sales, and its activities related primarily to the developmentof its Commerce Network Server (“CNS”) technology related to electroniccommerce.  In 1996, the Company began tofocus its business development efforts on the software industry, building itsinventory of software products through contracts with software publishers.  In 1997, the Company began to developsoftware distribution relationships through contracts with onlineretailers.  In late 1998, the Companybegan to offer its comprehensive electronic commerce outsourcing services inthe form of a transaction fee-based e-commerce service to clients outside ofthe software industry.  The Companycurrently offers more than 32,000 sitesthe ability to cut costs and grow their businesses by using its completee-commerce systems and services.

 

The Company derives its revenue primarily fromtransaction and service fees associated with the e-commerce services that theCompany provides to its clients.  Theseservices include Web commerce development and hosting, transaction processing,digital delivery, integration to physical fulfillment, fraud screening,customer service and merchandising and analytical marketing services.  The Company acts as the merchant of recordon the majority of the transactions processed and has contractual relationshipswith its clients, primarily software publishers and online retailers, whichobligate the Company to pay to the client a specified percentage of eachsale.  The Company retains itstransaction fee and also charges for other services.  The Company also derives revenue from fees charged to use itssoftware, integration, development and consulting services provided to itsclients.  This revenue is recognized asservices are performed, except for software usage fee and certain integrationand development fees, which are recognized evenly over the initial term of thecontract.

 

The Company has a limited operating history upon which investors mayevaluate its business and prospects. Since inception, the Company has incurred significant losses, and as ofSeptember 30, 2002, had an accumulated deficit of $106,894,000.  The Company intends to expend financial andmanagement resources on the development of additional services, sales andmarketing, technology and operations to support larger-scale operations andgreater service offerings.  Although theCompany expects to generate positive cash flow from operations in 2002, therecan be no assurance that the Company’s revenue will increase or even continueat its current level or that the Company will achieve or maintain profitabilityor generate cash from operations in future periods.

 

 

11

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The Company’s prospects must be considered in light of the risks,expenses and difficulties frequently encountered by companies in their earlystage of development, particularly companies in new and rapidly evolvingmarkets such as electronic commerce.  Toaddress these risks, the Company must, among other things, maintain existingand develop new relationships with software publishers, online retailers andE-Business Services clients, implement and successfully execute its businessand marketing strategy, continue to develop and upgrade its technology andtransaction-processing systems, provide superior customer service and orderfulfillment, respond to competitive developments, and attract, retain andmotivate qualified personnel.  There canbe no assurance that the Company will be successful in addressing such risks,and the failure to do so would have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

The Company’s current and future expense levels are based largely onits planned operations and estimates of future revenue.  Revenue and operating results generallydepend on the volume and timing of orders received, which are difficult toforecast.  The Company may be unable toadjust spending in a timely manner to compensate for any unexpected revenueshortfall.  Accordingly, any significantshortfall in revenue could have an immediate adverse effect on the Company’sbusiness, financial condition and results of operations.  The Company is also likely to continue tosee revenue in its Software and Digital Commerce Services Division fluctuate ona seasonal basis typical for the software publishing market in general.  The Company believes that its fiscal firstand fourth quarters are seasonally stronger than its second and third quartersdue to the timing of demand for tax preparation software and the holiday sellingperiod.  In addition, it is the Company’sbelief that software publishers generally avoid new product releases in thesummer months.  In view of the rapidlyevolving nature of the Company’s business and its limited operating history,the Company is unable to accurately forecast its revenue and believes thatperiod-to-period comparisons of its operating results are not necessarilymeaningful and should not be relied upon as an indication of futureperformance.

 

**Results of Operations**

 

The following table sets forth certain items from the Company’scondensed consolidated statements of operations as a percentage of totalrevenue for the periods indicated.

 
|                                                                          |   | **Three  months ended  September 30,** |       | **Nine  months ended  September 30,** |       |
|-------------------------------------------------------------------------------|--------|----------------------------------------|------------|---------------------------------------|------------|
|                                                                          |   | **2002**                               |       | **2001**                              |       | **2002** |   | **2001** |   |
|                                                                          |   |                                   | ** ** |                                  | ** ** |   | ** ** |   | ** ** |
| Revenue                                                                       |   | 100.0                                  | %          | 100.0                                 | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                            |   |                                   |       |                                  |       |   |   |   |   |
| Direct cost of services                                                       |   | 3.0                                    |       | 5.5                                   |       | 3.1 |   | 5.0 |   |
| Network and infrastructure                                                    |   | 15.9                                   |       | 15.3                                  |       | 15.1 |   | 19.0 |   |
| Sales and marketing                                                           |   | 41.6                                   |       | 47.2                                  |       | 43.1 |   | 49.5 |   |
| Product research and development                                              |   | 14.6                                   |       | 19.7                                  |       | 16.6 |   | 19.9 |   |
| General and administrative                                                    |   | 9.6                                    |       | 8.0                                   |       | 9.1 |   | 8.0 |   |
| Litigation and other charges                                                  |   | —                                 |       | —                                |       | 4.5 |   | — |   |
| Depreciation and amortization                                                 |   | 7.9                                    |       | 8.8                                   |       | 7.6 |   | 8.8 |   |
| Amortization of goodwill and other intangibles and acquisition related  costs |   | 7.2                                    |       | 28.0                                  |       | 8.1 |   | 30.9 |   |
| Total operating expenses                                                      |   | 99.8                                   |       | 132.5                                 |       | 107.2 |   | 141.1 |   |
| Income (loss) from operations                                                 |   | 0.2                                    |       | (32.5                                 | )          | (7.2 | ) | (41.1 | ) |
| Interest income, net                                                          |   | 0.3                                    |       | 1.2                                   |       | 0.5 |   | 2.0 |   |
| Net income (loss)                                                             |   | 0.5                                    | %          | (31.3                                 | )%         | (6.7 | )% | (39.1% | ) |

 

 

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***REVENUE.*** Revenue increased to $18,872,000 for thethree months ended September 30, 2002 from $13,991,000 for the same period inthe prior year, an increase of $4,881,000 or 34.9%.  For the nine months ended September 30, 2002, revenue totaled$56,289,000, an increase of $16,197,000 or 40.4% from revenue of $40,092,000recorded in the same period of the prior year. Revenue for the Software andDigital Commerce Services division increased to $15,430,000 for the threemonths ended September 30, 2002 from $10,629,000 for the three months endedSeptember 30, 2001 and increased to $45,231,000 for the nine months endedSeptember 30, 2002, up from $30,601,000 for the same period in 2001.  The increase in the three and nine-month periodsprimarily resulted from growth in the number of the Company’s softwarepublisher and online retailer clients, including the impact of the clientsgained in the acquisition of the eStore Group of Beyond.com Corporation inMarch 2002, as well as increasing market acceptance of electronic softwaredelivery.  In addition, results for thecurrent year three and nine-month periods include the impact of revenuegenerated by RegSoft.com, a company acquired by the Company in August2001.  Revenue for the E-BusinessServices division increased to $3,442,000 for the three months ended September30, 2002 from $3,362,000 for the three months ended September 30, 2001 andincreased to $11,058,000 for the nine months ended September 30, 2002, up from$9,491,000 for the same period in 2001. These increases reflect the impact of the Company’s acquisitions ofOrbit Commerce assets in September 2001, the FreeMerchant.com assets of NetworkCommerce in December 2001 and the CCNow assets of Innuity Acquisition Corp. inMarch 2002.

 

International sales represented approximately 22% and 23% of totalrevenue in the three-month periods ended September 30, 2002 and 2001,respectively, and approximately 21% of total revenue in the nine-month periodsended September 30, 2002 and 2001, respectively.

 

***GROSS PROFIT.***Cost of revenue, which consists of directcost of services and network and infrastructure costs (both shown exclusive ofdepreciation and amortization expense), increased to $3,557,000 for the threemonths ended September 30, 2002 from $2,922,000 for the same period in theprior year.  For the nine months endedSeptember 30, 2002, cost of revenue increased to $10,250,000, up from$9,592,000 for the same period in the prior year.  The increase for the three-month period primarily resulted fromincreased personnel costs in customer service to handle the additional clientload along with increases in information systems costs.  The increase for the nine-month periodprimarily resulted from increases in information systems and bandwidthcosts.  The gross profit margin for theSoftware and Digital Commerce Services division rose in the three and ninemonths ended September 30, 2002 to 83.6% and 84.2%, respectively, from 83.3%and 78.5% for the same periods of the prior year.  The gross profit margin for the E-Business Services divisionincreased in the three and nine months ended September 30, 2002 to 70.3% and72.1%, respectively, compared to 65.9% and 68.2% for the same periods of theprior year.  The increase in margin inboth divisions is primarily due to leveraging the Company’s infrastructure oversignificantly more revenue and clients. The Company believes that Internet commerce and related services couldbecome more competitive in the future. Accordingly, the Company may reduce or alter its pricing structure andpolicies in the future and any such change could reduce gross margins.

 

***SALES AND MARKETING.***Sales andmarketing expense consists primarily of personnel and related expenses,advertising and promotional expenses, bad debt expense and credit cardtransaction fees.  Sales and marketingexpense increased to $7,854,000 for the three months ended September 30, 2002from $6,599,000 for the same period in the prior year, an increase of $1,255,000or 19.0%.  For the nine months endedSeptember 30, 2002, sales and marketing expense increased to $24,269,000compared to $19,863,000 for the same period in the prior year, an increase of$4,406,000 or 22.2%.  The increase inboth the three and nine-month periods primarily resulted from an increase incredit card fees and chargeback costs along with an increase in personnelcosts, offset by a decrease in advertising and marketing expense.  Sales and marketing expense for the Softwareand Digital Commerce Services division increased to $5,513,000 and $16,610,000for the three and nine months ended September 30, 2002, respectively, from$4,115,000 and $12,424,000 for the same periods in the prior year.  Sales and marketing expense for theE-Business Services division was $2,341,000 and $7,659,000 for the three andnine months ended September 30, 2002, respectively, compared to $2,484,000 and$7,439,000 for the same periods in the prior year.  As a percentage of revenue, sales and marketing expense was 41.6%and 43.1% in the three and nine-month periods ended September 30, 2002,respectively, compared to 47.2% and 49.5% for the same periods in the prioryear, primarily reflecting the Company’s increased revenue.  The Company expects that sales and marketingexpense will continue to increase in absolute dollars as the Company continuesto build its sales and marketing infrastructure and develops marketing programsand as volume–driven credit card and bad debt expenses increase.  As a percentage of revenue, these expensesare expected to decrease as revenue increases.

 

 

13

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***PRODUCT RESEARCH AND DEVELOPMENT.*** Product research and development expenseconsists primarily of personnel and related expenses and consulting costsassociated with developing and enhancing the Company’s CNS and related internalsystems.  Product research anddevelopment expense was $2,764,000 in both the three-month periods endedSeptember 30, 2002 and 2001.  For thenine months ended September 30, 2002, product research and development expenseincreased to $9,327,000 compared to $7,962,000 for the same period in the prioryear, an increase of $1,365,000 or 17.1%. The increase in the nine-month period primarily resulted from thediscontinuance of capitalizing product development costs in the later part of2001.  In the prior year nine-monthperiod, the Company capitalized $937,000 in product development costs relatedto the Company’s new platform.  Noproduct development costs were capitalized in the current year period.  Product research and development expense forthe Software and Digital Commerce Services division was $1,103,000 for thethree months ended September 30, 2002, compared to $1,244,000 for the sameperiod of the prior year and was $3,873,000 for the nine months ended September30, 2002, compared to $3,462,000 for the same period in the prior year.  Product research and development expense forthe E-Business Services division increased to $1,661,000 and $5,454,000 for thethree and nine months ended September 30, 2002, respectively, from $1,520,000and $4,500,000 for the same periods in the prior year.  As a percentage of revenue, product researchand development expense was 14.6% and 16.6% in the three and nine-month periodsended September 30, 2002, respectively, compared to 19.7% and 19.9% for thesame periods in the prior year.  As apercentage of revenue, these expenses are expected to decrease further asrevenue increases.

 

***GENERAL ANDADMINISTRATIVE.***Generaland administrative expense consists primarily of executive, accounting andadministrative personnel and related expenses including professional fees andinvestor relations expenses.  Generaland administrative expenses increased to $1,807,000 for the three months endedSeptember 30, 2002 from $1,116,000 for the same period in the prior year, anincrease of $691,000 or 61.9%.  For thenine months ended September 30, 2002, general and administrative expenseincreased to $5,130,000 compared to $3,218,000 for the same period in the prioryear, an increase of $1,912,000 or 59.4%. These increases resulted primarily from an increase in legal costsrelated to the outstanding claims against the Company. In addition, the Companyhas incurred increased personnel and insurance related costs in the currentyear periods.  General andadministrative expense for the Software and Digital Commerce Services divisionincreased to $1,149,000 and $3,467,000 for the three and nine months endedSeptember 30, 2002, respectively, from $796,000 and $2,240,000 for the sameperiods in the prior year.  General andadministrative expense for the E-Business Services division increased to$658,000 and $1,663,000 for the three and nine months ended September 30, 2002,respectively, from $320,000 and $978,000 for the same periods in the prior year.  As a percentage of revenue, general andadministrative expense was 9.6% and 9.1% in the three and nine-month periodsended September 30, 2002, respectively, compared to 8.0% for the same periodsin the prior year, primarily reflecting the increase in legal fees in thecurrent year periods.  The Companyexpects that general and administrative expense will increase in absolutedollars over time as the Company defends its positions related to legal claimsand as it continues to build infrastructure to support its revenue growth.

 

***LITIGATION ANDOTHER CHARGES.***Duringthe nine months ended September 30, 2002, the Company recorded a charge forpending litigation of $2,300,000.  Thisreserve was established based upon developments in new and existing litigationfor which management determined, in the first quarter of 2002, that payment wasboth probable and estimable. Additionally, the Company recorded a charge of $200,000 during the ninemonths ended September 30, 2002 in connection with its decision during theperiod to consolidate one of its offices.

 

Subsequent to September 30, 2002, the Company’s ongoing contractualdispute with ePedas Sdn Bhd was settled with no admission of liability byeither party and the Company’s agreement to pay $625,000 to ePedas.  Such amount will be charged against thepending litigation reserve.  Each partyreleased the other from all claims related to the dispute and dismissed theirrespective claims with prejudice.

 

***AMORTIZATION OFGOODWILL AND OTHER INTANGIBLES AND ACQUISITION RELATED COSTS.***Amortization of goodwill and otherintangibles and acquisition related costs decreased to $1,356,000 for the threemonths ended September 30, 2002 from $3,912,000 for the same period in theprior year.  For the nine months endedSeptember 30, 2002, amortization of goodwill and other intangibles andacquisition related costs decreased to $4,556,000 compared to $12,396,000 forthe same period in the prior year.  Thedecrease is primarily related to the impact of the Company’s adoption of Statementof Financial Accounting Standards No. 142, resulting in goodwill no longerbeing amortized (see Note 4 of Notes to Condensed Consolidated FinancialStatements).  In addition, compensationbased earn-out payments totaling $1,514,000 were made in the nine months endedSeptember 30, 2001.  There were nocompensation based earn-out payments in the nine months ended September 30,2002.

 

 

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***INCOME TAXES.***The Company paid no income taxes in anyreported period.  As of September 30,2002, the Company had approximately $86,180,000 of net operating losscarryforwards for federal income tax purposes, which expire beginning in2009.  Due to the uncertainty of futureprofitability, a valuation allowance equal to the deferred tax asset has beenrecorded.  Certain changes in ownershipthat resulted from the sales of common and preferred stock will limit thefuture annual realization of the tax operating loss carryforwards to a specifiedpercentage under Section 382 of the Internal Revenue Code.

 

**Liquidity and Capital Resources**

 

During the nine months ended September 30, 2002, theCompany’s operations generated $11,099,000 of cash compared to a $836,000 useof cash for the same period of the prior year. The improvement is mainly due to the reduction in the net loss in thecurrent year nine-month period.  Netcash used in investing activities during the nine months ended September 30,2002 totaled $3,380,000.  This wascomprised of investments in equipment and for acquired companies totaling$6,867,000 offset by net sales of investments totaling $3,487,000.  Net cash used in financing activities duringthe nine months ended September 30, 2002 totaled $634,000, comprised of thepayoff of a $2,500,000 note payable offset by cash received upon the sale ofstock and the exercise of stock options and warrants.

 

As of September 30, 2002, the Company had $28,762,000 of cash and cashequivalents and $6,491,000 of short-term investments.  The Company’s principal commitments consisted of obligationsoutstanding under operating leases. Although the Company has no material commitments for capitalexpenditures, it anticipates continued capital expenditures consistent with itsanticipated growth in operations, infrastructure and personnel.  The Company anticipates that it will expendapproximately $9,000,000 over the next 15 months on capital expenditures basedon its current anticipated growth rate. The Company further anticipates that it will expend approximately$12,000,000 over the next 15 months on product development based on its currentanticipated growth rate in operations. The Company may also use cash to acquire or license technology, productsor businesses related to the Company’s current business.  The Company also anticipates that it willexperience growth in its operating expenses for the foreseeable future and thatits operating expenses will be a material use of the Company’s cash resources.

 

In April 2001, the Company initiated a share repurchase program of upto $5,000,000 of its outstanding shares of Common Stock.  Repurchases will be at the Company’sdiscretion based on ongoing assessments of the capital needs of the businessand the market price of its shares.  Notime limit was set for completion of the repurchase program.  Through September 30, 2002, the Companyexpended approximately $267,000 to repurchase its shares.

 

The Company believes that existing sources of liquidity and the resultsof its operations will provide adequate cash to fund its operations for at leastthe next 15 months, although the Company may seek to raise additional capitalduring that period.  In January 2002,the Company filed a universal shelf registration statement with the Securitiesand Exchange Commission pursuant to which the Company may issue up to$100,000,000 in common stock, preferred stock, debt securities and/orwarrants.  The sale of additional equityor convertible securities could result in additional dilution to the Company’sstockholders.  There can be no assurancethat financing will be available in amounts or on terms acceptable to theCompany, if at all.

 

 

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**Recent Accounting Pronouncements**

 

In July 2001, the Financial Accounting Standards Board issued SFAS No.144, “Impairment or Disposal of Long-Lived Assets”, which is effective forfiscal years beginning after December 15, 2001. The provisions of thisstatement provide a single accounting model for impairment of long-livedassets. The Company adopted SFAS No. 144 effective January 1, 2002.  The adoption of this statement did not havea material impact on the Company’s financial position or results of operations.

 

In June 2002, the Financial Accounting Standards Board issued SFAS No.146, “Accounting for Costs Associated with Exit or Disposal Activities”.  SFAS No. 146 addresses financial accountingand reporting for costs associated with exit or disposal activities.  It nullifies Emerging Issues Task ForceIssue No. 94-3, “Liability Recognition for Certain Employee Termination Benefitsand Other Costs to Exit an Activity”. SFAS No. 146 requires that a liability be recognized for costsassociated with an exit or disposal activity only when the liability isincurred.  SFAS No. 146 also establishesfair value as the objective for initial measurement of liabilities related toexit or disposal activities.  SFAS No.146 is effective for exit or disposal activities that are initiated afterDecember 31, 2002.  The Company does notbelieve that this statement will have a material impact on its consolidatedfinancial statements.

 

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

 

The Company does not enter into financial instruments for trading orspeculative purposes and does not currently utilize derivative financial instruments.  The operations of the Company are conductedprimarily in the United States and as such are not subject to material foreigncurrency exchange rate risk.  TheCompany has no long-term debt.

 

**Item 4.  Controls andProcedures**

 

(a) Based on their evaluationof the Company’s disclosure controls and procedures conducted within 90 days ofthe date of filing this report on Form 10-Q, the Company’s Chief ExecutiveOfficer and Chief Financial Officer have concluded that the Company’sdisclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)promulgated under the Securities Exchange Act of 1934) are effective.

(b) There havebeen no significant changes (including corrective actions with regard tosignificant deficiencies or material weaknesses) in the Company’s internalcontrols or in other factors that could significantly affect these controlssubsequent to the date of the evaluation referenced in paragraph (a)above.

 

**Limitations on the Effectiveness of Controls**

 

The Company’s management, including the Chief Executive Officer andChief Financial Officer, does not expect that the Company's disclosure controlsand procedures or internal controls will prevent all error and all fraud. Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the design of a control system must reflect the fact thatthere are resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within the Company have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerror or mistake. Additionally, controls can be circumvented by the individualacts of some persons, by collusion of two or more people, or by managementoverride of the control. The design of any system of controls also is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions; over time, control may become inadequatebecause of changes in conditions, or the degree of compliance with the policiesor procedures may deteriorate.  Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error or fraud may occur and not be detected.

 

 

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**PART II.  OTHERINFORMATION**

 

**Item 1.  LegalProceedings**

 

Beginning in August 2001, the Company and certain of its officers anddirectors were named as defendants in several class action shareholdercomplaints filed in the United States District Court for the Southern Districtof New York, now consolidated under the caption In re Digital River, Inc.Initial Public Offering Securities Litigation, Case No. 01-CV-7355.  In each of these complaints, the plaintiffsallege that the Company, certain of its officers and directors and theunderwriters of the Company's initial public offering, or IPO, violated thefederal securities laws because the Company's IPO registration statement andprospectus contained untrue statements of material fact or omitted materialfacts regarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters.  Theplaintiffs seek unspecified monetary damages and other relief.  Similar complaints were filed in the sameCourt against hundreds of other public companies that conducted IPOs of theircommon stock in the late 1990s.  OnAugust 8, 2001, the IPO Lawsuits were consolidated for pretrial purposes beforeUnited States Judge Shira Scheindlin of the Southern District of New York.Judge Scheindlin held an initial case management conference on September 7,2001, at which time she ordered, among other things, that the time for alldefendants in the IPO Lawsuits to respond to any complaint be postponed untilfurther order of the Court. Thus, the Company has not been required to answerany of the complaints, and no discovery has been served on the Company.  In accordance with Judge Scheindlin’s ordersat further status conferences in March and April 2002, the appointed leadplaintiffs’ counsel filed amended, consolidated complaints in the IPO Lawsuitson April 19, 2002.  Defendants then fileda global motion to dismiss the IPO Lawsuits on July 15, 2002, as to which theCompany does not expect a decision until late 2002.  On October 9, 2002, the Court entered an order dismissing theCompany's named officers and directors from the IPO Lawsuits without prejudice,pursuant to an agreement tolling the statute of limitations with respect tothese officers and directors until September 30, 2003.

 

On February 27, 2002, ePedas Sdn Bhd initiated anarbitration before the American Arbitration Association against theCompany.  The demand for arbitrationalleged breach of contract and tortuous interference claims against theCompany. The prayer for relief requested RM 28,809,137.09 (Ringit Malaysia orapproximately US $7,581,150) plus pre-judgment interest, punitive damages, alllegal costs and other unspecified fees and expenses. The case was subsequentlytransferred to the International Section of the American ArbitrationAssociation. The Company responded to ePedas’ demand on April 12, 2002. In thatresponse, the Company denied all allegations set forth in ePedas’ demand andcounterclaimed against ePedas for breach of contract, seeking damages of atleast $30,822, as well as the costs of the arbitration, reasonable costs forexperts and other witnesses, and all legal costs.

 

On October 23, 2002, this dispute was settled with no admission ofliability by either party and the Company's agreement to pay $625,000 toePedas.  Each party released the otherfrom all claims related to the dispute and dismissed their respective claimswith prejudice.

 

 

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**Item 6.  Exhibits andReports on Form 8-K**

 

(A) Exhibits

 
| **EXHIBIT********NUMBER** |   | **DESCRIPTION OF DOCUMENTS** |   |
|---------------------------|--------|------------------------------|--------|
|                      |   |                         |   |   |   |
| 3.1                       |   | (1)                          |   | Amended and Restated  Certificate of Incorporation, as amended, as currently in effect |   |
| 3.2                       |   | (2)                          |   | Amended and Restated Bylaws, as  currently in effect |   |
| 4.1                       |   | (3)                          |   | Specimen of Common Stock  Certificate |   |
| 11.1                      |   | (4)                          |   | Statement of Computation of Per  Share Earnings |   |
| 99.1                      |   |                         |   | 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 the Company’s 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 the Company’s 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 the Company’s Registration Statement on Form S-1, File No.  333-56787, declared effective on August 11, 1998, and incorporated herein by  reference.                                        |
| (4) |   | See  Note 3 to Condensed Consolidated Financial Statements.                                                                                                                                                              |

 

(B) Reports on Form 8-K

 

On August 14, 2002, the Company filed a current report on Form 8-Kreporting that the Company’s quarterly report on Form 10-Q for the quarterended June 30, 2002 had been accompanied by a certification from the Company’sChief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350 adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

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SIGNATURES

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| Date:  | November 13, 2002 |   |   | DIGITAL RIVER, INC.                                                      |
|--------|-------------------|--------|--------|--------------------------------------------------------------------------|
|   |              |   |   |                                                                     |
|   |              |   | By:    | /s/ CARTER D. HICKS                                                      |
|   |              |   |   |                                                                     |
|   |              |   |   | Carter D. Hicks                                                          |
|   |              |   |   | *Chief  Financial Officer  (Principal Financial and Accounting Officer)* |

 

 

CERTIFICATIONS

 

 

I, Joel A Ronning, certify that:

 

1. I have reviewed this quarterly report on Form 10-Q of Digital River,Inc.;

 

2. Based on my knowledge, this quarterly report does not contain anyuntrue statement of a material fact or omit to state a material fact necessaryto make the statements made, in light of the circumstances under which suchstatements were made, not misleading with respect to the period covered by thisquarterly report;

 

3. Based on my knowledge, the financial statements, and other financialinformation included in this quarterly report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theCompany as of, and for, the periods presented in this quarterly report;

 

4. The Company’s other certifying officer and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the Company and we have:

 

a) Designed such disclosure controls and procedures toensure that material information relating to the Company, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b) Evaluated the effectiveness of the Company’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the “Evaluation Date”); and

 

c) Presented in this quarterly report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

 

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5. The Company’s other certifying officer and I have disclosed, basedon our most recent evaluation, to the Company’s auditors and the auditcommittee of Company’s board of directors (or persons performing the equivalentfunction):

 

a) All significant deficiencies in the design oroperation of internal controls which could adversely affect the Company’sability to record, process, summarize and report financial data and haveidentified for the Company’s auditors any material weaknesses in internalcontrols; and

 

b) Any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the Company’sinternal controls; and

 

6. The Company’s other certifying officer and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 
| Date:  | November 13, 2002 |   |                       |
|--------|-------------------|--------|----------------------------|
|   |              |   |                       |
|   |              | By:    | /s/ JOEL A. RONNING        |
|   |              |   | Joel A. Ronning            |
|   |              |   | *Chief  Executive Officer* |

 

 

 

 

I, Carter D. Hicks, certify that:

 

1. I have reviewed this quarterly report on Form 10-Q of Digital River,Inc.;

 

2. Based on my knowledge, this quarterly report does not contain anyuntrue statement of a material fact or omit to state a material fact necessaryto make the statements made, in light of the circumstances under which suchstatements were made, not misleading with respect to the period covered by thisquarterly report;

 

3. Based on my knowledge, the financial statements, and other financialinformation included in this quarterly report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theCompany as of, and for, the periods presented in this quarterly report;

 

4. The Company’s other certifying officer and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the Company and we have:

 

a) Designed such disclosure controls and procedures toensure that material information relating to the Company, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b) Evaluated the effectiveness of the Company’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the “Evaluation Date”); and

 

c) Presented in this quarterly report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

 

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5. The Company’s other certifying officer and I have disclosed, basedon our most recent evaluation, to the Company’s auditors and the auditcommittee of Company’s board of directors (or persons performing the equivalentfunction):

 

a) All significant deficiencies in the design oroperation of internal controls which could adversely affect the Company’sability to record, process, summarize and report financial data and haveidentified for the Company’s auditors any material weaknesses in internalcontrols; and

 

b) Any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the Company’sinternal controls; and

 

6. The Company’s other certifying officer and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 
| Date:  | November 13, 2002 |   |                       |
|--------|-------------------|--------|----------------------------|
|   |              |   |                       |
|   |              | By:    | /s/ CARTER D. HICKS        |
|   |              |   |                       |
|   |              |   | Carter D. Hicks            |
|   |              |   | *Chief  Financial Officer* |

 

 

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EXHIBIT INDEX

 
| **EXHIBIT********NUMBER** |   | **DESCRIPTION OF DOCUMENTS** |   |
|---------------------------|--------|------------------------------|--------|
|                      |   |                         |   |   |   |
| 3.1                       |   | (1)                          |   | Amended and Restated  Certificate of Incorporation, as amended, as currently in effect |   |
| 3.2                       |   | (2)                          |   | Amended and Restated Bylaws, as  currently in effect |   |
| 4.1                       |   | (3)                          |   | Specimen of Common Stock  Certificate |   |
| 11.1                      |   | (4)                          |   | Statement of Computation of Per  Share Earnings |   |
| 99.1                      |   |                         |   | 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 the Company’s 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 the Company’s 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 the Company’s Registration Statement on Form S-1, File No.  333-56787, declared effective on August 11, 1998, and incorporated herein by  reference.                                        |
| (4) |   | See  Note 3 to Condensed Consolidated Financial Statements.                                                                                                                                                              |

 

 

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