**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe Fiscal Year Ended December 31, 2005**

**or**

**o**                                  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe transition period from                   to                  **

**Commissionfile number 000-33367**

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**UNITED ONLINE, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                             |   | **77-0575839**       |
|------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of         |   | (I.R.S. Employer     |
| incorporation or  organization)          |   | Identification  No.) |
| **21301 Burbank Boulevard**              |   | ** **           |
| **Woodland  Hills, California**          |   | **91367**            |
| (Address of  principal executive office) |   | (Zip Code)           |

**(818) 287-3000**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant toSection 12(b) of the Act:

**None**

Securities registered pursuant toSection 12(g) of the Act:

**Common Stock, par value$0.0001 per sharePreferred Stock Purchase Rights**

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes x No o

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all documents and reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

| Large accelerated filero | Accelerated  filer x | Non-accelerated filer o |
|--------------------------|---------------------------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2)of the Act). Yes o No x

At June 30, 2005, theaggregate market value of voting stock held by non-affiliates of theregistrant, based on the last reported sales price of the registrant’s commonstock on such date reported by the Nasdaq National Market, was $652,096,978(calculated by excluding shares beneficially owned by directors and officers).

At February 28, 2006,there were a total of 63,390,060 shares of the registrant’s common stockoutstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Theinformation required by Part III of this annual report, to the extent notset forth herein, is incorporated herein by reference to the registrant’sdefinitive proxy statement relating to the 2006 annual meeting of stockholdersto be filed with the Securities and Exchange Commission not later than120 days after the end of the registrant’s fiscal year.

 

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**UNITEDONLINE, INC.INDEX TO FORM 10-KFor the Year Ended December 31, 2005**
|                    | ** ** |                                                                                                                    | ** ** | **Page** |
|--------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I.**   |       |                                                                                                               |       |     |
| Item 1.            |       | Business                                                                                                           |       | 3        |
| Item 1A.           |       | Risk Factors                                                                                                       |       | 18       |
| Item 1B.           |       | Unresolved Staff Comments                                                                                          |       | 31       |
| Item 2.            |       | Properties                                                                                                         |       | 31       |
| Item 3.            |       | Legal Proceedings                                                                                                  |       | 31       |
| Item 4.            |       | Submission of Matters to a  Vote of Security Holders                                                               |       | 32       |
| **PART II.**  |       |                                                                                                               |       |     |
| Item 5.            |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 33       |
| Item  6.           |       | Selected  Financial Data                                                                                           |       | 35       |
| Item 7.            |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                   |       | 36       |
| Item 7A.           |       | Quantitative and Qualitative  Disclosures About Market Risk                                                        |       | 60       |
| Item 8.            |       | Financial Statements and  Supplementary Data                                                                       |       | 61       |
| Item 9.            |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                              |       | 61       |
| Item 9A.           |       | Controls and Procedures                                                                                            |       | 62       |
| Item 9B.           |       | Other  Information                                                                                                 |       | 63       |
| **PART III.** |       |                                                                                                               |       |     |
| Item 10.           |       | Directors and Executive Officers of the  Registrant                                                                |       | 63       |
| Item 11.           |       | Executive Compensation                                                                                             |       | 63       |
| Item 12.           |       | Security Ownership of Certain Beneficial Owners  and Management and Related Stockholder Matters                    |       | 63       |
| Item 13.           |       | Certain Relationships and Related  Transactions                                                                    |       | 63       |
| Item 14.           |       | Principal Accounting Fees and Services                                                                             |       | 63       |
| **PART IV.**  |       |                                                                                                               |       |     |
| Item 15.           |       | Exhibits, Financial  Statement Schedules                                                                           |       | 63       |
| **Signatures**     |       | 66                                                                                                                 |

 

In this document, “UnitedOnline,” the “Company,” “we,” “us” and “our” refer to United Online, Inc.and its wholly-owned subsidiaries.

*This Annual Report on Form 10-K and thedocuments incorporated herein by reference contain forward-lookingstatements based on our current expectations, estimates and projections aboutour operations, industry, financial condition and liquidity. Statementscontaining words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “may,”“will” or similar expressions constitute forward-looking statements.These forward-looking statements include, but are not limited to,statements about the markets in which we compete, our pay accounts andsubscriptions, our product and service offerings, the advertising market,operating expenses, operating efficiencies, revenues, capital requirement, taxpayments and our cash position. In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances, including any underlying assumptions, are forward-lookingstatements. Such statements are not guarantees of future performance and aresubject to risks, uncertainties and assumptions that are difficult to predict.Therefore, our actual results could differ materially and adversely from thoseexpressed in any forward-looking statements as a result of variousfactors. The section entitled “Risk Factors” in this Annual Report on Form 10-Kand our other filings with the SEC set forth some of the important risk factorsthat may affect our business, financial position, results of operations andcash flows. Statements indicating factors that we believe may impact ourresults are not intended to be exclusive. We undertake no obligation to reviseor update publicly any forward-looking statements, other than as requiredby law.*

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**PART I**

**ITEM 1.**                BUSINESS

**OVERVIEW**

We are a leading providerof consumer Internet subscription services through a number of brands,including NetZero, Juno and Classmates Online. Our subscription servicesinclude dial-up Internet access, social-networking, Voice-over-InternetProtocol (VoIP) telephony, personal Web-hosting, premium email, Internetsecurity and online digital photo-sharing, among others. We also offeradvertising-supported versions of many of our services at no charge toconsumers. On a combined basis, our Web properties attract a significant numberof Internet users each month. Advertisers can reach this audience through theUnited Online Media Group, which offers marketers a broad array of Internetadvertising products as well as online market research and measurementservices.

At December 31, 2005,we had approximately 5.0 million pay accounts representing approximately6.4 million total subscriptions, and approximately 17.6 million activeaccounts. A pay account represents a unique billing relationship with acustomer who subscribes to one or more of our pay services. “Active” accountsinclude total pay accounts as well as free users who have logged onto ouraccess, VoIP, social-networking or email services during the preceding31 days. Active accounts also include those free hosted Web sites thathave received at least one visit during the preceding 90 days and thenumber of free photo-sharing users that logged on to the service at least oncewithin the preceding 90 days.

United Online is a Delawarecorporation that commenced operations in 2001 following the merger of Internetaccess providers NetZero, Inc. and Juno Online Services, Inc. (the“Merger”). We completed the acquisition of Classmates Online, Inc.(“Classmates”), a leading provider of social-networking services, inNovember 2004 and in November 2005, we launched our VoIP telephonyservice. Our corporate headquarters are located in Woodland Hills, California.

**ConsumerBrands and Services**

We offer a variety ofconsumer Internet services, both free of charge and subscription-based,under a number of brands, which include the following:

*Internet Access:*   NetZero,Juno and BlueLight;

*Social Networking:**  *Classmates,StayFriends and Klasstraffen;

*VoIP:*   NetZeroVoice and NetZero FreeVoice;

*Web Hosting:**  *FreeServers,50megs, Bizhosting and Global Servers;

*Email:**  *NetZeroMegaMail, Juno MegaMail and emailMyName;

*Online Photos:**  *PhotoSite;and

*Other Services:**  *NetZeroFamily Pack, Juno Family Pack and Norton Internet Security.

*Internet Access*

Our basic pay accessservices include Internet access and an email account and are offered throughvarious pricing plans, generally $9.95 per month. We also offer acceleratedaccess services, which include accelerated Web surfing and additional benefitssuch as pop-up blocking, anti-virus software and enhanced email storage,generally for an additional $5.00 per month, or a total monthly charge of$14.95. Our accelerated access services utilize compression, caching and othertechnologies that reduce the time for certain Web pages to download tousers’ computers when compared to our basic access services. We offerdiscounted pricing on our monthly access rates for subscribers that makeextended service commitments, for example a discounted price of $9.95 for our acceleratedaccess plan with a one year commitment. The 

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NetZeroand Juno pay access services differ from their respective free access servicesin that the hourly and certain other limitations set for the free services donot apply. In addition, the free access services incorporate certainadvertising initiatives, including a persistent advertising banner, not presenton the pay services. Our access services are available in more than 8,200cities across the United States and Canada.

*Social Networking*

Connecting millions ofusers primarily across the United States and, to a lesser extent, Canada,Germany and Sweden, our social-networking services allow members to stay intouch with people from their past. Membership in our social-networking servicesis free and allows users to post a personal profile, access and search ourdatabase of other registered members within personally relevant onlinecommunities from school, work and the military. In addition to features of ourfree social-networking services, our pay services also enable subscribers tocommunicate with other members and are offered through various pricing plans,generally $39.00 per year or $15.00 for three months in the U.S. Oursocial-networking properties also contain several advertising initiativesthroughout their Web sites.

*VoIP*

NetZero Voice, a VoIPtelephony service, provides local and long distance calling over dial-up andbroadband Internet connections. We offer a free version of our VoIP service,NetZero FreeVoice, which enables users to make unlimited computer-to-computercalls and instant text message one another at no charge and includes a free voicemailaccount integrated with email into one convenient message center. Our pay VoIPservice plans have all of the features of the free service and we offer a rangeof pricing plans from $3.95 to $14.95 per month which include a dedicatedpersonal phone number with unlimited inbound minutes and between 100 andunlimited monthly outbound minutes to the publicly switched telephone network(PSTN) within the U.S., Canada and Puerto Rico. We also offer a “pay asyou go” plan where PSTN calling minutes can be purchased in $5, $10, $25 and$50 increments for as little as $0.02 per minute. In addition, NetZero Voiceoffers international PSTN calling at attractively priced rates per minute and anumber of other features such as call forwarding.

*Web Hosting*

Our Web-hosting services,which include domain name registration services, are offered through variouspricing plans, generally from $1.99 to $9.99 per month. A limited, advertising-supportedversion of the service is offered free of charge.

*Email*

We offer free Web-basedemail services, including up to one gigabyte of storage, anti-spam protection,address book importing, photo viewing and more. NetZero and Juno offer premiumemail services under the MegaMail brand with expanded features and storagecapabilities through various pricing plans, generally $9.95 per year. We alsooffer personalized, vanity email services with enhanced features and storagefor $1.99 per month.

*Online Photos*

PhotoSite is an onlinedigital photo-sharing service, which enables users to display photos, orderprints and create custom photo albums, Web logs and full computer screenslideshows on their own personal photo Web site. With PhotoSite, users cancatalog and store digital photos by subject matter, allowing convenientsearches of photos by other users. Prices for subscription services range from$1.99 per month to $4.99 per month and a limited version of the service isoffered free of charge.

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*Other Services*

The Family Pack of premiumcontent bundles together leading family-orientated subscription services and isoffered to subscribers through our NetZero and Juno brands for $4.95 per month.Our accelerated access services include Norton’s antivirus service free ofcharge and members can upgrade to a more complete Norton Internet Securitypackage that includes antispyware, parental controls and other features for anadditional $1.95 per month.

**AdvertisingServices**

The United Online MediaGroup connects advertisers to consumers through a variety of online marketingproperties and channels integrated throughout our services. Our advertising ande-commerce products include a broad range of targeting techniques for onlineadvertising, email campaigns, start-page and user registration placementsand channel sponsorship opportunities, and the ability to deliver videocommercials online. We also provide consumers convenient access to third partyInternet search services from many of our Web properties and services, and wegenerate a significant portion of our advertising and commerce revenues fromsuch search services. In addition, we offer advertisers sophisticated marketresearch capabilities through our CyberTarget division, which can design andexecute customized, real-time market research in an Internet environment andhelp advertisers better understand their target audience.

**INDUSTRY BACKGROUND**

**Internet Access**

The number of householdsin the U.S. using broadband has grown significantly over the last few years,while the number using dial-up has declined. Analysts’ estimates indicate that,as of the end of 2005, approximately 74 million U.S. households had some formof Internet access, up from approximately 59 million U.S. households in 2000.Of these “Internet households,” analysts’ estimates indicate that approximately54% used broadband as of the end of 2005. They predict that by 2009, there willbe approximately 84 million Internet households, and approximately 80% of themwill use broadband. The decline in the dial-up market has resulted primarilyfrom users of premium dial-up access migrating to broadband services.

There are many dial-upaccess providers in the U.S., with a small number of nationwide providersdominating the competitive landscape. The top four providers, including UnitedOnline, currently account for a significant majority of the U.S. dial-upmarket. All of these providers, except United Online, offer premium-pricedservices as their primary offering, and two of them, America Online (“AOL”) andEarthLink, market value-priced dial-up access services throughalternative brands. Providers of broadband access, which include cable, digitalsubscriber lines (“DSL”), satellite and wireless, generally offer users fasterconnections and download speeds than dial-up for higher prices. DSL broadbandprices range from approximately $13 to $60 per month while cable modembroadband runs from approximately $35 to $55 per month. In general, broadbandpricing has been declining and a number of providers offer aggressive pricingand discounted packages, particularly when their access offerings are combinedwith other services including telephone and television. As the Internetevolves, many analysts believe that the convergence of data, voice, video andwireless services, among others, will increasingly differentiate broadband fromdial-up beyond just faster connection speeds. These trends, along with changesin broadband pricing, will have a significant impact on the rate of broadbandadoption in the future and the rate of decline of the dial-up market.

Monthly standard pricingfor unlimited dial-up Internet access generally ranges from approximately $7 to$26 per month. Providers distinguish their offerings through a variety offactors. The major premium-priced offerings generally provide, amongother features, some or all of the following at no additional cost: telephonetechnical support, proprietary content, parental controls, spam controls,pop-up 

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blockingcapability, multiple account names and email addresses, enhanced email storage,virus protection, firewalls, spyware protection, and accelerator functionality.Accelerator functionality enables users to view certain Web pages morequickly, but it does not offer a faster connection or improve download speeds.In contrast, of the value-priced services, only a few, if any, offer mostof these features as part of their standard offering and charge an additionalfee for specific features. In particular, many major value-pricedproviders, including United Online, charge an additional fee for accelerateddial-up, with $5 being a typical price point. However, both Netscape andPeoplePC have, from time to time, marketed their accelerated services at noextra charge, in some cases in conjunction with an extended service commitmentfrom consumers, and a number of smaller providers are also incorporatingaccelerator services into their standard offering at no extra charge. We havealso marketed our accelerated services at no additional charge, primarily inassociation with promotions requiring an extended service commitment by theuser.

Competitive pressures frombroadband services have resulted in significant declines in subscribers topremium-priced dial-up access services and recently to our services. Inresponse, premium-priced services have become increasingly aggressive inboth introductory offers and in pricing concessions to obtain and retainsubscribers, with some services offering up to six months free in particularmarket channels. In addition, providers are including enhanced features intheir premium-priced services at no additional cost, and AOL andEarthLink, through their Netscape and People PC subsidiaries, have become muchmore aggressive in marketing their value-priced services. Additionaldeclines in broadband pricing, declines in pricing for premium-pricedofferings, and enhanced functionality of premium-priced offerings couldincrease the pressure of add-on pricing for accelerator or other services or causethe segment to decline in the future. These factors could also result in pricedeclines in the value-priced segment, as well as increased use of freemonths and other discounts.

We believe that the futureof value-priced dial-up access will depend largely on continued consumerprice sensitivity and on potential changes in user demographics. It isestimated that a majority of U.S. dial-up households currently subscribe todial-up services priced above $15 per month. We believe that the sustainabilityof value-priced dial-up access will be driven, in part, by subscribers ofpremium-priced services switching to lower-priced services. We alsobelieve an increase in lower-income households accessing the Internet,where penetration rates have historically been lowest, position thevalue-priced segment to increase its share of the U.S. market for dial-upaccess, although we do not expect our access services to grow.

**Online SocialNetworking**

Classmates.com is part ofthe “online social-networking market,” which is based on user-generated contentand includes personals, dating services, careers and community-basednetworks. The online social networking market serves consumers seeking torediscover, create and strengthen relationships with friends, relatives, andacquaintances who share common interests or past experiences, or who may belooking to network for their career or a love interest. A recent surveyestimated that one-third of Internet users have expressed a strong interest insocial and business networking, and we believe that Classmates’ businesseffectively serves a segment of these interests. It is estimated thatsubscription sales for social networking Web sites (including personals,dating, communities, and careers) was $556 million in 2005, up 7.6% from 2004.

We believe that consumerinterest in the online social-networking market will be fueled by a number offactors, including increased willingness of consumers to purchase onlinecontent, increased consumer awareness of the types of services offered withinthe online social-networking market, and a continued influx of new potentialsubscribers. There are several trends that we believe could indicate growthopportunities for the segment of the online social-networking market in whichClassmates.com participates, including a continual stream of graduates fromhigh schools and colleges. The number of high school students graduatingannually in the U.S. is expected to increase from 3.1 million in 2005 to 

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3.2 millionby 2013. Population relocation could also contribute to consumer demand forcommunity-based networks like Classmates.com and it is estimated that41 million people in the U.S. relocate each year.

We believe that the onlinesocial networking market presents an attractive growth opportunity, bothdomestically and internationally, and that the addition of Classmates to ourfamily of consumer Internet services positions United Online to capitalize onthat opportunity.

**ConsumerInternet Services Strategy**

Through 2003, virtuallyall of United Online’s operations were focused on providing value-priceddial-up Internet access services in the U.S. and Canada. During 2005,competitive factors caused our access revenues to decrease and we expect thistrend to continue. While we intend to attempt to minimize the decline in ourInternet access business, we also believe that non-access consumer Internetservices present new opportunities to expand our business. As such, during 2004we began to diversify our business beyond dial-up access through theacquisition of a Web-hosting business and through the acquisition ofClassmates. We further diversified our business by acquiring PhotoSite, anonline digital photo-sharing business, in 2005. We also developed and launchedother new non-access services, including our premium email and premium contentservices. Additionally, with the recent recovery and growth of Internetadvertising, we have begun to focus additional resources toward addressing theonline advertising market through the United Online Media Group.

We believe our assets andcore competencies, including our brands, consumer and advertiser relationships,customer billing relationships, technologies, database capabilities, internalnetwork infrastructure and personnel, can be leveraged to develop or acquire,market and grow a variety of non-access related services. As such, we activelyreview a variety of businesses, product lines and technologies which we believemay provide us with the opportunity to leverage our assets and core competenciesor which may otherwise be complementary to our existing businesses. In general,we have focused our attention on consumer offerings that are delivered over theInternet and which feature recurring subscription revenue, although we maypursue opportunities that do not involve these characteristics such asadvertising-supported business models.

**VoiceOver Internet Protocol Telephony Service**

In November, 2005, welaunched NetZero Voice, a value-priced VoIP telephony service. VoIP enablesanalog phone calls to be converted to data packets and transmitted over theInternet, allowing users to save money on long distance phone calls. NetZeroVoice works well over virtually any Internet connection, broadband or dial-up.While analyst estimates vary greatly, VoIP adoption is expected to increasedramatically in the U.S. and worldwide over the next several years. Vonagecurrently leads the residential U.S. VoIP subscriber market, but VoIP servicesoffered by Cablevision, Time Warner Cable and others are cutting into theirmarket share. eBay, which acquired Skype in 2005, Microsoft, AOL, Yahoo! andGoogle are also marketing VoIP services, making competition intense whileraising VoIP’s profile in the media.

**SOURCES OF REVENUE**

We generate revenue frombillable services and advertising and commerce transactions.

**Billable ServicesRevenues**

In general, we charge ourpay accounts in advance of providing a service, which results in the deferralof billable services revenue to the period in which the services are provided.We have experimented with a variety of pricing plans, both in connection withoffers extended to some of our existing accounts and through external marketingchannels. We intend to continue testing a variety of pricing plans in the futureto determine their impact on profitability, pay account acquisition, conversionrates of free accounts to pay 

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accountsand retention rates. We intend to regularly evaluate the desirability andeffectiveness of our pricing plans and may, in the future, make changes tothese plans. We may also offer additional fee-based products and services aswell as a wide range of discounted metered plans and promotions, such as one ormore free months of service or discounted rates for an initial period or anextended commitment.

**Advertisingand Commerce Revenues**

We are able to designatethe initial Web site displayed to users of our access services during anInternet session. This Web site, or “start page,” displays sponsored links to avariety of content, products and services, including Internet search. Inaddition, a significant portion of the Web pages for our Web-based email,free community-based networking and consumer Web-hosting services arededicated to advertising partners. We also display a toolbar on access users’screens throughout their online access sessions that is always visibleregardless of the particular Web site they visit. The toolbar contains Internetsearch functionality and a variety of buttons, icons and drop-down menus. Onour free access services, the toolbar is larger than on our pay access servicesand also contains banner advertisements. We generate revenues from our Webpages and the toolbar by displaying, or users clicking on, banner,text-link and other advertisements that are linked to advertisers’ andsponsors’ Web sites, or by users utilizing functionality offerings such asInternet search services.

We also generateadvertising and commerce revenues by users clicking on, or by displaying, richmedia advertisements in a small window on the computer screens of certainaccess users while they initially make a dial-up Internet connection andimmediately prior to terminating their connection; by delivering email messageson behalf of advertisers or by users clicking on such messages and being referredto sponsors’ Web sites; by enabling customer registrations for partners; and byproviding third parties with data analysis capabilities and other marketresearch services, such as surveys and questionnaires.

**MARKETINGAND NEW ACCOUNT ACQUISITION**

Our marketing efforts arefocused primarily on attracting free and pay accounts, building our brands andup-selling existing free accounts and pay accounts to new and additional payservices. These efforts include television, Internet, sponsorships, radio, printand outdoor advertising as well as a variety of distribution initiatives withpartners including retailers, personal computer manufacturers and softwareproviders. We also devote a significant portion of our own advertisinginventory to up-sell and cross-sell our pay services. Our internal marketingresources consist of marketing management, media, creative services, Webdevelopment, strategic alliance and business development personnel. We producea significant amount of our marketing materials in-house, usingstate-of-the-art design computers and graphics program techniques.

In addition to ourtraditional marketing activities, we view our free services as an effectivecomponent of our pay account acquisition strategy. We have not spentsignificant marketing resources on our free access services since the Mergerand have experienced a decrease both in our active free access account base andin the number of people signing up for free access services. Our active freeaccess account base and the number of users who convert from our free accessservices to our pay access services may continue to decrease, particularly ifwe do not actively promote our free access services or if we impose additionallimitations on our free access services in the future.

We also view our freecommunity-based networking and consumer Web-hosting services as importantsources of pay subscribers. We seek to up-sell the free account bases of theseservices to pay versions of each service, as well as to Internet access andother pay services. Our marketing efforts to date for community-basednetworking and consumer Web hosting have been comprised almost entirely ofInternet advertising and paid search.

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We use a variety ofmarketing channels to promote our pay access services. Prospective users canobtain the software necessary to run our access services by either downloadingit from the Internet or by using a CD to install it on their computers. Ourtraditional marketing activities are designed to drive prospective accounts toeither visit our main Web sites and download our software, to call our tollfree numbers to purchase our services or order a CD containing our accesssoftware.

We have also entered intoa variety of distribution relationships where third parties assist in themarketing of our software and services. Such arrangements include distributionof our Internet access software on CDs at retail locations, the preloading ofour software on personal computers and partner CDs, and links to our serviceson partner Web sites. In most cases we pay a per pay account acquisition fee tothese distributors. We intend to continue to evaluate and engage in a varietyof distribution channels to enable us to make our services better known andavailable to a large population of potential users.

**SALESOF ADVERTISING INVENTORY**

We have an internal salesforce dedicated to selling our Internet advertising products and services.While we derive a significant portion of our advertising revenues fromtransactions directly with advertising customers, we also sell a portion of ouradvertising inventory through wholesale resellers. We have an agreement withYahoo! Search to place search boxes and links to their search services oncertain of our Web properties, and substantially all of our search revenues arederived from this agreement. We have an advertising operations group that workswith our sales force to serve and monitor the performance of all of ouradvertising inventory. In addition, we allocate a portion of our advertising inventoryfor the purpose of marketing and selling our own services.

**BILLING**

The vast majority of ourpay accounts pay for our services in advance with a credit card. Other paymentoptions for some of our pay services include ACH, personal check or moneyorder, or via their local telephone bill. Pay access accounts that elect to paywith a personal check or money order are not provisioned until their payment isreceived and they are required to sign-up for one of our prepaid multi-monthbilling plans. Fees charged to accounts for live telephone technical supportare generally billed to a credit card and are charged on a per-minute basis.

We utilize a combinationof third-party and internally developed software applications for customerbilling. Customer billing is a complex process and our billing systems mustefficiently interface with third-parties’ systems, such as our creditcard, ACH and telephone bill processors’ systems. Our ability to accurately andefficiently bill and collect payment from our accounts is dependent on thesuccessful operation of our billing systems and various third-partyprocessors. In addition, our ability to offer new pay services or alternativepayment plans is dependent on our ability to customize our billing systems.

**CUSTOMERSUPPORT AND RETENTION**

Our customer relationshipmanagement and support infrastructure includes employees at our facilities inHyderabad, India; Woodland Hills, California; New York, New York; Renton,Washington; and Orem, Utah. However, we outsource substantially all of ourtelephone support to a third party. We offer a variety of online and offline“self-help” tools for our access services, including our offline “Quick Help”software that is loaded onto a user’s computer when the access service isinitially installed. This tool can be accessed without connecting to our accessservices and provides valuable troubleshooting for connection-relatedinquiries. Our Web site, automated email response system and self-help toolsare all designed to provide comprehensive tutorials, advice, tips, step-by-stepsolutions and answers to many frequently asked questions. These self-help toolsare also designed to assist users in updating and verifying billinginformation, downloading and operating our software and setting up their emailaccounts. In addition, we provide traditional email support where our personnelgenerally respond to users within a day of receiving an inquiry.

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We offer live telephonetechnical support for our access services billed on a per-minute basis andtelephone billing support for free. We monitor the effectiveness of our usersupport functions and measure performance metrics such as average hold time andfirst call resolution and abandonment rates. Communications with accounts arelogged and categorized to enable us to recognize and act on trends. An internalquality assurance team monitors the performance of our vendors and providesfeedback to improve their skills and establish consistency throughout ourcustomer support functions.

**TECHNOLOGY**

Our access and VoIP services are provided through acombination of internally developed and third-party software, industrystandard hardware and outsourced network services. We have developed softwareto enhance the functionality of certain components of our services, includingconnectivity, Web services, billing, email, customer support and targetedadvertising. We maintain data centers in multiple locations around the countrywith, in many cases, redundant systems to provide high levels of serviceavailability and connectivity. We host the majority of our data center servicesin third-party co-location facilities and outsource all of our bandwidthand managed modem services. We deliver our VoIP services over an infrastructurethat is largely shared with our access services.

In order to utilize our access services, accounts arerequired to install our access client software onto their computers. Thissoftware allows us to manage and enhance connection quality, deliver importantmessages and upgrade accounts with new features and functionality. We also useour client software to collect important data regarding the quality of accessconnections so that we can quickly resolve network problems that may occur. Theclient software also contains our internally developed “autodialer” technologythat presents accounts with a list of telephone numbers for their area andhelps to ensure they are connected to a cost-effective and reliable network.Our client software also enables us to deliver targeted advertising and collectother data as well. Our VoIP software client includes technology that enablesthe delivery of quality voice connections over a variety of network connections,including dial-up. This VoIP client can also operate in a free mode than allowsus to serve targeted advertising to our NetZero FreeVoice customers.

One key feature of ouraccess client software is the initial download size. We have developed aninitial client application that can download to a computer in less than twominutes over a standard dial-up connection. Once installed, a user can createan account with us and connect to the Internet. The remaining portion of ourclient software is, in certain cases, downloaded to the computer over timeduring future Internet sessions. Our access client software currently operateson the Windows 95, Windows 98, Windows 2000, Windows ME,Windows XP, Windows NT 4.x, Mac OS IX and X andLindows operating systems. Our accelerator client software currently operateson each of these platforms with the exception of Mac OS IX and X andLindows operating systems.

Another major component ofour access technology is our server software, written primarily in the Java andC++ development languages, which consists of a group of software applicationsrunning on multiple servers that manage each user’s account and onlinesessions. Our server software interacts with the access client software to sendand receive information such as authentication data, telephone lists,advertisements and usage data. Database servers store session information,account information and advertisement data. Advertisement targeting serversmanage advertising inventory and determine which advertisements accounts willview and which will be downloaded to computers during online sessions. Othermajor server software systems include our internally developed and partiallyopen source email server software, our accelerated dial-up services serversoftware and our billing server software. All of these services are run on Unixand Linux servers.

We license a number of oursoftware applications and components. Our principal billing system is based ona software application that is licensed from Portal Software, Inc. and ourcustomer support system utilizes a software application that is licensed fromRemedy, a BMC Software, Inc. company. The 

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majorityof our database systems run on Oracle database applications and we use Oraclefinancial and human resources management applications for internaladministrative purposes. We license Sun Microsystem’s Java technology for ourclient and server software applications. Our accelerator services use softwaretechnology components licensed from SlipStream Data Inc. We license VoIPtechnology from a number of vendors, including CrystalVoice Communications andUbiquity. These licenses generally have terms ranging from seven additionalyears to perpetual.

Our VoIP service shares aconsiderable portion of the access service infrastructure, notably the datacenter networking facilities, Oracle customer databases, email system, andbilling facilities, as described above. Software to support PC to PC calling islicensed from CrystalVoice for both the server and subscriber PC-resident portions.Calls involving the public switched telephone network, as well as a variety ofother services, are supported by software licensed from Ubiquity, Inc.Audio media support is provided through software licensed from Brooktrout. Allthree licenses provide perpetual rights. Devices to protect the internalnetwork were purchased from Netrake. Internally developed software is writtenin C++ and Java. Redundant service is provided by deployment in multiple datacenters with a variety of fail-over logic.

We also maintaininfrastructure to support our PhotoSite photo service, our Web-hostingservices, and our Classmates social-networking service.

Our photo businessprincipally utilizes internally developed and acquired software. The servercomponents are written in C++ and Java, and run on Microsoft Windows 2003 andIIS platforms, with an Oracle database. The photo client is made available tosubscribers at no cost, is written principally in Java, and executes on variousversions of Microsoft Windows. Various other third party licensed componentsare employed, with most terms being perpetual. All production systems arehosted in a commercial co-location center.

Our Web-hosting businessutilizes both internally developed and licensed software, exclusively runningon Unix and Linux systems. Most of the internally developed software is writtenin Perl. Most third party software licenses are perpetual or open source.Billing is done through open source software, or in some cases uses Portal’sapplication.

Support for our social-networkingbusiness and its Web services is provided by a combination of open source,internally developed, and licensed software. One of the principal internallydeveloped applications uses Art Technology Group’s Dynamo software environment,which we license. Internally developed software is principally written in Java,C++ and, in some cases, Perl. Web pages are served via the Apache opensource software system. User information is stored in an Oracle database, whichis also used to support Web sites, target advertising, and prepare emailcampaigns. MySql is also employed for certain data. These various packages arerun on Unix systems provided by Sun Microsystems, Hewlett Packard and others,principally hosted in an outsourced data center. Customer support is providedthrough an outsourced system, Talisma. Billing is handled by a combination ofATG software, internally built software, and processing through TrustCommerce.Third party software licensing terms vary from yearly renewable to perpetual.

**PROPRIETARY RIGHTS**

Our trademarks, patents,copyrights, domain names and trade secrets are important to the success of ourbusiness. We principally rely upon patent, trademark, copyright, trade secretand contract laws to protect our proprietary technology. We have filed numerouspatent applications relating to a variety of business methods and technologies.We generally enter into confidentiality or license agreements with ouremployees, consultants and corporate partners, and generally control access to,and distribution of, our technologies, documentation and other proprietaryinformation. We consider our NetZero, Juno and Classmates trademarks to be veryvaluable assets, and we have registered all of these trademarks in the United Statesand certain of them in some other countries.

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**COMPETITION**

**InternetAccess Competition**

Competition in theInternet access market is intense. We compete with established online serviceand content providers such as AOL, AOL’s Netscape subsidiary and MSN;independent national ISPs such as EarthLink and its PeoplePC subsidiary;companies combining their resources to offer Internet access in conjunctionwith other services such as Yahoo! and AT&T Internet Services, Yahoo! andVerizon, and AOL and Walmart.com; national communications companies and localexchange carriers such as AT&T WorldNet, Qwest CommunicationsInternational, Inc. and Verizon; cable companies such as ComcastCorporation, Cox Communications, Inc., Charter Communications, Inc.and Adelphia Communications Corporation; local telephone companies; andregional and local commercial ISPs. Also, a number of municipalities, such asSan Francisco, have announced their intention to make available wirelessbroadband access services to their communities free of charge or for discountedfees, and significant companies, including Google, are bidding to provide someor all of these services. While this form of competition is new and itspotential impact unknown, the availability of free or inexpensive wirelessbroadband services in major metropolitan markets could have a significantimpact upon the industry and on our business.

The number of U.S.households using broadband has grown significantly over the last few years andis expected to continue to grow. Broadband access, which includes cable, DSL,satellite and wireless, generally offers users faster connection and downloadspeeds than dial-up access for monthly fees currently ranging fromapproximately $13 to $55 per month, although offers for promotional periodshave been as low as $10 per month. Pricing for broadband services, particularlyfor introductory promotional periods, services bundled with cable and telephoneservices, and services with slower speeds, has been declining and the pricinggap between broadband and dial-up access services has been narrowing with, insome cases, premium and value dial-up access services priced at or abovepricing for certain broadband services. For example, Verizon Yahoo! recentlyoffered DSL at $14.95 per month to customers who agree to a one-year commitmentand AT&T Yahoo! recently offered DSL at $12.99 per month to new customerswho agree to a one-year commitment. As a result of broadband adoption, thetotal number of dial-up accounts in the U.S. has declined and industry analystspredict that it will continue to decline. The decline in the size of thedial-up market has accelerated and will likely continue to accelerate asbroadband services become more widely available at lower prices and consumeradoption of broadband applications, such as online video, telephony and musicdownloads, which depend upon connections that provide significant bandwidth,increases. While we review the possibility of offering broadband services fromtime to time, including wireless services, we currently do not plan to offerbroadband services on a significant scale, which has adversely impacted, andwill continue to adversely impact, our ability to compete for new subscribersand to retain existing subscribers.

Our success historicallyhas been based on offering dial-up Internet access services at prices below thestandard monthly pricing of the premium dial-up services of most of our majorcompetitors. Competition from broadband providers and value-pricedproviders such as United Online has resulted in significant declines in thenumber of subscribers to premium priced dial-up services over the last fewyears. In response to this competition, many competitors have engaged, and maycontinue to engage, in more aggressive pricing of their dial-up services undertheir premium-priced brands to obtain and retain users, such as offeringdiscounted pricing or extended periods of free service such as six months free.AOL has previously tested decreased price points on their dial-up service andmay continue to do so in the future, although AOL recently announced a priceincrease for its premium service. Additionally, AOL, through its Netscapesubsidiary, EarthLink, through its PeoplePC subsidiary, and a number of smallproviders now offer value-priced services at prices similar to our pricesand which are, in some cases, priced below the prices of our services.Partially in response to this competition, we have become more aggressive inoffering discounted services and one or more free months of services in orderto obtain and retain pay 

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accessaccounts. Despite these measures, our pay access base has declined and the rateof decline has been increasing. We experienced a net decline of approximately125,000 pay access accounts in the December 2005 quarter. We expect thatwe will continue to experience declines in our pay access account base in thefuture, and the rate of decline may continue to accelerate. We believeincreased competition, including pricing competition, has adversely impactedour ability to obtain new pay access accounts and to retain our existingaccounts, will adversely impact our ability to minimize the decline in our payaccess account base in the future and may make it more difficult to maintainthe current pricing of our services.

Price competition isparticularly relevant to our ability to maintain or grow our acceleratorsubscription base, especially at our $14.95 standard monthly price. Maintainingthis price point is critical to our profitability. When we began offering thisservice in early 2003, many of our competitors either did not offer a similarservice or charged substantially more than we charge for a similar service.Since that time, most of our competitors have started offering a similarservice, and several competitors have either decreased their price for theseservices or have bundled these services into their premium services with noadditional fee. Many competitors now market these services as a feature oftheir value-priced services at no additional cost and these services arenow offered, in certain cases, at a price point similar to or lower than ourstandard monthly price. In particular, Netscape has previously marketed theiraccelerator service as part of their standard $9.95 offering and currently marketsthis service at a $9.95 price point with a 12-month commitment. PeoplePCcurrently offers their accelerator service combined with their standard value-pricedoffering at $7.47 per month for an introductory period of three months or$10.95 per month with a 12-month commitment. In addition, pricecompetition for broadband services has been growing and several providers, suchas AT&T Yahoo! and Verizon Yahoo!, have offered bundled broadband servicesat promotional prices similar to, or lower than, the prices of our acceleratedaccess services. We cannot assure you that broadband providers will notcontinue to offer promotional pricing for broadband services similar to orlower than the price of our accelerated access services. Increased competition forsubscribers to accelerated access services and broadband services couldadversely impact our ability to grow or maintain our accelerator subscriptionbase, or could cause us to lower or eliminate our pricing for these services,which would adversely impact our revenues and profits. We recently beganoffering our NetZero accelerator service at a $9.95 price point with a 12-monthcommitment. We are also offering additional features without additional chargeas part of our accelerated dial-up service, including enhanced email andanti-virus features, and we may incorporate additional features in the future.Adding additional features would likely increase our cost of providing theservice which would make the service less profitable, although there is noassurance that additional features will make the service more attractive toconsumers or will enable us to maintain its $14.95 standard monthly price. Thenumber of users paying us the standard monthly price for our acceleratedservice has been decreasing and it is likely that we will experience decreasesin both the number of subscriptions to these services as well as the averageprice we receive for these services in the future.

Premium-pricedInternet access services, in general, include a much wider variety of featuresthan are included in value-priced services, and providers of premium-pricedservices continue to enhance the features of their offerings in response tocompetition from broadband and value-priced providers. In particular,many premium-priced services include at no additional charge telephonetechnical support, proprietary content, parental controls, multiple accountsand email addresses, increased email storage, virus protection, firewalls,spyware protection and accelerated dial-up functionality. Some providers ofvalue-priced offerings are also incorporating certain of these featuresinto their offerings either at no charge or for an incremental fee. Inaddition, certain providers of premium-priced services occasionally offerpromotional pricing that is similar to the pricing of value-priced offerings.For example, EarthLink has offered its premium-priced services at $9.95 permonth for an introductory period of six months. While we offer some additionalfeatures to users at no charge or for an incremental fee, we do not offer therange of features included in premium-priced services and, in some cases,included in value-priced services. In particular, we do not offer our ownproprietary content. In addition, the incremental fees that we charge 

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forcertain features are, in some cases, higher than the incremental fee, if any,charged by other value-priced providers for comparable features. Ourdecision not to offer a broader variety of features and our charges foradditional services or features, particularly accelerated functionality, virusprotection and telephone technical support, may adversely impact our ability tocompete and undermine our position as a value-priced provider.

Many of our competitorshave significantly greater brand recognition than we do and spend significantlymore on marketing their services than we spend. As a result, we have notparticipated as extensively as our major competitors in a variety of largedistribution channels, such as being pre-bundled on branded computers or beingoffered at retail outlets of many different major franchises. To the extent ourcompetitors spend significantly more than we do in these and other channels, weare at a competitive disadvantage. In addition, during 2005, we decreased ourmarketing expenditures for our access services and intend to further decreasethese expenditures in the future. Decreased marketing of our access serviceshas adversely impacted our ability to obtain access subscribers and is likelyto adversely impact our access subscriber base in the future. We cannot assureyou that the marketing resources we allocate to our access services will besufficient for us to continue to compete effectively with our majorcompetitors, and we believe our base of access subscribers will continue todecline.

We expect competition forpay access accounts to continue to intensify and cannot assure you that we willbe able to compete successfully. As competition in the Internet access marketcontinues to intensify, competitors may merge or form strategic alliances thatwould increase their ability to compete with us. Our inability to competeeffectively could require us to make significant revisions to our services andpricing strategies, which could result in increased costs, decreased revenuesand the loss of pay access accounts, all of which could materially andadversely impact our financial condition, results of operations and cash flows.

**Competitionin the Online Relationships Market**

Competition forsubscribers in the online relationships market is intense and rapidly evolving.Classmates competes directly against a small number of companies, includingReunion.com, Facebook.com and Monster.com’s Military.com service, offeringsimilar online social-networking services based on work, school and militarycommunities. Classmates also competes directly with many schools, employers,Web sites, and associations that maintain their own Internet-based alumniinformation services. In addition to this direct competition, Classmatescompetes for subscribers with companies offering a wide variety ofsocial-networking services including Web portals such as Yahoo!, MSN and AOLthat maintain chat rooms and are developing new Web community services such asYahoo! 360, MSN Spaces and AOL People Connection, and other community-basedWeb sites and personal networking communities such as Friendster and MySpace.Many of these social-networking services offer more sophisticated features thanours, such as personalized Web pages, instant messaging and blogs. Many ofthese companies also offer a wide variety of services in addition to theirsocial-networking services, which provides them with an additional competitiveadvantage in obtaining and retaining subscribers. Currently, Classmates is usedprimarily to locate and contact acquaintances from school, work and militaryaffiliations, and Classmates’ subscribers, in general, do not spend asignificant amount of time on the site for other purposes. Our strategy is toexpand the features and functionality of the site, but there can be noassurance we will be commercially successful in doing so.

Many consumers maintainsimultaneous relationships with multiple communities, including Internet alumninetworks and offline associations, and can easily shift their interest or theirspending from one online or offline provider to another. Competitors may beable to launch new businesses serving various communities at relatively lowcost. Competitors may be able to hold themselves out as specialists in singlecommunities, making them more appealing to consumers or giving them a perceivedcompetitive advantage. In addition, many social-networking services are free oronly require payment if certain additional functionality is desired by theuser. The continued prevalence of free services could adversely 

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impactour ability to market both our free and pay services, maintain our currentprice levels, or maintain or grow our pay account base at current price levels,or at all.

Many competitors in thismarket have longer operating histories, larger customer bases, greater brandrecognition and significantly greater financial, marketing and other resourcesthan we do. In addition, Classmates has relied extensively on Internetadvertising through portals and other Internet service providers, includingAOL, MSN and Yahoo!, to grow its base of free and pay accounts. A number of thesecompanies are competitors of United Online with respect to Internet access andother services, and they may not be willing to retain the same advertisingrelationship going forward. To the extent we are not able to maintainadvertising relationships with these companies, our ability to obtain newClassmates’ pay and free accounts would be adversely impacted.

**Competitionin the Telephony Market**

We recently launched ournew consumer VoIP telephony services. The market for consumer telephoneservices is extremely competitive and competitors include established local andlong distance telephone companies, cellular companies and providers of VoIPservices. VoIP services are a new and emerging application and it is uncertainwhether VoIP services will receive wide-spread consumer adoption. Competitorsfor our VoIP services include established telecommunications and cablecompanies, certain of our current competitors for Internet access servicesincluding AOL, MSN and EarthLink, leading Internet companies including Yahoo!,Google and eBay through its recently acquired Skype subsidiary, and a number ofother companies that offer VoIP-based services as their primary business suchas Vonage. Most of our major competitors in the VoIP market have longeroperating histories, larger customer bases, greater brand recognition andsignificantly greater financial, marketing and other resources than we do. Someof our competitors, such as Vonage, spend a significant amount of resources onmarketing their services and participate in large, retail distribution channelssuch as Best Buy. We currently do not intend to expend the marketing resourcesnecessary to compete in large, retail distribution channels or to extensivelyadvertise our VoIP services on television. We have expended resources onproducing television commercials and other marketing materials, and we may notrealize a return on these investments. If we do choose to expend significantmarketing resources on our VoIP services, there is no assurance that such effortswill be commercially successful. We cannot assure you that our marketingefforts will be effective, that our VoIP services will achieve significantconsumer adoption or, even if such services do achieve consumer adoption, thatour VoIP services will generate growth in pay accounts, subscriptions, revenuesor profitability.

**Competitionin Additional Service Markets**

One element of ourstrategy is to offer a variety of non-access subscription services. In additionto social-networking and VoIP services, we currently offer Web-hosting anddomain registration services, standalone premium email services, a broadbandaccelerator product, a prepackaged premium content offering, and digital photo-sharingservices. While these services do not generate a significant portion of ourrevenues, we are actively investing resources in certain of these services.Competition for users of premium email services is intense. The companies wecompete with for Internet access subscribers also compete with us forsubscribers to email services. In addition, a number of companies, includingYahoo!, MSN, AOL and Google, offer premium email services, in certain cases,for free. The market for premium email services is evolving at a rapid pace andwe cannot assure you that our offerings will be competitive or commerciallyviable. While the personal Web-hosting business is fragmented, a number ofsignificant companies, including Yahoo!, currently compete actively for theseusers. In addition, the personal Web-hosting industry is very applicationspecific, with many of the competitors focusing on specific applications, suchas photo sharing, to generate additional users. We have not expendedsignificant resources to marketing our digital photo sharing services, althoughwe may allocate additional resources to improving and promoting these servicesgoing forward. Digital photo sharing is an extremely competitive market and 

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there isno assurance our services will be able to compete effectively. We cannot assureyou that any of these subscription services will be competitive or willgenerate growth in pay accounts, subscriptions or revenues.

In addition, we haveevaluated, and expect to continue to evaluate, the development or acquisitionof new subscription services. New services may subject us to competition fromcompanies that have more experience with such services, more establishedbrands, and greater financial, marketing and other resources to devote to suchservices. We cannot assure you that our new services, if any, will becompetitive or will generate growth in pay accounts, subscriptions or revenues.

**Competitionfor Advertising Customers**

We are dependent uponadvertising revenues for a significant portion of our revenues and profits. Wecompete for advertising revenues with major ISPs, content providers, large Webpublishers, Web search engine and portal companies, Internet advertisingproviders, content aggregation companies, social-networking Web sites, andvarious other companies that facilitate Internet advertising. Many of our competitorshave longer operating histories, greater name recognition, larger user basesand significantly greater financial, technical and sales and marketingresources than we do. This may allow them to devote greater resources to thedevelopment, promotion and sale of their products and services. Thesecompetitors may also engage in more extensive research and development, offermore sophisticated products and services, undertake more far-reaching marketingcampaigns and adopt more aggressive pricing policies. We also compete withtelevision, radio, cable and print media for a share of advertisers’ totaladvertising budgets. In certain instances, we generate advertising revenuesfrom companies who are also our competitors. In particular, we generatesignificant advertising revenues from Yahoo! Search. We compete directly withYahoo! for Internet access, email, Web-hosting and online photo-sharingsubscribers and indirectly for subscribers to our social-networking services.To the extent competitors who are also sources of significant advertisingrevenue cease to do business with us, our revenues and profits could suffer.

**PRIVACY POLICY**

We believe that issuesrelating to the privacy of Internet users and the use of personal informationabout these users are critically important as commercial uses of the Internetgrow. We have adopted and disclosed to our accounts detailed policies outliningthe permissible uses of information about users and the extent to which suchinformation may be shared with others. Our users must acknowledge and agree tothese policies when registering to use our services. We do not sell or licenseto unaffiliated third parties any personally identifiable information of usersunless they specifically authorize us to do so. However, we use informationabout our users to improve the quality of our services and the effectiveness ofadvertising by our advertising customers.

**SEASONALITY**

We have experiencedseasonal trends in connection with our access services. In general, we haveexperienced increased Internet usage and increased pay access accountsubscriptions in the fall and winter when compared to the summer. These trendshave had some impact on our advertising revenues, with lower revenues inperiods of lower usage, and on our cost of billable services, withtelecommunications cost per user lower in periods of lower usage. We do notknow if these seasonal trends will continue.

**INTERNATIONALOPERATIONS**

We have foreign operationsin India and Germany. We have a significant number of employees located in ourIndia office. Our operations in India primarily handle email customer support,product development and quality assurance. A portion of our outsourced customersupport is also based in India. Our operation in Germany provides community-basednetworking services similar to those provided by 

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Classmates.The revenues generated by our operations in Germany constitute a very smallportion of our total revenues and we do not generate revenues directly from ouroperations in India. We are dependent, however, upon our internal andoutsourced operations in India, and our product development, customer supportand quality assurance operations would be severely disrupted iftelecommunications issues, political instability or other factors adverselyimpacted these operations or our ability to communicate with these operations.Any disruption that continued for an extended period of time would likely havea material adverse effect on our ability to service our customers and develop ourproducts since it would take a significant period of time to transition theseoperations internally or to an outside vendor. If we were to cease ouroperations in India and transfer these operations to another geographic area,such change could result in increased overhead costs, which could materiallyand adversely impact our results of operations.

**EMPLOYEES**

At December 31, 2005,we had 900 employees, 651 of which were located in the United States, 244 ofwhich were located in Hyderabad, India and 5 of which were located in Europe.We had 505 employees in product development, including all employees located inour Hyderabad office, 169 employees in general and administrative, 158employees in sales and marketing, and 68 employees in network operations. Noneof these employees is subject to a collective bargaining agreement, and weconsider our relationships with employees to be good.

**AVAILABLEINFORMATION**

Our corporate Web site iswww.untd.com. On this Web site, we make available, free of charge, our annual,quarterly and current reports, changes in the stock ownership of our directorsand executive officers, our code of ethics and other documents filed with, orfurnished to, the SEC as soon as reasonably practicable after such documentsare filed with, or furnished to, the SEC.

The public may read andcopy any materials we file with the SEC at the SEC’s Public ReferenceRoom at 450 Fifth Street, NW, Washington, DC 20549. The public mayobtain information on the operation of the Reference Room by calling theSEC at 1-800-SEC-0330. The SEC maintains an Internet sitethat contains reports, proxy and information statements and other informationfiled electronically at www.sec.gov.

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**ITEM 1A.   RISKFACTORS**

*Before deciding to invest in our company or tomaintain or increase your investment, you should carefully consider the risksdescribed below as well as the other information in this report and our otherfilings with the SEC. The risks and uncertainties described below are not theonly ones facing our company. Additional risks and uncertainties not presentlyknown to us or that we currently deem immaterial may also affect us. If any ofthese risks actually materialize, our business, financial position, results ofoperations and cash flows could be adversely impacted. In that event, themarket price of our common stock could decline and you may lose all or part ofyour investment.*

**Ourbusiness will suffer if we are unable to compete effectively.**

See the discussion of thecompetition we face in Item 1.

**Ourrevenues may continue to decrease and our profitability may decrease.**

Our revenues in the fourth quarter of 2005 decreasedfrom our revenues in the third quarter of 2005, and we expect our revenues tocontinue to decline, at least in the near term. Our ability to stabilize or minimizedecreases in our revenues is primarily dependent upon our ability to increaseour number of pay subscriptions and accounts, our average monthly revenue per payaccount (“ARPU”) and our advertising revenues. We have been experiencing anincreasing rate of decline in our pay access accounts and currently anticipatethat our pay access accounts will continue to decline in the future and thatthe rate of decline may accelerate. The ARPU for our access services,including our accelerated access services, has also declined and we anticipateit will continue to decline. Even if we are successful in growing our number ofpay accounts as a result of increases in our non-access accounts, due to thelower ARPU for our non-access services we believe that our revenues willcontinue to decline, at least in the near term. We are budgeting ourexpenditures for 2006 based upon assumptions with respect to growth in ournon-access pay accounts, growth in advertising revenues and decreases in payaccess subscribers and ARPU. If we are unable to grow our non-access payaccounts as anticipated, if our ARPU declines more than anticipated, if we donot generate anticipated advertising revenues or if our pay access basedeclines faster than anticipated, our profitability could be materially andadversely impacted.

We anticipate a significant decrease in our marketingexpenditures during 2006 from what we spent in 2005. At the same time, wecurrently have more services to market than we did in throughout 2005 and wehave increasing competition with respect to all of our service offerings. Theamount we have budgeted for marketing may be insufficient to effectively marketall of our services, and subscriptions to our access services may decline muchfaster than anticipated and subscriptions to our non-access services may notgrow as anticipated, all of which would negatively impact our revenues andprofitability in the near term and our prospects in the long term. If we chooseto increase our marketing expenditures beyond what we currently anticipate, ourprofitability will likely be adversely affected, at least in the near term.

Our ability to grow ormaintain our number of pay accounts and subscriptions may also be dependent onour success in commercializing new services that we either acquire or develop.To the extent we are unable to successfully market our existing services to newusers, successfully cross-market additional subscriptions to existingusers or successfully acquire or develop and commercialize new services, ourpay accounts and subscriptions could continue to decline.

**Ourbusiness is subject to fluctuations.**

Our results of operationsand changes in the number and mix of pay accounts from period to period havevaried in the past and may fluctuate significantly in the future due to avariety of factors, many of which are outside of our control and difficult topredict. A number of factors that may impact us are discussed in greater detailin this Form 10-K, and these factors may affect us from period toperiod and 

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mayaffect our long-term performance. As a result, you should not rely onperiod-to-period comparisons as an indication of future or long-termperformance. In addition, these factors create difficulties with respect to ourability to forecast our financial performance and account metrics accurately.We believe that these difficulties in forecasting present even greaterchallenges for financial analysts who publish their own estimates of our futurefinancial results and account metrics. We cannot assure you that we willachieve the expectations or financial projections made by our management or bythe financial analysts. In the event we do not achieve such expectations orprojections, the price of our common stock could be adversely affected.

**If wecannot identify and complete acquisitions, we may not be able to grow andachieve our strategic objectives.**

One of our strategicobjectives is to acquire businesses, product lines or technologies which willprovide us with an opportunity to leverage our assets and core competencies, orwhich otherwise will be complementary to our existing businesses. It is likelythat we will not succeed in growing our revenues unless we are able tosuccessfully complete acquisitions. The merger and acquisition market forcompanies offering Internet services is extremely competitive, particularly forcompanies who have demonstrated a profitable business model with long-termgrowth potential. Recently, the public equity markets have been very receptiveto companies with these characteristics. As a result, in many cases, companieswith these characteristics trade publicly or are privately valued at multiplesof earnings, revenues, operating income and other metrics significantly higherthan the multiples at which we are currently valued. Acquisitions may requireus to obtain additional debt or equity financing, which may not be available tous on reasonable terms, or at all. These and other factors may make itdifficult for us to acquire additional businesses, product lines ortechnologies at affordable prices, or at all, and there is no assurance that wewill be successful in completing additional acquisitions.

**Wecannot assure you that we will be able to successfully manage, integrate orgrow our Web-hosting, photo-sharing and Classmates businesses.**

In April 2004, weacquired the assets of About, Inc.’s Web-hosting business, in November 2004,we acquired Classmates and in March 2005, we acquired the assets ofHomestead Technologies, Inc.’s online digital photo-sharing business. Wedo not have prior experience in any of these lines of business and may not beable to compete successfully in them. To the extent we attempt to integratevarious aspects of these businesses, we may not be successful. There may beunanticipated risks, liabilities and costs associated with these businesses,and we cannot assure you that these businesses will have a positive impact onour results of operations. In addition, we cannot assure you that we will besuccessful in maintaining or growing their pay or free accounts.

**Evenif we are successful at acquiring additional businesses, product lines ortechnologies, acquisitions may not improve our results of operations and mayadversely impact our business and financial condition.**

We have evaluated,and expect to continue to evaluate, a wide variety of potential strategictransactions that we believe may complement our current or future businessactivities. We routinely engage in discussions regarding potential acquisitionsand any of these transactions could be material to our financial condition andresults of operations. However, we cannot assure you that the anticipatedbenefits of an acquisition will materialize. Acquiring a business, product lineor technology involves many risks, including:

·       disruptionof our ongoing business and diversion of resources and management time;

·       unforeseenobligations or liabilities;

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·       difficultyassimilating the acquired customer bases, technologies and operations;

·       difficultyassimilating and retaining employees from the acquired business;

·       risksof entering markets in which we have little or no direct prior experience;

·       lackof controls, policies and procedures appropriate for a public company, and thetime and cost related to the remediation of such controls, policies andprocedures;

·       potentialimpairment of relationships with employees, users, or vendors as a result ofchanges in management; and

·       potentialdilutive issuances of equity, large write-offs either at the time of theacquisition or in the future, the incurrence of restructuring charges, theincurrence of debt, the amortization of identifiable intangible assets, and theimpairment of amounts capitalized as intangible assets if we should fail tosuccessfully further develop acquired technology.

Classmates has asubsidiary operating in Germany and we may seek to expand our internationalbusiness through acquisitions. Acquisitions of foreign businesses involve risksin addition to those mentioned above, including risks associated withpotentially unfamiliar economic, political and regulatory environments andintegration difficulties due to language, cultural and geographic differences.We cannot assure you that any further acquisitions we make will be successful.

**Ourmarketing activities may not be successful.**

Our marketing activities may not be effective inmaintaining or increasing the size of our pay and active account bases. We willbe required to incur significant marketing expenses to maintain or develop ourbrands and we may not be successful in increasing active and pay accounts andsubscriptions. We have increased the number of brands under which our servicesare marketed and increased the number of services we offer. We may not haveadequate resources to maintain all of our brands or promote all of ourservices. Our VoIP services, in particular, may require significant marketingresources and we do not currently intend to allocate significant resources tomarket these services. Even if we choose to allocate significant marketingresources to these services, there is no assurance that our marketingactivities will be successful. We intend to decrease our marketing budget from2005 levels, which may adversely impact our ability to maintain or grow ourrevenues. We cannot assure you that our marketing activities will besuccessful.

We obtain a significantnumber of new pay access accounts through our offline distribution channels,primarily Best Buy. If the number of new pay accounts acquired through Best Buywere to decrease, such decrease could negatively impact the number of pay accessaccounts and our revenues and profitability could be negatively impacted.

**If weare unable to retain users, our business and financial results will suffer.**

Historically, we have lost an average of four to fivepercent of our pay accounts each month, which we refer to as churn. Our churnpercentage is calculated based on the average number of pay accounts for a period.The average number of pay accounts is a simple average calculated based on thenumber of pay accounts at the beginning and end of a period. We make certainnormalizing adjustments to the calculation of our churn percentage for periodsin which we add a significant number of pay accounts due to acquisitions. We donot include in our churn calculation those accounts cancelled during the firstthirty days of service unless the accounts have upgraded from free accounts,although a number of such accounts will be included in our account totals atany given measurement date. Subscribers who cancel one pay service butsubscribe to another pay service are not considered to have cancelled a payaccount and, as such, our overall churn rate is not necessarily indicative ofthe percentage of subscribers canceling any 

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particular service. Wehave experienced, and will likely continue to experience, a higher percentageof subscribers canceling our accelerated access and Classmates services than isindicated by our churn rate, and the percentage of subscribers cancelingClassmates service has fluctuated significantly from quarter to quarter due toseasonality and the timing of termination of multi-month programs. Duringthe December 2005 quarter, we experienced increased churn in our access base asa whole, and this trend may continue. As a result, our overall churn, which wasapproximately 5% in the December 2005 quarter, may be higher in futureperiods and will fluctuate from period to period. If we continue to experiencea high percentage of pay accounts canceling our Classmates and acceleratorservices, it will make it more difficult to grow or retain the number of payaccounts to those services and the size of our overall pay accounts base. If weexperience an increased percentage of cancellations, or if we are unable toattract new pay accounts in numbers sufficient to increase our overall payaccounts, our revenues and profitability may be adversely affected.

In addition, the number ofactive free accounts has a significant impact on our ability to attractadvertisers, on the number of advertising impressions we have available tosell, and on how many pay accounts and subscriptions we can potentially acquirethrough marketing our pay services to our active free accounts. Each month, asignificant number of free accounts become inactive and we may experiencecontinued declines in the number of active free accounts, particularly if wecontinue to focus all of our marketing efforts on our pay services or imposelimitations on our free services. In addition, a user may have more than oneaccount on more than one of our services, and we are not able to determine inmost cases the number of accounts held by an individual. As such, the actualnumber of unique individuals using our services may be much lower than ourtotal number of accounts.

**Wemay not successfully develop and market new services in a timely orcost-effective manner; consumers or advertisers may not accept our new products.**

We may not be able to compete effectively if we arenot able to adapt to changes in technology and industry standards or develop oracquire and successfully commercialize new and enhanced services. New servicesmay be dependent on our obtaining needed technology or services from thirdparties, which we may not be able to obtain in a timely manner, upon termsacceptable to us, or at all. Our ability to compete successfully will alsodepend upon the continued compatibility of our services with products offeredby various vendors, which we may not be able to achieve.

We have expended, and mayin the future expend, significant resources enhancing our existing services,such as our enhanced accelerator service, and developing, acquiring andimplementing new services, such as our recently launched VoIP services. Productdevelopment involves a number of uncertainties, including unanticipated delaysand expenses. New or enhanced services, such as our VoIP services and ourenhanced accelerator service, may have technological problems or may not beaccepted by our consumers or advertisers. We cannot assure you that we will besuccessful in developing, acquiring or implementing new or enhanced services,or that new or enhanced services will be commercially successful.

**OurVoIP services may not be commercially successful.**

Only a limited number ofusers have signed up for our new VoIP services, and we have experienced lossesin connection with these services due to fraud and the costs of developing and operatingthem. It is likely we will continue to expend significant resources developing,enhancing, operating and marketing these services. We expect these services tocontinue to adversely impact our profitability, at least in the near term. Ifour VoIP services are not commercially successful we will continue to incuroperating losses in connection with these services, which would negativelyimpact our financial condition and results of operations.

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**Seasonaltrends in Internet usage and advertising sales may cause fluctuations in ourresults of operations.**

Seasonal trends couldaffect revenues, operating expenses and the rate at which users sign up for ourservices. Decreased usage during seasonal periods could decrease advertisinginventory and search activity and adversely impact advertising revenue. Increasedusage due to seasonality may result in increased telecommunications costs forsuch period. We have experienced lower usage of our access services in thesummer months and this trend may continue. We also have experienced a lowerrate of people signing up for our access services during the spring and summermonths when compared to the fall and winter months, and this trend maycontinue. Seasonality may result in significant fluctuations in our results ofoperations and the number of users signing up for, or accessing, our services.

**Wemay be unable to maintain or grow our advertising revenues, particularly if welose key advertising relationships. Reduced advertising revenues may reduce ourprofits.**

Advertising and commerce revenues are an importantcomponent of our revenues and profitability. Our revenues from advertising havein the past fluctuated, and may in the future fluctuate, due to a variety offactors including, without limitation, changes in the online advertisingmarket, decreases in capital available to Internet and other companies, changesin our advertising inventory, changes in usage and the effect of keyadvertising relationships. Although we experienced an increase in advertisingrevenues in the December 2005 quarter from the immediately precedingquarter, we have experienced declines in advertising revenues in certain priorperiods. The majority of our advertising revenues are derived from our accessservices and decreases in our access account base would likely result indecreased inventory and, potentially, decreased advertising revenues. Asdiscussed above, competition for advertising dollars is intense and ouradvertising revenues may decline in future periods.

A small number ofcustomers have accounted for, and may in the future account for, a significantportion of our advertising and commerce revenues. In the past, we haveexperienced a number of situations where significant advertising arrangementswere terminated early, were not renewed, were renewed at significantly lowerrates or were renegotiated during the term of the arrangement. We derivedapproximately 26% of our advertising and commerce revenues during the yearended December 31, 2005 from Internet search fees provided through ouragreement with Yahoo! Search. Our agreement with Yahoo! Search expires in March 2007.The competition among search services is increasing. If there were asignificant decrease in search fees from our agreement with Yahoo! Search dueto users using competitive services or other factors, such decrease wouldadversely impact our results of operations. Our business, financial position,results of operations and cash flows may be materially and adversely affectedif we are unable either to maintain or renew our significant agreements or toreplace such agreements with similar agreements with new customers.

**Ifour access accounts usage increases or our telecommunications costs increase,our business may suffer.**

Other than sales andmarketing, our telecommunications costs are our largest expense. If the averagemonthly usage of our access users increases, or if our average hourlytelecommunications cost increases, our profitability may be adversely impacted.

**Ouraccess business is dependent on a small number of telecommunications carriers.Our inability to maintain agreements at attractive rates with these carriersmay negatively impact our business.**

Our access business substantially depends on thecapacity, affordability, reliability and security of our telecommunicationsnetworks. Only a small number of telecommunications providers offer the networkand data services we require, and most of our telecommunications services iscurrently purchased from Level 3 Communications, MCI, Pac-West and Qwest.Furthermore, in the past, several vendors have 

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ceased operations orceased offering the services we require, causing us to switch vendors. Vendorsmay experience significant financial difficulties and be unable to performsatisfactorily or to continue to offer their services. MCI, Level 3Communications, Pac-West and Qwest have significant amounts of debtobligations. The loss of vendors has resulted, and may in the future result, inincreased costs, decreased service quality and the loss of users. Inparticular, the failure of Level 3 Communications, MCI, Pac-West or Qwest tocontinue to provide the scope, quality and pricing of services currentlyprovided could materially and adversely affect our business and results ofoperations. Some of our telecommunications services are provided pursuant toshort-term agreements that the providers can terminate or elect not to renew.In addition, each of our telecommunications carriers provides network access tosome of our competitors and could choose to grant those competitorspreferential network access or pricing. Certain of our telecommunicationsproviders compete with us in the market to provide consumer Internet access. Asa result, any or all of our current telecommunications service providers coulddiscontinue providing us with service at rates acceptable to us, or at all,which could materially and adversely affect our business, financial position,results of operations and cash flows.

Market rates fortelecommunications services used in our business have declined significantly inrecent years. We do not anticipate that such rates will continue to decline atthe same rate in the future, if at all. General market forces, the failure ofproviders, regulatory issues and other factors could result in increased rates.Any increase in market rates would increase the cost of providing our servicesand, if significant, could have a material adverse effect on our business,financial position, results of operations and cash flows.

**If wefail to manage our telecommunications or our internal network capacities, ouraccess service levels may suffer or we may experience increased per-accountcosts.**

We will have to accurately anticipate our futuretelecommunications capacity needs within lead-time requirements. If we fail toprocure sufficient quantities of telecommunications services, we may be unableto provide our users with acceptable service levels. Conversely, if we purchaseexcessive amounts of telecommunications services we will have increased costs,which could decrease our profitability. We have experienced such overcapacityin the past, and we may experience overcapacity in the future. Our failure toeffectively manage telecommunications costs could adversely affect ourreputation as a quality provider of Internet services or could adversely affectour profitability.

In addition, we may fromtime to time experience increases in our telecommunications usage that exceedour then-available telecommunications capacity and the capacity of our internalservers. As a result, users may be unable to register or log on to ourservices, may experience a general slow-down in their Internet access or may bedisconnected from their sessions. Excessive user demand could also result insystem failures of our internal server networks, which would prevent us fromgenerating advertising revenues. Inaccessibility, interruptions or otherlimitations on the ability to access our services due to excessive user demand,or any failure of our servers to handle user traffic, could adversely effectour reputation, lead to subscriber cancellations and could adversely affect ourrevenues.

**Ourbusiness will suffer if the scope or quality of service from ourtelecommunications carriers is inadequate.**

If our telecommunicationsservice providers deliver unacceptable service, the quality of our Internetaccess service would suffer. In this event, we would likely lose users who aredissatisfied with our service. Since we do not have direct control over ourtelecommunications carriers’ network reliability and the quality of theirservice, we cannot assure you that we will be able to provide consistentlyreliable Internet access for our users.

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**Ourbusiness is highly dependent on our billing and customer support systems, whichare based on a combination of third-party software and internallydeveloped software.**

The software that operatesmost of our billing and customer support systems for our access service islicensed from Portal Software, Inc. and Remedy, a BMC Software company,and we use a combination of Portal, Remedy and other third-party andinternally developed software applications for such customer billing andsupport. The billing system for Classmates relies on a combination of softwarelicensed from Art Technology Group Inc. (“ATG”), other third-partysoftware applications as well as internally developed software applications.Customer billing and support is a highly complex process, and our systems mustefficiently interface with other third parties’ systems such as the systems ofcredit card processing companies and other companies to whom we outsourcebilling and support functions. Our ability to accurately and efficiently billand support our users is dependent on the successful operation of our billingand support systems and third parties’ systems upon which we rely. In addition,our ability to offer new pay services or alternative payment plans is dependenton our ability to customize our billing and support systems. Issues associatedwith these systems could cause a variety of problems including the failure tobill and collect from users on a timely basis, over-charging or under-chargingusers, inaccurate financial and customer data, excessive credit cardchargebacks or refunds, delays in new product or payment plan introductions andother billing-related errors. Such problems could lead to inaccuratereporting from time to time, which could adversely affect our business,financial position, results of operations and cash flows. We have experiencedbilling and support problems from time to time and may experience additionalproblems in the future. The failure of our software vendors to provide softwareupgrades and technical support, the failure of the Portal, Remedy, ATG orinternally developed software to operate accurately, problems with our creditcard processor or other billing and support vendors and any other failures orerrors in our billing and support systems could materially and adversely affectour business, financial position, results of operations and cash flows.

**Weare dependent on third parties for technical support and customer service andour business may suffer if they are unable to provide these services, cannotexpand to meet our needs or terminate their relationships with us.**

Our business and financialresults depend, in part, on the availability and quality of our customersupport services. We outsource a majority of the live technical and billingsupport functions to ClientLogic Corporation. As a result, we maintain only asmall number of internal customer service personnel. We are not equipped toprovide the necessary range of customer service functions in the event thatClientLogic becomes unable or unwilling to offer these services to us. Attimes, users seeking live customer support have experienced lengthy waitingperiods to reach support personnel who are trained to provide the technical orbilling support they require. ClientLogic has also experienced outages andother issues in the past which resulted in inadequate service quality andsupport which adversely impacted our business. Maintaining desired customersupport levels may require significantly more support personnel than arecurrently available to us, or significantly greater expense than we choose toincur. If ClientLogic does not provide us with quality services, or if our relationshipwith ClientLogic terminates and we are unable to transition such servicesin-house or to a replacement vendor in an orderly, cost-effective and timelymanner, our reputation, business and results of operations would suffer. Inaddition, we prepay significant amounts in advance to ClientLogic under ouragreement with them, and any failure by them to perform the services for whichwe have prepaid would negatively impact our financial position.

**Ifour software or hardware contains errors or fails, if we fail to operate ourservices effectively or if we encounter difficulties integrating our systemsand technologies, our business could be seriously harmed.**

Our services, andthe hardware and software systems underlying our services, are complex. Our systemsmay contain undetected errors or failures and are susceptible to human error.We have in the past 

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encountered,and may in the future encounter, software and hardware errors, system designerrors and errors in the operation of our systems. This has resulted in, andmay in the future result in, a number of adverse consequences, which haveincluded or may include:

·       usersbeing disconnected from our services or being unable to access our services;

·       lossof data or revenue;

·       injuryto reputation; and

·       diversionof development resources.

We have experienced technical and customer supportissues associated with our services and software releases. These issues haveresulted in users discontinuing their service and have adversely impacted ourrevenues. A number of our material technologies and systems are based ondifferent platforms. To the extent we attempt to integrate these technologiesand systems, we may experience a number of difficulties, errors, failures andunanticipated costs. In addition, our business relies on third-partysoftware including, without limitation, software licensed from Oracle for ourinternal operations, software licensed from Portal and Remedy for billing andcustomer support, software licensed from SlipStream Data Inc. for our acceleratedservices, software licensed from certain third parties for our VoIP services,and software licensed from certain third parties for our advertising productsand services. Any significant failure of this software could materially andadversely affect our business, financial position, results of operations andcash flows. Our services also rely on their compatibility with other third-partysystems, particularly operating systems. Incompatibility with future changes tothird-party software upon which our systems rely could materially affectour ability to deliver our services. We cannot assure you that we will notexperience significant technical problems with our services in the future.

Our recently launched VoIPservices are dependent upon internally developed software, licensed softwareand third party telecommunications services, all of which are relatively new.Our VoIP services have not yet been operated on a significant scale. There willbe bugs and other issues associated with these services. If we experience anymaterial difficulties operating these services on a significant scale, or ifthe bugs or other issues we encounter with these services are material, ourability to obtain and maintain users will be adversely impacted.

**Asecurity breach or inappropriate use of our network or services could expose usto claims or a loss of revenue.**

The success of ourbusiness depends on the security of our networks and, in part, on the securityof the network infrastructures of our third-party telecommunicationsservice providers, providers of customer support services and other vendors.Unauthorized or inappropriate access to, or use of, our networks, computersystems and services could potentially jeopardize the security of confidentialinformation, including credit card information, of our users and of thirdparties. Third parties have in the past used our networks, services and brandnames to perpetrate crimes, such as identity theft or credit card theft, andmay do so in the future. Users or third parties may assert claims of liabilityagainst us as a result of any failure by us to prevent security breaches,unauthorized disclosure of user information or other such activities. Althoughwe use security measures that we believe to be industry standard, we cannotassure you that the measures we take will be successfully implemented or willbe effective in preventing these types of activities. We also cannot assure youthat the security measures of our third-party network providers,providers of customer and billing support services or other vendors will beadequate. In addition to potential legal liability, these activities mayadversely impact our reputation or our revenues and may interfere with ourability to provide our services, all of which could adversely impact ourbusiness.

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**Harmfulsoftware programs such as viruses could disrupt our business.**

Our business is dependenton the continued acceptance of the Internet as an effective medium. Damagingsoftware programs, such as computer viruses, worms and Trojan horses, have fromtime to time been disseminated through the Internet and have caused significantdisruption to Internet users. Certain of these programs have disabled theability of computers to access the Internet, requiring users to obtaintechnical support in order to gain access to the Internet. Other programs havehad the potential to damage or delete computer programs. The development andwidespread dissemination of harmful programs has the potential to seriouslydisrupt Internet usage. If Internet usage is significantly disrupted for anextended period of time, or if the prevalence of these programs results indecreased residential Internet usage, our business could be materially andadversely impacted. In addition, actions taken by us or our telecommunicationsproviders to attempt to minimize the spread of harmful programs could adverselyimpact our users’ ability to utilize our services.

**Ourfailure to protect our proprietary rights could harm our business.**

Our trademarks, patents, copyrights, domain names andtrade secrets are important to the success of our business. We principally relyupon patent, trademark, copyright, trade secret and contract laws to protectour proprietary technology. We cannot be certain that we have taken adequatesteps to prevent misappropriation of our rights. Our failure to adequatelyprotect our proprietary rights could adversely affect our brands.

Governmental agencies andtheir designees generally regulate the acquisition and maintenance of domainnames. The regulation of domain names in the United States and in foreigncountries is in flux and may change. As a result, we may be unable to acquireor maintain relevant domain names in the countries that we conduct, or plan toconduct, business. For example, we do not own the domain name *www.unitedonline.com*. Furthermore, the relationship betweenregulations governing domain names and laws protecting trademarks and similarproprietary rights is unclear. Therefore, we may be unable to prevent thirdparties from acquiring domain names that are similar to, infringe upon, diluteor otherwise decrease the value of our trademarks and other proprietary rights.

**Legalactions, particularly those associated with proprietary rights, could subjectus to substantial liability and expense and require us to change our businesspractices.**

We are currently, and have been in the past, party tovarious legal actions in the ordinary course of our business. These actionsinclude, without limitation, claims that we infringe third party patents, claimsand investigations by governmental agencies and private parties in connectionwith consumer protection and other laws, claims in connection with employmentpractices, securities laws claims, breach of contract claims and other businessrelated claims. The nature of our business could subject us to additionalclaims for similar matters, as well as a wide variety of other claimsincluding, without limitation, claims for defamation, negligence, trademarkinfringement, copyright infringement, and privacy matters.

Defending against lawsuitsinvolves significant expense and diversion of management’s attention andresources from other matters. We may not prevail in existing actions or actionsthat may be brought in the future. The failure to successfully defend againstcertain types of claims, including claims based on infringement of proprietaryrights, could require us to change our business practices or obtain licensesfrom third parties, which licenses may not be available on acceptable terms, ifat all. Lawsuits also involve the risk of significant settlements or judgmentsagainst us. Both the cost of defending claims, as well as the effect ofsettlements and judgments, could cause our results of operations to fluctuatesignificantly from period to period and could materially and adversely affectour business, financial position, results of operations and cash flows.

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**Wemay not realize the benefits associated with our intangible assets and may berequired to record a significant charge to earnings if we are required toimpair our goodwill or identifiable intangible assets.**

We are required, underaccounting principles generally accepted in the United States, to review ourintangible assets for impairment when events occur or circumstances change thatwould more likely than not reduce the fair value of a reporting unit below itscarrying value amount. Goodwill is required to be tested for impairment atleast annually. We have experienced impairment losses in the past and we cannotassure you that we will not experience impairment losses in the future. Anysuch loss could adversely and materially impact our financial condition andresults of operations.

Our VoIP services and ourdigital photo-sharing services are relatively new and have not generatedsignificant revenues. We have capitalized certain proprietary rights related toour VoIP services as well as certain costs incurred by us in connection withthe development of our VoIP services. We have also capitalized goodwill andintangible assets in connection with the acquisition of certain assets relatedto PhotoSite in March 2005. If these services are not commercially successful,we would likely be required to impair these assets which would negativelyimpact our financial condition and results of operations.

**Ourability to operate our business could be seriously harmed if we lose members ofour senior management team or other key employees.**

Our business is largelydependent on the efforts and abilities of our senior management, particularlyMark Goldston, our chairman, chief executive officer and president, and otherkey personnel. Any of our officers or employees can terminate his or heremployment relationship at any time. The loss of these key employees or ourinability to attract or retain other qualified employees could seriously harmour business and prospects. We do not carry key person life insurance on any ofour employees.

**Governmentregulation or taxation of the provision of Internet access, VoIP services andother services could decrease our revenues and increase our costs.**

Changes in the regulatoryenvironment regarding the Internet could decrease our revenues and increase ourcosts. Currently, ISPs are considered “information service” providers ratherthan “telecommunications” providers, and regulations that apply to telephonecompanies and other telecommunications common carriers currently do not applyto our Internet access services. However, our Internet access services couldbecome subject to Federal Communications Commission and state regulation asInternet access services and telecommunications services converge. If theregulatory status of ISPs changes, our business may be adversely affected.

In general, VoIP servicesare deemed interstate services subject to regulation by the FCC. The FCC madethis determination concerning a VoIP service offering by a particular providerof VoIP services. This FCC finding was specific to a particular company thatprovides a different service than we offer, and our offering of VoIP servicesmay or may not be found to be an interstate offering. Further, the FCC’s orderfinding that a particular type of VoIP service is interstate**has been appealed. We cannot predict what the outcome ofthe appeal will be nor can we predict what impact, if any, it may have on ourbusiness.

On February 12, 2004,the FCC opened a rulemaking proceeding that is considering, among other things,whether to classify VoIP services as information or telecommunications servicesunder federal law. Other issues under consideration include access to telephonenumbers, contributions to the Universal Service Fund, the applicability ofcertain consumer protection rules, intercarrier compensation arrangements andissues relating to the impact of VoIP services on providers of traditionaltelecommunications services in rural areas. Based on the conclusions reached inthat rulemaking, additional regulatory requirements, fees and surcharges mayapply to our VoIP services, which may increase the costs associated with ourVoIP offerings. As a result, we may have to raise prices or terminate certainor all of our VoIP offerings.

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On June 3, 2005, theFCC released an order and notice of proposed rulemaking concerning theprovision of emergency services by certain VoIP providers. While the order doesnot currently apply to our VoIP services, the FCC’s rulemaking is consideringwhether to extend the order requiring providers of VoIP services to offer E-911capabilities to VoIP services like ours. Should this occur, we would incuradditional expenses and could be restricted from offering our service oraccepting new customers in markets where we have not deployed an E-911solution that conforms to the requirements of the order. We have not deployedan E-911 solution and do not expect to have an E-911 solutionavailable in the near term, if at all.

On September 9, 2005,the FCC granted, in part, a petition from the California Public UtilitiesCommission, or CPUC, seeking authority to implement two statewide specializedarea code overlays in California. VoIP and dialup Internet access services maybe subject to the specialized overlays should the CPUC choose to implementtheir delegated authority. If the CPUC does so, users of VoIP services could berequired to obtain telephone numbers from specific area codes and we could berequired to provision new telephone numbers to our customers that access ourservice via dialup accounts. The FCC’s order allows the CPUC to determine whatservices will be required to assign numbers from the specialized overlay areacodes. Should the CPUC determine that VoIP providers must assign telephonenumbers from the specialized overlay area codes, we could be placed at acompetitive disadvantage compared to traditional telecommunications providersbecause our ability to offer telephone numbers from a variety of Californiaarea codes would be limited. Also, future customers may not be able to transfertheir existing telephone numbers to our service. These results could have amaterial adverse effect on our business. Certain parties have filed petitionsfor reconsideration of the FCC’s order that could result in the modification ofthe FCC’s delegation of authority to the CPUC.

The CommunicationsAssistance for Law Enforcement Act, or CALEA, mandates that providers ofcommunications services assist law enforcement agencies in conducting lawfullyauthorized electronic surveillance. On September 23, 2005, the FCCreleased an order concluding that CALEA applies to certain VoIP providers.Currently, that order does not apply to VoIP services like those we provide.However, the FCC is considering whether to expand the scope of the order toinclude VoIP providers like us. We cannot predict what the FCC will conclude inthat proceeding or what effect, if any, it may have on our business.

On February 14, 2006,the FCC released a Notice of Proposed Rulemaking that will examine existingpractices in the telecommunications industry to protect consumers’ privacy. TheFCC is considering, among other issues, the security measures carrierscurrently have in place, what inadequacies exist in those measures, and whatadditional or enhanced security measures may be warranted to better protectconsumers’ privacy. The FCC is also seeking comment on whether it isappropriate to extend these privacy rules to providers of VoIP and otherIP-enabled services. If the rules are adopted and applied to our VoIPservices, the proposed requirements could change the way that we interact withour subscribers and how we maintain or share customer records, and couldtherefore impose new costs on our business.

Although these federalregulations applicable to certain VoIP services do not currently apply to ourVoIP services, our VoIP services may subsequently become subject to theseregulations as well as other state or federal regulations as a result ofchanges we make to these services, changes made to the regulations or theinterpretation of them, or the adoption of new laws and regulations applicableto our VoIP services. Moreover, if we offer new services that are subject todifferent and additional governmental regulation, we may have to comply withadditional laws and regulations that currently are not applicable to us. If theregulatory status of our VoIP service offerings changes or if we offer newservices that subject us to new laws and regulations, our business may beadversely affected.

The Internet Tax FreedomAct, which placed a moratorium on new state and local taxes on Internetcommerce, has been extended through November 2007. However, future lawsimposing taxes or other regulations on the provision of goods and services overthe Internet could make it substantially more 

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expensiveto operate our business. In addition, the FCC is in the process of determiningwhether certain federal taxes and other regulatory charges, such as UniversalService Funding, should apply to VoIP service providers. The FCC’s statepreemption order also did not preclude states from attempting to tax VoIPservice providers or from imposing surcharges like those applicable to E-911services. Accordingly, future action could be taken to impose various federal,state and local taxes on our VoIP services or to subject us to E-911surcharges regardless of whether the FCC’s VoIP E-911 order applies toour service offering.

Our business is alsosubject to a variety of other U.S. and foreign laws and regulations that couldsubject us to liabilities, claims or other remedies, such as laws relating tobulk email or “spam,” access to various types of content by minors,anti-spyware initiatives, encryption, data protection, security breaches andconsumer protection. Compliance with these laws and regulations is complex andmay impose significant additional costs on us. The compliance efforts of thirdparties could also make it more expensive for us to operate our business. Forexample, AOL and Yahoo! recently announced their plans to reduce the amount ofbulk email or “spam” sent through their email services by changing their “whitelists”into a pay program pursuant to which bulk email senders would be required topay a per-email-fee to guarantee the delivery of their messages.

In addition, theregulatory framework relating to Internet services is evolving and both thefederal government and states from time to time pass legislation that impactsour business. There are a number of legislative proposals before the UnitedStates Congress and various state legislative bodies that may relate to ourbusiness. It is likely that additional laws and regulations will be adoptedthat would affect our business. The adoption of additional laws and regulationsthat affect our competitors, for example, network neutrality proposals, couldalso have an effect our business. We cannot predict the impact that futureregulatory changes or developments may have on our business, financialcondition, results of operations or cash flows. The enactment of any additionallaws or regulations, increased enforcement activity of existing laws andregulations, or claims by individuals could significantly impact our costs orthe manner in which we conduct business, all of which could adversely impactour results of operations and cause our business to suffer.

**Changesin, or interpretations of, laws regarding consumer protection could subject usto liability or cause us to change our practices.**

Consumer protection lawsand enforcement actions regarding advertising and user privacy, especiallyrelating to children, are becoming more prevalent. The FTC has conductedinvestigations into the privacy practices of companies that collect informationabout individuals on the Internet. The FTC has also investigated us and otherISPs in connection with marketing, billing, customer retention, cancellationand disclosure practices. Juno and the FTC entered into a consent agreement,which was approved by the FTC on June 29, 2001, that provides for redresspayments and specific disclosures or notices regarding, among other things, thecost of its Internet access services, its cancellation terms and local versuslong-distance charges, as well as the requirement to provide adequate customersupport to process cancellations. We received an inquiry regarding ourcompliance with the consent agreement on October 14, 2005, and wesubmitted a response on December 14, 2005. We have not received anyfurther communication on this matter.

Various state agencies aswell as individuals have also asserted claims against, or instituted inquiriesinto, ISPs, including Juno and NetZero, in connection with marketing, billing,customer retention, cancellation and disclosure practices. We cannot assure youthat our services and business practices, or changes to our services andbusiness practices, will not subject us to claims and liability by privateparties, the FTC or other governmental agencies.

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**Ourbusiness could be shut down or severely impacted by a catastrophic event.**

Our computer equipment andthe telecommunications infrastructure of our third-party networkproviders are vulnerable to damage from fire, earthquakes, power loss,telecommunications failures, terrorism and similar events. We have experiencedsituations where power loss and telecommunications failures have adverselyimpacted our services, although to date such failures have not been material toour operations. A significant portion of our computer equipment, includingcritical equipment dedicated to our Internet access services, is located at ourheadquarters in Woodland Hills, California and at facilities in and around LosAngeles, California; San Jose, California; Ashburn, Virginia; Renton,Washington and New York, New York. In the past, areas in California haveexperienced repeated episodes of diminished electrical power supply, or “rollingblackouts.” A natural disaster, terrorism, power blackout or otherunanticipated problem at our headquarters or at a network hub, or within athird-party network provider’s network, could cause interruptions in theservices that we provide. Our systems are not fully redundant. Any prolongeddisruption of our services due to system failures could result in user turnoverand decreased revenues.

**Ourbusiness could be severely impacted due to political instability or otherfactors in India.**

We have a significantnumber of employees located in our India office. Our operations in Indiaprimarily handle email customer support, product development and qualityassurance. A portion of our outsourced customer support is also based in India.Our product development, customer support and quality assurance operationswould be severely disrupted if telecommunications issues, political instabilityor other factors adversely impacted these operations or our ability tocommunicate with these operations. Any disruption that continued for anextended period of time would likely have a material adverse effect on ourability to service our customers and develop our products since it would take asignificant period of time to transition these operations internally or to anoutside vendor. If we were to cease our operations in India and transfer theseoperations to another geographic area, such change could result in increasedoverhead costs which could materially and adversely impact our results ofoperations.

**Wecannot predict our future capital needs and we may not be able to secureadditional financing.**

We may need to raiseadditional funds in the future to fund our operations, for acquisitions ofbusinesses or technologies or for other purposes. Additional financing may notbe available on terms favorable to us, or at all. If adequate funds are notavailable or not available when required in sufficient amounts or on acceptableterms, we may not be able to devote sufficient cash resources to continue toprovide our services in their current form, acquire additional users, enhanceor expand our services, respond to competitive pressures or take advantage ofperceived opportunities, and our business and its future prospects may suffer.

**Wemay stop paying quarterly cash dividends on our common stock.**

Commencing with the secondquarter of 2005, we have declared and paid a quarterly cash dividend of $0.20per share of common stock. The payment of future dividends is discretionary andwill be subject to determination by our board of directors each quarterfollowing its review of our financial performance. Our future cash flows willsignificantly decline from what we experienced in 2005 due to the payment of incometaxes, and our cash balances will decline if we use our cash to acquirebusinesses, repurchase stock or for other purposes. We cannot assure you thatwe will continue to pay quarterly cash dividends, and if we do not, our stockprice could be negatively impacted.

**Wehave anti-takeover provisions that may make it difficult for a third party toacquire us.**

Provisions of ourcertificate of incorporation, our bylaws and Delaware law could make itdifficult for a third party to acquire us, even if doing so might be beneficialto our stockholders because of a premium 

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priceoffered by a potential acquirer. In addition, our board of directors adopted astockholder rights plan, which is an anti-takeover measure that will causesubstantial dilution to a person who attempts to acquire our company on termsnot approved by our board of directors.

**Ourstock price has been highly volatile and may continue to be volatile.**

The market price of ourcommon stock has fluctuated significantly since our stock began trading on theNasdaq National Market in September 2001 and it is likely to continue tobe volatile with extreme volume fluctuations. In addition, the Nasdaq NationalMarket, where most publicly held Internet companies are traded, has experiencedsubstantial price and volume fluctuations. These broad market and industryfactors may harm the market price of our common stock, regardless of our actualoperating performance, and for this or other reasons we could suffer significantdeclines in the market price of our common stock.

**ITEM1B.  UNRESOLVED STAFF COMMENTS**

None.

**ITEM 2.     PROPERTIES**

Wecurrently maintain the following principal facilities:

| **Facilities**                              | ** ** | ** **                           | ** ** | **Location** | ** ** | **Approximate  Square Feet** | ** ** | **Lease  Expiration** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|--------------|------------|-----------------------------------|------------|-----------------------|------------|
| Principal executive  and corporate  offices |       | Woodland Hills, California |       |         | 112,000    |                              |       |                  | 2014       |   |   |
| Operations  facility                        |       | Renton,  Washington                  |       |         | 61,000     |                              |       |                  | 2009       |   |   |
| Customer support  and technology  facility  |       | Hyderabad,  India                    |       |         | 30,000     |                              |       |                  | 2008       |   |   |
| Operations and  technology facility         |       | New  York, New York                  |       |         | 23,000     |                              |       |                  | 2010       |   |   |
| Operations facility                         |       | Orem, Utah                           |       |         | 16,000     |                              |       |                  | 2010       |   |   |

 

Our corporate headquartersare located in Woodland Hills, California, and we also maintain offices inRenton, Washington; New York, New York; Brisbane, California; Orem, Utah;Hyderabad, India; and Munich, Germany. We believe that our existing facilitiesare adequate to meet our current requirements and that suitable additional orsubstitute space will be available as needed to accommodate any physicalexpansion of our corporate and operations facilities, customer support andtechnology centers or for any additional sales offices.

**ITEM 3.**                LEGALPROCEEDINGS

On April 20, 2001,Jodi Bernstein, on behalf of himself and all others similarly situated, filed alawsuit in the United States District Court for the Southern District of NewYork against NetZero, certain officers and directors of NetZero and theunderwriters of NetZero’s initial public offering, Goldman Sachs Group, Inc.,BancBoston Robertson Stephens, Inc. and Salomon Smith Barney, Inc.The complaint alleges that the prospectus through which NetZero conducted itsinitial public offering in September 1999 was materially false andmisleading because it failed to disclose, among other things, that (i) theunderwriters had solicited and received excessive and undisclosed commissionsfrom certain investors in exchange for which the underwriters allocated tothose investors material portions of the restricted number of NetZero sharesissued in connection with the offering; and (ii) the underwriters hadentered into agreements with customers whereby the underwriters agreed toallocate NetZero shares to those customers in the offering in exchange forwhich the customers agreed to purchase additional NetZero shares in the aftermarketat pre-determined prices. Plaintiffs are seeking injunctive relief and damages.Additional lawsuits setting forth substantially similar allegations were alsoserved against NetZero on behalf of additional plaintiffs in 

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April andMay 2001. The case against NetZero was consolidated with approximately 300other suits filed against more than 300 issuers that conducted their initialpublic offerings between 1998 and 2000, their underwriters and an unspecifiednumber of their individual corporate officers and directors. In a court orderdated February 15, 2005, the District Court granted preliminary approvalof the issuer defendants’ proposed settlement. On June 30, 2005, theUnited States Court of Appeals for the Second Circuit granted the underwriter defendants’petition for permission to appeal the District Court’s order grantingplaintiffs’ motion for class certification. A hearing on the settlement isscheduled for April 24, 2006.

On August 21, 2001,Juno commenced an adversary proceeding in U.S. Bankruptcy Court in the SouthernDistrict of New York against Smart World Technologies, LLC, dba “Freewwweb”(the “Debtor”), a provider of free Internet access that had elected to ceaseoperations and had sought the protection of Chapter 11 of the Bankruptcy Code.The adversary proceeding arose out of a subscriber referral agreement betweenJuno and the Debtor. In response to the commencement of the adversaryproceeding, the Debtor and its principals filed a pleading with the BankruptcyCourt asserting that Juno is obligated to pay compensation in an amount inexcess of $80 million as a result of Juno’s conduct in connection with thesubscriber referral agreement. In addition, a dispute arose between Juno andUUNET Technologies, Inc., an affiliate of MCI WorldCom Network Services, Inc.,regarding the value of services provided by UUNET, with UUNET claiming inexcess of $1.0 million and Juno claiming less than $0.3 million. On April 25,2003, Juno, the Committee of Unsecured Creditors, WorldCom and UUNET (allegedlythe largest secured creditor) entered into a Stipulation of Settlement, whichprovided for the payment by Juno of $5.5 million in final settlement ofall claims against Juno, and we have reserved $5.5 million in connectionwith this proceeding. On September 11, 2003, the court issued an orderapproving the Stipulation of Settlement. On September 12, 2005, the SecondCircuit Court of Appeals vacated the judgment of the bankruptcy court andremanded the case to the bankruptcy court. Discovery in the adversaryproceeding in the bankruptcy court has commenced. No trial date has been set.

On April 27, 2004,plaintiff MyMail Ltd. filed a lawsuit in the United States District Courtfor the Eastern District of Texas against NetZero, Juno, NetBrands, AmericaOnline, Inc., AT&T, EarthLink, Inc., SBC Communications, Inc.,and Verizon Communications, Inc. alleging infringement of plaintiff’spatent which purports to cover user access to a computer network. On October 28,2005, the court issued an order granting defendants’ motions for summaryjudgment of non-infringement of the patent. MyMail has filed a notice of appealof the trial court’s ruling.

The pending lawsuitsinvolve complex questions of fact and law and may require the expenditure ofsignificant funds and the diversion of other resources to defend. Although wedo not believe the outcome of the above outstanding legal proceedings, claimsand litigation will have a material adverse effect on our business, financialcondition, results of operations or cash flows, the results of litigation areinherently uncertain and we cannot assure you that we will not be materiallyand adversely impacted by the results of such proceedings. We have establisheda reserve for the Freewwweb matter discussed above and such reserve isreflected in our consolidated financial statements. We cannot assure you,however, that any of the reserves that have been established for outstandinglitigation are sufficient to cover the possible losses from such litigation.

We are subject to variousother legal proceedings and claims that arise in the ordinary course ofbusiness. We believe the amount, and ultimate liability, if any, with respectto these actions will not materially affect our business, financial condition,results of operations or cash flows. We cannot assure you, however, that suchactions will not be material and will not adversely affect our business,financial condition, results of operations or cash flows.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

We did not submit anymatters to a vote of security holders during the quarter ended December 31, 2005.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Ourcommon stock has been quoted on the Nasdaq National Market (“NASDAQ”) under thesymbol “UNTD” since September 26, 2001. Prior to that, NetZero commonstock had been quoted on the NASDAQ under the symbol “NZRO” since September 23,1999. The following table sets forth, for the quarters indicated, the high andlow prices per share of our common stock as reported on the NASDAQ.

| ** **                                                       | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|---------|------------|
| **Year Ended December 31,  2004**                           |       |     |       |    |       |
| Quarter ended  March 31, 2004                               |       | $        | 20.97      |    | $          | 14.93 |   |
| Quarter ended  June 30, 2004                                |       | 20.75    |       | 15.76   |       |
| Quarter ended  September 30, 2004                           |       | 17.47    |       | 8.59    |       |
| Quarter ended  December 31, 2004                            |       | 12.00    |       | 9.10    |       |
| **Year  Ended December 31, 2005**                           |       |     |       |    |       |
| Quarter ended  March 31, 2005                               |       | $        | 11.85      |    | $          | 9.75 |   |
| Quarter ended  June 30, 2005                                |       | 13.08    |       | 8.51    |       |
| Quarter ended  September 30, 2005                           |       | 14.05    |       | 10.70   |       |
| Quarter ended  December 31, 2005                            |       | 15.03    |       | 12.57   |       |
| Period from  January 1, 2006 through February 28, 2006 |       | $        | 15.40      |    | $          | 11.70 |   |

 

On February 28, 2006,there were 864 holders of record of our common stock.

**Dividends**

In May, August and October of 2005, theCompany’s Board of Directors declared a quarterly cash dividend of $0.20 pershare of common stock. The quarterly dividends were paid on May 31, 2005, August 31,2005 and November 30, 2005 and totaled $12.6 million,$12.7 million and $12.8 million, respectively.

In February 2006, the Company’s Board ofDirectors declared a quarterly cash dividend of $0.20 per share of commonstock, which was paid on February 28, 2006 and totaled $12.9 million.

The payment of futuredividends is discretionary and will be subject to determination by the Board ofDirectors each quarter following its review of the Company’s financialperformance. Dividends declared and paid are not a return of profits but rathera distribution of amounts paid in by the stockholders.

**Common Stock Repurchase Program**

Our Board of Directors authorized a common stockrepurchase program that allows us to repurchase shares of our common stockthrough open market or privately negotiated transactions based on prevailingmarket conditions and other factors. From time to time, the Board of Directorshas increased the amount authorized for repurchase under this program. On April 22,2004, the Board of Directors authorized us to purchase up to an additional$100 million of our common stock through May 31, 2005 under theprogram, bringing the total amount authorized under the program to$200 million. On April 29, 2005, the Board of Directors extended theprogram through December 31, 2006. At December 31, 2005, we hadrepurchased $139.2 million of our common stock under the program.

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Sharerepurchases executed under the common stock repurchase program at December 31,2005 were as follows (in thousands, except per share amounts):

| **Period**         | ** ** | ** ** | ** ** | **Shares  Repurchased(1)** | ** ** | **Average Price Paid  per Share** | ** ** | **Maximum Approximate Dollar  Value that May Yet be  Purchased Under the Program** | ** ** |
|--------------------|------------|------------|------------|----------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|
| August 2001   |       |       | 138        |                       |       |                                             | $          | 1.67                                                                                                                            |       |   |   | $ | 9,770 |   |   |
| November 2001 |       |       | 469        |                       |       |                                             | 1.77       |                                                                                                                            |       |   | 8,940 |   |   |
| February 2002 |       |       | 727        |                       |       |                                             | 3.38       |                                                                                                                            |       |   | 6,485 |   |   |
| August 2002   |       |       | 288        |                       |       |                                             | 7.51       |                                                                                                                            |       |   | 27,820 |   |   |
| February 2003 |       |       | 193        |                       |       |                                             | 9.43       |                                                                                                                            |       |   | 26,005 |   |   |
| May 2003      |       |       | 281        |                       |       |                                             | 13.51      |                                                                                                                            |       |   | 22,207 |   |   |
| November 2003 |       |       | 2,024      |                       |       |                                             | 19.76      |                                                                                                                            |       |   | 48,706 |   |   |
| February 2004 |       |       | 2,887      |                       |       |                                             | 16.86      |                                                                                                                            |       |   | — |   |   |
| May 2004      |       |       | —     |                       |       |                                             | —     |                                                                                                                            |       |   | 100,000 |   |   |
| August 2004   |       |       | 2,657      |                       |       |                                             | 9.41       |                                                                                                                            |       |   | 74,989 |   |   |
| February 2005 |       |       | 1,268      |                       |       |                                             | 11.20      |                                                                                                                            |       |   | 60,782 |   |   |
| Total              |       |       | 10,932     |                       |       |                                             | $          | 12.74                                                                                                                           |       |   |   |   |   |   |

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(1)          Allshares were repurchased as part of a publicly announced program.

In February 2006, weannounced our intention to offer our eligible employees the opportunity toexchange any outstanding stock options granted to them which have an exerciseprice per share of our common stock at or above $16.00 (the “Eligible Options”)in return for restricted stock units (“RSUs”). The number of RSUs that will beissued in exchange for each tendered Eligible Option will be based on the per shareexercise price of that option and will, in all events, be less than the numberof shares subject to the tendered option. Eligible options with exercise pricesbetween $16.00 and $20.00 will be exchanged based on a ratio of one RSU forfour eligible options. Eligible options with exercise prices greater than$20.00 will be exchanged based on a ratio of one RSU for five eligible options.There are approximately 1.9 million Eligible Options, which could be exchangedfor approximately 0.4 million RSUs.

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**ITEM 6.     SELECTEDFINANCIAL DATA**

The followingselected consolidated financial data should be read in conjunction with ourconsolidated financial statements and related notes and Management’s Discussionand Analysis of Financial Condition and Results of Operations includedelsewhere in this Annual Report on Form 10-K.

The following tablepresents the consolidated statements of operations data for the years ended December 31,2005 and 2004, the six months ended December 31, 2003, and the year ended June 30,2003, and the consolidated balance sheet data at December 31, 2005 and2004. Such financial data are derived from our audited consolidated financialstatements included elsewhere in this Annual Report on Form 10-K.The table also presents the consolidated statements of operations data for theyears ended June 30, 2002 and 2001 and the consolidated balance sheet dataat December 31, 2003 and June 30, 2003, 2002 and 2001 and are derivedfrom our audited consolidated financial statements that are not included in thisAnnual Report on Form 10-K.

The followingamounts are in thousands, except per share data:

| ** **                                       | ** ** | **Year Ended December 31,** | ** ** | **Six Months  Ended  December 31,** | ** ** | **Year Ended June 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                   | ** ** | **2004(1)**                                   | ** ** | **2003(2)**                            | ** ** | **2003(3)** | ** ** | **2002(4)** | ** ** | **2001(5)** | ** ** |
| **Consolidated  Statements of Operations Data:** |       |                                       |       |                                          |       |                                   |       |   |   |   |   |   |   |   |   |
| Total revenues                                   |       | $                                          | 525,061    |                                          | $          | 448,617                                |       |   | $ | 185,738 |   |   | $ | 277,295 |   | $ | 167,515 |   | $ | 57,217 |   |
| Operating income  (loss)                         |       | $                                          | 86,560     |                                          | $          | 79,493                                 |       |   | $ | 32,639 |   |   | $ | 21,721 |   | $ | (53,946 | ) | $ | (215,087 | ) |
| Net income (loss)                                |       | $                                          | 47,127     |                                          | $          | 117,480                                |       |   | $ | 33,327 |   |   | $ | 27,792 |   | $ | (47,810 | ) | $ | (205,756 | ) |
| Net income (loss)  per  share—basic         |       | $                                          | 0.77       |                                          | $          | 1.91                                   |       |   | $ | 0.52 |   |   | $ | 0.45 |   | $ | (0.90 | ) | $ | (6.03 | ) |
| Net income (loss) per  share—diluted        |       | $                                          | 0.74       |                                          | $          | 1.81                                   |       |   | $ | 0.48 |   |   | $ | 0.41 |   | $ | (0.90 | ) | $ | (6.03 | ) |

 

| ** **                                | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004**          | ** ** | **2003** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Consolidated  Balance Sheet Data:**     |       |                  |       |              |       |   |   |   |   |   |   |   |   |
| Total assets                              |       | $                     | 521,188    |              | $          | 519,852 |   | $ | 307,879 |   | $ | 280,676 |   | $ | 233,593 |   | $ | 183,863 |   |
| Non-current  liabilities                  |       | $                     | 45,863     |              | $          | 81,207 |   | $ | — |   | $ | — |   | $ | — |   | $ | 3,314 |   |
| Cash dividends declared  per common share |       | $                     | 0.60       | (6)               | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |

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(1)          In November 2004,we acquired Classmates. The results of Classmates are included in ourconsolidated results of operations from the date of acquisition. Net incomeincluded tax benefits of $68.6 million for the year ended December 31,2004.

(2)          Net income included taxbenefits of $12.3 million for the six months ended December 31, 2003.

(3)          Net income included taxbenefits of $4.3 million for the year ended June 30, 2003.

(4)          In September 2001,NetZero and Juno merged and became wholly-owned subsidiaries of UnitedOnline. The results of Juno are included in our consolidated results ofoperations from the date of the Merger.

(5)          In March 2001, werecorded an impairment charge of $48.6 million, reflecting the amount bywhich the carrying amounts of our goodwill and identifiable intangible assetsexceeded their respective fair values.

(6)          In May, August and October of2005, the Company’s Board of Directors declared a quarterly cash dividend of$0.20 per share of common stock.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Overview**

We are a leading provider of consumer Internetsubscription services through a number of brands, including NetZero, Juno andClassmates Online. Our subscription services include dial-up Internet access,social-networking, VoIP telephony, personal Web-hosting, premium email,Internet security and online digital photo-sharing, among others. We also offeradvertising-supported versions of many of our services at no charge toconsumers. On a combined basis, our Web properties attract a significant numberof Internet users each month. Advertisers can reach this audience through theUnited Online Media Group, which offers marketers a broad array of Internet advertisingproducts as well as online market research and measurement services.

At December 31, 2005,we had approximately 5.0 million pay accounts representing approximately6.4 million total subscriptions, and approximately 17.6 million activeaccounts. A pay account represents a unique billing relationship with acustomer who subscribes to one or more of our pay services. A subscriptionrepresents a unique subscription to any individual pay service. “Active”accounts include total pay accounts as well as free users who have logged ontoour access, social-networking, email or VoIP services during the preceding31 days. Active accounts also include those free hosted Web sites thathave received at least one visit during the preceding 90 days and thenumber of free photo-sharing users that logged on to the service at least oncewithin the preceding 90 days.

**Pay Accounts and Subscriptions**

Thefollowing table sets forth (in thousands), for the periods presented, ananalysis of our pay accounts and subscriptions. A pay account represents aunique billing relationship with a customer who subscribes to one or more ofour services. A subscription represents a unique subscription to any individualpay service offered by us including Internet access, social-networking, acceleratorservices, premium email, Web-hosting and domain name registration, premiumcontent, VoIP, Internet security and online photo-sharing subscriptions.Internet access and accelerator are counted as two subscriptions, although mostsubscribers to the accelerated service currently purchase it bundled with ourstandard Internet access. While we currently consider our non-access servicesto include VoIP, social-networking, premium email, Web-hosting and domain nameregistration, premium content and photo-sharing, certain of these services arederived from, or are dependent on, our access services.

| ** **           | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------|------------|-----------------------------|------------|------------------------------|------------|-------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Pay Accounts:        |       |                        |       |                         |       |                    |       |                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Internet access      |       |                        | 2,855      |                         |       |                    | 2,980      |                     |       |                        | 3,078      |   |   |   | 3,130 |   |   |   | 3,100 |   |   |
| Non-access services  |       |                        | 2,154      |                         |       |                    | 2,060      |                     |       |                        | 1,955      |   |   |   | 1,822 |   |   |   | 1,726 |   |   |
| Total pay accounts   |       |                        | 5,009      |                         |       |                    | 5,040      |                     |       |                        | 5,033      |   |   |   | 4,952 |   |   |   | 4,826 |   |   |
| Subscriptions:       |       |                        |       |                         |       |                    |       |                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Internet access      |       |                        | 2,855      |                         |       |                    | 2,980      |                     |       |                        | 3,078      |   |   |   | 3,130 |   |   |   | 3,100 |   |   |
| Accelerator          |       |                        | 1,214      |                         |       |                    | 1,205      |                     |       |                        | 1,196      |   |   |   | 1,170 |   |   |   | 1,105 |   |   |
| Non-access services  |       |                        | 2,303      |                         |       |                    | 2,186      |                     |       |                        | 2,064      |   |   |   | 1,900 |   |   |   | 1,781 |   |   |
| Total  subscriptions |       |                        | 6,372      |                         |       |                    | 6,371      |                     |       |                        | 6,338      |   |   |   | 6,200 |   |   |   | 5,986 |   |   |

 

In general we count and track pay accounts and freeaccounts by unique member identification. Users have the ability to registerfor separate services under separate brands and member identificationsindependently. We do not track whether a pay account has purchased more thanone of our services unless the account uses the same member identification. Asa result, unique pay accounts may not represent 

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unique subscribers and,similarly, total active free accounts may not represent unique free users. Inaddition, a free Web-hosting account is determined to be active if there was avisit to the site during the preceding 90 days, and it may be that thecreator of the site no longer maintains or updates the site. As such, a freeWeb-hosting account may not represent an ongoing relationship with the personwho set up the account. At any point in time, our pay account base includes anumber of accounts receiving a free period of service as either a promotion orretention tool, a number of accounts that have notified us that they areterminating their service but whose service is still in effect and may alsoinclude a few thousand internal test accounts. 

We have experienced declinesin our pay access accounts beginning in the quarter ended June 30, 2005and currently anticipate that our pay access accounts will continue to declinein the future. In the quarter ended December 31, 2005, we experienced adecline in our total pay accounts for the first time due to a decrease in payaccess accounts exceeding the growth in non-access pay accounts during thequarter. In addition, growth in non-access subscriptions was almost entirelyoffset by a decrease in access subscriptions and we experienced a decline inthe rate of growth in subscriptions to our accelerator services. We anticipatedeclines in access and accelerator subscriptions in the future. While weanticipate limited growth in our total pay accounts during the first quarter of2006, there can be no assurance that we will achieve such growth or that payaccounts and subscriptions will not decline during the quarter and in thefuture. The dial-up Internet access market as a whole is decreasing, and thevalue-priced segment is intensely competitive. We, as well as our competitors,have become more aggressive in offering discounts and free months of service toobtain and retain dial-up subscribers. In addition, providers of broadbandservices have become increasingly aggressive in discounting their services withseveral broadband offerings now priced at or below the prices for dial-upservices, at least for introductory periods. While we intend to continue todevote significant resources to our Internet access services, we havediversified our business by acquiring or developing a number of non-accessInternet services, including social-networking, VoIP, personal Web-hosting,premium email and content, and online digital photo-sharing. A significant partof our strategy is to enhance and market certain of these services as well asto expand the non-access services we offer by acquiring or developing newservices. As a result, we have shifted a greater portion of our managementfocus, marketing expenditures and product development initiatives away fromInternet access to non-access services.

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**Results of Operations**

Thefollowing table sets forth (with dollars in thousands), for the periodspresented, selected historical statements of operations data. The informationcontained in the table below should be read in conjunction with Liquidity andCapital Resources, Critical Accounting Policies and Estimates and FinancialCommitments included in this Item 7 as well as the consolidated financialstatements and notes thereto included elsewhere in this Annual Report on Form 10-K.

| ** **                                     | ** ** | **Year Ended December, 31,** | ** ** | **Six Months Ended December 31,** | ** ** | **Year Ended  June 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                    | ** ** | **2004**                                              | ** ** | **2003**                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | ** **                                  | ** ** | ** **                                            | ** ** | ** **                         | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Statements  of Operations Data:**            |       |                                        |       |                                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues:                                      |       |                                        |       |                                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Billable services                              |       | $                                           | 465,980    |                                                  | 89         | %                                  | $          | 410,821 |   | 92 | % | $ | 306,086 |   | 90 | % | $ | 167,639 |   | 90 | % | $ | 109,343 |   | 88 | % | $ | 247,790 |   | 89 | % |
| Advertising and commerce                       |       | 59,081                                      |       | 11                                                    |       | 37,796                             |       | 8 |   | 33,079 |   | 10 |   | 18,099 |   | 10 |   | 14,525 |   | 12 |   | 29,505 |   | 11 |   |
| Total revenues                                 |       | 525,061                                     |       | 100                                                   |       | 448,617                            |       | 100 |   | 339,165 |   | 100 |   | 185,738 |   | 100 |   | 123,868 |   | 100 |   | 277,295 |   | 100 |   |
| Operating  expenses:                           |       |                                        |       |                                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of billable services                      |       | 98,157                                      |       | 19                                                    |       | 94,999                             |       | 21 |   | 92,785 |   | 27 |   | 46,182 |   | 25 |   | 42,690 |   | 34 |   | 89,293 |   | 32 |   |
| Cost of free services                          |       | 12,515                                      |       | 2                                                     |       | 7,393                              |       | 2 |   | 9,659 |   | 3 |   | 3,953 |   | 2 |   | 6,897 |   | 6 |   | 12,603 |   | 5 |   |
| Sales and marketing                            |       | 209,292                                     |       | 40                                                    |       | 178,981                            |       | 40 |   | 120,619 |   | 36 |   | 70,526 |   | 38 |   | 36,530 |   | 30 |   | 86,623 |   | 31 |   |
| Product development                            |       | 40,009                                      |       | 8                                                     |       | 27,454                             |       | 6 |   | 21,881 |   | 6 |   | 10,488 |   | 6 |   | 11,661 |   | 9 |   | 23,054 |   | 8 |   |
| General and administrative                     |       | 56,729                                      |       | 11                                                    |       | 39,894                             |       | 9 |   | 29,087 |   | 9 |   | 14,022 |   | 7 |   | 12,740 |   | 10 |   | 27,805 |   | 10 |   |
| Amortization of goodwill and intangible assets |       | 21,799                                      |       | 4                                                     |       | 20,403                             |       | 5 |   | 15,856 |   | 5 |   | 7,928 |   | 4 |   | 8,483 |   | 7 |   | 16,411 |   | 6 |   |
| Restructuring charges                          |       | —                                      |       | —                                                |       | —                             |       | — |   | (215 | ) | — |   | — |   | — |   | — |   | — |   | (215 | ) | — |   |
| Total operating expenses                       |       | 438,501                                     |       | 84                                                    |       | 369,124                            |       | 82 |   | 289,672 |   | 85 |   | 153,099 |   | 82 |   | 119,001 |   | 96 |   | 255,574 |   | 92 |   |
| Operating income                               |       | 86,560                                      |       | 16                                                    |       | 79,493                             |       | 18 |   | 49,493 |   | 15 |   | 32,639 |   | 18 |   | 4,867 |   | 4 |   | 21,721 |   | 8 |   |
| Interest and other income, net                 |       | 6,885                                       |       | 1                                                     |       | 5,138                              |       | 1 |   | 5,640 |   | 2 |   | 2,994 |   | 2 |   | 2,379 |   | 2 |   | 5,025 |   | 2 |   |
| Interest expense                               |       | (6,073                                      | )          | (1                                                    | )          | (1,202                             | )          | — |   | (1,004 | ) | — |   | (587 | ) | — |   | (318 | ) | — |   | (735 | ) | — |   |
| Income before income taxes                     |       | 87,372                                      |       | 17                                                    |       | 83,429                             |       | 19 |   | 54,129 |   | 16 |   | 35,046 |   | 19 |   | 6,928 |   | 6 |   | 26,011 |   | 9 |   |
| Provision (benefit) for income  taxes          |       | 40,245                                      |       | 8                                                     |       | (34,051                            | )          | (8 | ) | (754 | ) | — |   | 1,719 |   | 1 |   | 692 |   | 1 |   | (1,781 | ) | (1 | ) |
| Net income                                     |       | $                                           | 47,127     |                                                  | 9          | %                                  | $          | 117,480 |   | 26 | % | $ | 54,883 |   | 16 | % | $ | 33,327 |   | 18 | % | $ | 6,236 |   | 5 | % | $ | 27,792 |   | 10 | % |

 

**Revenues**

*Billable ServicesRevenues*

Billable services revenues consist of subscriptionfees charged to pay accounts for dial-up and accelerated Internet accessservices, social-networking, Web-hosting and domain name registration services,premium email services, premium content, Internet security, photo-sharingservices and VoIP. In addition, we charge fees for certain VoIP telephony forminutes and live telephone technical support. Our billable services revenuesare primarily dependent on two factors: the average number of pay accounts fora period and the average monthly revenue per pay account (“ARPU”) for a period.The average number of pay accounts is a simple average calculated based on thenumber of pay accounts at the beginning and end of a period. Changes in our payaccount base are dependent on a number of factors including the effects ofacquisitions, if any, during a period; the effectiveness of our marketing anddistribution activities; the effects of competition; the number of freeaccounts upgrading to pay services, particularly during periods when we effectchanges to our free services; the number of pay accounts that cancel theiraccounts or have their accounts terminated; changes in our marketing andrelated distribution channels; changes in our marketing expenditures; theeffects of seasonality; and the impact of new types of pay services. ARPU iscalculated by dividing billable services revenues for a period by the averagenumber of pay accounts for that period. ARPU may fluctuate from period toperiod as a result of a variety of factors including changes in the mix of paysubscriptions and their related pricing plans; the use of promotions, such asone or more free months of service, and discounted pricing plans to obtain orretain subscribers; increases or decreases in the price of our services; thenumber of services subscribed to by each pay account; pricing and success ofnew pay services and the penetration of these types of services as a percentageof total pay accounts; and the timing of pay accounts being added or removedduring a period.

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Billable services revenues increased by $55.2 million,or 13%, to $466.0 million for the year ended December 31, 2005,compared to $410.8 million for the year ended December 31, 2004. Theincrease in billable services revenues was due to an increase in our averagenumber of pay accounts from 3,859,000 for the year ended December 31, 2004to 4,917,000 for the year ended December 31, 2005. The increase in theaverage number of pay accounts is primarily attributable to the Classmatesacquisition which had approximately 1,452,000 pay accounts at the time ofacquisition and, to a lesser extent, growth in pay accounts for the Classmates’social-networking services following the Classmates acquisition and growth inpremium email and other non-access pay accounts. The increase in the averagenumber of pay accounts was offset partially by a decrease in the number of payaccess accounts, which resulted in a slight decrease in revenues from our payaccess services. This decrease in revenues from our pay access services waspartially offset by an increase in revenues attributable to our acceleratorservices due to an increase in the number of subscriptions to such services.

The increase in billable services revenues as a resultof the increase in our average number of pay accounts was offset partially by adecrease in ARPU from $8.87 for the year ended December 31, 2004 to $7.90for the year ended December 31, 2005. The decrease in ARPU is attributableto the increased percentage of non-access accounts as a percentage of total payaccounts since our non-access accounts generally have a significantly lowerARPU. The decrease in ARPU is also attributable to a small decline in ARPU forour access services due to increased use of free months of service andpromotional pricing to obtain or retain pay access accounts, offset partiallyby an increased number of subscriptions to our accelerator services.

For the year ended December 31,2005, approximately 16% of our billable services revenues were attributable tonon-access services as compared to approximately 3% for the year ended December 31,2004. We anticipate continued increases in non-access pay accounts anddecreases in pay access accounts. As a result, we anticipate that an increasingpercentage of our billable services revenues will be attributable to non-accessservices. However, because the ARPU for our access services is expected tocontinue to decline, and most of our non-access services have a significantlylower ARPU than our access services, we anticipate a continued decrease in ARPU.Currently we do not anticipate that growth in pay accounts, if any, will offsetthe revenue declines associated with declines in ARPU. As such, we anticipatedeclines in billable services revenues. The December 2005 quarter was thefirst quarter we experienced a decline in billable services revenues.

*Advertising andCommerce Revenues*

Our advertising and commerce revenues consist of feesfrom our Internet search partners that are generated as a result of our usersutilizing our partners’ Internet search services, fees generated by our usersviewing and clicking on third-party Web site advertisements and fees fromreferring our users to, and our users creating pay accounts or making purchaseson, sponsors’ Web sites. We also generate revenues from providing third partieswith data analysis capabilities and traditional market research services, suchas surveys and questionnaires. Our advertising and commerce revenues aregenerated from our active account base, including our pay accounts. Factorsimpacting our advertising and commerce revenues generally include changes inorders from significant customers, the state of the online search andadvertising markets, seasonality, increases or decreases in our activeaccounts, limitations on our free services and increases or decreases in advertisinginventory available for sale.

Advertising and commerce revenues increased by$21.3 million, or 56%, to $59.1 million for the year ended December 31,2005, from $37.8 million for the year ended December 31, 2004. Theincrease was attributable primarily to increased advertising revenuesassociated with our social-networking business and, to a lesser extent,advertising revenues generated from our Web-hosting business and our searcharrangement with Yahoo! Search. These increases were offset partially by adecrease in revenues 

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generated from our expiredagreement with General Motors Corporation (“GM”), from which we derivedapproximately 6% of our advertising and commerce revenues for the year ended December 31,2004.

For the year ended December 31,2005, 43% of advertising and commerce revenues were attributable to ournon-access services, which compares to 11% for the year ended December 31,2004. We anticipate that an increasing percentage of our advertising andcommerce revenues will be attributable to our non-access services.

**Cost of Billable Services**

Cost of billable services includes direct costs ofbillable services and costs that have been allocated to billable services.Direct costs consist of costs related to providing telephone technical support,customer billing and billing support to our pay accounts, domain nameregistration fees and costs associated with our VoIP telephony service, whichinclude telecommunications costs and costs for license fees, customer supportand depreciation. Allocated costs consist primarily of telecommunications anddata center costs, personnel and overhead-related costs associated withoperating our networks and data centers, depreciation of network computers andequipment, email technical support and license fees. We allocate costsassociated with access services between billable services and free servicesbased on the aggregate hourly usage of our pay access accounts as a percentageof total hours used by our active access accounts. We allocate costs associatedwith Web hosting and online photos between billable services and free servicesbased on estimated bandwidth used by pay Web-hosting and online photo accountsrelative to estimated bandwidth used by free Web-hosting and online photoaccounts. Costs associated with our social-networking services are allocated betweenbillable services and free services based on the number of Web site visits bypay accounts relative to the total number of visits. Costs associated with ourVoIP telephony service are all allocated to cost of billable services.

Cost of billable services increased by $3.2 million,or 3%, to $98.2 million for the year ended December 31, 2005, compared to$95.0 million for the year ended December 31, 2004. The increase wasprimarily due to our social-networking business and $1.2 million in costsassociated with our VoIP telephony service, including a $3.7 million increasein network personnel and overhead-related costs, a $1.8 million increase incustomer support and billing-related costs as a result of an increase in thenumber of pay accounts, and a $1.6 million increase in network depreciationallocated to billable services. These increases were partially offset by a $4.1million decrease in telecommunications costs. Telecommunications costsdecreased as a result of a decrease in the average monthly usage per pay accessaccount and a slight decrease in average hourly telecommunications costs.Telecommunications hours allocated to our pay access account base increased toapproximately 97% of total telecommunications hours purchased during the yearended December 31, 2005, compared to approximately 94% during the yearended December 31, 2004.

Cost of billable services as a percentage of billableservices revenues decreased by 2% to 21.1% in the year ended December 31,2005, compared to 23.1% in the year ended December 31, 2004. The decreaseresulted primarily from lower costs as a percentage of revenues associated withour pay social-networking and Web-hosting services relative to our pay accessservices, and lower costs as a percentage of revenues associated with our payaccess services due primarily to a decrease in average hourlytelecommunications costs and average hourly usage per pay access account.However, cost of billable services as a percentage of billable servicesrevenues increased to 20.7% and 21.9% during the September 2005 and December 2005quarters, respectively, due primarily to decreases in ARPU for our accessservices and increased costs associated with our VoIP telephony service. Wecurrently anticipate that cost of billable services as a percentage of billableservices revenues will continue to increase due to a number of factors,including, increased compensation expense recognized in connection with theadoption of Statement of Financial Accounting Standards (“SFAS”) No. 123R,*Share-Based Payment*, commencing in theMarch 2006 quarter.

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Our cost of billableservices as a percentage of billable services revenues is highly dependent onthe pricing for our services, our average hourly telecommunications cost andusage, and our average customer billing and support costs per pay account. Ifwe are not successful in the percentage of our pay access accounts subscribingto our accelerated access services, or increasing the percentage of our payaccount base subscribing to higher margin services including our social-networkingservices, or if due to competitive or other factors we decrease the pricing forour access or other services or increase the use of promotions such as one ormore free months of service, or if our new pay services are less profitablethan our existing pay services, it is likely that our cost of billable servicesas a percentage of billable services revenues would be adversely impacted. Inparticular, we anticipate that our VoIP service will be less profitable thanour existing pay services and have launched our pay VoIP services offeringthree months of free service which will negatively impact our cost of billableservices as a percentage of revenues. While our average hourlytelecommunications costs have decreased consistently for some time, weexperienced slightly higher hourly telecommunications costs in the June 2005quarter versus the March 2005 quarter due to less efficient port utilizationassociated with a decrease in total telecommunications hours utilized by ourpay access account base. The decrease in total hours utilized was attributableto lower average monthly usage per pay access account and a decrease in payaccess accounts. We may experience increased average hourly telecommunicationscosts in future periods, particularly if these trends continue or if we expandour service coverage to additional geographic areas where telecommunicationscosts are higher. Additionally, while the average hourly usage of our payaccess accounts decreased in the year ended December 31, 2005 compared tothe year ended December 31, 2004, we may experience increased averagehourly usage in future periods when compared to the comparable period of theprior year, which would adversely impact this percentage.

**Cost of Free Services**

Cost of free services includes direct costs and coststhat have been allocated to free services. Allocated costs consist primarily oftelecommunications and data center costs, personnel and overhead-related costsassociated with operating our network and data centers, depreciation of networkcomputers and equipment and email technical support. We allocate costsassociated with access services between billable services and free servicesbased on the aggregate hourly usage of our free access accounts as a percentageof total hours used by our active access accounts. We allocate costs associatedwith Web hosting and online photos between billable services and free servicesbased on estimated bandwidth used by free Web-hosting and online photoaccounts. Costs associated with our social-networking services are allocated betweenbillable services and free services based on the number of Web site visits byfree accounts relative to the total number of user visits.

Cost of free servicesincreased by $5.1 million, or 69%, to $12.5 million for the yearended December 31, 2005, compared to $7.4 million for the year ended December 31,2004. The increase was due primarily to increased costs associated with oursocial-networking business since the acquisition. The increases include a $4.3million increase in personnel and overhead-related costs and a $1.7 millionincrease in depreciation. The increases were partially offset by a $0.8 milliondecrease in telecommunications costs. The decrease in telecommunications costswas a result of a decrease in average hourly telecommunications costs, adecrease in the number of active free access accounts and a slight decrease inthe average hourly usage of these accounts. The decrease in free active accessaccounts resulted from free accounts upgrading to our pay services, fewer newfree account sign-ups and additional accounts becoming inactive.Telecommunications hours allocated to our free access accounts decreased toapproximately 3% of total telecommunications hours purchased during the yearended December 31, 2005, compared to approximately 6% during the yearended December 31, 2004. Cost of free services could increase as apercentage of revenues in 2006 as a result of a number of factors, including increasedcompensation expense recognized in connection with the adoption of SFAS No. 123R,commencing in the March 2006 quarter.

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**Sales and Marketing**

Sales and marketing expenses include advertising andpromotion expenses, fees paid to distribution partners to acquire new pay andfree accounts, personnel-related expenses for sales and marketing personnel andtelemarketing costs incurred to acquire and retain pay accounts and up-sell payaccounts to additional services. We have expended significant amounts onmarketing, including national branding campaigns comprised of television,Internet, sponsorships, radio, print and outdoor advertising and on retail andother performance-based distribution relationships. Marketing and advertisingcosts to promote our products and services are expensed in the period incurred.Advertising and promotion expenses include media, agency and promotionexpenses. Media production costs are expensed the first time the advertisementis run. Media and agency fees are expensed over the period the advertisingruns.

Sales and marketing expenses increased by$30.3 million, or 17%, to $209.3 million for the year ended December 31,2005, compared to $179.0 million for the year ended December 31, 2004. Theincrease was primarily due to increased expenditures for our social-networkingservice. Marketing, promotion and distribution costs increased by $12.3 millionprimarily due to promotion of our non-access businesses, particularly oursocial-networking service, offset partially by a reduction in expenses relatedto promoting our access services. In addition, personnel-related expensesincreased by $10.0 million and telemarketing expenses related to customeracquisition, retention and up-sell activities increased by$5.2 million. Increases in prices to purchase advertising, combined withseasonal factors in the access business and more intense competition for payaccounts, may adversely impact the effectiveness of our marketing activitiesand our ability to grow our pay account base and maintain our revenues. Whileour sales and marketing expenses increased in 2005 versus 2004, quarterly salesand marketing expenses, both in terms of absolute dollars and as a percentage ofrevenues, decreased beginning the second quarter of 2005 through the fourthquarter of 2005. We currently anticipate a significant decrease in sales andmarketing expenses for 2006 versus 2005. However, the anticipated decreasecould be substantially offset by increased compensation expense recognized inconnection with the adoption of SFAS No. 123R, commencing in the March 2006quarter. In addition, if we determine that decreased marketing expenses areadversely impacting our business, we may choose to allocate more to marketingexpenses than we currently anticipate, which may adversely impact ourprofitability.

Our marketing expendituresand the allocation of our marketing resources among our various services mayvary significantly from quarter to quarter depending on a number of factorsincluding the effectiveness of our marketing activities, changes in the mix ofour marketing activities, changes in the cost to purchase advertising, changesin the number of pay accounts, the introduction of new services such as VoIP,and the impact of such activities on our results of operations. While weanticipate that sales and marketing expenses as a percentage of revenues,excluding the impact of increased compensation expense associated with theadoption of SFAS No. 123R will decrease in 2006 to between 30% and 35%from approximately 40% in 2005, we may choose to either significantly increaseor decrease such expenses as a percentage of revenues in any particularquarterly period. We have decreased our sales and marketing expenses for ourpay access services and expect to continue to decrease such expenses in futurequarters. We have entered into a number of longer-term offline distributionrelationships for our access services. We intend to continue to focus onincreasing both our offline and online distribution channels in the near term. Increasedfees paid to distribution partners could result in our spending more onmarketing than we currently anticipate. Our ability to increase or decrease ourmarketing expenditures from period to period may be more limited to the extentdistribution partners constitute a significant portion of our marketingexpenditures. Our pay account base declined during the fourth quarter of 2005.Continued decreases in marketing expenditures will likely adversely impact ourability to increase or maintain our pay account base.

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**Product Development**

Product developmentexpenses include expenses for the maintenance of existing software andtechnology and the development of new or improved software and technology,including personnel-related expenses for the software engineering departmentand the costs associated with operating our facility in India. Costs incurredby us to manage, monitor and operate our services are generally expensed asincurred, except for certain costs relating to the acquisition and developmentof internal-use software, which are capitalized and depreciated over theirestimated useful lives, generally three years or less.

Product developmentexpenses increased by $12.6 million, or 46%, to $40.0 million for theyear ended December 31, 2005, compared to $27.5 million for the yearended December 31, 2004. The increase was primarily the result ofincreased personnel-related expenses for our social-networking and Web-hostingbusinesses which we acquired during 2004, including a $7.8 millionincrease in compensation costs. Additionally, headcount and compensation costsincreased as a result of increased personnel related to the development of newproducts during 2005, including our enhanced accelerator service and our VoIPtelephony service. The increase was also the result of a $2.0 million increasein depreciation; a $1.0 million increase in stock-based compensation related tothe issuance of RSUs beginning in the March 2005 quarter; a $0.5 millionincrease in license fees; and a $0.4 million increase in professional andconsulting fees. We anticipate that we will continue to increase our productdevelopment expenses, both in dollar terms and as a percentage of revenues in2006. Product development expenses were reduced by capitalized compensationcosts of approximately $4.2 million during the year ended December 31,2005, compared to approximately $0.2 million for the year ended December 31,2004. The majority of the capitalized compensation costs in the year ended December 31,2005 related to the development of our VoIP telephony service and the newversion of our accelerator service. Product development expenses could increaseas a percentage of revenues in 2006 as a result of a number of factors,including increased compensation expense recognized in connection with theadoption of SFAS No. 123R, commencing in the March 2006 quarter.

**General andAdministrative**

General and administrativeexpenses include personnel-related expenses for executive, finance, legal,human resources and internal customer support personnel. In addition, generaland administrative expenses include fees for professional legal, accounting andfinancial services, office relocation costs, non-income taxes, insurance,and occupancy and other overhead-related costs, as well as the expensesincurred and credits received as a result of certain legal settlements.

General and administrativeexpenses increased by $16.8 million, or 42%, to $56.7 million for the yearended December 31, 2005, compared to $39.9 million for the year endedDecember 31, 2004 primarily due to increases in expenses attributable toour social-networking business, which we acquired in November 2004, and a$5.4 million increase in stock-based compensation primarily related to RSUsissued beginning in March 2005. We incurred a $6.4 million increasein personnel-related expenses as a result of higher compensation costs; a $2.9million increase in professional and consulting fees; a $2.8 million increasein overhead-related costs, including an increase of $2.0 million in depreciation;and a $1.9 million increase in facilities costs as a result of increased rentfor our corporate headquarters and facilities related to our Web-hosting andsocial-networking businesses. These increases were partially offset by theincurrence of $3.3 million in lease termination fees, accelerateddepreciation and other facility-exit costs in the year ended December 31,2004 in connection with the relocation of our corporate offices in August 2004.General and administrative expenses could increase as a percentage of revenuesin 2006 as a result of a number of factors, including increased compensationexpense recognized in connection with the adoption of SFAS No. 123R,commencing in the March 2006 quarter.

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**Amortizationof Intangible Assets**

Amortization of intangibleassets includes amortization of acquired pay accounts and free accounts,acquired trademarks and trade names, purchased technologies and otheridentifiable intangible assets. At December 31, 2005, we had approximately$59.3 million in net identifiable intangible assets resulting primarilyfrom the acquisitions of Classmates, BlueLight Internet assets and theWeb-hosting and PhotoSite businesses. At December 31, 2005, we hadapproximately $80.5 million in goodwill resulting from the acquisitions ofClassmates and the Web-hosting and PhotoSite businesses. In accordance with theprovisions set forth in SFAS No. 142, *Goodwill and OtherIntangible Assets*, goodwill is not being amortized but is tested forimpairment at a reporting unit level on an annual basis and between annualtests if an event occurs or circumstances change that would more likely thannot reduce the fair value of a reporting unit below its carrying value amount.

Amortization of intangibleassets increased by $1.4 million, or 7%, to $21.8 million for theyear ended December 31, 2005, compared to $20.4 million for the yearended December 31, 2004. The increases are due to the amortization ofidentifiable intangible assets from our acquisitions of Classmates and thePhotoSite business, offset partially by a decrease in amortization ofintangible assets from the Merger. We recorded a reduction in the remainingintangible assets from the Merger of approximately $11.2 million duringthe December 2004 quarter in connection with the release of the deferredtax valuation allowance. In addition, the increase was related to theamortization of identifiable intangible assets throughout 2005 from theacquisition of our Web-hosting business in April 2004. Certain of theacquired intangible assets are amortized on an accelerated basis to bettermatch the expense to the expected cash flows from those assets.

**Interestand Other Income, Net**

Interest income consistsof earnings on our cash, cash equivalents and short-term investments. Otherincome and expense, net consists of realized gains and losses recognized inconnection with the sale of short-term investments. Interest and other income,net increased by $1.7 million, or 34%, to $6.9 million for the yearended December 31, 2005, compared to $5.1 million for the year ended December 31,2004 as a result of higher interest rates and higher average balances on ourcash and cash equivalents and short-term investments. Net realized gains on ourshort-term investments were not significant for the year ended December 31,2005. Net realized gains on our short-term investments were approximately$0.1 million for the year ended December 31, 2004.

**Interest Expense**

Interest expense consistsof interest expense on our term loan, capital leases and the amortization ofpremiums on certain of our short-term investments. Interest expense increasedby $4.9 million to $6.1 million for the year ended December 31, 2005,compared to $1.2 million for the year ended December 31, 2004. Theincrease was primarily the result of interest on the outstanding balance on theterm loan, which was issued in December 2004. In January 2006, werepaid the remaining balance of $54.2 million on the term loan. As a result, weanticipate a significant decrease in interest expense in 2006.

**Provision forIncome Taxes**

For the year ended December 31,2005, we recorded a tax provision of $40.2 million on pre-tax income of $87.4million, resulting in an effective tax rate of 46.1%. The effective tax rate differsfrom the statutory rate primarily due to compensation, including stock-basedcompensation, that was limited under Section 162(m) of the InternalRevenue Code (the “Code”); foreign losses, the benefit of which is notcurrently recognizable due to uncertainty regarding realization; and there-measurement of net deferred tax assets, including a change in New York Statetax law. This re-measurement resulted in an increase to the tax provision forthe year ended December 31, 2005 by approximately $2.5 million, or 2.8%.

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For the year endedDecember 31, 2004, we recorded a tax benefit of $34.1 million on pre-taxincome of $83.4 million, resulting in an effective tax rate benefit of 40.8%. Theeffective tax rate differs from the statutory rate primarily due to the releaseof substantially all of the balance of the valuation allowance attributable tothe expected utilization of net deferred tax assets in the future.

At December 31, 2005,the Company had net operating loss and tax credit carryforwards for federal andstate income tax purposes of approximately $192 million and $249 million,respectively, which begin to expire in 2018 and 2007, respectively. Withrespect to the state net operating losses, certain amounts will be furtherreduced pursuant to the state allocation and apportionment laws. Thesecarryforwards have been adjusted to reflect limitations under Section 382of the Code.

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**Year Ended December 31,2004 compared tothe Year Ended December 31, 2003 (unaudited)**

**Revenues**

*Billable ServicesRevenues*

Billable services revenues increased by$104.7 million, or 34%, to $410.8 million for the year ended December 31,2004, compared to $306.1 million for the year ended December 31,2003. The increase was due to an increase in the number of Internet accessaccounts, particularly those accounts subscribing to our accelerator services,and an increase in our average number of pay accounts, offset partially by adecrease in our ARPU.

Our average number of pay accounts was approximately3,859,000 for the year ended December 31, 2004, compared to approximately2,534,000 for the year ended December 31, 2003. The increase in ouraverage number of pay accounts resulted from a number of factors including ouracquisition of Classmates in November 2004, from which we acquiredapproximately 1,452,000 pay accounts and which increased our average number ofpay accounts by 726,000; increased spending on marketing and promotion of ourpay services, particularly our accelerator services; the introduction of newpay services, particularly our premium email services; an expansion of ouronline and offline distribution channels; our Web-hosting acquisition in April 2004;and a significant number of our free accounts upgrading to our pay services.However, we experienced limited growth in the June 2004 and September 2004quarters in pay access accounts and, for the first time since we began offeringpay access services, experienced a decline in pay access accounts in the December 2004quarter. Excluding the pay accounts from the Classmates acquisition, our growthin pay accounts during the December 2004 quarter was 142,000. Themagnitude of this growth was primarily attributable to an increase in premiumemail accounts resulting from an email consolidation program which resulted ina number of our free accounts upgrading to pay accounts.

ARPU was $8.87 for theyear ended December 31, 2004, compared to $10.07 for the year ended December 31,2003. ARPU for the December 2004 quarter was $8.98, a decrease from $10.60in the September 2004 quarter. These decreases in ARPU were due primarilyto the timing of the addition of 1,452,000 pay accounts from our acquisition ofClassmates in November 2004, and due to the lower ARPU of the Classmatespay service. Additionally, these decreases were due to an increase in thepercentage of pay accounts with a lower ARPU, particularly our premium emailservices; a decrease in the percentage of total pay accounts comprised of ouraccelerator services which generates a significantly higher average ARPU; anincrease in the number of free months of service offered for initial trialperiods and retention programs; and an increase in the number of accountssigning up for promotional pricing plans. In addition, we experienced slowergrowth in the number of accelerator subscriptions.

*Advertising andCommerce Revenues*

Advertising and commercerevenues increased by $4.7 million, or 14%, to $37.8 million for theyear ended December 31, 2004, from $33.1 million for the year ended December 31,2003. The increase was attributable to an increase in revenue generated fromour search arrangement with Yahoo! Search, and advertising revenues generatedfrom our 2004 Web-hosting and Classmates acquisitions. The increase was offsetpartially by a decrease in revenues generated from our expired agreement withGM, from which we derived 6% and 41% of our advertising and commerce revenuesfor the years ended December 31, 2004 and 2003, respectively.

**Cost of Billable Services**

Cost of billable services increased by$2.2 million, or 2%, to $95.0 million for the year ended December 31,2004, compared to $92.8 million for the year ended December 31, 2003.The increase was 

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due to a $4.2 millionincrease in customer support and billing-related costs as a result of anincrease in the number of pay accounts, a $1.3 million increase in networkpersonnel and overhead-related costs allocated to billable services and a$0.5 million increase in network depreciation allocated to billableservices. These costs were offset partially by a $3.8 million decrease intelecommunications costs. Telecommunications costs decreased as a result of adecrease in the average monthly usage per pay access account and a decrease inaverage hourly telecommunications costs, offset partially by an increase in thenumber of pay access accounts. Our average hourly telecommunications costsdecreased as a result of better port utilization, improvements made inallocating our telecommunications usage to our lower cost vendors and lowertelecommunications prices. Telecommunications hours allocated to our pay accessaccount base increased to approximately 94% of total telecommunications hourspurchased during the year ended December 31, 2004, compared toapproximately 88% during the year ended December 31, 2003.

Cost of billable servicesas a percentage of billable services revenues was 23.1% in the year ended December 31,2004, compared to 30.3% in the year ended December 31, 2003. The decreaseresulted from a decrease in average hourly telecommunications costs per payaccess account; decreased customer billing and support costs per pay accountprimarily as a result of better pricing obtained from our principal customersupport vendor; and a decrease in average hourly usage per pay access account.

**Cost of Free Services**

Cost of free servicesdecreased by $2.3 million, or 23%, to $7.4 million for the year endedDecember 31, 2004, compared to $9.7 million for the year ended December 31,2003. The decrease was due primarily to a $2.5 million decrease intelecommunications costs. The decrease in telecommunications costs was a resultof a decrease in average hourly telecommunications costs, a decrease in thenumber of active free access accounts and a decrease in the average hourlyusage of these accounts. The decrease in free access accounts resulted fromfree accounts upgrading to our pay services and fewer new free accountsign-ups. Telecommunications hours allocated to our free access accountsdecreased to approximately 6% of total telecommunications hours purchasedduring the year ended December 31, 2004, compared to approximately 12%during the year ended December 31, 2003. The decrease in cost of freeservices was partially offset by a $0.2 million increase in personnel andoverhead-related costs.

**Sales and Marketing**

Sales and marketingexpenses increased by $58.4 million, or 48%, to $179.0 million forthe year ended December 31, 2004, compared to $120.6 million for theyear ended December 31, 2003. Sales and marketing was approximately 40% ofrevenues for the year ended December 31, 2004, compared to approximately36% of revenues for the year ended December 31, 2003. The increase wasprimarily attributable to a $48.7 million increase in marketing, promotionand distribution costs. Additionally, sales and marketing expenses increased asa result of an $8.2 million increase in telemarketing expenses related tocustomer acquisition, retention and up-sell activities and a $1.2 millionincrease in personnel-related expenses.

**Product Development**

Product developmentexpenses increased by $5.6 million, or 25%, to $27.5 million for theyear ended December 31, 2004, compared to $21.9 million for the yearended December 31, 2003. The increase was primarily the result of a$6.4 million increase in personnel-related expenses as a result ofincreased headcount and compensation costs, including increased costsassociated with our acquisitions of our Web-hosting and community-basednetworking businesses, partially offset by a $0.8 million decrease indepreciation. Depreciation expense decreased as a result of assets placed inservice in prior years becoming fully depreciated and lower levels of capitalexpenditures in recent years versus prior years.

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**General and Administrative**

General and administrativeexpenses increased by $10.8 million, or 37%, to $39.9 million for theyear ended December 31, 2004, compared to $29.1 million for the yearended December 31, 2003. The increase was the result of $3.3 millionin lease termination fees and accelerated depreciation expenses in connectionwith the relocation of our corporate offices; a $3.2 million increase inprofessional and consulting fees primarily related to our Sarbanes-Oxley Section 404compliance efforts, the due diligence process associated with a potentialacquisition that was terminated and increased legal fees; a $2.3 millionincrease in stock-based compensation primarily related to restrictedstock issued to certain of our executive officers in January 2004; a$2.3 million increase in overhead-related costs and a$1.4 million increase in personnel-related expenses as a result ofhigher compensation costs, including increased costs associated with ouracquisitions of our Web-hosting and community-based networkingbusinesses. These increases were partially offset by a $1.7 milliondecrease in legal settlement costs.

**Amortization of Intangible Assets**

At December 31, 2004, we had approximately$70.6 million in net identifiable intangible assets resulting primarilyfrom the acquisition of Classmates, the acquisition of the Internet accessassets of BlueLight and the acquisition of the Web-hosting assets of About, Inc.At December 31, 2004, we had approximately $76.5 million in goodwillresulting from the acquisition of Classmates and the acquisition of theWeb-hosting assets of About, Inc.

Amortization of intangibleassets increased by $4.5 million, or 29%, to $20.4 million for theyear ended December 31, 2004, compared to $15.9 million for the yearended December 31, 2003. The increase was due to the amortization ofidentifiable intangible assets from the acquisition of the Web-hosting assetsof About, Inc. in April 2004 and the acquisition of Classmates in November 2004.We recorded a reduction in intangible assets of approximately$11.2 million during the December 2004 quarter in connection with therelease of the deferred tax valuation allowance.

**Restructuring Charges**

We had no restructuringcharges or benefits during the year ended December 31, 2004 as compared toa $0.2 million benefit to restructuring charges during the year ended December 31,2003 as a result of contract termination fees expensed in earlier periods inexcess of final negotiated settlements.

**Interest and Other Income, Net**

Interest and other income,net decreased by $0.5 million, or 9%, to $5.1 million for the yearended December 31, 2004, compared to $5.6 million for the year ended December 31,2003. The decrease was the result of lower average returns due to a shift towardtax-exempt holdings. Other income associated with net realized gains on ourshort-term investments was $0.1 million for the year ended December 31,2004.

**Interest Expense**

Interest expense increasedby $0.2 million, or 20%, to $1.2 million for the year ended December 31,2004, compared to $1.0 million for the year ended December 31, 2003.Interest expense increased as a result of the outstanding balance on the termloan in the December 2004 quarter.

**Provision for Income Taxes**

For the year ended December 31, 2004, we recordeda tax benefit of $34.1 million on pre-tax income of $83.4 million.The effective tax rate differs from the statutory rate primarily due to therelease of 

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substantially all of thevaluation allowance attributable to the expected utilization of deferred taxassets in the future.

For the year ended December 31, 2003, we recordeda tax benefit of $0.8 million on pre-tax income of $54.1 million. Theeffective tax rate differs from the statutory rate primarily as a result of taxbenefits recognized in the June 2003 and December 2003 quarters fromthe release of a portion of the valuation allowance against deferred tax assetsrelating primarily to the actual and expected utilization of net operating lossand credit carryforwards in the years ending December 31, 2004 and 2005,offset by state income taxes.

Consistent with prior periods, in determining the needfor a valuation allowance related to our deferred tax assets at December 31,2004, we reviewed both positive and negative evidence pursuant to therequirements of SFAS No. 109, *Accountingfor Income Taxes*, including current and historical results ofoperations, the annual limitation on utilization of net operating losscarryforwards pursuant to Section 382 of the Code, future income projectionsand potential tax-planning strategies. Based upon our assessment of allavailable evidence, we concluded that, primarily with the exception of certainforeign net operating losses, it is more likely than not that the remainingdeferred tax assets will be realized. This conclusion was based primarily onour trend of profitable operations and financial projections to generatesignificant amounts of taxable income in future periods, on a consistent andprolonged basis, in order to utilize the remaining deferred tax assets.

At December 31, 2004we had net operating loss and tax credit carryforwards for federal and stateincome tax purposes of approximately $235 million and $300 million,respectively, which begin to expire in 2018 and 2007, respectively. Withrespect to the state net operating losses, certain amounts will be furtherreduced pursuant to the state allocation and apportionment laws. Thesecarryforwards have been adjusted to reflect limitations under Section 382of the Code.

**Six Months Ended December 31,2003 Compared tothe Six Months Ended December 31, 2002 (unaudited)**

**Revenues**

*Billable ServicesRevenues*

Billable services revenuesincreased by $58.3 million, or 53%, to $167.6 million for the sixmonths ended December 31, 2003, compared to $109.3 million for thesix months ended December 31, 2002. The increase was due to an increase inour average number of pay accounts and an increase in our ARPU. Our averagenumber of pay accounts was approximately 2,720,000 during the six months ended December 31,2003, compared to approximately 1,942,000 for the six months ended December 31,2002. The increase in our average number of pay accounts resulted from a numberof factors including increased marketing and promotion of our pay services, theacquisition of approximately 174,000 pay accounts from BlueLight in November 2002and a significant number of our free users upgrading to our pay accessservices. ARPU was $10.27 for the six months ended December 31, 2003,compared to $9.39 for the six months ended December 31, 2002. The increasein ARPU was due to an increase in the number of access accounts purchasing our$14.95 accelerator services, which were introduced in March 2003. Inaddition, the ARPU for the six months ended December 31, 2002 wasnegatively impacted by the acquisition of approximately 174,000 pay accountsfrom BlueLight at the end of November 2002. At December 31, 2003,subscriptions to our accelerated dial-up services comprised approximately 22%of our total pay account base.

*Advertising and CommerceRevenues*

Advertising and commercerevenues increased by $3.6 million, or 25%, to $18.1 million for thesix months ended December 31, 2003, compared to $14.5 million for thesix months ended December 31, 

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2002.The increase was primarily due to higher advertising revenues generated fromour advertising agreement with GM and an increase in fees derived from ourInternet search partners. We derived approximately 44% of our advertising andcommerce revenues for the six months ended December 31, 2003 from GM,compared to approximately 36% for the six months ended December 31, 2002.The increase in advertising revenues from GM was partially a result of a$1.5 million performance bonus earned during the September 2003quarter. We derived approximately 21% and 19% of our advertising and commercerevenues, respectively, for the six months ended December 31, 2003 and2002 from Internet search fees primarily provided through our search agreementwith Yahoo! Search. Our agreement with GM expired in December 2003 and wasnot renewed.

**Cost of Billable Services**

Cost of billable services increased by$3.5 million, or 8%, to $46.2 million for the six months ended December 31,2003, compared to $42.7 million for the six months ended December 31,2002. The increase was due to a $2.1 million increase in customer supportand billing-related costs, a $1.3 million increase intelecommunications costs and a $0.7 million increase in network personneland overhead-related costs allocated to billable services. These costswere partially offset by a $0.6 million decrease in network depreciationallocated to billable services. Telecommunications costs increased as a resultof an increase in the average number of pay access accounts, which waspartially offset by a 23% decrease in average hourly telecommunications costsand, to a lesser extent, a decrease in the average hourly usage per pay accessaccount. Our average hourly telecommunications costs decreased as a result ofbetter port utilization, improvements made in allocating our telecommunicationsusage to our lower cost vendors and lower telecommunications prices.Telecommunications hours allocated to our pay access account base increased toapproximately 90% of total telecommunications hours purchased during the sixmonths ended December 31, 2003, compared to approximately 84% during thesix months ended December 31, 2002. Network personnel and overhead-relatedcosts allocated to billable services increased due to the increase intelecommunications hours utilized by pay access accounts as a percentage oftotal telecommunications hours purchased. Customer support and billing-relatedcosts increased as a result of the increase in the average number of pay accessaccounts. Depreciation expense allocated to billable services has decreased dueto network assets placed in service in prior years becoming fully depreciatedand significantly lower levels of capital expenditures in recent years versusprior years.

Cost of billable servicesas a percentage of billable services revenues was 27.5% in the six months endedDecember 31, 2003, compared to 39.0% in the six months ended December 31,2002. This decrease resulted from an increase in ARPU due to significantadoption of our accelerator services; a decrease in average hourlytelecommunications costs per pay access account; decreased customer billing andsupport costs per pay access account as a result of better pricing obtainedfrom our primary customer support vendor; decreased depreciation expense; and aslight decrease in average hourly usage per pay access account.

**Cost of Free Services**

Cost of free servicesdecreased by $2.9 million, or 43%, to $4.0 million for the six monthsended December 31, 2003, compared to $6.9 million for the six monthsended December 31, 2002. The decrease was due to a $2.4 milliondecrease in telecommunications costs, a $0.3 million decrease in networkdepreciation allocated to free services, a $0.1 million decrease incustomer support costs allocated to free services and a $0.1 million decreasein network personnel and overhead-related costs allocated to cost of freeservices. The decrease in telecommunications costs was a result of a decreasein average hourly telecommunications costs, a decrease in the number of activefree access accounts and a decrease in the average hourly usage of our freeaccess accounts. Our active free access account base consisted of approximately2.4 million users at December 31, 2003, compared to approximately2.8 million users at 

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December 31,2002. Depreciation expense allocated to free access services has decreased dueto assets placed in service in prior years becoming fully depreciated,significantly lower levels of capital expenditures in recent years versus prioryears and a decrease in free access accounts as a percentage of total activeaccess accounts. Telecommunications hours allocated to our free access accountbase decreased to approximately 10% of total telecommunications hours purchasedduring the six months ended December 31, 2003, compared to approximately16% during the six months ended December 31, 2002.

**Sales and Marketing**

Sales and marketingexpenses increased by $34.0 million, or 93%, to $70.5 million for thesix months ended December 31, 2003, compared to $36.5 million for thesix months ended December 31, 2002. The increase was primarilyattributable to a $29.9 million increase in marketing and promotion costsas a result of an expansion in marketing activities that focus on increasingour pay account base, promoting our accelerated dial-up services and buildingour brands. Additionally, sales and marketing expenses increased as a result ofa $4.4 million increase in telemarketing expenses related to customeracquisition, retention and up sell activities. The increases were partiallyoffset by a $0.2 million decrease in overhead-related costs.

**Product Development**

Product developmentexpenses decreased by $1.2 million, or 10%, to $10.5 million for thesix months ended December 31, 2003, compared to $11.7 million for thesix months ended December 31, 2002. The decrease was primarily the resultof a $2.1 million decrease in depreciation, partially offset by a$0.7 million increase in personnel-related expenses as a result ofincreased headcount and compensation costs and a $0.2 million increase inoverhead-related costs. Depreciation expense allocated to productdevelopment decreased as a result of assets placed in service in prior yearsbecoming fully depreciated and significantly lower levels of capitalexpenditures in recent years versus prior years.

**General andAdministrative**

General and administrativeexpenses increased by $1.3 million, or 10%, to $14.0 million for thesix months ended December 31, 2003, compared to $12.7 million for thesix months ended December 31, 2002. The increase in general andadministrative expenses was primarily the result of a $1.2 millionincrease in personnel-related expenses as a result of higher compensationcosts, a $0.5 million increase in consulting and professional services anda $0.3 million net increase in legal settlement expenses, including therecognition of a $0.7 million credit as a result of a one-time favorablesettlement of a contractual dispute in the September 2002 quarter. Theseincreases were partially offset by a $0.6 million decrease in overhead-related costs.

**Amortization of Intangible Assets**

Amortization of intangible assets decreased by$0.6 million, or 7%, to $7.9 million for the six months ended December 31,2003, compared to $8.5 million for the six months ended December 31,2002 primarily as a result of certain acquired intangible assets from theMerger being fully amortized at September 30, 2002, partially offset by anincrease in amortization expense incurred in connection with the intangibleassets acquired from BlueLight in November 2002.

During the six months endedDecember 31, 2003, based upon our assessment of all available evidence, wereleased a portion of our deferred tax asset valuation allowance. The releaseof valuation allowance during the period ended December 31, 2003 in partrelated to the realization of a benefit for certain acquired deferred taxassets, which resulted in a decrease in a portion of goodwill recorded inconnection with the Merger.

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**Interest and Other Income, Net**

Interest income, netincreased by $0.6 million, or 26%, to $3.0 million for the six monthsended December 31, 2003, compared to $2.4 million for the six monthsended December 31, 2002. The increase in interest income was due to higheraverage cash, cash equivalent and short-term investment balances.

**Interest Expense**

Interest expense increasedby $0.3 million, or 85%, to $0.6 million for the six months ended December 31,2003, compared to $0.3 million for the six months ended December 31, 2002.

**Provision for Income Taxes**

Our deferred tax assets, net of valuation allowance,at December 31, 2003 of $26.4 million represented the expectedutilization of net deferred tax assets through the period ended December 31,2005. At December 31, 2002 our deferred tax assets were fully offset byvaluation allowance based upon our assessment of all available evidence.

Consistent with prior periods, in determining the needfor a valuation allowance at December 31, 2003, we reviewed both positiveand negative evidence pursuant to the requirements of SFAS No. 109,including current and historical results of operations, the annual limitationon utilization of net operating loss carryforwards pursuant to Section 382of the Code, future income projections and potential tax-planning strategies.Based upon our assessment of all available evidence, we concluded that, withthe exception of the net deferred tax assets that were at the time expected tobe utilized through December 31, 2005, it was not more likely than notthat the remaining deferred tax assets would be realized. This conclusion wasbased primarily on our history of net operating losses as compared to, at thetime, only a recent trend of profitable operations, the potential for futurestock option deductions to significantly reduce taxable income, our annual netoperating loss limitations under Section 382 of the Code and the need togenerate significant amounts of taxable income in future periods, on aconsistent and prolonged basis, in order to utilize the remaining deferred taxassets. Of the $87.2 million of valuation allowance recorded at December 31,2003, approximately $31.9 million was attributable to the deferred taxassets acquired in connection with the Merger.

For the six months ended December 31, 2003, werecorded a tax provision of $1.7 million on pre-tax income of$35.0 million, resulting in an effective tax rate of 4.9%. The effectivetax rate differs from the statutory tax rate primarily due to the release ofvaluation allowance attributable to the expected utilization of net operatingloss and tax credit carryforwards in the years ending December 31, 2004and 2005, offset by current California state income tax. In September 2002,the State of California enacted legislation that suspend the utilization of netoperating loss carryforwards to offset current taxable income for a two-yearperiod beginning in the year ended June 30, 2003. As a result, we recordeda California state income tax provision for the period.

For the six months ended December 31, 2002, werecorded a tax provision of $0.7 million on pre-tax income of$6.9 million, which resulted in an effective tax rate of approximately10%. The effective tax rate differed from the statutory tax rate primarily dueto the actual utilization of federal net operating loss carryforwards duringthe period, the benefit of which had not been previously recognized, offset bycurrent California state income tax due to the legislation enacted in September 2002.At December 31, 2002, based upon our assessment of all available evidence,we determined that it was not more likely than not that we would realize thebenefit of our remaining net deferred tax assets.

At December 31, 2003,we had net operating loss and tax credit carryforwards for federal and stateincome tax purposes of approximately $272 million and $324 million,respectively, which begin to expire in 

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2018 and2005, respectively. These carryforwards have been adjusted to reflect thelimitations under Section 382 of the Code resulting from the Merger.

**Liquidity and Capital Resources**

Ourtotal cash, cash equivalent and short-term investment balances increased byapproximately $11.6 million, or 5%, to $244.4 million at December 31,2005 compared to $232.8 million at December 31, 2004. Our summarycash flows for the years ended December 31, 2005 and 2004, the six monthsended December 31, 2003 and the year ended June 30, 2003 were asfollows (in thousands):

| ** **                                            | ** ** | **Year Ended December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** | **Year Ended  June 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                   | ** ** | **2004**                                          | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Net cash provided  by operating activities            |       | $                                          | 137,047    |                                              | $          | 123,960                            |       |   | $ | 47,892 |   |   |   | $ | 65,106 |   |   |
| Net cash used for  investing activities               |       | (3,389                                     | )          | (108,010                                          | )          |                               | (25,886    | ) |   |   | (79,643 | ) |   |
| Net cash provided by  (used for) financing activities |       | (89,643                                    | )          | 31,654                                            |       |                               | (29,386    | ) |   |   | (268 | ) |   |
|                                                       |            |                                            |            |                                                   |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

Net cash providedby operating activities increased by $13.1 million, or 11%, for the yearended December 31, 2005 compared to the year ended December 31, 2004.The increase is primarily the result of the following:

·       a$15.0 million net increase in working capital accounts due to increases inrevenues and operating expenses and the timing of related cash receipts andpayments, including an $8.7 million increase in income taxes payable; and

·       a$15.6 million increase in depreciation, amortization and stock-basedcompensation in the year ended December 31, 2005 compared to the yearended December 31, 2004 due to increases in capital expenditures and theacquisitions of Classmates and the PhotoSite business, offset significantly bya decrease in amortization of intangible assets from the Merger.

These increaseswere partially offset by:

·       a$9.8 million decrease in our income tax deductions resulting from the exerciseof stock options by employees. Our net operating loss and tax creditcarryforwards, when combined with exercises of employee stock options, havehelped to reduce the level of cash paid for income taxes. However, cash paidfor income taxes in 2005 was $14.0 million, compared to $2.9 million in 2004,with the majority occurring during the fourth quarter of 2005 which negativelyimpacted net cash provided by operating activities. We have approximately$17 million of net operating loss carryforwards available in 2006 and $12.5 millioneach year from 2007 through 2020. We anticipate that cash paid for income taxesin 2006 will be between $40 million and $45 million.

Net cash used forinvesting activities decreased by $104.6 million, or 97%, for the year ended December 31,2005 compared to the year ended December 31, 2004. The decrease isprimarily the result of the following:

·       a$101.5 million decrease in cash paid for acquisitions in the year ended December 31,2005, compared to the year ended December 31, 2004, primarily the resultof the Classmates acquisition for $98.2 million in cash, net of cash acquiredin November 2004; and

·       a$17.0 million increase in proceeds from maturities and sales of short-terminvestments, net of purchases in the year ended December 31, 2005 comparedto the year ended December 31, 2004.

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These decreaseswere partially offset by:

·       a$9.1 million increase in capital equipment purchases and capitalized softwarecosts in connection with the development of new products and the ongoingoperations of our business; and

·       a$4.6 million increase in purchases of rights, patents and trademarks, primarilyrelated to the purchase of proprietary rights associated with the NetZerotrademark for $6.0 million, $5.5 million of which was paid in the March 2005quarter. The remaining $0.5 million was paid in January 2006.

We have invested significantly in our networkinfrastructure, software licenses, leasehold improvements, and computerequipment and we will need to make further significant investments in thefuture. Capital expenditures for the year ended December 31, 2005 were$21.7 million. We anticipate that our total capital expenditures for 2006will be in the range of $23 million to $28 million. The actual amount offuture capital expenditures may fluctuate due to a number of factors including,without limitation, potential future acquisitions and new business initiatives,which are difficult to predict and could change significantly over time.Additionally, technological advances may require us to make capitalexpenditures to develop or acquire new equipment or technology in order toreplace aging or technologically obsolete equipment.

Net cash used forfinancing activities increased by $121.3 million for the year endedDecember 31, 2005 to $89.6 million compared to the year endedDecember 31, 2004. The increase is primarily the result of the following:

·       theborrowing of $100 million in December 2004 through a four-year term loanfacility;

·       paymentsof $45.8 million on the term loan in the year ended December 31, 2005,including voluntary prepayments of $28.8 million. In January 2006, wepaid, in full, the outstanding balance of the term loan of approximately $54.2million; and

·       paymentsof $38.1 million for dividends in the year ended December 31, 2005.

The increases wereoffset by:

·       a$60.3 million decrease in repurchases of common stock in the year endedDecember 31, 2005 compared to the year ended December 31, 2004.

The payment of dividends will negatively impact cashflows from financing activities. In May, August and October of 2005and February of 2006, our Board of Directors declared a quarterly cashdividend of $0.20 per share of common stock. The quarterly dividends were paidon May 31, 2005, August 31, 2005, November 30, 2005 andFebruary 28, 2006 and totaled $12.6 million, $12.7 million, $12.8 millionand $12.9 million, respectively. The payment of future dividends is discretionaryand will be subject to determination by the Board of Directors each quarterfollowing its review of our financial performance.

Future cash flows from financing activities may alsobe affected by repurchases of common stock. Our Board of Directors authorized acommon stock repurchase program that allows us to repurchase shares of ourcommon stock through open market or privately negotiated transactions based onprevailing market conditions and other factors. From time to time, the Board ofDirectors has increased the amount authorized for repurchase under thisprogram. On April 22, 2004, the Board of Directors authorized us topurchase up to an additional $100 million of our common stock throughMay 31, 2005 under the program, bringing the total amount authorized underthe program to $200 million. On April 29, 2005, the Board ofDirectors extended the program through December 31, 2006. AtDecember 31, 2005, we had repurchased $139.2 million of our commonstock under the program, and the remaining available under the program was$60.8 million.

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Cash flows from financing activities may also be negativelyimpacted by the RSUs by withholding shares we award to employees. Upon vesting,we currently anticipate that we will collect the applicable withholding taxesfor RSUs. As such, we will automatically withhold, from the RSUs that vest, theportion of those shares with a fair market value equal to the amount of thewithholding taxes due. We will then pay the applicable withholding taxes incash. The net effect of such withholding will adversely impact our cash flows.The amount remitted in February 2006, which was our first vesting of RSUs, was$1.6 million. The amount we pay in future quarters will vary based on our stockprice and the number of RSUs vesting during the quarter.

Based on our currentprojections, we expect to continue to generate positive cash flows fromoperations, at least in the near term. Cash flows from operations in the March 2006quarter will be reduced by the payment of approximately $12.4 million forannual employee bonuses for 2005 and by approximately $10.0 million for incometaxes. We intend to use our existing cash balances and future cash generatedfrom operations to fund dividend payments; to develop and acquire complementaryservices, businesses or technologies; to repurchase shares of our common stockif we believe market conditions to be favorable; pay the withholding taxes dueon vested RSUs; and to fund future capital expenditures. As noted above, in January 2006,we retired the remaining balance of $54.2 million of our term loan. Wecurrently anticipate that our future cash flows from operations and existingcash, cash equivalent and short-term investment balances will be sufficient tofund our operations over the next year, and in the near term we do notanticipate the need for additional financing to fund our operations. However,we may raise additional debt or equity capital for a variety of reasonsincluding, without limitation, developing new or enhancing existing services orproducts, repurchasing our common stock, acquiring complementary services,businesses or technologiesor funding significant capital expenditures. If weneed to raise additional capital through public or private debt or equityfinancings, strategic relationships or other arrangements, it might not beavailable to us in a timely manner, on acceptable terms, or at all. Our failureto raise sufficient capital when needed could have a material adverse effect onour business, financial position, results of operations and cash flows, andcould impair our ability to pay dividends. If additional funds were raisedthrough the issuance of equity securities, the percentage of stock owned by thethen-current stockholders would be reduced. Furthermore, such equity securitiesmight have rights, preferences or privileges senior to holders of our commonstock.

**Financial Commitments**

Ourfinancial commitments are as follows at December 31, 2005 (in thousands):

| ** **                        | ** ** | **Year Ending December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| **Contractual Obligations:** | ** ** | ** **                                  | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
| Term loan(1)                      |       | $                                           | 54,208     |   | $ | 16,498 |   | $ | 16,498 |   | $ | 21,212 |   | $ | — |   | $ | — |   |   | $ | — |   |   |
| Capital leases(2)                 |       | 731                                         |       | 399 |   | 332 |   | — |   | — |   | — |   |   | — |   |   |
| Operating leases                  |       | 46,638                                      |       | 6,979 |   | 7,155 |   | 7,162 |   | 6,078 |   | 4,464 |   |   | 14,800 |   |   |
| Telecommunications  purchases     |       | 19,388                                      |       | 10,892 |   | 8,496 |   | — |   | — |   | — |   |   | — |   |   |
| Media purchases                   |       | 8,398                                       |       | 8,398 |   | — |   | — |   | — |   | — |   |   | — |   |   |
| Total                             |       | $                                           | 129,363    |   | $ | 43,166 |   | $ | 32,481 |   | $ | 28,374 |   | $ | 6,078 |   | $ | 4,464 |   |   | $ | 14,800 |   |   |
|                                   |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Our variable-rate termloan accrued interest at rates generally equal to the London inter-bank offeredrate (LIBOR) for dollar deposits plus a margin of 3.0%. The table reflects onlyprincipal amounts. In January 2006, we paid in full the outstandingbalance of the term loan of approximately $54.2 million. See Note 3 to thecondensed consolidated financial statements.

(2)          Includes$33,000 of imputed interest.

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**Off-Balance Sheet Arrangements**

At December 31, 2005,we had no off-balance sheet arrangements that have, or are reasonably likely tohave, a current or future material effect on our consolidated financialcondition, results of operations, liquidity, capital expenditures or capitalresources.

**CriticalAccounting Policies and Estimates**

*General*

Our discussion and analysis of our financial conditionand results of operations is based upon our audited and unaudited consolidatedfinancial statements, which have been prepared in accordance with generallyaccepted accounting principles (“GAAP”) including those for interim financialinformation and with the instructions for Form 10-K and Article 10of Regulation S-X issued by the Securities and Exchange Commission (“SEC”).The preparation of financial statements in accordance with GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent liabilities and thereported amounts of revenues and expenses. Actual results could differ fromthose estimates. The results of operations for interim or transition periodsare not necessarily indicative of the operating results for a full year.

The following is adiscussion of the accounting policies and related estimates that we believe aremost critical to understanding our consolidated financial statements, financialposition and results of operations and which require complex managementjudgments, uncertainties and/or estimates.

*Revenue Recognition*

We apply the provisions of SEC Staff AccountingBulletin (“SAB”) No. 104, *RevenueRecognition in Financial Statements*, which provides guidance on therecognition, presentation and disclosure of revenue in financial statementsfiled with the SEC. SAB No. 104 outlines the basic criteria that must bemet to recognize revenue and provides guidance for disclosure related torevenue recognition policies. In general, we recognize revenue related to ourbillable services and advertising products when (i) persuasive evidence ofan arrangement exists, (ii) delivery has occurred or services have beenrendered, (iii) the fee is fixed or determinable and (iv) collectibilityis reasonably assured. We also apply the provisions of Emerging Issues TaskForce (“EITF”) Issue No. 00-21, *Revenue Arrangements withMultiple Deliverables*.

Billable services revenues are recognized in theperiod in which fees are fixed or determinable and the related products orservices are provided to the user. Our pay accounts generally pay in advancefor their service by credit card, and revenue is then recognized ratably overthe period in which the related services are provided. Advance payments frompay accounts are recorded on the balance sheet as deferred revenue. We offeralternative payment methods to credit cards for certain pay service plans.These alternative payment methods currently include payment by ACH, personalcheck or money order or through a local telephone company. In circumstanceswhere payment is not received in advance, revenue is only recognized ifcollectibility is reasonably assured.

Advertising and commercerevenues primarily consist of fees from Internet search partners that aregenerated as a result of our active accounts utilizing partner Internet searchservices, fees generated by our active accounts viewing or clicking on third-partyadvertisements, fees generated by enabling customer registrations for partnersand fees from referring our active accounts to, or from our active accountsmaking purchases on, sponsors’ Web sites. Revenues are recognized provided thatno significant obligations remain, fees are fixed or determinable, andcollection of the related receivable is reasonably assured. We recognizeadvertising and sponsorship revenues in the periods in which the advertisementor sponsorship placement is displayed, based upon the lesser of (i) impressionsdelivered divided by the total number of guaranteed impressions or (ii) ratablyover the period in which the advertisement is displayed. 

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Ourobligations typically include a minimum number of impressions or thesatisfaction of other performance criteria. Revenue from performance-basedarrangements, including referral revenues, is recognized as the relatedperformance criteria are met and when the fees become fixed and determinable.In determining whether an arrangement exists, we ensure that a contract is inplace, such as a standard insertion order or a fully executed customer-specificagreement. We assess whether performance criteria have been met and whether thefees are fixed or determinable based on a reconciliation of the performancecriteria and the payment terms associated with the transaction. Thereconciliation of the performance criteria generally includes a comparison ofinternally tracked performance data to the contractual performance obligation andto third-party or customer performance data in circumstances where thatdata is available. Probability of collection is assessed based on a number offactors, including past transaction history with the customer and thecreditworthiness of the customer. If it is determined that collection is notreasonably assured, revenue is not recognized until collection becomesreasonably assured, which is generally upon receipt of cash.

*Long-lived Assets*

We assess the impairment of long-lived assets, whichinclude property and equipment and identifiable intangible assets, wheneverevents or changes in circumstances indicate that such assets might be impairedand the carrying value may not be recoverable in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*. Events and circumstances that may indicate thatan asset is impaired include significant decreases in the market value of anasset, significant underperformance relative to expected historical orprojected future results of operations, a change in the extent or manner inwhich an asset is used, significant declines in our stock price for a sustainedperiod, shifts in technology, loss of key management or personnel, changes inour operating model or strategy and competitive forces.

If events andcircumstances indicate that the carrying amount of an asset may not berecoverable and the expected undiscounted future cash flows attributable to theasset are less than the carrying amount of the asset, an impairment loss equalto the excess of the asset’s carrying value over its fair value is recorded.Fair value is determined based on the present value of estimated expectedfuture cash flows using a discount rate commensurate with the risk involved,quoted market prices or appraised values, depending on the nature of theassets.

*Goodwill*

We adopted SFAS No. 142 on July 1, 2002.Under SFAS No. 142, goodwill is not amortized, but is tested forimpairment at a reporting unit level on an annual basis and between annualtests if an event occurs or circumstances change that would more likely thannot reduce the fair value of a reporting unit below its carrying value amount.Events or circumstances which could trigger an impairment review include asignificant adverse change in legal factors or in the business climate, anadverse action or assessment by a regulator, unanticipated competition, a lossof key personnel, significant changes in the manner of our use of the acquiredassets or the strategy for our overall business, significant negative industryor economic trends, significant declines in our stock price for a sustainedperiod or significant underperformance relative to expected historical orprojected future results of operations.

We determine reporting units by allocating assets, includinggoodwill, based on the related service offerings. In testing for a potentialimpairment of goodwill, the estimated fair values of our reporting units arecompared with their respective book values, including goodwill. If theestimated fair value exceeds book value, goodwill is considered not to beimpaired and no additional steps are necessary. If, however, the fair value ofthe reporting unit is less than book value, then we are required to compare thecarrying amount of the goodwill with its implied fair value. The estimate ofimplied fair value of goodwill may require independent valuations of certaininternally generated and unrecognized intangible assets such as our pay accountbase, software and technology, and patents and trademarks. If the carryingamount of our 

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goodwill exceeds theimplied fair value of that goodwill, an impairment loss would be recognized inan amount equal to the excess. In accordance with SFAS No. 142, weperformed an annual goodwill impairment test during the December 2005quarter and concluded that, at that time, there was no impairment of ourgoodwill.

Goodwill increased by$76.5 million and $4.0 million during the years ended December 31, 2004and 2005 as a result of acquisitions (see Note 2 to the consolidatedfinancial statements). We recorded a reduction in goodwill of $9.5 millionduring the December 2004 quarter in connection with the release of thedeferred tax valuation allowance (see Note 3 to the consolidated financialstatements).

*BusinessCombinations*

Our acquisitions to date have all been accounted foras purchase business combinations. Under the purchase method of accounting, thecost, including transaction costs, is allocated to the underlying net assets,based on their respective estimated fair values. The excess of the purchaseprice over the estimated fair values of the net assets acquired is recorded asgoodwill.

The judgments made in determining the estimated fairvalues and expected useful lives assigned to each class of assets andliabilities acquired can significantly impact net income. For example,different classes of assets will have useful lives that differ (e.g., theuseful life of acquired users may not be the same as the useful life ofacquired technologies). Consequently, to the extent a longer-lived assetis ascribed greater value under the purchase method than a shorter-livedasset, there may be less amortization recorded in a given period. Definite-livedidentifiable intangible assets are amortized on either a straight-linebasis or an accelerated basis. We determine the appropriate amortization methodby performing an analysis of expected cash flows over the expected useful lifeof the asset and match the amortization expense to the expected cash flows fromthose assets.

Determining the fair valueof certain assets and liabilities acquired is subjective in nature and ofteninvolves the use of significant estimates and assumptions. We use a one-yearperiod following the consummation of acquisitions to finalize estimates of thefair values of assets and liabilities acquired. Two areas, in particular, thatrequire significant judgment are estimating the fair values and related usefullives of identifiable intangible assets. To assist in this process, we mayobtain appraisals from valuation specialists for certain intangible assets.While there are a number of different methods used in estimating the value ofacquired intangibles, there are two approaches primarily used: the discountedcash flow and market comparison approaches. Some of the more significantestimates and assumptions inherent in the two approaches include: projectedfuture cash flows (including timing); discount rate reflecting the riskinherent in the future cash flows; perpetual growth rate; determination ofappropriate market comparables; and the determination of whether a premium or adiscount should be applied to comparables. Most of the foregoing assumptionsare made based on available historical information.

*Income Taxes*

Income taxes are accountedfor under SFAS No. 109. Under SFAS No. 109, deferred tax assets andliabilities are determined based on differences between the financial reportingand tax basis of assets and liabilities and are measured using the enacted taxrates and laws that will be in effect when the differences are expected toreverse. A valuation allowance is established when necessary to reduce deferredtax assets to the amount expected to be realized. In determining the need for avaluation allowance, we review both positive and negative evidence pursuant to therequirements of SFAS No. 109, including current and historical results ofoperations, the annual limitation on utilization of net operating losscarryforwards pursuant to Section 382 of the Code, future incomeprojections and potential tax-planning strategies.

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*Legal Contingencies*

We are currently involvedin legal proceedings, certain of which are discussed elsewhere in this Form 10-K.We record liabilities related to pending litigation when an unfavorable outcomeis probable and we can reasonably estimate the amount of loss. We have notrecorded liabilities for certain pending litigation because of theuncertainties related to assessing both the amount and the probable outcome ofthose claims. As additional information becomes available, we continually assessthe potential liability related to all pending litigation. While we currentlybelieve that the liabilities recorded on our balance sheet are sufficient tocover pending litigation for which an unfavorable outcome is probable and theamount of loss can be reasonably estimated, the outcome of litigation isinherently uncertain, and there can be no assurance that such estimates will beaccurate.

**Recent Accounting Pronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123R. This statement replacesSFAS No. 123, *Accounting for Stock-BasedCompensation*, and supersedes Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*. This statement requires that the cost resultingfrom all share-based payment transactions be recognized in the financialstatements. This statement establishes fair value as the measurement objectivein accounting for share-based payment arrangements and requires allentities to apply a fair-value-based measurement method in accounting forshare-based payment transactions with employees except for equityinstruments held by employee share ownership plans. This statement alsoestablishes fair value as the measurement objective for transactions in whichan entity acquires goods or services from nonemployees in share-basedpayment transactions. This statement uses the terms compensation and payment intheir broadest senses to refer to the consideration paid for goods or services,regardless of whether the supplier is an employee. SFAS No. 123R becomeseffective in the March 2006 quarter and is likely to have a materialeffect on our results of operations although the exact amount is not currentlyknown.

We will be required to determine the transition methodto be used at the date of adoption. The allowed transition methods are themodified prospective application and the modified retrospective application.Under the modified prospective application, this statement applies to newawards and to awards modified, repurchased, or cancelled after the requiredeffective date. Additionally, compensation cost for the portion of awards forwhich the requisite service has not been rendered that are outstanding as ofthe required effective date shall be recognized as the requisite service isrendered on or after the required effective date. The compensation cost forthat portion of awards will be based on the grant-date fair value of thoseawards as calculated for either recognition or pro forma disclosures underSFAS No. 123. The modified retrospective application requirescompanies to record compensation expense for all unvested stock options andrestricted stock beginning with the first disclosed period restated. At therequired effective date, we will apply this statement using the modified prospectiveapplication.

We have selected the Black-Scholes option-pricingmodel as the most appropriate fair-value method for our awards and willrecognize compensation cost on an accelerated basis over the awards’ vestingperiods in accordance with FIN 28. SFAS No. 123R becomes effective in the March 2006quarter, and we expect that the adoption of SFAS No. 123R will have amaterial impact on our operating income, net income and earnings per share.However, uncertainties, including our future stock-based compensation strategy,stock price volatility, estimated forfeitures and employee stock optionexercise behavior, make it difficult to determine whether the stock-basedcompensation expense that we will incur in future periods will be similar tothe SFAS No. 123 pro forma expense disclosed in Note 1. In addition, theamount of stock-based compensation expense to be incurred in future periodswill be reduced by the acceleration of certain unvested and “out-of-the-money”stock options in December 2005 as disclosed in Note 8.

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In March 2005, the SEC issued SAB No. 107, *Share-Based Payment*. The interpretations in this SAB expressviews of the staff regarding the interaction between SFAS No. 123R andcertain SEC rules and regulations and provide the staff’s views regardingthe valuation of share-based payment arrangements for public companies. Inparticular, this SAB provides guidance related to share-based paymenttransactions with nonemployees, the transition from nonpublic to public entitystatus, valuation methods (including assumptions such as expected volatilityand expected term), the accounting for certain redeemable financial instrumentsissued under share-based payment arrangements, the classification ofcompensation expense, non-GAAP financial measures, capitalization ofcompensation cost related to share-based payment arrangements, the accountingfor income tax effects of share-based payment arrangements upon adoption ofSFAS No. 123R, the modification of employee share options prior toadoption of SFAS No. 123R and disclosures in Management’s Discussionand Analysis subsequent to adoption of SFAS No. 123R.

In June 2005, theFASB issued SFAS No. 154, *Accounting Changes andError Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3*.SFAS No. 154 changes the requirements for the accounting for and reportingof a change in accounting principle and applies to all voluntary changes inaccounting principle. APB Opinion No. 20 previously required that mostvoluntary changes in accounting principle be recognized by including in netincome of the period of change the cumulative effect of changing to the newaccounting principle. SFAS No. 154 requires retrospective application toprior periods’ financial statements of changes in accounting principle, unlessit is impracticable to determine either the period-specific effects or thecumulative effect of the change. When it is impracticable to determine theperiod-specific effects of an accounting change on one or more individual priorperiods presented, SFAS No. 154 requires that the new accounting principlebe applied to the balances of assets and liabilities as of the beginning of theearliest period for which retrospective application is practicable and that acorresponding adjustment be made to the opening balance of retained earningsfor that period rather than being reported in an income statement. When it isimpracticable to determine the cumulative effect of applying a change inaccounting principle to all prior periods, SFAS No. 154 requires that thenew accounting principle be applied as if it were adopted prospectively fromthe earliest date practicable. In addition, SFAS No. 154 makes adistinction between retrospective application of an accounting principle andthe restatement of financial statements to reflect the correction of an error.SFAS No. 154 is effective for accounting changes and corrections of errorsmade beginning in the March 2006 quarter. We do not expect theimplementation of SFAS No. 154 to have a material impact on our financialposition, results of operations or cash flows.

**Inflation**

Inflation did not have amaterial impact during the years ended December 31, 2005 and 2004, and wedo not currently anticipate that inflation will have a material impact on ourresults of operations going forward.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certainmarket risks arising from transactions in the normal course of business,principally risk associated with interest rate and foreign currencyfluctuations.

*Interest Rate Risk*

We have interest rate risk primarily related to ourinvestment portfolio and our term loan.

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We maintain a short-term investment portfolioconsisting of U.S. commercial paper, U.S. Government or U.S. Government Agencyobligations, municipal obligations, auction rate securities and money marketfunds. Our primary objective is the preservation of principal and liquiditywhile maximizing yield. The minimum long-term rating is A, and if along-term rating is not available, we require a short-term credit rating of A1and P1. The value of these investments may fluctuate with changes in interestrates. However, we believe this risk is immaterial due to the short-term natureof the investments.

We were exposed tointerest rate risk on the outstanding balance of our term loan through the datewe repaid the outstanding balance in full, which was January 3, 2006. In January 2005,we converted the outstanding base rate loan into Eurodollar loans withstaggered interest periods including three months and up to six months. In July 2005,we converted the only outstanding Eurodollar loan into three Eurodollar loans withstaggered interest periods including three months and up to six months. In October 2005,we elected to continue our three month Eurodollar loan. Interest accrued atrates generally equal to the London inter-bank offered rate (LIBOR) for dollardeposits plus a margin of 3.0%. We purchased an interest-rate cap to reduce thevariability in the amount of expected future cash interest payments that areattributable to LIBOR-based market interest rates. The cap provided protectionthrough January 31, 2007 from an increase in three month LIBOR over 3.5%;however, in January 2006, we paid the outstanding balance on the term loanin full. In connection with the retirement of the term loan in January 2006,we sold the interest rate cap.

*Foreign CurrencyRisk*

We transact business indifferent foreign currencies and may be exposed to financial market riskresulting from fluctuations in foreign currency exchange rates, particularlythe Indian Rupee (INR), the Swedish Krona (SEK) and the Euro, which may resultin a gain or loss of earnings to us. The volatility of the INR, SEK and theEuro (and all other applicable currencies) are monitored throughout the year.We face two risks related to foreign currency exchange: translation risk andtransaction risk. Amounts invested in our foreign operations are translatedinto U.S. dollars using period-end exchange rates. The resulting translationadjustments are recorded as a component of accumulated other comprehensiveincome (loss) in stockholders’ equity. Our foreign subsidiaries generallycollect revenues and pay expenses in currencies other than the U.S. dollar.Since the functional currencies of our foreign operations are denominated inthe local currency of our subsidiaries, the foreign currency translation adjustmentsare reflected as a component of stockholders’ equity and do not impactoperating results. Revenues and expenses in foreign currencies translate intohigher or lower revenues and expenses in U.S. dollars as the U.S. dollarweakens or strengthens against other currencies. Therefore, changes in exchangerates may negatively affect our consolidated revenues and expenses (asexpressed in U.S. dollars) from foreign operations. Currency transaction gainsor losses arising from transactions in currencies other than the functionalcurrency are included in operating expenses. While we have not engaged inforeign currency hedging, we may in the future use hedging programs, currencyforward contracts, currency options and/or other derivative financialinstruments commonly utilized to reduce financial market risks if it isdetermined that such hedging activities are appropriate to reduce risk.

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

For financial statements,see the Index to Consolidated Financial Statements on page F-1.

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

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**ITEM 9A.**        CONTROLSAND PROCEDURES

*Disclosure Controlsand Procedures*

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of the Company’s disclosure controls and procedures(as such term is defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this report. Based on such evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that, as of theend of such period, the Company’s disclosure controls and procedures areeffective in recording, processing, summarizing and reporting, on a timelybasis, information required to be disclosed by the Company in the reports thatit files or submits under the Exchange Act and are effective in ensuring thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is accumulated and communicated to theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosure.

*Management’s Reporton Internal Control Over Financial Reporting*

Management of United Online, Inc. is responsiblefor establishing and maintaining adequate internal control over financialreporting. The Company’s internal control over financial reporting has beendesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external reportingpurposes in accordance with accounting principles generally accepted in theUnited States of America.

The Company’s internal control over financialreporting includes policies and procedures that pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect transactionsand dispositions of assets of the Company; provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with accounting principles generally accepted in theUnited States of America, and that receipts and expenditures are being madeonly in accordance with authorization of management and directors of theCompany; and provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use or disposition of the Company’sassets that could have a material effect on the Company’s financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Management assessed the effectiveness of the Company’sinternal control over financial reporting at December 31, 2005. In makingthis assessment, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) in *Internal Control—Integrated Framework*.Based on that assessment under those criteria, management has determined that,at December 31, 2005, the Company’s internal control over financialreporting was effective.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting atDecember 31, 2005 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report whichappears herein.

*Changes in InternalControls Over Financial Reporting*

There have not been anychanges in the Company’s internal controls over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during our most recent fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrols over financial reporting.

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**ITEM 9B.**       OTHER INFORMATION

None.

**PART III**

**ITEMS 10, 11, 12, 13 and 14**

The information requiredby Items 10, 11, 12, 13 and 14 is hereby incorporated by reference to ourdefinitive proxy statement relating to our 2006 annual meeting of stockholdersto be filed with the Securities and Exchange Commission within 120 daysafter the end of our fiscal year.

**PART IV**

**ITEM 15.**         EXHIBITS,FINANCIAL STATEMENT SCHEDULES

**(a)****         Thefollowing documents are filed as part of this report:**

1.**  *****ConsolidatedFinancial Statements:***

|                                                          | ** ** | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm |       | F-2        |     |
| Consolidated Balance Sheets                              |       | F-4        |     |
| Consolidated Statements of  Operations                   |       | F-5        |     |
| Consolidated Statements of  Comprehensive Income         |       | F-6        |     |
| Consolidated Statements of  Stockholders’ Equity    |       | F-7        |     |
| Consolidated Statements of  Cash Flows                   |       | F-9        |     |
| Notes to Consolidated Financial Statements               |       | F-10       |     |

 

2.*   FinancialStatement Schedule:*

|                                                     | ** ** | ** ** | **Page** | ** ** |
|-----------------------------------------------------|------------|------------|----------|------------|
| Schedule II—Valuation and  Qualifying Accounts |       | F-41       |     |

 

All other schedules havebeen omitted because the information required to be set forth therein is notapplicable, not required or is shown in the consolidated financial statementsor notes thereto.

3.*   Exhibits:*

|         | ** ** | ** **                                                                                                                                              | ** ** | **Filed   with this**        | ** ** | **Incorporated by Reference to** |
|---------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------|
| **No.** | ** ** | ** **                                                                                                                                              | ** ** | **Exhibit Description** | ** ** | **Form 10-K**               | ** ** | **Form** | ** ** | **File No.** | ** ** | **Date Filed** |
| 2.1     |       | Agreement and Plan of Merger, dated October 23,  2004, among United Online, Inc., Mariner Acquisition Corp. and  Classmates Online, Inc. |       |                         |       | 8-K                              |   | 000-33367 |   | 11/4/2004 |
| 3.1     |       | Amended and Restated  Certificate of Incorporation                                                                                                      |       |                         |       | 8-K                              |   | 000-33367 |   | 10/1/2001 |
| 3.2     |       | Amended and Restated  Bylaws                                                                                                                            |       |                         |       | 8-K                              |   | 000-33367 |   | 10/1/2001 |
| 3.3     |       | Certificate of  Designation for Series A Junior Participating Preferred Stock (included  in exhibit 4.1 below)                                |       |                         |       | 8-K                              |   | 000-33367 |   | 11/23/2001 |
|         |            |                                                                                                                                                         |            |                              |            |                                  |  |  |  |  |  |  |

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| 4.1   |   | Rights Agreement, dated  as of November 15, 2001, between the Company and U.S. Stock Transfer  Corporation, which includes the form of Certificate of Designation for the  Series A junior participating preferred stock as Exhibit A, and the  form of Rights Certificate as Exhibit B |   |   |   | 8-K   |   | 000-33367  |   | 11/23/2001 |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|-------|--------|------------|--------|------------|
| 4.2   |   | Amendment No. 1 to  Rights Agreement, dated as of April 29, 2003, between the Registrant and  U.S. Stock Transfer Corporation                                                                                                                                                                     |   |   |   | 10-Q  |   | 000-33367  |   | 5/1/2003   |
| 10.1  |   | 2001 Amended and  Restated Employee Stock Purchase Plan                                                                                                                                                                                                                                                     |   |   |   | 10-Q  |   | 000-33367  |   | 5/3/2004   |
| 10.2  |   | 2001 Stock Incentive Plan                                                                                                                                                                                                                                                                                   |   |   |   | 10-Q  |   | 000-33367  |   | 11/14/2001 |
| 10.3  |   | Form of Option Agreement for 2001 Stock  Incentive Plan                                                                                                                                                                                                                                                |   |   |   | 10-Q  |   | 000-33367  |   | 10/27/2004 |
| 10.4  |   | Form of Restricted  Stock Unit Issuance Agreement for 2001 Stock Incentive Plan                                                                                                                                                                                                                        |   |   |   | 10-Q  |   | 000-33367  |   | 8/8/2005   |
| 10.5  |   | 2001 Supplemental Stock  Incentive Plan                                                                                                                                                                                                                                                                     |   |   |   | 10-Q  |   | 000-33367  |   | 11/14/2001 |
| 10.6  |   | Form of Option  Agreement for 2001 Supplemental Stock Incentive Plan                                                                                                                                                                                                                                   |   |   |   | 10-Q  |   | 000-33367  |   | 10/27/2004 |
| 10.7  |   | Classmates  Online, Inc. Amended and Restated 1999 Stock Plan                                                                                                                                                                                                                                          |   |   |   | S-8   |   | 333-121217 |   | 2/11/2005  |
| 10.8  |   | Classmates  Online, Inc. 2004 Stock Plan                                                                                                                                                                                                                                                               |   |   |   | 10-Q  |   | 000-33367  |   | 5/10/2005  |
| 10.9  |   | Form of Option  Agreement for Classmates Online, Inc. 2004 Stock Plan                                                                                                                                                                                                                             |   |   |   | 10-Q  |   | 000-33367  |   | 5/10/2005  |
| 10.10 |   | United Online, Inc.  2005 Management Bonus Plan                                                                                                                                                                                                                                                        |   |   |   | 8-K   |   | 000-33367  |   | 3/30/2005  |
| 10.11 |   | Amended and Restated  Employment Agreement between the Registrant and Mark R. Goldston                                                                                                                                                                                                                 |   |   |   | 10-KT |   | 000-33367  |   | 2/5/2004   |
| 10.12 |   | Amended and Restated  Employment Agreement between the Registrant and Charles S. Hilliard                                                                                                                                                                                                              |   |   |   | 10-KT |   | 000-33367  |   | 2/5/2004   |
| 10.13 |   | Amended and Restated  Employment Agreement between the Registrant and Frederic A.  Randall, Jr.                                                                                                                                                                                                   |   |   |   | 10-KT |   | 000-33367  |   | 2/5/2004   |
| 10.14 |   | Employment Agreement  between the Registrant and Matt Wisk                                                                                                                                                                                                                                                  |   |   |   | 10-Q  |   | 000-33367  |   | 8/8/2005   |
| 10.15 |   | Employment Agreement  between the Registrant and Ted Cahall                                                                                                                                                                                                                                                 |   |   |   | 10-Q  |   | 000-33367  |   | 8/8/2005   |
| 10.16 |   | Employment Agreement  between the Registrant and Jon Fetveit                                                                                                                                                                                                                                                |   |   |   | 10-Q  |   | 000-33367  |   | 8/8/2005   |

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| 10.17 |   | Employment Agreement between the Registrant and  Gerald Popek                                                                                                                                                                                                                         |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|-----------|--------|------------|
| 10.18 |   | Employment Agreement  between the Registrant and Robert Taragan                                                                                                                                                                                                                       |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.19 |   | Office Lease between LNR  Warner Center, LLC and NetZero, Inc.                                                                                                                                                                                                                   |   |   |   | 10-Q   |   | 000-33367 |   | 5/3/2004   |
| 10.20 |   | Credit Agreement, dated  as of December 3, 2004, among United Online, the Lenders party thereto  from time to time, Deutsche Bank Trust Company Americas, as Administrative  Agent, and Deutsche Bank Securities Inc., as Lead Arranger (the “Credit  Agreement”) |   |   |   | 8-K    |   | 000-33367 |   | 12/3/2004  |
| 10.21 |   | First Amendment to Credit Agreement, dated as of  December 13, 2004                                                                                                                                                                                                              |   |   |   | 8-K    |   | 000-33367 |   | 12/14/2004 |
| 10.22 |   | Second Amendment to Credit Agreement, dated as of  March 11, 2005                                                                                                                                                                                                                |   |   |   | 10-K   |   | 000-33367 |   | 3/16/2005  |
| 21.1  |   | List of Subsidiaries                                                                                                                                                                                                                                                                  |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 23.1  |   | Consent of Independent  Registered Public Accounting Firm                                                                                                                                                                                                                             |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 31.1  |   | Certification of the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 31.2  |   | Certification of the  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 32.1  |   | Certification of the  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 32.2  |   | Certification of the  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |

 

**(b)****         Exhibits**

The exhibits filed as partof this report are listed in Item 15(a)(3) of this Form 10-K.

**(c)****      ****Financial Statement Schedules**

The financial statement schedules required byRegulation S-X and Item 8 of this form are listed in Item 15(a)(2) ofthis Form 10-K.

65

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**SIGNATURES**

Pursuantto the requirements of Section 13 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 on March 6, 2006.
|          | UNITED  ONLINE, INC. |
|----------|---------------------------|
|     | By:                       | /s/ MARK R. GOLDSTON |
|     |                      | Mark R. Goldston |
| * * | * *                  | *Chairman, Chief Executive Officer and President* |

 

KNOW ALL PERSONS BY THESE PRESENT, that each personwhose signature appears below constitutes and appoints Mark R. Goldston andCharles S. Hilliard, as his or her attorneys-in-fact, each with the power ofsubstitution, for him or her in any and all capacities, to sign any amendmentto this Annual Report on Form 10-K, and to file the same, with exhibitsthereto and other documents in connection therewith with the Securities andExchange Commission, hereby ratifying and confirming all that each of saidattorneys-in-fact, or his or her substitute or substitutes may do or cause tobe done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Company and in thecapacities indicated on March 6, 2006.
|                          | **Signature** | ** **                                             | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|--------------------------|---------------|--------------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/  MARK R. GOLDSTON    |          | Chairman, Chief  Executive Officer, President and      |       | March 6, 2006  |
| Mark  R. Goldston        |          | Director (Principal Executive Officer and Director)    |       |                |
| /s/ CHARLES  S. HILLIARD |          | Executive Vice  President, Finance and                 |       | March 6,  2006 |
| Charles  S. Hilliard     |          | Chief Financial Officer (Principal Financial  Officer) |       |                |
| /s/ NEIL  P. EDWARDS     |          | Senior Vice  President, Finance, Treasurer and Chief   |       | March 6,  2006 |
| Neil  P. Edwards         |          | Accounting Officer (Principal Accounting Officer)      |       |                |
| /s/ JAMES  T. ARMSTRONG  |          | Director                                               |       | March 6,  2006 |
| James  T. Armstrong      |          |                                                   |       |                |
| /s/ ROBERT  BERGLASS     |          | Director                                               |       | March 6,  2006 |
| Robert  Berglass         |          |                                                   |       |                |
| /s/ KENNETH  L. COLEMAN  |          | Director                                               |       | March 6,  2006 |
| Kenneth  L. Coleman      |          |                                                   |       |                |
| /s/ DENNIS  HOLT         |          | Director                                               |       | March 6,  2006 |
| Dennis  Holt             |          |                                                   |       |                |
| /s/ CAROL  A. SCOTT      |          | Director                                               |       | March 6,  2006 |
| Carol A. Scott           |          |                                                   |       |                |

 

66

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**EXHIBIT INDEX**

|         | ** ** | ** **                                                                                                                                                                                                                                                                                                  | ** ** | **Filed   with this**        | ** ** | **Incorporated   by Reference to** |
|---------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------------|
| **No.** | ** ** | ** **                                                                                                                                                                                                                                                                                                  | ** ** | **Exhibit Description** | ** ** | **Form 10-K**                 | ** ** | **Form** | ** ** | **File No.** | ** ** | **Date Filed** |
| 2.1     |       | Agreement and Plan of  Merger, dated October 23, 2004, among United Online, Inc., Mariner  Acquisition Corp. and Classmates Online, Inc.                                                                                                                                                     |       |                         |       | 8-K                                |   | 000-33367 |   | 11/4/2004 |
| 3.1     |       | Amended and  Restated Certificate of Incorporation                                                                                                                                                                                                                                                          |       |                         |       | 8-K                                |   | 000-33367 |   | 10/1/2001 |
| 3.2     |       | Amended and  Restated Bylaws                                                                                                                                                                                                                                                                                |       |                         |       | 8-K                                |   | 000-33367 |   | 10/1/2001 |
| 3.3     |       | Certificate of  Designation for Series A Junior Participating Preferred Stock (included  in exhibit 4.1 below)                                                                                                                                                                                    |       |                         |       | 8-K                                |   | 000-33367 |   | 11/23/2001 |
| 4.1     |       | Rights Agreement,  dated as of November 15, 2001, between the Company and U.S. Stock  Transfer Corporation, which includes the form of Certificate of Designation  for the Series A junior participating preferred stock as Exhibit A,  and the form of Rights Certificate as Exhibit B |       |                         |       | 8-K                                |   | 000-33367 |   | 11/23/2001 |
| 4.2     |       | Amendment  No. 1 to Rights Agreement, dated as of April 29, 2003, between the  Registrant and U.S. Stock Transfer Corporation                                                                                                                                                                     |       |                         |       | 10-Q                               |   | 000-33367 |   | 5/1/2003 |
| 10.1    |       | 2001 Amended and  Restated Employee Stock Purchase Plan                                                                                                                                                                                                                                                     |       |                         |       | 10-Q                               |   | 000-33367 |   | 5/3/2004 |
| 10.2    |       | 2001 Stock  Incentive Plan                                                                                                                                                                                                                                                                                  |       |                         |       | 10-Q                               |   | 000-33367 |   | 11/14/2001 |
| 10.3    |       | Form of  Option Agreement for 2001 Stock Incentive Plan                                                                                                                                                                                                                                                |       |                         |       | 10-Q                               |   | 000-33367 |   | 10/27/2004 |
| 10.4    |       | Form of  Restricted Stock Unit Issuance Agreement for 2001 Stock Incentive Plan                                                                                                                                                                                                                        |       |                         |       | 10-Q                               |   | 000-33367 |   | 8/8/2005 |
| 10.5    |       | 2001 Supplemental  Stock Incentive Plan                                                                                                                                                                                                                                                                     |       |                         |       | 10-Q                               |   | 000-33367 |   | 11/14/2001 |
| 10.6    |       | Form of  Option Agreement for 2001 Supplemental Stock Incentive Plan                                                                                                                                                                                                                                   |       |                         |       | 10-Q                               |   | 000-33367 |   | 10/27/2004 |
| 10.7    |       | Classmates  Online, Inc. Amended and Restated 1999 Stock Plan                                                                                                                                                                                                                                          |       |                         |       | S-8                                |   | 333-121217 |   | 2/11/2005 |
| 10.8    |       | Classmates  Online, Inc. 2004 Stock Plan                                                                                                                                                                                                                                                               |       |                         |       | 10-Q                               |   | 000-33367 |   | 5/10/2005 |
| 10.9    |       | Form of  Option Agreement for Classmates Online, Inc. 2004 Stock Plan                                                                                                                                                                                                                             |       |                         |       | 10-Q                               |   | 000-33367 |   | 5/10/2005 |
| 10.10   |       | United  Online, Inc. 2005 Management Bonus Plan                                                                                                                                                                                                                                                        |       |                         |       | 8-K                                |   | 000-33367 |   | 3/30/2005 |
| 10.11   |       | Amended and Restated Employment Agreement between  the Registrant and Mark R. Goldston                                                                                                                                                                                                                 |       |                         |       | 10-KT                              |   | 000-33367 |   | 2/5/2004 |
|         |            |                                                                                                                                                                                                                                                                                                             |            |                              |            |                                    |  |  |  |  |  |  |

67

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| 10.12 |   | Amended and Restated  Employment Agreement between the Registrant and Charles S. Hilliard                                                                                                                                                                                        |   |   |   | 10-KT  |   | 000-33367 |   | 2/5/2004   |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|-----------|--------|------------|
| 10.13 |   | Amended and  Restated Employment Agreement between the Registrant and Frederic A.  Randall, Jr.                                                                                                                                                                             |   |   |   | 10-KT  |   | 000-33367 |   | 2/5/2004   |
| 10.14 |   | Employment  Agreement between the Registrant and Matt Wisk                                                                                                                                                                                                                            |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.15 |   | Employment  Agreement between the Registrant and Ted Cahall                                                                                                                                                                                                                           |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.16 |   | Employment  Agreement between the Registrant and Jon Fetveit                                                                                                                                                                                                                          |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.17 |   | Employment  Agreement between the Registrant and Gerald Popek                                                                                                                                                                                                                         |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.18 |   | Employment  Agreement between the Registrant and Robert Taragan                                                                                                                                                                                                                       |   |   |   | 10-Q   |   | 000-33367 |   | 8/8/2005   |
| 10.19 |   | Office Lease  between LNR Warner Center, LLC and NetZero, Inc.                                                                                                                                                                                                                   |   |   |   | 10-Q   |   | 000-33367 |   | 5/3/2004   |
| 10.20 |   | Credit Agreement,  dated as of December 3, 2004, among United Online, the Lenders party  thereto from time to time, Deutsche Bank Trust Company Americas, as  Administrative Agent, and Deutsche Bank Securities Inc., as Lead  Arranger (the “Credit Agreement”) |   |   |   | 8-K    |   | 000-33367 |   | 12/3/2004  |
| 10.21 |   | First Amendment  to Credit Agreement, dated as of December 13, 2004                                                                                                                                                                                                              |   |   |   | 8-K    |   | 000-33367 |   | 12/14/2004 |
| 10.22 |   | Second Amendment  to Credit Agreement, dated as of March 11, 2005                                                                                                                                                                                                                |   |   |   | 10-K   |   | 000-33367 |   | 3/16/2005  |
| 21.1  |   | List of  Subsidiaries                                                                                                                                                                                                                                                                 |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 23.1  |   | Consent of  Independent Registered Public Accounting Firm                                                                                                                                                                                                                             |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 31.1  |   | Certification of  the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 31.2  |   | Certification of  the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 32.1  |   | Certification of  the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |
| 32.2  |   | Certification of the  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                         |   | X      |   |   |   | 000-33367 |   | 3/6/2006   |

 

68

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**UNITED ONLINE, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                          | ** ** | **Page** |
|----------------------------------------------------------|------------|----------|
| Report  of Independent Registered Public Accounting Firm |       | F-2      |
| Consolidated  Balance Sheets                             |       | F-4      |
| Consolidated  Statements of Operations                   |       | F-5      |
| Consolidated  Statements of Comprehensive Income         |       | F-6      |
| Consolidated  Statements of Stockholders’ Equity    |       | F-7      |
| Consolidated  Statements of Cash Flows                   |       | F-9      |
| Notes to Consolidated Financial Statements               |       | F-10     |
| Schedule  II—Valuation and Qualifying Accounts      |       | F-41     |

 

F-1

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders of UnitedOnline, Inc.:

We have completed anintegrated audit of United Online, Inc.’s 2005 and 2004 consolidatedfinancial statements and of its internal control over financial reporting as ofDecember 31, 2005 and an audit of its December 31, 2003 and June 30,2003 consolidated financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Our opinions, basedon our audits, are presented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, theconsolidated financial statements listed in the index appearing underItem 15(a)(1) present fairly, in all material respects, the financialposition of United Online, Inc. and its subsidiaries at December 31,2005 and 2004, and the results of their operations and their cash flows for theyears ended December 31, 2005 and 2004, the six months ended December 31,2003, and the year ended June 30, 2003 in conformity with accountingprinciples generally accepted in the United States of America. In addition, inour opinion, the financial statement schedule listed in the index appearingunder Item 15(a)(2) presents fairly, in all material respects, theinformation set forth therein when read in conjunction with the relatedconsolidated financial statements. These financial statements and the financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements and thefinancial statement schedule based on our audits. We conducted our audits ofthese statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit of financialstatements includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in “Management’s Report on Internal Control Over Financial Reporting”appearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2005 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

F-2

----

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of the company;and (iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.
| /s/ PRICEWATERHOUSECOOPERS LLP |   |
|--------------------------------|--------|
| Los Angeles,  California       |
| March 3,  2006            |

 

F-3

----

**UNITED ONLINE, INC.CONSOLIDATED BALANCE SHEETS(in thousands, except per share amounts)**

| ** **                                                                                                                                                     | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                     |       |                        |       |                        |       |   |   |   |   |
| Current assets:                                                                                                                                                |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                      |       |                        | $          | 100,397                     |       |   |   | $ | 56,512 |   |   |
| Short-term investments                                                                                                                                         |       |                        | 143,965    |                        |       |   | 176,281 |   |   |
| Accounts receivable, net  of allowance for doubtful accounts of $1,325 and $647 at December 31,  2005 and 2004, respectively                         |       |                        | 19,201     |                        |       |   | 17,534 |   |   |
| Deferred tax assets, net                                                                                                                                       |       |                        | 14,808     |                        |       |   | 24,630 |   |   |
| Other current assets                                                                                                                                           |       |                        | 12,332     |                        |       |   | 13,058 |   |   |
| Total current assets                                                                                                                                           |       |                        | 290,703    |                        |       |   | 288,015 |   |   |
| Property and  equipment, net                                                                                                                                   |       |                        | 33,093     |                        |       |   | 27,006 |   |   |
| Deferred tax  assets, net                                                                                                                                      |       |                        | 53,547     |                        |       |   | 51,573 |   |   |
| Goodwill                                                                                                                                                       |       |                        | 80,499     |                        |       |   | 76,458 |   |   |
| Intangible assets,  net                                                                                                                                        |       |                        | 59,338     |                        |       |   | 70,558 |   |   |
| Other assets                                                                                                                                                   |       |                        | 4,008      |                        |       |   | 6,242 |   |   |
| Total assets                                                                                                                                                   |       |                        | $          | 521,188                     |       |   |   | $ | 519,852 |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                 |       |                        |       |                        |       |   |   |   |   |
| Current liabilities:                                                                                                                                           |       |                        |       |                        |       |   |   |   |   |
| Accounts payable                                                                                                                                               |       |                        | $          | 46,955                      |       |   |   | $ | 45,379 |   |   |
| Accrued liabilities                                                                                                                                            |       |                        | 36,249     |                        |       |   | 18,320 |   |   |
| Deferred revenue                                                                                                                                               |       |                        | 52,835     |                        |       |   | 49,293 |   |   |
| Current portion of term  loan                                                                                                                                  |       |                        | 16,498     |                        |       |   | 23,333 |   |   |
| Current portion of  capital leases                                                                                                                             |       |                        | 373        |                        |       |   | 621 |   |   |
| Total current liabilities                                                                                                                                      |       |                        | 152,910    |                        |       |   | 136,946 |   |   |
| Deferred revenue                                                                                                                                               |       |                        | 3,449      |                        |       |   | 1,661 |   |   |
| Term loan                                                                                                                                                      |       |                        | 37,710     |                        |       |   | 76,667 |   |   |
| Capital leases                                                                                                                                                 |       |                        | 325        |                        |       |   | 698 |   |   |
| Other liabilities                                                                                                                                              |       |                        | 4,379      |                        |       |   | 2,181 |   |   |
| Total liabilities                                                                                                                                              |       |                        | 198,773    |                        |       |   | 218,153 |   |   |
| Commitments and contingencies (see Note 9)                                                                                                                     |       |                        |       |                        |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                     |       |                        |       |                        |       |   |   |   |   |
| Preferred stock, $0.0001 par value; 5,000 shares  authorized; no shares issued or outstanding at December 31, 2005 and  2004                              |       |                        |       |                        |       |   |   |   |   |
| Common stock, $0.0001 par  value; 300,000 shares authorized; 62,606 and 61,074 shares issued and  outstanding at December 31, 2005 and 2004, respectively |       |                        | 6          |                        |       |   | 6 |   |   |
| Additional paid-in  capital                                                                                                                                    |       |                        | 472,745    |                        |       |   | 491,757 |   |   |
| Deferred stock-based  compensation                                                                                                                             |       |                        | (15,558    | )                           |       |   | (8,477 | ) |   |
| Accumulated other  comprehensive loss                                                                                                                          |       |                        | (327       | )                           |       |   | (9 | ) |   |
| Accumulated deficit                                                                                                                                            |       |                        | (134,451   | )                           |       |   | (181,578 | ) |   |
| Total stockholders’  equity                                                                                                                               |       |                        | 322,415    |                        |       |   | 301,699 |   |   |
| Total liabilities and stockholders’ equity                                                                                                                |       |                        | $          | 521,188                     |       |   |   | $ | 519,852 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-4

----

**UNITEDONLINE, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)**

| ** **                                                                            | ** ** | **Year Ended December 31,**                                       | ** ** | **Six Months Ended  December 31,**                                | ** ** | **Year Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Revenues:                                                                             |       |                                                                             |       |                                                                             |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Billable services                                                                     |       |                                                                             | $          | 465,980                                                                          |       |                               |       | $ | 410,821 |   |   |   | $ | 167,639 |   |   |   | $ | 247,790 |   |   |
| Advertising and commerce                                                              |       |                                                                             | 59,081     |                                                                             |       |                               | 37,796     |   |   |   | 18,099 |   |   |   | 29,505 |   |   |
| Total revenues                                                                        |       |                                                                             | 525,061    |                                                                             |       |                               | 448,617    |   |   |   | 185,738 |   |   |   | 277,295 |   |   |
| Operating expenses:                                                                   |       |                                                                             |       |                                                                             |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Cost of billable services (including stock-based compensation,  see Note 8) |       |                                                                             | 98,157     |                                                                             |       |                               | 94,999     |   |   |   | 46,182 |   |   |   | 89,293 |   |   |
| Cost of free services                                                                 |       |                                                                             | 12,515     |                                                                             |       |                               | 7,393      |   |   |   | 3,953 |   |   |   | 12,603 |   |   |
| Sales and marketing (including stock-based  compensation, see Note 8)            |       |                                                                             | 209,292    |                                                                             |       |                               | 178,981    |   |   |   | 70,526 |   |   |   | 86,623 |   |   |
| Product development (including stock-based  compensation, see Note 8)                 |       |                                                                             | 40,009     |                                                                             |       |                               | 27,454     |   |   |   | 10,488 |   |   |   | 23,054 |   |   |
| General and administrative (including stock-based  compensation, see Note 8)          |       |                                                                             | 56,729     |                                                                             |       |                               | 39,894     |   |   |   | 14,022 |   |   |   | 27,805 |   |   |
| Amortization of intangible assets                                                     |       |                                                                             | 21,799     |                                                                             |       |                               | 20,403     |   |   |   | 7,928 |   |   |   | 16,411 |   |   |
| Restructuring charges                                                                 |       |                                                                             | —     |                                                                             |       |                               | —     |   |   |   | — |   |   |   | (215 | ) |   |
| Total operating expenses                                                              |       |                                                                             | 438,501    |                                                                             |       |                               | 369,124    |   |   |   | 153,099 |   |   |   | 255,574 |   |   |
| Operating income                                                                      |       |                                                                             | 86,560     |                                                                             |       |                               | 79,493     |   |   |   | 32,639 |   |   |   | 21,721 |   |   |
| Interest and  other income, net                                                       |       |                                                                             | 6,885      |                                                                             |       |                               | 5,138      |   |   |   | 2,994 |   |   |   | 5,025 |   |   |
| Interest expense                                                                      |       |                                                                             | (6,073     | )                                                                                |       |                               | (1,202     | ) |   |   | (587 | ) |   |   | (735 | ) |   |
| Income before  income taxes                                                           |       |                                                                             | 87,372     |                                                                             |       |                               | 83,429     |   |   |   | 35,046 |   |   |   | 26,011 |   |   |
| Provision  (benefit) for income taxes                                                 |       |                                                                             | 40,245     |                                                                             |       |                               | (34,051    | ) |   |   | 1,719 |   |   |   | (1,781 | ) |   |
| Net income                                                                            |       |                                                                             | $          | 47,127                                                                           |       |                               |       | $ | 117,480 |   |   |   | $ | 33,327 |   |   |   | $ | 27,792 |   |   |
| Net income per  share—basic                                                      |       |                                                                             | $          | 0.77                                                                             |       |                               |       | $ | 1.91 |   |   |   | $ | 0.52 |   |   |   | $ | 0.45 |   |   |
| Net income per  share—diluted                                                    |       |                                                                             | $          | 0.74                                                                             |       |                               |       | $ | 1.81 |   |   |   | $ | 0.48 |   |   |   | $ | 0.41 |   |   |
| Shares used to  calculate basic net income per share                             |       |                                                                             | 61,135     |                                                                             |       |                               | 61,404     |   |   |   | 64,163 |   |   |   | 61,688 |   |   |
| Shares used to  calculate diluted net income per share                                |       |                                                                             | 63,815     |                                                                             |       |                               | 65,012     |   |   |   | 69,504 |   |   |   | 67,074 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-5

----

**UNITED ONLINE, INC.CONSOLIDATED STATEMENTSOF COMPREHENSIVE INCOME(in thousands)**

| ** **                                                                                                                                                                                                                                | ** ** | **Year Ended December 31,**                           | ** ** | **Six Months  Ended  December 31,**                        | ** ** | **Year Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                                                                                | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Net income                                                                                                                                                                                                                                |       |                                                                 | $          | 47,127                                                               |       |                               | $          | 117,480 |   |   | $ | 33,327 |   |   |   | $ | 27,792 |   |   |
| Unrealized gain  (loss) on short-term investments, net of tax of $(193), $(452), $(553)  and $992 for the years ended December 31, 2005 and 2004, the six months  ended December 31, 2003 and the year ended June 30, 2003 |       |                                                                 | (282       | )                                                                    |       | (1,666                             | )          |   | (796 | ) |   |   | 1,429 |   |   |
| Unrealized gain  on derivative, net of tax of $60 for the year ended December 31, 2005                                                                                                                                               |       |                                                                 | 83         |                                                                 |       | —                             |       |   | — |   |   |   | — |   |   |
| Foreign currency  translation                                                                                                                                                                                                             |       |                                                                 | (119       | )                                                                    |       | 9                                  |       |   | — |   |   |   | — |   |   |
| Comprehensive income                                                                                                                                                                                                                      |       |                                                                 | $          | 46,809                                                               |       |                               | $          | 115,823 |   |   | $ | 32,531 |   |   |   | $ | 29,221 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-6

----

**UNITED ONLINE, INC.CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY(in thousands)**

| ** **                                                       | ** ** | **Common Stock** | ** ** | **Additional   Paid-In** | ** ** | **Notes   Receivable   From** | ** ** | **Deferred   Stock-   Based** | ** ** | **Accumulated   Other   Comprehensive** | ** ** | **Accumulated**        | ** ** | **Total   Stockholders’** | ** ** |       |
|------------------------------------------------------------------|------------|-----------------------|------------|--------------------------|------------|-------------------------------|------------|-------------------------------|------------|-----------------------------------------|------------|------------------------|------------|--------------------------------|------------|------------|
| ** **                                                       | ** ** | **Shares**            | ** ** | **Amount**               | ** ** | **Capital**                   | ** ** | **Stockholders**              | ** ** | **Compensation**                        | ** ** | **Income (Loss)** | ** ** | **Deficit**                    | ** ** | **Equity** | ** ** |   |
| Balance at July 1, 2002                                     |       |                  | 60,851     |                     |       |                          | $          | 6                             |       |                                    |       | $                      | 539,624    |                           |       |       | $ | (1,575 | ) |   |   | $ | (107 | ) |   |   | $ | 1,015 |   |   |   | $ | (360,177 | ) |   |   | $ | 178,786 |   |   |
| Issuance of common stock  through employee stock purchase plan   |       |                  | 939        |                     |       |                          | —     |                          |       |                                    | 1,862      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,862 |   |   |
| Exercises of stock options                                       |       |                  | 2,682      |                     |       |                          | —     |                          |       |                                    | 6,962      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 6,962 |   |   |
| Repurchases of common stock                                      |       |                  | (762       | )                        |       |                          | —     |                          |       |                                    | (7,777     | )                      |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (7,777 | ) |   |
| Stock-based compensation                                         |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | 107 |   |   |   | — |   |   |   | — |   |   |   | 107 |   |   |
| Unrealized gain on short-term investments, net  of tax           |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 992        |                   |       |                           | —     |       |   |   | — |   |   |   | 1,429 |   |   |   | — |   |   |   | 2,421 |   |   |
| Tax benefits from stock  options                                 |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 5,184      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 5,184 |   |   |
| Interest earned on notes receivable from stockholders            |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | (78        | )          |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (78 | ) |   |
| Repayments of notes receivable from stockholders                 |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | 1,653      |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,653 |   |   |
| Net income                                                       |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | 27,792 |   |   |   | 27,792 |   |   |
| Balance at June 30, 2003                                    |       |                  | 63,710     |                     |       |                          | 6          |                          |       |                                    | 546,847    |                   |       |                           | —     |       |   |   | — |   |   |   | 2,444 |   |   |   | (332,385 | ) |   |   | 216,912 |   |   |
| Issuance of common stock  through employee stock purchase plan   |       |                  | 525        |                     |       |                          | —     |                          |       |                                    | 1,679      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,679 |   |   |
| Exercises of stock options                                       |       |                  | 1,698      |                     |       |                          | —     |                          |       |                                    | 8,971      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 8,971 |   |   |
| Exercise of warrants                                             |       |                  | 35         |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Repurchases of common stock                                      |       |                  | (2,024     | )                        |       |                          | —     |                          |       |                                    | (40,002    | )                      |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (40,002 | ) |   |
| Unrealized loss on short-term investments, net  of tax           |       |                  | —     |                     |       |                          | —     |                          |       |                                    | (553       | )                      |       |                           | —     |       |   |   | — |   |   |   | (796 | ) |   |   | — |   |   |   | (1,349 | ) |   |
| Tax benefits from stock  options                                 |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 18,286     |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 18,286 |   |   |
| Net income                                                       |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | 33,327 |   |   |   | 33,327 |   |   |
| Balance at December 31, 2003                                |       |                  | 63,944     |                     |       |                          | 6          |                          |       |                                    | 535,228    |                   |       |                           | —     |       |   |   | — |   |   |   | 1,648 |   |   |   | (299,058 | ) |   |   | 237,824 |   |   |
| Issuance of common stock  through employee stock purchase plan   |       |                  | 381        |                     |       |                          | —     |                          |       |                                    | 3,045      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,045 |   |   |
| Exercises of stock options                                       |       |                  | 1,856      |                     |       |                          | —     |                          |       |                                    | 6,015      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 6,015 |   |   |
| Repurchases of common stock                                      |       |                  | (5,582     | )                        |       |                          | —     |                          |       |                                    | (74,509    | )                      |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (74,509 | ) |   |
| Issuance of restricted stock                                     |       |                  | 575        |                     |       |                          | —     |                          |       |                                    | 11,448     |                   |       |                           | —     |       |   |   | (11,448 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Repurchase of restricted stock                                   |       |                  | (100       | )                        |       |                          | —     |                          |       |                                    | (1,991     | )                      |       |                           | —     |       |   |   | 1,991 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Options assumed in connection with acquisition                   |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 4,325      |                   |       |                           | —     |       |   |   | (1,445 | ) |   |   | — |   |   |   | — |   |   |   | 2,880 |   |   |
| Stock-based compensation                                         |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 24         |                   |       |                           | —     |       |   |   | 2,425 |   |   |   | — |   |   |   | — |   |   |   | 2,449 |   |   |
| Unrealized loss on short-term investments, net  of tax           |       |                  | —     |                     |       |                          | —     |                          |       |                                    | (452       | )                      |       |                           | —     |       |   |   | — |   |   |   | (1,666 | ) |   |   | — |   |   |   | (2,118 | ) |   |
| Foreign currency translation                                     |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | — |   |   |   | 9 |   |   |   | — |   |   |   | 9 |   |   |
| Tax benefits from stock  options                                 |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 8,624      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 8,624 |   |   |
| Net income                                                       |       |                  | —     |                     |       |                          | —     |                          |       |                                    | —     |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | 117,480 |   |   |   | 117,480 |   |   |
| Balance at December 31, 2004                                |       |                  | 61,074     |                     |       |                          | 6          |                          |       |                                    | 491,757    |                   |       |                           | —     |       |   |   | (8,477 | ) |   |   | (9 | ) |   |   | (181,578 | ) |   |   | 301,699 |   |   |
| Issuance of common stock  through employee stock purchase plan   |       |                  | 426        |                     |       |                          | —     |                          |       |                                    | 3,169      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,169 |   |   |
| Exercises of stock options                                       |       |                  | 2,374      |                     |       |                          | —     |                          |       |                                    | 5,874      |                   |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 5,874 |   |   |
| Repurchases of common stock                                      |       |                  | (1,268     | )                        |       |                          | —     |                          |       |                                    | (14,206    | )                      |       |                           | —     |       |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (14,206 | ) |   |
| Issuance of restricted stock  units                              |       |                  | —     |                     |       |                          | —     |                          |       |                                    | 18,033     |                   |       |                           | —     |       |   |   | (18,033 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Cancellation of  restricted stock units                     |       |                  | —     |                     |       |                          | —     |                          |       |                                    | (340       | )                      |       |                           | —     |       |   |   | 340 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Cancellation of options  assumed  in connection with acquisition |       |                  | —     |                     |       |                          | —     |                          |       |                                    | (668       | )                      |       |                           | —     |       |   |   | 668 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |

F-7

----

 

| Dividends paid on  shares outstanding and restricted stock units |   |   | — |   |   |   | — |   |   |   | (38,067 | )      |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (38,067 | )      |   |
|------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|
| Stock-based compensation                                         |   |   | — |   |   |   | — |   |   |   | 8       |   |   |   | — |   |   |   | 9,944  |   |   |   | — |   |   |   | — |   |   |   | 9,952   |   |   |
| Unrealized loss on short-term investments, net  of tax           |   |   | — |   |   |   | — |   |   |   | —  |   |   |   | — |   |   |   | — |   |   |   | (282   | )      |   |   | — |   |   |   | (282    | )      |   |
| Unrealized gain on derivative                                    |   |   | — |   |   |   | — |   |   |   | —  |   |   |   | — |   |   |   | — |   |   |   | 83     |   |   |   | — |   |   |   | 83      |   |   |
| Foreign currency translation                                     |   |   | — |   |   |   | — |   |   |   | —  |   |   |   | — |   |   |   | — |   |   |   | (119   | )      |   |   | — |   |   |   | (119    | )      |   |
| Tax benefits from stock options                                  |   |   | — |   |   |   | — |   |   |   | 7,185   |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 7,185   |   |   |
| Net income                                                       |   |   | — |   |   |   | — |   |   |   | —  |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 47,127 |   |   |   | 47,127  |   |   |

| Balance at  December 31, 2005 |   |   | 62,606 |   |   |   | $ | 6 |   |   |   | $ | 472,745 |   |   |   | $ | — |   |   |   | $ | (15,558 | ) |   |   | $ | (327 | ) |   |   | $ | (134,451 | ) |   |   | $ | 322,415 |   |   |
|------------------------------------|--------|--------|--------|--------|--------|--------|---|---|--------|--------|--------|---|---------|--------|--------|--------|---|--------|--------|--------|--------|---|---------|---|--------|--------|---|------|---|--------|--------|---|----------|---|--------|--------|---|---------|--------|--------|

 

The accompanying notes are an integral part of these consolidated financial statements.

F-8

----

**UNITED ONLINE, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS(in thousands)**

| ** **                                                                                                    | ** ** | **Year Ended   December 31,** | ** ** | **Six Months   Ended   December 31,** | ** ** | **Year   Ended   June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                    | ** ** | **2005**                                     | ** ** | **2004**                                                  | ** ** | **2003**                                   | ** ** | **2003** | ** ** |
| Cash flows from operating  activities:                                                                        |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Net income                                                                                                    |       | $                                            | 47,127     |                                                      | $          | 117,480                                    |       |   | $ | 33,327 |   |   | $ | 27,792 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                            |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Depreciation and amortization                                                                                 |       | 37,280                                       |       | 29,151                                                    |       |                                       | 11,076     |   |   | 27,560 |   |
| Stock-based compensation                                                                                      |       | 9,952                                        |       | 2,449                                                     |       |                                       | —     |   |   | 107 |   |
| Deferred taxes                                                                                                |       | 1,577                                        |       | (61,478                                                   | )          |                                       | (5,632     | ) |   | (4,336 | ) |
| Tax benefits from stock options                                                                               |       | 15,170                                       |       | 25,156                                                    |       |                                       | 7,000      |   |   | 1,464 |   |
| Other                                                                                                         |       | 748                                          |       | 1,005                                                     |       |                                       | 621        |   |   | 866 |   |
| Changes in  operating assets and liabilities (excluding the effects of acquisitions):                         |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                                           |       | (1,669                                       | )          | 220                                                       |       |                                       | (1,645     | ) |   | (2,832 | ) |
| Other assets                                                                                                  |       | 1,806                                        |       | (4,122                                                    | )          |                                       | (3,180     | ) |   | 4,050 |   |
| Accounts payable and accrued liabilities                                                                      |       | 17,677                                       |       | 11,356                                                    |       |                                       | 5,302      |   |   | 6,678 |   |
| Deferred revenue                                                                                              |       | 5,181                                        |       | 848                                                       |       |                                       | 1,023      |   |   | 3,757 |   |
| Other liabilities                                                                                             |       | 2,198                                        |       | 1,895                                                     |       |                                       | —     |   |   | — |   |
| Net cash provided by operating activities                                                                     |       | 137,047                                      |       | 123,960                                                   |       |                                       | 47,892     |   |   | 65,106 |   |
| Cash flows from investing  activities:                                                                        |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Purchases of property and equipment                                                                           |       | (21,653                                      | )          | (12,510                                                   | )          |                                       | (5,075     | ) |   | (5,983 | ) |
| Purchases of rights, patents and trademarks                                                                   |       | (5,562                                       | )          | (926                                                      | )          |                                       | —     |   |   | — |   |
| Purchases of short-term investments                                                                           |       | (320,869                                     | )          | (329,083                                                  | )          |                                       | (228,941   | ) |   | (141,422 | ) |
| Proceeds from maturities and sales of short-term  investments                                                 |       | 353,333                                      |       | 344,519                                                   |       |                                       | 208,130    |   |   | 75,400 |   |
| Proceeds from sales of assets, net                                                                            |       | —                                       |       | 92                                                        |       |                                       | —     |   |   | — |   |
| Proceeds from sale of cost-basis investment                                                                   |       | —                                       |       | —                                                    |       |                                       | —     |   |   | 750 |   |
| Cash paid for acquisitions, net of cash acquired                                                              |       | (8,638                                       | )          | (110,102                                                  | )          |                                       | —     |   |   | (8,388 | ) |
| Net cash used for investing activities                                                                        |       | (3,389                                       | )          | (108,010                                                  | )          |                                       | (25,886    | ) |   | (79,643 | ) |
| Cash flows from financing  activities:                                                                        |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Payments on capital leases                                                                                    |       | (621                                         | )          | (166                                                      | )          |                                       | (34        | ) |   | (2,968 | ) |
| Proceeds from term loan and line of credit, net                                                               |       | —                                       |       | 107,569                                                   |       |                                       | —     |   |   | — |   |
| Payments on term loan                                                                                         |       | (45,792                                      | )          | —                                                    |       |                                       | —     |   |   | — |   |
| Repayment of line of credit                                                                                   |       | —                                       |       | (10,300                                                   | )          |                                       | —     |   |   | — |   |
| Repayment of notes receivable from stockholders                                                               |       | —                                       |       | —                                                    |       |                                       | —     |   |   | 1,653 |   |
| Payments for dividends                                                                                        |       | (38,067                                      | )          | —                                                    |       |                                       | —     |   |   | — |   |
| Proceeds from exercises of stock options                                                                      |       | 5,874                                        |       | 6,015                                                     |       |                                       | 8,971      |   |   | 6,962 |   |
| Proceeds from employee stock purchase plan                                                                    |       | 3,169                                        |       | 3,045                                                     |       |                                       | 1,679      |   |   | 1,862 |   |
| Repurchases of common stock and option shares  exercised                                                      |       | (14,206                                      | )          | (74,509                                                   | )          |                                       | (40,002    | ) |   | (7,777 | ) |
| Net cash provided by (used for) financing activities                                                          |       | (89,643                                      | )          | 31,654                                                    |       |                                       | (29,386    | ) |   | (268 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                                 |       | (130                                         | )          | —                                                    |       |                                       | —     |   |   | — |   |
| Change in cash and cash equivalents                                                                           |       | 43,885                                       |       | 47,604                                                    |       |                                       | (7,380     | ) |   | (14,805 | ) |
| Cash and cash equivalents, beginning of period                                                                |       | 56,512                                       |       | 8,908                                                     |       |                                       | 16,288     |   |   | 31,093 |   |
| Cash and cash equivalents, end of period                                                                      |       | $                                            | 100,397    |                                                      | $          | 56,512                                     |       |   | $ | 8,908 |   |   | $ | 16,288 |   |
| Supplemental disclosure  of cash flows:                                                                       |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Cash paid for interest                                                                                        |       | $                                            | 4,245      |                                                      | $          | 9                                          |       |   | $ | 1 |   |   | $ | 86 |   |
| Cash paid for income taxes                                                                                    |       | 13,970                                       |       | 2,851                                                     |       |                                       | 250        |   |   | 225 |   |
| Supplemental disclosure  of non-cash investing and financing activities:                                      |       |                                         |       |                                                      |       |                                       |       |   |   |   |   |
| Stock option tax benefits recognized in connection  with the release of the deferred tax valuation allowance  |       | $                                            | —     |                                                      | $          | —                                     |       |   | $ | 15,006 |   |   | $ | 3,720 |   |
| Reduction in goodwill and intangibles in connection  with the release of the deferred tax valuation allowance |       | —                                       |       | 20,782                                                    |       |                                       | 1,399      |   |   | — |   |
| Issuance of common  stock and options assumed for acquisitions                                                |       | —                                       |       | 2,880                                                     |       |                                       | —     |   |   | — |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-9

----

**UNITED ONLINE, INC.NOTES TO THECONSOLIDATED FINANCIAL STATEMENTS**

**1. DESCRIPTION OFBUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTACCOUNTING PRONOUNCEMENTS**

**Description of Business**

United Online, Inc. (“United Online” or the “Company”)is a leading provider of consumer Internet subscription services through anumber of brands, including NetZero, Juno and Classmates Online. The Company’ssubscription services include dial-up Internet access, social-networking, VoIPtelephony, personal Web-hosting, premium email, Internet security and onlinedigital photo-sharing, among others. The Company also offersadvertising-supported versions of many of its services at no charge tocustomers. On a combined basis, the Company’s Web properties attract asignificant number of Internet users each month. Advertisers can reach thisaudience through the United Online Media Group, which offers marketers a broadarray of Internet advertising products as well as online market research andmeasurement services.

United Online is a Delaware corporation that commencedoperations in 2001 following the merger of Internet access providers NetZero, Inc.and Juno Online Services, Inc. (the “Merger”). During 2004, the Companycompleted the acquisitions of Classmates Online, Inc. (“Classmates”), aleading provider of social-networking services, and the Web-hosting and domainname registration business of About Web Services, Inc. In March 2005,the Company acquired certain assets related to PhotoSite, the online digitalphoto-sharing business of Homestead Technologies, Inc. The Company’scorporate headquarters are located in Woodland Hills, California, and theCompany also maintains offices in Renton, Washington; New York, New York; Orem,Utah; Brisbane, California; Hyderabad, India and Munich, Germany.

From inception through theyear ended June 30, 2002, the Company and NetZero, as the Company’spredecessor, incurred operating losses and reported negative operating cashflows. In the six months ended December 31, 2003 and the year ended June 30,2003, the Company reported operating income and positive cash flows fromoperations. For the years ended December 31, 2005 and 2004, the Companyreported operating income of $86.6 million and $79.5 million, respectively, andcash flows from operations of $137.0 million and $124.0 million,respectively. At December 31, 2005, the Company had cash and cashequivalents of $100.4 million and short-term investments of$144.0 million. The Company believes that its existing cash, cashequivalents and short-term investments, and cash generated from operations willbe sufficient to fund its working capital requirements, capital expenditures,dividend payments, repayments on its term loan and other obligations through atleast the next twelve months. However, additional capital may be needed inorder to fund the Company’s operations, expand marketing activities, developnew or enhance existing services or products, respond to competitive pressuresor acquire complementary services, businesses or technologies.

**Basis of Presentation**

The accompanyingconsolidated financial statements for the years ended December 31, 2005and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 include United Online and its wholly-owned subsidiaries. Allsignificant intercompany accounts and transactions have been eliminated inconsolidation. The consolidated financial statements, in the opinion ofmanagement, reflect all adjustments (consisting only of normal recurringadjustments) that are necessary for a fair presentation of the results for theperiods shown. The results of operations for such periods are not necessarilyindicative of the results expected for any future periods. The preparation offinancial statements in accordance with generally accepted accountingprinciples (“GAAP”) requires management to make 

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estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent liabilities and the reported amounts of revenues andexpenses. Actual results could differ from those estimates.

**Significant Accounting Policies**

*Useof Estimates—**The*preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andreported amounts of revenues and expenses during the reporting period. Actualresults may differ from those estimates.

*Cash,Cash Equivalents and Short-Term Investments—**The*Company considerscash equivalents to be only those investments which are highly liquid, readilyconvertible to cash and which have a maturity date within ninety days from thedate of purchase. The Company’s short-term investments consist ofavailable-for-sale securities with original maturities exceeding ninety days.Consistent with Statement of Financial Accounting Standards (“SFAS”) No. 115,*Accounting for Certain Investments in Debtand Equity Securities,* the Company has classified these securities,all of which have readily determinable fair values and are highly liquid, asshort term because the sale of such securities may be required prior to maturityto implement management’s strategies. The Company has short-term investmentsprimarily in U.S. commercial paper, U.S. Government or U.S. Government Agencyobligations, municipal obligations, auction rate securities and money marketfunds. The minimum long-term credit rating is A, and if a long-term rating isnot available, the Company requires a minimum short-term credit rating of A1and P1. The Company’s short-term investments are reported at fair value, withunrealized gains and losses, net of taxes, recorded in the consolidatedstatements of comprehensive income. Realized gains or losses and permanentdeclines in value, if any, on available-for-sale securities are reported inother income or expense. The cost basis of a security that has been sold andany amount reclassified out of accumulated other comprehensive income intoearnings was determined by the specific identification method. The Companyrecognized $0.1 million in realized gains during the year ended December 31,2004. The Company had no material realized gains or losses during the yearended December 31, 2005, the six months ended December 31, 2003 andthe year ended June 30, 2003. Significant fluctuations in short-terminterest rates could have a material impact on interest income and unrealizedgains and losses from the Company’s investment portfolio.

The primary objectives of the Company’s short-terminvestment portfolio are preservation of principal and liquidity whilemaximizing yield. Investments are made to achieve the highest possible rate ofreturn for the Company, consistent with these two objectives.

The Company classifies outstanding interest paymentsdue on its short-term investments as interest receivable, the balance of whichis reflected in other current assets.

The Company assesses whether an other-than-temporaryimpairment loss on our investments has occurred due to declines in fair valueor other market conditions. Declines in fair value that are considered otherthan temporary are recorded as an impairment charge in the consolidatedstatements of income. During the years ended December 31, 2005 and 2004,the six months ended December 31, 2003 and the year ended June 30,2003, the Company did not record any impairment charges forother-than-temporary losses.

*RestrictedCash—**Restricted*cash, which is includedin other current assets and other assets, consists of certificates of depositand, in general, collateralizes the Company’s obligations for operating leasesand amounts held in escrow related to certain of the Company’s merchantservices agreements.

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*Concentrationsof Credit and Business Risk—**Financial*instrumentsthat potentially subject the Company to a concentration of credit risk consistof cash and cash equivalents, short-term investments and accounts receivable.The Company’s accounts receivable are derived primarily from revenue earnedfrom pay accounts and advertising customers located in the United States. TheCompany extends credit based upon an evaluation of the customer’s financialcondition and, generally, collateral is not required. The Company maintains anallowance for doubtful accounts based upon the expected collectibility ofaccounts receivable, and, to date, such losses have been within management’sexpectations.

The Company evaluates specific accounts whereinformation exists that the customer may have an inability to meet itsfinancial obligations. In these cases, based on the best available facts andcircumstances, a specific reserve is recorded for that customer against amountsdue to reduce the receivable to the amount that is expected to be collected.These specific reserves are reevaluated and adjusted as additional informationis received that impacts the amount reserved. Also, a general reserve isestablished for all customers based on the aging of the receivables. Ifcircumstances change (i.e., higher than expected defaults or an unexpectedmaterial adverse change in a major customer’s ability to meet its financialobligations), the estimates of the recoverability of amounts due to the Companycould be adjusted.

At December 31, 2005, two customers comprisedapproximately 21% and 12% of the consolidated accounts receivable balance. At December 31,2004, two customers comprised approximately 18% and 14% of the consolidatedaccounts receivable balance. For the years ended December 31, 2005 and2004, the six months ended December 31, 2003 and the year ended June 30,2003, the Company did not have any individual customers that comprised morethan 10% of total revenues.

At December 31, 2005, the majority of the Company’scash and cash equivalents was maintained primarily with three major financialinstitutions in the United States. At December 31, 2004, the majority ofthe Company’s cash and cash equivalents was maintained primarily with fourmajor financial institutions in the United States. Deposits with theseinstitutions generally exceed the amount of insurance provided on suchdeposits.

The Company’s business depends substantially on thecapacity, affordability, reliability and security of third-party telecommunicationsand data service providers. Only a small number of providers offer the networkservices the Company requires, and the majority of its telecommunicationsservices is currently purchased from a limited number of vendors. A number ofthe Company’s historical vendors have ceased operations or ceased offering theservices that the Company requires, causing the need to switch vendors. Inaddition, several vendors have experienced significant financial difficultiesand filed for and emerged from bankruptcy. To the extent vendors experiencefuture difficulties, they may be unable to perform satisfactorily or tocontinue to offer their services. Any material disruption of these servicescould have a material adverse effect on the Company’s financial position,results of operations and cash flows.

*Long-LivedAssets—**Property*and equipment are statedat historical cost less accumulated depreciation. Depreciation is computedusing the straight-line method over the estimated useful lives of the assets,which is generally two to three years for computer software and equipment andthree to seven years for furniture, fixtures and office equipment. Leaseholdimprovements are amortized over the shorter of the lease term or the estimateduseful lives. Upon the sale or retirement of property or equipment, the costand related accumulated depreciation or amortization is removed from theCompany’s financial statements with the resulting gain or loss reflected in theCompany’s results of operations. Repairs and maintenance expenses are expensedas incurred.

Definite-lived identifiable intangible assetsare amortized over their estimated useful lives, ranging from two to ten years.The Company’s intangible assets were acquired primarily in connection withbusiness combinations (see Note 2).

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The Company assesses the impairment of long-livedassets, which include property and equipment and intangible assets, wheneverevents or changes in circumstances indicate that such assets might be impairedand the carrying value may not be recoverable in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*. Events and circumstances that may indicate thatan asset is impaired include significant decreases in the market value of anasset, significant underperformance relative to expected historical orprojected future results of operations, a change in the extent or manner inwhich an asset is used, significant declines in the Company’s stock price for asustained period, shifts in technology, loss of key management or personnel,changes in the Company’s operating model or strategy and competitive forces.

If events and circumstances indicate that the carryingamount of an asset may not be recoverable and the expected undiscounted futurecash flows attributable to the asset are less than the carrying amount of theasset, an impairment loss equal to the excess of the asset’s carrying valueover its fair value is recorded. Fair value is determined based on the presentvalue of estimated expected future cash flows using a discount ratecommensurate with the risk involved, quoted market prices or appraised values,depending on the nature of the assets.

*Goodwill—**The*Company adoptedSFAS No. 142, *Goodwill and OtherIntangible Assets*, on July 1, 2002. Under SFAS No. 142,goodwill is not amortized, but is tested for impairment at a reporting unitlevel on an annual basis and between annual tests if an event occurs orcircumstances change that would more likely than not reduce the fair value of areporting unit below its carrying amount. Events or circumstances which couldtrigger an impairment review include a significant adverse change in legalfactors or in the business climate, an adverse action or assessment by aregulator, unanticipated competition, a loss of key personnel, significantchanges in the manner of the Company’s use of the acquired assets or thestrategy for the Company’s overall business, significant negative industry oreconomic trends, significant declines in the Company’s stock price for a sustainedperiod or significant underperformance relative to expected historical orprojected future results of operations.

The Company determines reporting units by allocatingassets, including goodwill, based on its related service offerings. In testingfor a potential impairment of goodwill, the estimated fair values of theCompany’s reporting units are compared with their respective book values,including goodwill. If the estimated fair value exceeds book value, goodwill isconsidered not to be impaired and no additional steps are necessary. If,however, the fair value of the reporting unit is less than book value, then thecarrying amount of the goodwill is compared with its implied fair value. Theestimate of implied fair value of goodwill may require independent valuationsof certain internally generated and unrecognized intangible assets such as theCompany’s pay account base, software and technology and patents and trademarks.If the carrying amount of goodwill exceeds the implied fair value of that goodwill,an impairment loss would be recognized in an amount equal to the excess. Inaccordance with SFAS No. 142, the Company performed a goodwill impairmenttest during the December 2005 quarter and concluded that, at that time,there was no impairment of goodwill.

At December 31, 2005, goodwill recorded on theCompany’s books totaled $80.5 million. Goodwill increased by $76.5 million and$4.0 million during the years ended December 31, 2004 and 2005,respectively, as a result of acquisitions (see Note 2). The Companyrecorded a reduction in goodwill of $9.5 million during the December 2004quarter in connection with the release of the deferred tax valuation allowance(see Note 3).

*BusinessCombinations—**All*of the Company’s acquisitionshave been accounted for as purchase business combinations. Under the purchasemethod of accounting, the cost, including transaction costs, is allocated tothe underlying net assets, based on their respective estimated fair values. Theexcess of the purchase price over the estimated fair values of the net assetsacquired is recorded as goodwill.

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The judgments made in determining the estimated fairvalue and expected useful lives assigned to each class of assets andliabilities acquired can significantly impact net income. Consequently, to theextent an indefinite-lived or a longer-lived asset is ascribedgreater value under the purchase method than a shorter-lived asset, theremay be less amortization recorded in a given period. Definite-livedidentifiable intangible assets are amortized on either a straight-line basis oran accelerated basis. The Company determines the appropriate amortizationmethod by performing an analysis of expected cash flows over the expecteduseful life of the asset and matches the amortization expense to the expectedcash flows from those assets.

Determining the fair value of certain assets andliabilities acquired is subjective in nature and often involves the use ofsignificant estimates and assumptions. Two areas, in particular, that requiresignificant judgment are estimating the fair value and related useful lives ofidentifiable intangible assets. To assist in this process, the Company mayobtain appraisals from valuation specialists for certain intangible assets.While there are a number of different methods used in estimating the value ofacquired intangibles, there are two approaches primarily used: the discountedcash flow and market comparison approaches. Some of the more significantestimates and assumptions inherent in the two approaches include: projectedfuture cash flows (including timing); discount rate reflecting the riskinherent in the future cash flows; perpetual growth rate; subscriber churn andterminal value; determination of appropriate market comparables; and thedetermination of whether a premium or a discount should be applied tocomparables. Most of the above assumptions are made based on availablehistorical information.

*RevenueRecognition—**The*Company applies the provisionsof Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”)No. 104, *Revenue Recognition inFinancial Statements,* which provides guidance on the recognition,presentation and disclosure of revenue in financial statements filed with theSEC. SAB No. 104 outlines the basic criteria that must be met to recognizerevenue and provides guidance for disclosure related to revenue recognitionpolicies. In general, the Company recognizes revenue related to its billableservices and advertising products when (i) persuasive evidence of anarrangement exists, (ii) delivery has occurred or services have beenrendered, (iii) the fee is fixed or determinable and (iv) collectibilityis reasonably assured. The Company also applies the provisions of EmergingIssues Task Force (“EITF”) Issue No. 00-21, *Revenue Arrangementswith Multiple Deliverables*.

Billable services revenues are recognized in theperiod in which fees are fixed or determinable and the related products orservices are provided to the user. The Company’s pay account users generallypay in advance for their service by credit card, and revenue is then recognizedratably over the period in which the related services are provided. Advancepayments from users are recorded on the balance sheet as deferred revenue. TheCompany offers alternative payment methods to credit cards for certain payservice plans. These alternative payment methods currently include electroniccheck payment, payment by personal check or money order or through a localtelephone company. In circumstances where payment is not received in advance,revenue is only recognized if collectibility is reasonably assured.

Advertising and commerce revenues consist primarily offees from Internet search partners that are generated as a result of usersutilizing partner Internet search services, fees generated by users viewing andclicking on third-party Web site banners and text-link advertisements,fees generated by enabling customer registrations for partners and fees fromreferring users to, or from users making purchases on, sponsors’ Web sites.Revenues are recognized provided that no significant obligations remain, feesare fixed or determinable, and collection of the related receivable isreasonably assured. The Company recognizes banner advertising and sponsorshiprevenues in the periods in which the advertisement or sponsorship placement isdisplayed, based upon the lesser of (i) impressions delivered divided bythe total number of guaranteed impressions or (ii) ratably over the periodin which the advertisement is displayed. The Company’s obligations typicallyinclude a minimum number of impressions or the satisfaction of otherperformance criteria. Revenue from performance-based arrangements,including referral revenues, is recognized as the related performance criteriaare met. In determining whether an arrangement exists, the 

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Company ensures that abinding contract is in place, such as a standard insertion order or a fullyexecuted customer-specific agreement. The Company assesses whetherperformance criteria have been met and whether the fees are fixed ordeterminable based on a reconciliation of the performance criteria and thepayment terms associated with the transaction. The reconciliation of theperformance criteria generally includes a comparison of internally trackedperformance data to the contractual performance obligation and to third-partyor customer performance data in circumstances where that data is available.Probability of collection is assessed based on a number of factors, includingpast transaction history with the customer and the creditworthiness of thecustomer. If it is determined that collection is not reasonably assured,revenue is not recognized until collection becomes reasonably assured, which isgenerally upon receipt of cash.

*Costof Billable Services—**With*respect to Internet accessservices, cost of billable services includes direct costs of billable servicesand Internet access costs that have been allocated to billable services basedon the aggregate hourly usage of pay accounts as a percentage of total hoursused by active accounts. Direct costs consist of costs related to providingtechnical support, customer billing and billing support to pay accounts.Allocated costs consist primarily of telecommunications and data center costs,personnel and overhead-related costs associated with operating theCompany’s network and data centers, and depreciation of network computers andequipment. The Company allocates costs associated with Web hosting and onlinephotos between billable services and free services based on estimated bandwidthused by pay Web-hosting and online photo accounts relative to estimatedbandwidth used by free Web-hosting and online photo accounts. Costs associatedwith the Company’s social networking services are allocated based on the numberof Web site visits by pay accounts relative to the total number of visits.Costs associated with our VoIP telephony service primarily includetelecommunications costs and costs for license fees, customer support anddepreciation.

*Costof Free Services—**With*respect to Internet accessservices, cost of free services includes direct costs incurred in providingcertain technical and customer support services to free access accounts as wellas costs that have been allocated to free services based on the aggregatehourly usage of free access accounts as a percentage of total hours used by theCompany’s active access accounts. Allocated costs consist primarily oftelecommunications and data center costs, personnel and overhead-relatedcosts associated with operating the Company’s network and data centers, anddepreciation of network computers and equipment. The Company allocates costsassociated with Web hosting and online photos between pay services and freeservices based on estimated bandwidth used by free Web-hosting and online photoaccounts. Costs associated with the Company’s social-networking services areallocated based on the number of Web site visits by free accounts relative tothe total number of visits.

*Salesand Marketing—**Sales*and marketing expensesinclude advertising and promotion expenses, fees paid to distribution partnersto acquire new pay and free accounts, personnel-related expenses forsales and marketing personnel and telemarketing costs incurred to acquire payaccounts, retain pay accounts and up-sell pay accounts to additional services,such as the Company’s accelerator services. The Company has expendedsignificant amounts on sales and marketing, including national brandingcampaigns comprised of television, Internet, sponsorships, radio, print andoutdoor advertising and on retail and other performance-baseddistribution relationships. Marketing and advertising costs to promote theCompany’s products and services are expensed in the period incurred.Advertising and promotion expenses include media, agency and promotionexpenses. Media production costs are expensed the first time the advertisementis run. Media and agency costs are expensed over the period the advertisingruns. Advertising and promotion expense for the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 was $159.5 million, $147.1 million, $57.6 million and$67.7 million, respectively. At December 31, 2005 and 2004, $3.6million and $4.3 million, respectively, of prepaid advertising andpromotion expense was included in other current assets.

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*ProductDevelopment Costs—**The*Company capitalizes certaincosts incurred for the development of software. Product development expensesinclude expenses for the maintenance of existing software and the developmentof new or improved software and technology, including personnel-relatedexpenses for the software engineering department and the costs associated withoperating the Company’s facility in India. Costs incurred by the Company tomanage, monitor and operate the Company’s services are generally expensed asincurred, except for certain costs relating to the acquisition and developmentof internal-use software that are capitalized and depreciated over theirestimated useful lives, generally three years or less.

*Generaland Administrative—**General*and administrative expensesinclude personnel-related expenses for executive, finance, legal, humanresources and internal customer support personnel. In addition, general andadministrative expenses include fees for professional, legal, accounting andfinancial services, non-income taxes, insurance, and occupancy and otheroverhead-related costs, as well as the expenses incurred and creditsreceived as a result of certain legal settlements.

*Stock-BasedCompensation—**The*Company accounts for stock-basedemployee compensation arrangements in accordance with the provisions ofAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*,Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”)44, *Accounting for Certain TransactionsInvolving Stock Compensation*, and EITF Issue No. 00-23,*Issues Related to the Accounting for StockCompensation under APB Opinion No. 25 and FIN No. 44* andcomplies with the disclosure provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*and SFAS No. 148, *Accounting for Stock-BasedCompensation—Transition and Disclosure, an amendment of FASB Statement No. 123*.Under APB Opinion No. 25, employee stock-based compensation expenseis recognized over the vesting period based on the difference, if any, on thedate of grant, between the fair value of the Company’s stock and the exerciseprice. The Company accounts for stock issued to non-employees in accordancewith the provisions of SFAS No. 123 and EITF Issue No. 96-18, *Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices*. Compensation expense is recorded in accordance with FIN28, *Accounting for Stock Appreciation Rightsand Other Variable Stock Option or Award Plans, an interpretation of APBOpinions No. 15 and 25.*

As required by SFAS No. 148, the followingprovides pro forma net income and pro forma net income per common sharedisclosures for stock-based awards as if the fair-value-based methoddefined in SFAS No. 123 had been applied.

Foreach option granted up to and including September 23, 1999, the Companycalculated the minimum fair value on the date of grant using the minimum valueoption-pricing model as prescribed by SFAS No. 123. The fair valueof the options granted subsequent to September 23, 1999 has been estimatedat the date of grant using the Black-Scholes option-pricing model,using the following weighted-average assumptions:

| ** **                | ** ** | **Year Ended  December 31,** | ** ** | **Six Months  Ended  December 31,** | ** ** | **Year Ended  June 30,** | ** ** |
|---------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                | ** ** | **2005**                               | ** ** | **2004**                                      | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Risk-free  interest rate  |       |                                   | 4          | %                                             |       |                               | 3          | % |   |   | 3 | % |   |   | 2 | % |   |
| Expected life (in  years) |       |                                   | 5          |                                          |       |                               | 5          |   |   |   | 5 |   |   |   | 5 |   |   |
| Dividend yield            |       |                                   | 2          | %                                             |       |                               | 0          | % |   |   | 0 | % |   |   | 0 | % |   |
| Volatility                |       |                                   | 92         | %                                             |       |                               | 103        | % |   |   | 107 | % |   |   | 110 | % |   |

 

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If thefair value based method had been applied in measuring stock-basedcompensation expense, the pro forma effect on net income and net income pershare would have been as follows (in thousands, except per share amounts):

| ** **                                                                                                   | ** ** | **Year Ended  December 31,** | ** ** | **Six Months  Ended  December 31,** | ** ** | **Year Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                               | ** ** | **2004**                                      | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Net income, as  reported                                                                                     |       | $                                      | 47,127     |                                          | $          | 117,480                            |       |   | $ | 33,327 |   |   |   | $ | 27,792 |   |   |
| Add: Stock-based  compensation included in net income, net of tax                                            |       | 8,264                                  |       | 2,449                                         |       |                               | —     |   |   |   | 107 |   |   |
| Deduct: Total  stock-based compensation determined under fair value-based method  for all awards, net of tax |       | (23,360                                | )          | (12,712                                       | )          |                               | (12,510    | ) |   |   | (21,600 | ) |   |
| Pro forma net  income                                                                                        |       | $                                      | 32,031     |                                          | $          | 107,217                            |       |   | $ | 20,817 |   |   |   | $ | 6,299 |   |   |
| Net income per  share—basic, as reported                                                                |       | $                                      | 0.77       |                                          | $          | 1.91                               |       |   | $ | 0.52 |   |   |   | $ | 0.45 |   |   |
| Net income per  share—basic, pro forma                                                                  |       | $                                      | 0.52       |                                          | $          | 1.75                               |       |   | $ | 0.32 |   |   |   | $ | 0.10 |   |   |
| Net income per  share—diluted, as reported                                                              |       | $                                      | 0.74       |                                          | $          | 1.81                               |       |   | $ | 0.48 |   |   |   | $ | 0.41 |   |   |
| Net income per  share—diluted, pro forma                                                                |       | $                                      | 0.50       |                                          | $          | 1.64                               |       |   | $ | 0.30 |   |   |   | $ | 0.09 |   |   |

 

The weighted average grant-date fair value of optionsgranted was $7.08, $13.75, $16.29 and $13.04 per share for the years endedDecember 31, 2005 and 2004, the six months ended December 31, 2003and the year ended June 30, 2003, respectively.

During the year ended December 31, 2005, theCompany issued 1.7 million restricted stock units (“RSUs”) with a weightedaverage grant-date fair value of $10.77. During the year ended December 31,2004, the Company issued 0.6 million shares of restricted stock with a weightedaverage grant-date fair value of $19.91.

*ComprehensiveIncome—**SFAS*No. 130, *Reporting Comprehensive Income,*establishes standards for reporting comprehensive income and its components infinancial statements. Comprehensive income, as defined, includes all changes inequity (net assets) during a period from non-owner sources. For the Company,comprehensive income consists of its reported net income, the net unrealizedgains or losses on short-term investments and derivatives and foreign currencytranslation.

*DebtIssuance Costs—**Debt*issuance costs are amortizedover the duration of the related term loan using the effective interest method.The Company capitalized debt issuance costs totaling $0.1 million and $1.7million during the years ended December 31, 2005 and 2004. AtDecember 31, 2005, debt issuance costs of $1.5 million were included inother current assets and other assets. During the years ended December 31,2005 and 2004, the Company amortized $1.2 million and $28,000 of debt issuancecosts, respectively.

*ForeignCurrency—**The*functional currency of theCompany’s international subsidiaries is the local currency. The financialstatements of these subsidiaries are translated to U.S. dollars usingperiod-end rates of exchange for assets and liabilities, and average rates ofexchange for the period for revenues and expenses. Translation gains and lossesare recorded in accumulated other comprehensive income as a component ofstockholders’ equity. Net gains and losses resulting from foreign exchangetransactions were not significant during the periods presented.

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*IncomeTaxes—**Income*taxes are accounted forunder SFAS No. 109, *Accounting forIncome Taxes*. Under SFAS No. 109, deferred tax assets andliabilities are determined based on differences between the financial reportingand tax basis of assets and liabilities and are measured using the enacted taxrates and laws that will be in effect when the differences are expected toreverse. A valuation allowance is established when necessary to reduce deferredtax assets to the amount expected to be realized.

*EarningsPer Share—**Basic*earnings per share iscomputed using the weighted average number of common shares outstanding duringthe period, net of shares subject to repurchase rights, and excludes anydilutive effects of options or warrants, restricted stock, RSUs and convertiblesecurities, if any. Diluted earnings per share is computed using the weightedaverage number of common stock and common stock equivalent shares outstanding(including the effect of restricted stock) during the period. Common stockequivalent shares are excluded from the computation if their effect isantidilutive.

*LegalContingencies—**The*Company is currently involvedin certain legal proceedings. The Company records liabilities related topending litigation when an unfavorable outcome is probable and management canreasonably estimate the amount of loss. The Company has not recordedliabilities for certain pending litigation because of the uncertainties relatedto assessing both the amount and the probable outcome of those claims. Asadditional information becomes available, the Company continually assesses thepotential liability related to all pending litigation.

*Segments—**In*accordance withSFAS No. 131, *Disclosures aboutSegments of an Enterprise and Related Information*, the Companyoperates in one principal operating segment, a provider of consumer Internetsubscription services through a number of brands, including NetZero, Juno, andClassmates Online. The Company’s pay services include dial-up Internetaccess, social-networking, VoIP telephony, personal Web-hosting, onlinedigital photo sharing and premium email services, among others. The Companyalso offers, at no charge, advertising supported versions of certain of itsservices. In addition, the Company offers marketers a broad array of Internetadvertising products and services, including online market research andmeasurement services. The vast majority of the Company’s revenues and relatedresults of operations and identifiable assets are in the United States ofAmerica.

*StockSplits—**On*September 24, 2003, theCompany announced that its Board of Directors had declared a 3-for-2split of the Company’s common stock. The split was effected in the form of astock dividend. The new shares were issued on October 31, 2003, and theshares began trading on NASDAQ on a post-split basis on November 3, 2003.All prior period share and per share amounts herein have been restated toaccount for the stock dividend.

*Reclassifications—**Certain*prior yearamounts have been reclassified to conform to current year presentation. Thesechanges had no impact on previously reported results of operations orstockholders’ equity.

**Recent Accounting Pronouncements**

In December 2004, the FASB issued SFAS No. 123R,*Share-Based Payment*. Thisstatement replaces SFAS No. 123 and supersedes APB Opinion No. 25.This statement requires that the cost resulting from all share-based paymenttransactions be recognized in the financial statements. This statementestablishes fair value as the measurement objective in accounting for share-basedpayment arrangements and requires all entities to apply a fair-value-basedmeasurement method in accounting for share-based payment transactions withemployees except for equity instruments held by employee share ownership plans.This statement also establishes fair value as the measurement objective fortransactions in which an entity acquires goods or services from non employeesin share-based payment transactions. This statement uses the terms compensationand payment in their broadest senses to refer to the consideration paid forgoods or services, regardless of whether the supplier is an employee.

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The Company will be required to determine thetransition method to be used at the date of adoption. The allowed transitionmethods are the modified prospective application and the modified retrospectiveapplication. Under the modified prospective application, this statement appliesto new awards and to awards modified, repurchased, or cancelled after therequired effective date. Additionally, compensation cost for the portion ofawards for which the requisite service has not been rendered that areoutstanding as of the required effective date will be recognized as therequisite service is rendered on or after the required effective date. Thecompensation cost for that portion of awards shall be based on the grant-datefair value of those awards as calculated for either recognition or pro formadisclosures under SFAS No. 123. The modified retrospective applicationrequires companies to record compensation expense for all unvested stockoptions and restricted stock beginning with the first disclosed periodrestated. At the required effective date, the Company will apply this statementusing the modified prospective application.

The Company has selected the Black-Scholesoption-pricing model as the most appropriate fair-value method for its awardsand will recognize compensation cost on an accelerated basis over the awards’vesting periods in accordance with FIN 28. SFAS No. 123R becomes effectivein the March 2006 quarter, and the Company expects that the adoption ofSFAS No. 123R will have a material impact on the Company’s operatingincome, net income and earnings per share. However, uncertainties, includingthe Company’s future stock-based compensation strategy, stock price volatility,estimated forfeitures and employee stock option exercise behavior, make itdifficult to determine whether the stock-based compensation expense that theCompany will incur in future periods will be similar to the SFAS No. 123pro forma expense disclosed in Note 1. In addition, the amount of stock-basedcompensation expense to be incurred in future periods will be reduced by theacceleration of certain unvested and “out-of-the-money” stock options in December 2005as disclosed in Note 8.

In March 2005, the SEC issued SAB No. 107, *Share-Based Payment*. The interpretationsin this SAB express views of the staff regarding the interaction betweenSFAS No. 123R and certain SEC rules and regulations and provide thestaff’s views regarding the valuation of share-based payment arrangements forpublic companies. In particular, this SAB provides guidance related toshare-based payment transactions with non employees, the transition fromnonpublic to public entity status, valuation methods (including assumptionssuch as expected volatility and expected term), the accounting for certainredeemable financial instruments issued under share-based payment arrangements,the classification of compensation expense, non-GAAP financial measures,capitalization of compensation cost related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS No. 123R, the modification of employeeshare options prior to adoption of SFAS No. 123R and disclosures inManagement’s Discussion and Analysis (“MD&A”) subsequent to adoption ofSFAS No. 123R.

In June 2005, theFASB issued SFAS No. 154, *AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3*. SFAS No. 154 changes the requirements forthe accounting for and reporting of a change in accounting principle andapplies to all voluntary changes in accounting principle. APB Opinion No. 20previously required that most voluntary changes in accounting principle berecognized by including in net income of the period of change the cumulativeeffect of changing to the new accounting principle. SFAS No. 154 requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. When it isimpracticable to determine the period-specific effects of an accounting changeon one or more individual prior periods presented, SFAS No. 154 requiresthat the new accounting principle be applied to the balances of assets andliabilities as of the beginning of the earliest period for which retrospectiveapplication is practicable and that a corresponding adjustment be made to theopening balance of retained earnings for that period rather than being reportedin an income statement. When it is impracticable to determine the cumulativeeffect of applying a change in accounting principle to all prior periods, SFAS No. 154requires that the new 

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accountingprinciple be applied as if it were adopted prospectively from the earliest datepracticable. In addition, SFAS No. 154 makes a distinction betweenretrospective application of an accounting principle and the restatement offinancial statements to reflect the correction of an error. SFAS No. 154is effective for accounting changes and corrections of errors made beginning inthe March 2006 quarter. The Company does not expect the implementation ofSFAS No. 154 to have a material impact on the Company’s financialposition, results of operations or cash flows.

**2.**   ACQUISITIONS

*PhotoSite*

In March 2005, the Company acquired certainassets related to PhotoSite, the online digital photo-sharing business ofHomestead Technologies, Inc., for approximately $10.1 million in cash,including acquisition costs, and entered into a related licensing and supportagreement with Homestead Technologies. Included in the purchase price of $10.1million is a $1.5 million payment due in March 2006, which is included inaccrued liabilities at December 31, 2005. The acquisition was accountedfor under the purchase method in accordance with SFAS No. 141, *Business Combinations*. The primary reasonfor the acquisition was to acquire PhotoSite’s software and services to expandthe Company’s subscription offerings.

Thepurchase price was allocated to the net assets acquired based on theirestimated fair values, including identifiable intangible assets. The purchaseprice allocation is considered final. The following table summarizes the netliabilities assumed and the intangible assets and goodwill acquired inconnection with the acquisition (in thousands):

| **Description**                  | ** ** | ** ** | ** ** | **Estimated  Fair  Value** | ** ** | **Estimated  Amortizable  Life** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------|------------|----------------------------------|------------|
| Net liabilities  assumed:        |       |       |       |                       |       |                             |       |   |   |
| Property and equipment           |       |       | $          | 4                          |       |                             |       |   |   |   |
| Deferred revenue                 |       |       | (190       | )                          |       |                             |       |   |   |
| Total net liabilities assumed    |       |       | (186       | )                          |       |                             |       |   |   |
| Intangible assets  acquired:     |       |       |       |                       |       |                             |       |   |   |
| Pay accounts                     |       |       | 330        |                       |       |                             | 2 years    |   |   |
| Proprietary rights               |       |       | 20         |                       |       |                             | 5 years    |   |   |
| Software and technology          |       |       | 4,200      |                       |       |                             | 5 years    |   |   |
| Total intangible assets acquired |       |       | 4,550      |                       |       |                             |       |   |   |
| Goodwill                         |       |       | 5,738      |                       |       |                             |       |   |   |
| Total purchase  price            |       |       | $          | 10,102                     |       |                             |       |   |   |   |

 

The weighted averageamortizable life of the acquired intangible assets is 4.8 years. The $5.7million of goodwill acquired is deductible for tax purposes. The pro formaeffect of the transaction is immaterial to the consolidated financialstatements.

*Classmates Online, Inc.*

In November 2004, the Company acquiredClassmates, which operates Classmates.com (www.classmates.com), connectingmillions of members throughout the U.S. and Canada with friends andacquaintances from school, work and the military. Its Classmates Internationalsubsidiary also operates leading community-based networking sites inSweden (www.klasstraffen.com), and in Germany (www.stayfriends.de). Theacquisition was accounted for under the purchase method in accordance with SFASNo. 141. The primary reason for the acquisition was to acquire Classmates’services and account 

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base to continue to expandthe Company’s subscription offerings. Classmates’ results of operations areincluded in the consolidated financial statements from the date of acquisition.

Thepurchase price of approximately $131.4 million, including acquisitioncosts of $3.1 million for professional, accounting, legal and administrativefees, was allocated to Classmates’ net assets based on their fair values. Theexcess of the purchase price over the estimated fair values of the net assetsacquired, including identifiable intangible assets, was recorded as goodwill.The Company assumed 0.5 million unvested options as of the acquisitiondate, and the fair value of the options assumed was determined based on theBlack-Scholes option pricing model using a weighted average expected lifeof five years, 0% dividend, volatility of 99%, and a risk-free interest rate of3%. The following table summarizes the purchase price (in thousands):

| Cash                                 |   | $      | 125,453 |   |
|--------------------------------------|--------|--------|---------|--------|
| Fair value of  options assumed       |   | 4,325  |    |
| Intrinsic value  of unvested options |   | (1,445 | )       |
| Acquisition costs                    |   | 3,065  |    |
| Total purchase price                 |   | $      | 131,398 |   |

 

Thefollowing table summarizes the net liabilities assumed and goodwill andintangible assets acquired in connection with the acquisition of Classmates (inthousands):

| **Description**                                 | ** ** | ** ** | ** ** | **Estimated  Fair Value** | ** ** | **Estimated  Amortizable  Life** | ** ** |
|-------------------------------------------------|------------|------------|------------|--------------------------------|------------|----------------------------------|------------|
| Net liabilities  assumed:                       |       |       |       |                           |       |                             |       |
| Cash                                            |       | $          | 30,350     |                           |       |                             |       |   |
| Accounts receivable                             |       | 3,396      |       |                           |       |                             |       |
| Property and equipment                          |       | 9,700      |       |                           |       |                             |       |
| Other assets                                    |       | 2,384      |       |                           |       |                             |       |
| Accounts payable and accrued liabilities        |       | (6,742     | )          |                           |       |                             |       |
| Deferred revenue                                |       | (23,757    | )          |                           |       |                             |       |
| Deferred income taxes                           |       | (14,170    | )          |                           |       |                             |       |
| Capital leases                                  |       | (1,485     | )          |                           |       |                             |       |
| Other long-term liabilities                     |       | (286       | )          |                           |       |                             |       |
| Total net liabilities assumed                   |       | (610       | )          |                           |       |                             |       |
| Intangible assets  acquired:                    |       |       |       |                           |       |                             |       |
| Trademark and trade name                        |       | 13,800     |       |                           | 10 years   |                             |       |
| Advertising contracts and related relationships |       | 7,200      |       |                           | 3.5 years  |                             |       |
| Pay accounts                                    |       | 21,700     |       |                           | 4 years    |                             |       |
| Free accounts                                   |       | 21,500     |       |                           | 10 years   |                             |       |
| Other intangibles                               |       | 536        |       |                           | 7 years    |                             |       |
| Total intangible assets acquired                |       | 64,736     |       |                           |       |                             |       |
| Goodwill                                        |       | 67,272     |       |                           |       |                             |       |
| Total purchase  price                           |       | $          | 131,398    |                           |       |                             |       |   |

 

The weighted average amortizable life of acquireddefinite-lived intangible assets is 7.2 years. The goodwill is notdeductible for tax purposes.

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Thefollowing summarized unaudited pro forma financial information assumes that theacquisition of Classmates had occurred at the beginning of each of the periodspresented (in thousands, except per share amounts).

| ** **                         | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| Revenues                           |       | $                                      | 513,300    |   | $ | 417,642 |   |
| Net income                         |       | $                                      | 111,882    |   | $ | 51,189 |   |
| Net income per  share—basic   |       | $                                      | 1.82       |   | $ | 0.81 |   |
| Net income per  share—diluted |       | $                                      | 1.70       |   | $ | 0.74 |   |

 

*About Web Services*

In April 2004, the Company acquired substantiallyall of the assets associated with the Web-hosting business of About, Inc.The business offers consumers Web-site services, including hosting, domain andemail services. The acquisition has been accounted for under the purchasemethod in accordance with SFAS No. 141. The primary reason for theacquisition was to acquire About, Inc.’s Web-hosting services and accountbase in order to expand the Company’s service offerings.

Thepurchase price of approximately $11.9 million was paid in cash andallocated to the net assets acquired based on their estimated fair values,including identifiable intangible assets. The following table summarizes thenet liabilities assumed and the intangible assets and goodwill acquired inconnection with the acquisition (in thousands):

| **Description**                  | ** ** | ** ** | ** ** | **Estimated  Fair Value** | ** ** | **Estimated  Amortizable  Life** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------|------------|----------------------------------|------------|
| Net liabilities assumed:         |       |       |       |                           |       |                             |       |   |   |
| Accounts receivable              |       |       | $          | 292                            |       |                             |       |   |   |   |
| Property and equipment           |       |       | 199        |                           |       |                             |       |   |   |
| Other assets                     |       |       | 69         |                           |       |                             |       |   |   |
| Accounts payable                 |       |       | (215       | )                              |       |                             |       |   |   |
| Deferred revenue                 |       |       | (1,710     | )                              |       |                             |       |   |   |
| Total net liabilities assumed    |       |       | (1,365     | )                              |       |                             |       |   |   |
| Intangible assets  acquired:     |       |       |       |                           |       |                             |       |   |   |
| Pay accounts                     |       |       | 3,190      |                           |       |                             | 4 years    |   |   |
| Proprietary rights               |       |       | 400        |                           |       |                             | 7 years    |   |   |
| Software and technology          |       |       | 2,220      |                           |       |                             | 3 years    |   |   |
| Total intangible assets acquired |       |       | 5,810      |                           |       |                             |       |   |   |
| Goodwill                         |       |       | 7,489      |                           |       |                             |       |   |   |
| Total purchase  price            |       |       | $          | 11,934                         |       |                             |       |   |   |   |

 

The weighted averageamortizable life of acquired intangible assets is 3.8 years. The$7.5 million of goodwill acquired is deductible for tax purposes. The proforma effect of the transaction is immaterial to the consolidated financialstatements.

*BlueLight*

On November 4, 2002, the Company acquired theInternet access assets of BlueLight. The acquisition has been accounted forunder the purchase method in accordance with SFAS No. 141. The primaryreason for the acquisition was to acquire BlueLight’s pay account base in orderto accelerate the Company’s pay account growth and leverage its operating andcost infrastructure.

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The purchase priceof approximately $8.4 million, including $0.1 million of acquisition-relatedcosts, was paid in cash and allocated to the assets acquired based on theirestimated fair values, including identifiable intangible assets. The followingtable summarizes the net assets and intangible assets acquired in connectionwith the acquisition (in thousands):

| **Description**                    | ** ** | ** ** | ** ** | **Estimated  Fair Value** | ** ** | **Estimated  Amortizable  Life** | ** ** |
|------------------------------------|------------|------------|------------|--------------------------------|------------|----------------------------------|------------|
| Net tangible assets  acquired:     |       |       |       |                           |       |                             |       |   |   |
| Accounts receivable                |       |       | $          | 1,611                          |       |                             |       |   |   |   |
| Property and equipment             |       |       | 585        |                           |       |                             |       |   |   |
| Accounts payable                   |       |       | (649       | )                              |       |                             |       |   |   |
| Deferred service liabilities       |       |       | (1,044     | )                              |       |                             |       |   |   |
| Total net tangible assets acquired |       |       | 503        |                           |       |                             |       |   |   |
| Intangible assets  acquired:       |       |       |       |                           |       |                             |       |   |   |
| Pay accounts                       |       |       | 7,500      |                           |       |                             | 4 years    |   |   |
| Proprietary rights                 |       |       | 235        |                           |       |                             | 3 years    |   |   |
| Software and technology            |       |       | 150        |                           |       |                             | 2.5 years  |   |   |
| Total intangible assets acquired   |       |       | 7,885      |                           |       |                             |       |   |   |
| Total purchase  price              |       |       | $          | 8,388                          |       |                             |       |   |   |   |

 

The weighted averageamortizable life of acquired intangible assets is 3.9 years. The pro formaeffect of the transaction is immaterial to the consolidated financial statements.

**3. BALANCE SHEET COMPONENTS**

**Short-Term Investments**

Short-term investments consist of the following (inthousands):

| ** **            | ** ** | **December 31, 2005** | ** ** |
|-----------------------|------------|---------------------------------|------------|
| ** **            | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. corporate  notes |       | $                               | 28,143     |   |   | $ | 3 |   |   |   | $ | (10 | ) |   | $ | 28,136 |   |
| Government  agencies  |       | 116,321                         |       |   | — |   |   |   | (492 | ) |   | 115,829 |   |
| Total                 |       | $                               | 144,464    |   |   | $ | 3 |   |   |   | $ | (502 | ) |   | $ | 143,965 |   |

 

| ** **            | ** ** | **December 31, 2004** | ** ** |
|-----------------------|------------|---------------------------------|------------|
| ** **            | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. corporate  notes |       | $                               | 10,055     |   |   | $ | 110 |   |   |   | $ | — |   |   | $ | 10,165 |   |
| Government  agencies  |       | 166,250                         |       |   | 76 |   |   |   | (210 | ) |   | 166,116 |   |
| Total                 |       | $                               | 176,305    |   |   | $ | 186 |   |   |   | $ | (210 | ) |   | $ | 176,281 |   |

 

Gross unrealized gains and losses are presented net oftax in accumulated other comprehensive income on the consolidated balancesheets. The Company recognized $0.1 million of realized gains from thesale of short-term investments in the year ended December 31, 2004. TheCompany had no material realized gains or losses from the sale of short-terminvestments in the year ended December 31, 2005, six months ended December 31,2003 and the year ended June 30, 2003.

 

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Thefollowing table summarizes the fair value and gross unrealized losses of ourshort-term investments, aggregated by type of investment instrument and lengthof time that individual securities have been in a continuous unrealized lossposition, at December 31, 2005 (in thousands):

| ** **            | ** ** | **Less than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**       | ** ** |
|-----------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|-----------------|------------|
| ** **            | ** ** | **Fair  Value**                        | ** ** | **Gross  Unrealized  Losses**           | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. corporate  notes |       | $                                      | 26,132     |                                    |       | $               | (10        | ) |   | $ | — |   |   | $ | — |   |   | $ | 26,132 |   |   | $ | (10 | ) |   |
| Government  agencies  |       | 33,990                                 |       |                                    | (172       | )               |       | 19,819 |   |   | (320 | ) |   | 53,809 |   |   | (492 | ) |   |
| Total                 |       | $                                      | 60,122     |                                    |       | $               | (182       | ) |   | $ | 19,819 |   |   | $ | (320 | ) |   | $ | 79,941 |   |   | $ | (502 | ) |   |

 

Our investment portfolio consists of both corporateand government securities that have a maximum maturity of three years. Thelonger the duration of these securities, the more susceptible they are tochanges in market interest rates and bond yields. As yields increase, thosesecurities purchased with a lower yield-at-cost show a mark-to-marketunrealized loss. All unrealized losses are due to changes in interest rates andbond yields. We expect to realize the full value of all these investments uponmaturity or sale.

Maturitiesof short-term investments were as follows (in thousands):

| ** **                           | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Amortized  Cost**             | ** ** | **Estimated  Fair Value**  | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Maturing within 1  year              |       | $                               | 39,119     |                            | $          | 39,091 |   | $ | 29,159 |   | $ | 29,158 |   |
| Maturing between  1 year and 4 years |       | 39,995                          |       | 39,584                          |       | 62,854 |   | 62,832 |   |
| Maturing after 4  years              |       | 65,350                          |       | 65,290                          |       | 84,292 |   | 84,291 |   |
| Total                                |       | $                               | 144,464    |                            | $          | 143,965 |   | $ | 176,305 |   | $ | 176,281 |   |

 

**Property andEquipment**

Propertyand equipment consists of the following (in thousands):

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Computer software  and equipment |       | $                     | 90,357     |   | $ | 70,329 |   |
| Furniture and  fixtures          |       | 11,351                |       | 10,077 |   |
|                             |       | 101,708               |       | 80,406 |   |
| Less: accumulated  depreciation  |       | (68,615               | )          | (53,400 | ) |
| Total                            |       | $                     | 33,093     |   | $ | 27,006 |   |

 

Depreciation expense forthe years ended December 31, 2005 and 2004, the six months ended December 31,2003 and the year ended June 30, 2003 was $15.5 million,$8.7 million, $3.1 million and $11.1 million, respectively.Assets under capital leases are included in computer software and equipment. AtDecember 31, 2005, the amount capitalized and the related accumulateddepreciation were $1.3 million and $0.7 million, respectively. At December 31,2004, the amount capitalized and the related accumulated depreciation were$1.3 million and $0.1 million, respectively.

F-24

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**Goodwill and Intangible Assets**

Thechanges in goodwill for the years ended December 31, 2004 and 2005 were asfollows (in thousands):

| Balance at  December 31, 2003                          |   | $      | 9,541  |   |
|-------------------------------------------------------------|--------|--------|--------|--------|
| Goodwill recorded in connection with acquisitions           |   | 76,458 |   |
| Recognition of acquired deferred tax assets                 |   | (9,541 | )      |
| Balance at  December 31, 2004                          |   | 76,458 |   |
| Adjustments to Classmates’ goodwill                    |   | (1,697 | )      |
| Goodwill recorded in connection with PhotoSite  acquisition |   | 5,738  |   |
| Balance at  December 31, 2005                          |   | $      | 80,499 |   |

 

The adjustment to Classmates’ goodwill is primarilydue to an increase in deferred tax assets for tax benefits associated withexpense deductions and a reduction in deferred tax liabilities due to anadjustment in the state income tax rate expected to apply to future reversalsof acquired book/tax basis differences.

Intangibleassets consist of the following (in thousands):

| ** **                                       | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **Cost**                        | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Pay accounts and  free accounts                  |       | $                               | 98,732     |   |   | $ | (66,103 | ) |   | $ | 32,629 |   |
| Trademarks and  trade names                      |       | 21,952                          |       |   | (4,254 | ) |   | 17,698 |   |
| Advertising  contracts and related relationships |       | 7,200                           |       |   | (3,871 | ) |   | 3,329 |   |
| Software and  technology                         |       | 9,280                           |       |   | (4,691 | ) |   | 4,589 |   |
| Patents, domain  names and other                 |       | 3,247                           |       |   | (2,154 | ) |   | 1,093 |   |
| Total                                            |       | $                               | 140,411    |   |   | $ | (81,073 | ) |   | $ | 59,338 |   |

 

| ** **                                       | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **Cost**                        | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Pay accounts and  free accounts                  |       | $                               | 98,402     |   |   | $ | (51,736 | ) |   | $ | 46,666 |   |
| Trademarks and  trade names                      |       | 15,952                          |       |   | (1,879 | ) |   | 14,073 |   |
| Advertising  contracts and related relationships |       | 7,200                           |       |   | (527 | ) |   | 6,673 |   |
| Software and  technology                         |       | 4,970                           |       |   | (3,285 | ) |   | 1,685 |   |
| Patents, domain  names and other                 |       | 3,309                           |       |   | (1,848 | ) |   | 1,461 |   |
| Total                                            |       | $                               | 129,833    |   |   | $ | (59,275 | ) |   | $ | 70,558 |   |

 

The Company recorded a reduction in intangible assetsof approximately $11.2 million during the December 2004 quarter inconnection with the release of the deferred tax valuation allowance.

Amortization expense for the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 was $21.8 million, $20.4 million, $7.9 million and$16.4 million, respectively.

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Estimatedfuture amortization expense at December 31, 2005 is as follows (inthousands):

| ** ** | ** ** | **Year Ending  December 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| 2006       |       |                                    | $          | 15,922 |   |   |
| 2007       |       |                                    | 10,268     |   |   |
| 2008       |       |                                    | 7,211      |   |   |
| 2009       |       |                                    | 6,395      |   |   |
| 2010       |       |                                    | 4,862      |   |   |
| Thereafter |       |                                    | 14,680     |   |   |
| Total      |       |                                    | $          | 59,338 |   |   |

 

**Accrued Liabilities**

Accruedliabilities consist of the following (in thousands):

| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Employee  compensation and related expenses |       | $                     | 20,353     |   | $ | 11,459 |   |
| Income taxes payable                        |       | 9,769                 |       | 1,119 |   |
| Subscriber  referral fees                   |       | 4,281                 |       | 4,281 |   |
| Other                                       |       | 1,846                 |       | 1,461 |   |
| Total                                       |       | $                     | 36,249     |   | $ | 18,320 |   |

 

**Line of Credit**

In December 2003, United Online obtained aone-year $25 million unsecured revolving line of credit from a bank thatwas to expire in December 2004. This facility was available for generalcorporate purposes and the interest rates on borrowings were based on currentmarket rates. The line of credit contained covenants pertaining to themaintenance of a minimum quick ratio, minimum cash balances with the lender andminimum profitability levels. The line of credit provided additional workingcapital to support the Company’s growth and overall business strategy.

In November 2004, theCompany borrowed $10.3 million from the line of credit and repaid theamount on the same business day. No interest expense was incurred related tothe borrowing. The line of credit was canceled in December 2004 inconnection with the signing of the term loan agreement under which the Companyborrowed $100 million.

**Term Loan and Interest Rate Cap**

In December 2004, the Company borrowed $100million through a term loan facility dated December 3, 2004. A smallportion of the proceeds of the term loan facility were used to purchase sharestendered pursuant to the Company’s tender offer and pay related fees andexpenses. The funds are available for general corporate purposes, stockrepurchases and acquisitions, subject to certain limitations.

The term loan matures in four years and amortizes inan annual amount of $23.3 million in years one, two and three and $30 millionin year four, payable in quarterly installments. Any voluntarily prepaymentsmade by the Company will reduce, on a pro-rata basis, the remaining outstandingamortization payments. The Company has the option to maintain the term loan aseither base rate loans or Eurodollar loans, but at no time shall there beoutstanding more than four Eurodollar loans. Interest on the loans outstandingunder the term loan facility will be payable, at the Company’s option, at (a) abase rate equal to the higher of (i) the prime rate plus a margin of 2%and (ii) 0.50% in excess of the overnight federal funds rate plus a 

F-26

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margin of 2% or (b) ata eurodollar rate generally equal to LIBOR with a maturity comparable to a selectedinterest period, plus a margin of 3%.

The Company may make optional prepayments of the termloan, in whole or in part (subject to a minimum prepayment amount), withoutpremium or penalty, and subject to the reimbursement of lenders’ customarybreakage costs in the case of a prepayment of Eurodollar borrowings. Subject tocertain limitations, the Company is required to make prepayments of a portionof the term loan from excess cash flow (commencing in the first quarter of2006), proceeds of asset sales, insurance recovery and condemnation events andthe issuance of equity and debt. During the year ended December 31, 2005,the Company made voluntary prepayments of $28.8 million on the term loan whichreduced future principal repayments on a pro rata basis.

The facility is collateralized by substantially all ofthe Company’s assets and is unconditionally guaranteed by each of the Company’sdomestic subsidiaries.

The credit agreement contains certain financial andother covenants that place restrictions on additional indebtedness by theCompany, liens against the Company’s assets, payment of dividends,consolidation, merger, purchase or sale of assets, capital expenditures,investments and acquisitions. At December 31, 2005, the Company was incompliance with all covenants.

The credit agreement also includes certain customaryevents of default such as payment defaults, cross defaults to otherindebtedness, bankruptcy and insolvency, and a change in control, theoccurrence of which would cause all amounts under the agreement to becomeimmediately due and payable. At December 31, 2005, no events of defaulthad occurred.

On January 31, 2005, the Company purchased aninterest-rate cap to reduce the variability in the amount of expected futurecash interest payments that are attributable to LIBOR-based market interestrates. The interest-rate cap is designated and qualifies as a cash flow hedge.The Company paid a $0.2 million premium to enter into the cap, which providesprotection through January 31, 2007 on $25 million of the Company’soutstanding term loan balance. The cap protects the Company from an increase inthree month LIBOR over 3.5% on $25 million of borrowings over a two-year term.Changes in the fair value of the effective portion of the cap are recognized inaccumulated other comprehensive income. Should the cap become ineffective as ahedge, gains and losses would be recognized in the results of operations inthat period. The Company recognized an unrealized gain of approximately $0.1million in accumulated other comprehensive income during the year ended December 31,2005 related to the effective portion of the cash flow hedge as the cap wasconsidered perfectly effective during the year ended December 31, 2005.Amounts in accumulated other comprehensive income will be reclassified intoearnings in the same periods during which the future hedged cash interestpayments affect earnings.

Futureminimum principal payments on the term loan are as follows at December 31,2005 (in thousands):

| ** ** | ** ** | **Year Ending  December 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| 2006       |       |                                    | $          | 16,498 |   |   |
| 2007       |       |                                    | 16,498     |   |   |
| 2008       |       |                                    | 21,212     |   |   |
| Total      |       |                                    | $          | 54,208 |   |   |

 

In January 2006, theCompany paid, in full, the outstanding balance on the term loan ofapproximately $54.2 million. Effective upon payment of the outstanding balance,the Credit Agreement terminated and is of no further force or effect. Inconnection with the repayment of the term loan in January 2006, we soldthe interest rate cap.

F-27

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**4. STOCKHOLDERS’ EQUITY**

*Stockholders’Rights Plan*

On November 15, 2001,the Board of Directors declared a dividend of one preferred share purchaseright for each outstanding share of its common stock. The dividend was paid on November 26,2001 to the stockholders of record at the close of business on that date. Eachright entitles the registered holder to purchase from the Company one unitconsisting of one one-thousandth of a share of its Series A juniorparticipating preferred stock at a price of $25 per unit. On April 29,2003, the Board of Directors voted to amend the purchase price per unit from$25 to $140. The rights generally will be exercisable only if a person or groupacquires beneficial ownership of 15% or more of the Company’s common stock orannounces a tender or exchange offer which results in a person owning 15% ormore of the Company’s common stock. The Company generally will be entitled toredeem the rights at $0.0007 per right at any time until 10 days after apublic announcement that a 15% position in the Company’s common stock has beenacquired or that a tender or exchange offer which would result in a personowning 15% or more of the Company’s common stock has commenced. The rightsexpire on November 26, 2011.

*Preferred Stock*

The Company has5.0 million shares of preferred stock authorized with a par value of$0.0001, of which 300,000 shares are designated as Series A juniorparticipating preferred stock. At December 31, 2005 and 2004, the Companyhad no shares issued or outstanding.

*Common StockSubject to Repurchase*

At December 31, 2005and 2004, there were 475,000 shares of common stock that were subject torepurchase related to unvested shares under restricted stock agreements.

*Common StockRepurchase Program*

The Company’s Board of Directors authorized a commonstock repurchase program that allows the Company to repurchase shares of itscommon stock through open market or privately negotiated transactions based onprevailing market conditions and other factors. From time to time, the Board ofDirectors has increased the amount authorized for repurchase under this program.On April 22, 2004, the Board of Directors authorized the Company topurchase up to an additional $100 million of its common stock throughMay 31, 2005 under the program, bringing the total amount authorized underthe program to $200 million. On April 29, 2005, the Board of Directorsextended the program through December 31, 2006. At December 31, 2005,the Company had repurchased $139.2 million of its common stock under theprogram.

Under the term loan agreement, repurchases of commonstock and the payment of cash dividends were limited, in aggregate, to anadditional $97.3 million at December 31, 2005, subject to further annuallimitations. In January 2006, we the Company paid, in full, theoutstanding balance of the term loan of approximately $54.2 million. Effectiveupon payment of the outstanding balance, the Credit Agreement terminated and isof no further force or effect.

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Sharerepurchases executed under the common stock repurchase program at December 31,2005 were as follows (in thousands, except per share amounts):

| **Period**         | ** ** | ** ** | ** ** | **Shares  Repurchased(1)** | ** ** | **Average Price  Paid per Share** | ** ** | **Maximum Approximate  Dollar Value that May  Yet be Purchased Under the  Program** | ** ** |
|--------------------|------------|------------|------------|----------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|
| August 2001   |       |       | 138        |                       |       |                                             | $          | 1.67                                                                                                                        |       |   |   | $ | 9,770 |   |   |
| November 2001 |       |       | 469        |                       |       |                                             | 1.77       |                                                                                                                        |       |   | 8,940 |   |   |
| February 2002 |       |       | 727        |                       |       |                                             | 3.38       |                                                                                                                        |       |   | 6,485 |   |   |
| August 2002   |       |       | 288        |                       |       |                                             | 7.51       |                                                                                                                        |       |   | 27,820 |   |   |
| February 2003 |       |       | 193        |                       |       |                                             | 9.43       |                                                                                                                        |       |   | 26,005 |   |   |
| May 2003      |       |       | 281        |                       |       |                                             | 13.51      |                                                                                                                        |       |   | 22,207 |   |   |
| November 2003 |       |       | 2,024      |                       |       |                                             | 19.76      |                                                                                                                        |       |   | 48,706 |   |   |
| February 2004 |       |       | 2,887      |                       |       |                                             | 16.86      |                                                                                                                        |       |   | — |   |   |
| May 2004      |       |       | —     |                       |       |                                             | —     |                                                                                                                        |       |   | 100,000 |   |   |
| August 2004   |       |       | 2,657      |                       |       |                                             | 9.41       |                                                                                                                        |       |   | 74,989 |   |   |
| February 2005 |       |       | 1,268      |                       |       |                                             | 11.20      |                                                                                                                        |       |   | 60,782 |   |   |
| Total              |       |       | 10,932     |                       |       |                                             | $          | 12.74                                                                                                                       |       |   |   |   |   |   |

----

(1)          Allshares were repurchased as part of a publicly announced program.

*Dividends*

In May, August and October of 2005, theCompany’s Board of Directors declared a quarterly cash dividend of $0.20 pershare of common stock. The quarterly dividends were paid on May 31, 2005, August 31,2005 and November 30, 2005 and totaled $12.6 million, $12.7 million and$12.8 million, respectively.

The Company’s Board of Directors declared a quarterlydividend in February 2006, which was paid on February 28, 2006 andtotaled $12.9 million.

The payment of future dividends is discretionary andwill be subject to determination by the Board of Directors each quarter followingits review of the Company’s financial performance. Dividends declared and paidare not a return of profits but rather a distribution of amounts paid in by thestockholders.

Under the term loanagreement, repurchases of common stock and the payment of cash dividends werelimited, in aggregate, to an additional $97.3 million at December 31,2005, subject to further annual limitations. In January 2006, the Companypaid, in full, the outstanding balance of the term loan of approximately $54.2million. Effective upon payment of the outstanding balance, the CreditAgreement terminated and is of no further force or effect.

*Tender Offer*

In November 2004, theCompany commenced a modified Dutch auction tender offer to repurchase up to14.3 million shares of its common stock at a price ranging from $9.00 to$10.50 per share. The tender offer expired in December 2004, and theCompany repurchased 37,662 shares at $10.50 per share, excluding fees andexpenses.

F-29

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*Accumulated OtherComprehensive Income (Loss)*

Accumulatedother comprehensive income (loss) is as follows (in thousands):

| ** **                         | ** ** | **Unrealized  gain (loss) on  short-term  investments,  net of tax** | ** ** | **Unrealized  gain on  derivative,  net of tax** | ** ** | **Foreign  currency  translation** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** |
|------------------------------------|------------|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------|------------|
| Balance at  June 30, 2002     |       |                                                                                     | $          | 1,015                                                           |       |                               |       | $                                                         | —     |   |   |   | $ | — |   |   |   | $ | 1,015 |   |   |
| Current period change              |       |                                                                                     | 1,429      |                                                            |       |                               | —     |                                                      |       |   | — |   |   |   | 1,429 |   |   |
| Balance at  June 30, 2003     |       |                                                                                     | 2,444      |                                                            |       |                               | —     |                                                      |       |   | — |   |   |   | 2,444 |   |   |
| Current period change              |       |                                                                                     | (796       | )                                                               |       |                               | —     |                                                      |       |   | — |   |   |   | (796 | ) |   |
| Balance at  December 31, 2003 |       |                                                                                     | 1,648      |                                                            |       |                               | —     |                                                      |       |   | — |   |   |   | 1,648 |   |   |
| Current period change              |       |                                                                                     | (1,666     | )                                                               |       |                               | —     |                                                      |       |   | 9 |   |   |   | (1,657 | ) |   |
| Balance at  December 31, 2004 |       |                                                                                     | (18        | )                                                               |       |                               | —     |                                                      |       |   | 9 |   |   |   | (9 | ) |   |
| Current period change              |       |                                                                                     | (282       | )                                                               |       |                               | 83         |                                                      |       |   | (119 | ) |   |   | (318 | ) |   |
| Balance at  December 31, 2005 |       |                                                                                     | $          | (300                                                            | )          |                               |       | $                                                         | 83         |   |   |   | $ | (110 | ) |   |   | $ | (327 | ) |   |

 

**5. NET INCOME PERSHARE**

Thefollowing table sets forth the computation of basic and diluted net income pershare for the years ended December 31, 2005 and 2004, the six months endedDecember 31, 2003 and the year ended June 30, 2003 (in thousands,except per share amounts):

| ** **                                                                           | ** ** | **Year Ended December 31,**                                       | ** ** | **Six Months Ended  December 31,**                                | ** ** | **Year Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                           | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Numerator:                                                                           |       |                                                                             |       |                                                                             |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                           |       |                                                                             | $          | 47,127                                                                           |       |                               |       | $ | 117,480 |   |   |   | $ | 33,327 |   |   |   | $ | 27,792 |   |   |
| Denominator:                                                                         |       |                                                                             |       |                                                                             |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average  common shares—basic                                           |       |                                                                             | 61,641     |                                                                             |       |                               | 62,012     |   |   |   | 64,419 |   |   |   | 62,148 |   |   |
| Adjustment to  weighted average for common shares subject to repurchase         |       |                                                                             | (506       | )                                                                                |       |                               | (608       | ) |   |   | (256 | ) |   |   | (460 | ) |   |
| Adjusted weighted  average common shares—basic                                  |       |                                                                             | 61,135     |                                                                             |       |                               | 61,404     |   |   |   | 64,163 |   |   |   | 61,688 |   |   |
| Effect of  dilutive securities:                                                      |       |                                                                             |       |                                                                             |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Stock options,  restricted shares, warrants and employee stock purchase plan  shares |       |                                                                             | 2,680      |                                                                             |       |                               | 3,608      |   |   |   | 5,341 |   |   |   | 5,386 |   |   |
| Weighted average  common shares—  diluted                                       |       |                                                                             | 63,815     |                                                                             |       |                               | 65,012     |   |   |   | 69,504 |   |   |   | 67,074 |   |   |
| Net income per  share—basic                                                     |       |                                                                             | $          | 0.77                                                                             |       |                               |       | $ | 1.91 |   |   |   | $ | 0.52 |   |   |   | $ | 0.45 |   |   |
| Net income per  share—diluted                                                   |       |                                                                             | $          | 0.74                                                                             |       |                               |       | $ | 1.81 |   |   |   | $ | 0.48 |   |   |   | $ | 0.41 |   |   |

 

The diluted per sharecomputations exclude options, unvested common stock and warrants, which areantidilutive. The number of antidilutive shares at December 31, 2005, 2004and 2003 and June 30, 2003 was 6.8 million, 6.4 million,1.1 million and 4.8 million, respectively.

F-30

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**6. EMPLOYEE BENEFIT PLANS**

The Company has a savingsplan (the “Savings Plan”) that qualifies as a defined contribution plan under Section 401(k) ofthe Internal Revenue Code (the “Code”). Under the Savings Plan, participatingemployees may defer a percentage (not to exceed 40%) of their eligible pretaxearnings up to the Internal Revenue Service annual contribution limit. Allfull-time employees on the payroll of the Company are eligible to participatein the Plan. At December 31, 2004, the Company had made no contributionssince the inception of the Savings Plan; however, on January 1, 2005, theCompany began matching 25% of the employee’s contributions, up to plan limits.The Company recognized expenses of approximately $0.6 million during the yearended December 31, 2005 related to the 401(k) match.

**7. INCOME TAXES**

Theprovision (benefit) for income taxes for the years ended December 31, 2005and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 is comprised of the following (in thousands):

| ** **                            | ** ** | **Year Ended December 31,**                           | ** ** | **Six Months Ended  December 31,**                    | ** ** | **Year Ended  June 30,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                            | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Current:                              |       |                                                                 |       |                                                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Federal                               |       |                                                                 | $          | 33,043                                                               |       |                               | $          | 23,385 |   |   | $ | 6,038 |   |   |   | $ | — |   |   |
| State                                 |       |                                                                 | 5,625      |                                                                 |       | 4,042                              |       |   | 1,313 |   |   |   | 2,555 |   |   |
|                                  |       |                                                                 | 38,668     |                                                                 |       | 27,427                             |       |   | 7,351 |   |   |   | 2,555 |   |   |
| Deferred:                             |       |                                                                 |       |                                                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Federal                               |       |                                                                 | (4,684     | )                                                                    |       | 2,577                              |       |   | 5,675 |   |   |   | 8,734 |   |   |
| State                                 |       |                                                                 | 3,529      |                                                                 |       | 3,423                              |       |   | 985 |   |   |   | (863 | ) |   |
| Change in valuation allowance         |       |                                                                 | 2,732      |                                                                 |       | (67,478                            | )          |   | (12,292 | ) |   |   | (12,207 | ) |   |
|                                  |       |                                                                 | 1,577      |                                                                 |       | (61,478                            | )          |   | (5,632 | ) |   |   | (4,336 | ) |   |
| Provision (benefit)  for income taxes |       |                                                                 | $          | 40,245                                                               |       |                               | $          | (34,051 | ) |   | $ | 1,719 |   |   |   | $ | (1,781 | ) |   |

 

Thefollowing is a reconciliation of the statutory federal income tax rate to theCompany’s effective income tax rate (in thousands):

| ** **                                       | ** ** | **Year Ended December 31,**                           | ** ** | **Six Months Ended   December 31,**              | ** ** | **Year Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                       | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Taxes on income  at the statutory federal rate   |       |                                                                 | $          | 30,580                                                               |       |                               | $          | 29,200 |   |   | $ | 12,266 |   |   |   | $ | 9,104 |   |   |
| State income  taxes, net of federal tax benefits |       |                                                                 | 4,454      |                                                                 |       | 4,853                              |       |   | 1,493 |   |   |   | 1,100 |   |   |
| Re-measurement of  net deferred tax assets       |       |                                                                 | 2,473      |                                                                 |       | 4                                  |       |   | — |   |   |   | — |   |   |
| Other  differences, net                          |       |                                                                 | 6          |                                                                 |       | (630                               | )          |   | 252 |   |   |   | 222 |   |   |
| Change in  valuation allowance                   |       |                                                                 | 2,732      |                                                                 |       | (67,478                            | )          |   | (12,292 | ) |   |   | (12,207 | ) |   |
| Provision (benefit) for  income taxes            |       |                                                                 | $          | 40,245                                                               |       |                               | $          | (34,051 | ) |   | $ | 1,719 |   |   |   | $ | (1,781 | ) |   |

 

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For the year ended December 31, 2005, the Companyrecorded a tax provision of $40.2 million on pre-tax income of $87.4 million,resulting in an effective tax rate of 46.1%. The effective tax rate differsfrom the statutory rate primarily due to compensation, including stock-basedcompensation, that is limited under Section 162(m) of the Code;foreign losses, the benefit of which is not currently recognizable due touncertainty regarding realization; and the re-measurement of net deferred taxassets, including a change in New York State tax law.

For the year ended December 31, 2004, the Companyrecorded a tax benefit of $34.1 million on pre-tax income of$83.4 million, resulting in an effective tax rate benefit of 40.8%. Theeffective tax rate differs from the statutory rate primarily due to the releaseof substantially all of the balance of the valuation allowance attributable tothe expected utilization of net deferred tax assets in the future.

For the six months ended December 31, 2003, theCompany recorded a tax provision of $1.7 million on pre-tax income of$35.0 million, resulting in an effective tax rate of 4.9%. The effectivetax rate differs from the statutory tax rate primarily due to the release ofthe valuation allowance attributable to the expected utilization of netoperating loss and tax credit carryforwards in the years ending December 31,2004 and 2005, offset by state income taxes. In September 2002, the Stateof California enacted legislation that suspended the utilization of netoperating loss carryforwards to offset current taxable income for a two-yearperiod beginning in the year ended June 30, 2003. As a result, the Companyrecorded a California state income tax provision for the period.

For the year ended June 30, 2003, the Companyrecorded a tax benefit of $1.8 million on pre-tax income of$26.0 million for an effective tax rate benefit of 6.8%. The effective taxrate benefit differs from the statutory tax rate primarily due to the releaseof the valuation allowance attributable to the actual utilization of netoperating loss carryforwards, the benefit of which had not been previouslyrecognized, as well as the expected utilization of net operating loss and taxcredit carryforwards in the period ended June 30, 2004, offset by stateincome taxes.

Componentsof the deferred tax assets, liability and related valuation allowance at December 31,2005 and 2004 are as follows (in thousands):

| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax assets:                                |       |                  |       |   |   |
| Net operating loss carryforwards                    |       | $                     | 74,459     |   | $ | 93,602 |   |
| Depreciation and amortization                       |       | 2,126                 |       | 2,708 |   |
| Stock-based compensation                            |       | 4,817                 |       | 992 |   |
| Other                                               |       | 8,725                 |       | 5,398 |   |
| Total deferred tax assets                           |       | 90,127                |       | 102,700 |   |
| Less: valuation allowance                           |       | (4,670                | )          | (1,938 | ) |
| Total deferred tax assets after valuation allowance |       | 85,457                |       | 100,762 |   |
| Deferred tax liability:                             |       |                  |       |   |   |
| Amortization of acquired intangible assets          |       | (17,102               | )          | (24,559 | ) |
| Total deferred tax liability                        |       | (17,102               | )          | (24,559 | ) |
| Net deferred tax  assets                            |       | $                     | 68,355     |   | $ | 76,203 |   |

 

The decrease in the Company’s net deferred tax assetsduring the year ended December 31, 2005 of $7.8 million is primarilyattributable to the utilization of net operating loss carryforwards, partiallyoffset by the utilization of deferred tax liabilities recorded in connectionwith the acquisition of Classmates.

The increase in the Company’s net deferred tax assetsduring the year ended December 31, 2004 of $49.8 million is primarilyattributable to the release of the valuation allowance, offset to a certainextent by 

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the current utilization ofnet operating loss carryforwards and net deferred tax liabilities recorded inconnection with the acquisition of Classmates.

The increase in the valuation allowance of $2.7million during the year ended December 31, 2005 is attributable tocompensation that is expected to be limited under Section 162(m) ofthe Code and foreign losses, the benefit of which is not currently recognizabledue to uncertainty regarding utilization. Consistent with prior periods, indetermining the need for a valuation allowance related to the Company’sdeferred tax assets at December 31, 2005, the Company reviewed bothpositive and negative evidence pursuant to the requirements of SFAS No. 109,including current and historical results of operations, the annual limitationon utilization of net operating loss carryforwards pursuant to Section 382of the Code, future income projections and potential tax-planning strategies. Basedupon the Company’s assessment of all available evidence, it concluded that,primarily with the exception of certain foreign net operating losses, it ismore likely than not that the remaining deferred tax assets will be realized.This conclusion is based primarily on the Company’s trend of profitableoperations and current financial projections that indicate the continuedgeneration of taxable income in future periods and utilization of deferred taxassets. The Company will continue to monitor all available evidence inassessing the realization of its deferred tax assets in future periods,including recognizing an amount of taxable income during the carryforwardperiod that equals or exceeds the Section 382 limitation.

The decrease in the valuation allowance of$85.3 million during the year ended December 31, 2004 is primarilyattributable to the release of the valuation allowance due to the expectationthat the Company will realize its deferred tax assets in the future.

In accordance with APB Opinion No. 23, *Accounting for Income Taxes—Special Areas*, the Company hasnot recognized federal deferred income taxes on the undistributed earnings ofcertain of its foreign subsidiaries that are indefinitely reinvested outsidethe U.S. The Company has indefinitely reinvested approximately $1.2 million ofthe cumulative undistributed earnings of certain foreign subsidiaries, of which$0.4 million was earned during the year ended December 31, 2005. If theseearnings were distributed, a U.S. income tax liability would result.

At December 31, 2005,the Company had net operating loss and tax credit carryforwards for federal andstate income tax purposes of approximately $192 million and$249 million, respectively, which begin to expire in 2018 and 2007,respectively. With respect to the state net operating losses, certain amountswill be further reduced pursuant to the state allocation and apportionmentlaws. These carryforwards have been adjusted to reflect limitations under Section 382of the Code. The Company has also claimed income tax deductions from theexercise of certain stock options and the related sale of common stock byemployees, and for the years ended December 31, 2005 and 2004, the six monthsended December 31, 2003 and the year ended June 30, 2003, benefits of$7.2 million, $8.6 million, $18.3 million and $5.2 million,respectively, were credited to stockholders’ equity.

**8. STOCKOPTIONS AND STOCK ISSUANCE PLANS**

*Option Plans*

In September 2001, the Board of Directors adoptedthe United Online, Inc. 2001 Stock Incentive Plan (the “2001 SIP”). The2001 SIP is a shareholder-approved plan under which nonstatutory andincentive stock options, as well as direct stock issuances, may be granted toemployees, officers, directors and consultants of the Company. An aggregate of19.9 million shares have been reserved under the 2001 SIP, of which1.0 million shares were available for future grant at December 31,2005, and 9.0 million options and 1.6 million RSUs were outstanding at December 31,2005.

In September 2001, the Board of Directors alsoadopted the United Online, Inc. 2001 Supplemental Stock Incentive Plan(the “2001 SSIP”). The 2001 SSIP is a non-shareholder approved plan under which

F-33

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nonstatutory stock optiongrants or direct stock issuances may be made to employees of the Company (orany parent or subsidiary corporation) who are neither officers nor Boardmembers at the time of the option grant or direct issuance. An aggregate of4.4 million shares have been reserved under the 2001 SSIP, of whichapproximately 40,000 shares were available for future grant at December 31,2005, and 1.7 million options were outstanding at December 31, 2005.

In November 2004, the Company assumed theClassmates Online, Inc. Amended and Restated 1999 Stock Plan (the “Classmates1999 Stock Plan”) and the Classmates Online, Inc. 2004 Stock Plan (the “Classmates2004 Stock Plan”), including all unvested and outstanding options under suchplans. No future grants are permissible under the Classmates 1999 Stock Plan,although shares underlying options cancelled under the Classmates 1999 StockPlan will become available for grant under the Classmates 2004 Stock Plan.Nonstatutory options and direct stock issuances may be made under theClassmates 2004 Stock Plan (i) to employees, directors and officers ofClassmates or its subsidiaries whose service commenced prior to the date of theacquisition and (ii) to employees, consultants, directors and executiveofficers of United Online or its subsidiaries whose service commenced orcommences following the date of the acquisition. An aggregate of approximately0.4 million shares have been reserved under the Classmates 1999 StockPlan, of which approximately 60,000 options remained outstanding at December 31,2005. An aggregate of 1.1 million shares have been reserved under theClassmates 2004 Stock Plan of which 0.3 million shares were available forfuture grant and 0.8 million options were outstanding at December 31,2005. The Classmates 1999 Plan provides that the shares underlying any optionswhich are forfeited upon termination of employment will become available forissuance under the Classmates 2004 Plan and will accordingly increase thenumber of shares of our common stock issuable under that plan.

Options granted to employees under the Plans generallyvest over a three or four-year period. Options granted to directors generallyvest over a nine-month to three-year period, either monthly or annually. Optiongrants expire after ten years unless cancelled earlier due to termination ofemployment or Board service. Certain grants are immediately exercisable forunvested shares of common stock, with the unvested portion of the sharesremaining subject to repurchase by the Company at the exercise price until thevesting period is complete.

F-34

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The following tablesummarizes activity under the Plans during the year ended June 30, 2003,the six months ended December 31, 2003 and the years ended December 31,2004 and 2005 (in thousands, except per share amounts):

| ** **                                     | ** ** | **Number  of Shares** | ** ** | **Price  Per Share** | ** ** | **Weighted  Average  Exercise Price** | ** **      |
|------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|--------------------------------------------|-----------------|
| Options outstanding  at June 30, 2002     |       |                       | 15,217     |                      |       | $                                          | 0.11 -  $118.54 |   |   | $ | 7.83 |   |   |
| Granted                                        |       |                       | 3,306      |                      |       | 5.73 - 17.97                               |            |   | 16.42 |   |   |
| Exercised                                      |       |                       | (2,682     | )                         |       | 0.11 - 16.81                               |            |   | 2.63 |   |   |
| Canceled                                       |       |                       | (1,106     | )                         |       | 0.84 - 75.42                               |            |   | 16.29 |   |   |
| Options  outstanding at June 30, 2003     |       |                       | 14,735     |                      |       | 0.11 - 118.54                              |            |   | 9.98 |   |   |
| Granted                                        |       |                       | 292        |                      |       | 16.73 - 27.47                              |            |   | 20.69 |   |   |
| Exercised                                      |       |                       | (1,698     | )                         |       | 0.84 - 24.27                               |            |   | 5.22 |   |   |
| Canceled                                       |       |                       | (122       | )                         |       | 1.23 - 72.29                               |            |   | 9.25 |   |   |
| Options  outstanding at December 31, 2003 |       |                       | 13,207     |                      |       | 0.11 - 118.54                              |            |   | 10.83 |   |   |
| Assumed in  connection with acquisition        |       |                       | 540        |                      |       | 2.16 - 9.59                                |            |   | 5.09 |   |   |
| Granted                                        |       |                       | 1,818      |                      |       | 9.25 - 20.38                               |            |   | 17.83 |   |   |
| Exercised                                      |       |                       | (1,856     | )                         |       | 0.84 - 18.33                               |            |   | 3.24 |   |   |
| Canceled                                       |       |                       | (479       | )                         |       | 1.23 - 101.25                              |            |   | 14.37 |   |   |
| Options  outstanding at December 31, 2004 |       |                       | 13,230     |                      |       | 0.11 - 118.54                              |            |   | 12.50 |   |   |
| Granted                                        |       |                       | 2,541      |                      |       | 8.76 - 14.47                               |            |   | 11.20 |   |   |
| Exercised                                      |       |                       | (2,374     | )                         |       | 0.33 - 12.61                               |            |   | 2.47 |   |   |
| Canceled                                       |       |                       | (1,769     | )                         |       | 0.84 - 84.58                               |            |   | 18.71 |   |   |
| Options outstanding at  December 31, 2005 |       |                       | 11,628     |                      |       | $                                          | 0.11 - $118.54  |   |   | $ | 13.31 |   |   |

 

Additionalinformation with respect to the outstanding options at December 31, 2005is as follows (in thousands, except per share amounts):

| ** **           | ** ** | **Options Outstanding** | ** ** | ** **         | ** ** |
|----------------------|------------|------------------------------|------------|--------------------|------------|
| ** **           | ** ** | ** **                   | ** ** | ** **         | ** ** | **Weighted Average** | ** ** | ** ** | ** ** | **Options Exercisable** | ** ** |
| ** **           | ** ** | ** **                   | ** ** | **Number**         | ** ** | **Remaining** | ** ** | **Average Exercise** | ** ** | **Number** | ** ** | **Average Exercise** | ** ** |
| **Prices**           | ** ** | ** **                   | ** ** | **of Shares** | ** ** | **Contractual Life** | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
| $0.11 – $2.00   |       |                         | 1,135      |               |       |   | 5.7 |   |   |   | $ | 1.23 |   |   |   | 1,135 |   |   |   | $ | 1.23 |   |   |
| 2.01 – 5.00     |       |                         | 1,012      |               |       |   | 5.0 |   |   |   | 3.23 |   |   |   | 991 |   |   |   | 3.21 |   |   |
| 5.01 – 10.00    |       |                         | 2,078      |               |       |   | 6.5 |   |   |   | 6.24 |   |   |   | 1,839 |   |   |   | 6.11 |   |   |
| 10.01 – 13.00   |       |                         | 2,175      |               |       |   | 9.0 |   |   |   | 11.05 |   |   |   | 384 |   |   |   | 11.98 |   |   |
| 13.01 – 16.00   |       |                         | 320        |               |       |   | 9.0 |   |   |   | 13.92 |   |   |   | 85 |   |   |   | 13.98 |   |   |
| 16.01 – 20.00   |       |                         | 4,090      |               |       |   | 7.5 |   |   |   | 18.19 |   |   |   | 4,090 |   |   |   | 18.19 |   |   |
| 20.01 – 30.00   |       |                         | 313        |               |       |   | 5.6 |   |   |   | 24.53 |   |   |   | 313 |   |   |   | 24.53 |   |   |
| 30.01 – 50.00   |       |                         | 305        |               |       |   | 4.1 |   |   |   | 39.57 |   |   |   | 305 |   |   |   | 39.57 |   |   |
| 50.01 – 118.54  |       |                         | 200        |               |       |   | 4.1 |   |   |   | 72.35 |   |   |   | 200 |   |   |   | 72.35 |   |   |
| $0.11 – $118.54 |       |                         | 11,628     |               |       |   | 7.1 |   |   |   | $ | 13.31 |   |   |   | 9,342 |   |   |   | $ | 13.94 |   |   |

 

The number of option shares exercisable atDecember 31, 2005, 2004 and 2003 and June 30, 2003 were 9.3 million,10.8 million, 9.5 million and 10.3 million, respectively withweighted average exercise prices of $13.94, $12.98, $11.35 and $10.61,respectively.

F-35

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Options granted during the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 did not result in any deferred stock-based compensation. RSUs issuedduring the year ended December 31, 2005 resulted in total deferredstock-based compensation of $18.0 million, which was included in deferredstock-based compensation in stockholders’ equity. Restricted stock awardsissued during the year ended December 31, 2004 resulted in total deferredstock-based compensation of $11.4 million, which was included indeferred stock-based compensation in stockholders’ equity. In December 2004,the Company repurchased 100,000 restricted shares of common stock in connectionwith the resignation of an executive officer and reversed $2.0 million ofthe $11.4 million in deferred stock-based compensation. Deferredstock-based compensation is recognized over the service period. Duringthe years ended December 31, 2005 and 2004, the six months ended December 31,2003 and the year ended June 30, 2003, compensation expense included inthe statement of operations amounted to $10.0 million, $2.4 million, $0and $0.1 million, respectively.

Thefollowing table summarizes the stock-based compensation that has beenincluded in the following captions for each of the periods presented (inthousands):

| ** **                      | ** ** | **Year Ended December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** | **Year Ended  June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004**                                          | ** ** | **2003**                           | ** ** | **2003** | ** ** |
| Operating expenses:             |       |                                       |       |                                              |       |                               |       |   |   |   |   |   |   |
| Cost of billable  services      |       | $                                          | 183        |                                              | $          | 16                                 |       |   | $ | — |   |   |   | $ | 8 |   |   |
| Sales and  marketing            |       | 954                                        |       | 76                                                |       |                               | —     |   |   |   | 20 |   |   |
| Product  development            |       | 1,069                                      |       | 32                                                |       |                               | —     |   |   |   | 6 |   |   |
| General and  administrative     |       | 7,746                                      |       | 2,325                                             |       |                               | —     |   |   |   | 73 |   |   |
| Total stock-based  compensation |       | $                                          | 9,952      |                                              | $          | 2,449                              |       |   | $ | — |   |   |   | $ | 107 |   |   |

 

*Acceleration ofStock Options*

In December 2005, the Company’s CompensationCommittee of the Board of Directors approved the acceleration of vesting of alloptions to purchase the Company’s common stock with exercise prices in excessof $16.00. These options were granted to executive officers and other employeesof the Company under the Company’s 2001 Stock Incentive Plan and 2001Supplemental Stock Incentive Plan. Options to purchase 1.3 million shares ofthe Company’s common stock were subject to this acceleration and such options hadexercise prices ranging from $16.01 to $64.17, and had a weighted averageexercise price of $18.47.

The acceleration ofvesting of these out-of-the-money options was undertaken primarily to eliminateany future compensation expense the Company would otherwise recognize in itsincome statement with respect to these options with the implementation of SFAS No. 123Reffective January 1, 2006. The Company estimated this compensationexpense, before tax, would have totaled approximately $3.8 million over thecourse of the original vesting periods. Ninety five percent of the optionswould have vested within approximately 1.5 years from the effective date of theacceleration with the remaining 5% vesting within approximately 2.5 years fromthe date of acceleration. The Company also believed that because the options tobe accelerated had exercise prices in excess of the current market value of theCompany’s common stock, the options had limited economic value and were notfully achieving their original objective of incentive compensation and employeeretention.

*Employee StockPurchase Plan*

The Company has a 2001 Employee Stock Purchase Plan (“ESPP”),which expires in the year 2011, and under which an aggregate of4.8 million shares of the Company’s common stock have been authorized 

F-36

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and reserved for issuance.Under the ESPP, each eligible employee may authorize payroll deductions of upto 15% of their compensation to purchase shares of common stock on two “purchasedates” each year at a purchase price per share equal to 85% of the lower of (i) theclosing selling price per share of common stock on the employee’s entry dateinto the two-year offering period in which the purchase date occurs or (ii) theclosing selling price per share on the purchase date. Each offering period hasa twenty-four month duration and purchase intervals of six months.

During the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003, approximately 0.4 million, 0.4 million, 0.5 million and0.9 million shares were purchased under the Company’s ESPP at weightedaverage purchase prices of $7.46, $7.98, $3.16 and $1.99 per share,respectively. At December 31, 2005, there were approximately2.3 million shares available for future issuance. The weighted averagefair value of ESPP shares purchased during the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 were $3.54, $6.38, $2.21 and $1.29 per share, respectively.

*Equity Awards*

In January 2004, the Board of Directors issued575,000 restricted shares of common stock at par value to certain of theCompany’s executive officers. The shares vest entirely at the end of thefour-year period from the date of grant. In connection with these shares, theCompany recorded deferred stock-based compensation of $11.4 million,which is being amortized on a straight-line basis over the four-year vestingperiod. In December 2004, the Company repurchased 100,000 restricted sharesof common stock in connection with the resignation of an executive officer. Inconnection with the repurchase, the Company reversed $2.0 million indeferred stock-based compensation.

In January 2004, the Compensation Committee ofthe Board of Directors approved stock option grants of 1.2 million sharesto the Company’s executive officers. The shares are immediately exercisable,vest over a three-year period from the date of grant and have an exercise priceof $18.70.

In January 2004, the Compensation Committee ofthe Board of Directors approved stock option grants of 0.1 million sharesto the members of the Board. The shares are immediately exercisable, vestmonthly over a one-year period from the date of grant and have an exerciseprice of $18.70.

In March 2005, the Company issued approximately1.0 million RSUs to certain of the Company’s executive officers. Each RSUentitles the officer to receive one share of the Company’s common stock uponvesting. The units vest 25% annually over the four-year period beginning February 15,2005. In connection with these units, the Company recorded deferred stock-basedcompensation of $11.0 million, which is being amortized over the vestingperiod.

In March 2005, the Company issued approximately0.4 million additional RSUs to its other employees. Each RSU entitles theemployee to receive one share of the Company’s common stock upon vesting. Theunits vest 25% on February 15, 2006 and quarterly thereafter for threeyears. In connection with these units, the Company recorded deferredstock-based compensation of $3.7 million, which is being amortized over thevesting period.

In March 2005, the Company approved stock optiongrants of 1.3 million shares to the Company’s employees with exercise pricesranging from $10.55 per share to $10.58 per share. The options vest 25% on February 15,2006 and monthly thereafter for three years.

In April 2005, the Company issued 37,500 RSUs tomembers of its Board of Directors. Each RSU entitles the Board member toreceive one share of the Company’s common stock upon vesting. The units vest100% on February 15, 2006. In connection with these units, the Companyrecorded deferred stock-based compensation of approximately $0.3 million, whichis being amortized over the vesting period.

F-37

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In August 2005, the Company approved stock optiongrants of 0.3 million to certain of the Company’s executive officers withexercise prices ranging from $11.77 per share to $12.47 per share. The optionsvest 25% after one year and monthly thereafter for three years. In addition,the Company issued 0.2 million RSUs to these executive officers. Each RSUentitles the officer to receive one share of the Company’s common stock uponvesting. The units vest 25% annually over the four-year period beginning August 15,2005. In connection with these units, the Company recorded deferred stock-basedcompensation of $2.5 million, which is being amortized over the vesting period.

In February 2006, theCompany announced its intention to offer eligible employees of the Company theopportunity to exchange any outstanding stock options granted to them whichhave an exercise price per share of the Company’s common stock at or above$16.00 (the “Eligible Options”) in return for RSUs. The number of RSUs thatwill be issued in exchange for each tendered Eligible Option will be based onthe per share exercise price of that option and will, in all events, be lessthan the number of shares subject to the tendered option. Eligible options withexercise prices between $16.00 and $20.00 will be exchanged based on a ratio ofone RSU for four eligible options. Eligible options with exercise pricesgreater than $20.00 will be exchanged based on a ratio of one RSU for fiveeligible options. There are approximately 1.9 million Eligible Options, whichcould be exchanged for approximately 0.4 million RSUs.

**9. COMMITMENTS AND CONTINGENCIES**

*FinancialCommitments*

TheCompany’s financial commitments at December 31, 2005 are as follows (inthousands):

| ** **                        | ** ** | **Year Ending December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| **Contractual Obligations:** | ** ** | ** **                                  | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
| Term loan(1)                      |       | $                                           | 54,208     |   | $ | 16,498 |   | $ | 16,498 |   | $ | 21,212 |   | $ | — |   | $ | — |   |   | $ | — |   |   |
| Capital leases(2)                 |       | 731                                         |       | 399 |   | 332 |   | — |   | — |   | — |   |   | — |   |   |
| Operating leases                  |       | 46,638                                      |       | 6,979 |   | 7,155 |   | 7,162 |   | 6,078 |   | 4,464 |   |   | 14,800 |   |   |
| Telecommunications  purchases     |       | 19,388                                      |       | 10,892 |   | 8,496 |   | — |   | — |   | — |   |   | — |   |   |
| Media purchases                   |       | 8,398                                       |       | 8,398 |   | — |   | — |   | — |   | — |   |   | — |   |   |
| Total                             |       | $                                           | 129,363    |   | $ | 43,166 |   | $ | 32,481 |   | $ | 28,374 |   | $ | 6,078 |   | $ | 4,464 |   |   | $ | 14,800 |   |   |
|                                   |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Our variable-rate termloan accrues interest at rates generally equal to the London inter-bank offeredrate (LIBOR) for dollar deposits plus a margin of 3.0%. The table reflects onlyprincipal amounts. In January 2006, we paid in full the outstanding balance ofthe term loan of approximately $54.2 million. See Note 3.

(2)           The Company has enteredinto certain noncancelable lease obligations for computer and office equipment.The future minimum lease payments are discounted using varying rates over thelease terms. Amounts include $33,000of imputed interest.

The Company leases itsfacilities under operating leases expiring at various periods through 2014. Theleases generally contain annual escalation provisions as well as renewaloptions. Total rental expense for operating leases for the years ended December 31,2005 and 2004, the six months ended December 31, 2003 and the year ended June 30,2003 was $6.5 million, $4.3 million, $1.3 million and$3.3 million, respectively.

*Legal Contingencies*

On April 20, 2001, Jodi Bernstein, on behalf ofhimself and all others similarly situated, filed a lawsuit in the United StatesDistrict Court for the Southern District of New York against NetZero, certainofficers 

F-38

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and directors of NetZeroand the underwriters of NetZero’s initial public offering, Goldman Sachs Group, Inc.,BancBoston Robertson Stephens, Inc. and Salomon Smith Barney, Inc.The complaint alleges that the prospectus through which NetZero conducted itsinitial public offering in September 1999 was materially false andmisleading because it failed to disclose, among other things, that (i) theunderwriters had solicited and received excessive and undisclosed commissionsfrom certain investors in exchange for which the underwriters allocated tothose investors material portions of the restricted number of NetZero sharesissued in connection with the offering; and (ii) the underwriters hadentered into agreements with customers whereby the underwriters agreed toallocate NetZero shares to those customers in the offering in exchange forwhich the customers agreed to purchase additional NetZero shares in theaftermarket at pre-determined prices. Plaintiffs are seeking injunctive reliefand damages. Additional lawsuits setting forth substantially similarallegations were also served against NetZero on behalf of additional plaintiffsin April and May 2001. The case against NetZero was consolidated withapproximately 300 other suits filed against more than 300 issuers thatconducted their initial public offerings between 1998 and 2000, theirunderwriters and an unspecified number of their individual corporate officersand directors. In a court order dated February 15, 2005, the DistrictCourt granted preliminary approval of the issuer defendants’ proposedsettlement. On June 30, 2005, the United States Court of Appeals for theSecond Circuit granted the underwriter defendants’ petition for permission toappeal the District Court’s order granting plaintiffs’ motion for classcertification. A hearing on the settlement is scheduled for April 24,2006.

On August 21, 2001, Juno commenced an adversaryproceeding in U.S. Bankruptcy Court in the Southern District of New Yorkagainst Smart World Technologies, LLC, dba “Freewwweb” (the “Debtor”), aprovider of free Internet access that had elected to cease operations and hadsought the protection of Chapter 11 of the Bankruptcy Code. The adversaryproceeding arose out of a subscriber referral agreement between Juno and theDebtor. In response to the commencement of the adversary proceeding, the Debtorand its principals filed a pleading with the Bankruptcy Court asserting thatJuno is obligated to pay compensation in an amount in excess of $80 million asa result of Juno’s conduct in connection with the subscriber referralagreement. In addition, a dispute arose between Juno and UUNET Technologies, Inc.,an affiliate of MCI WorldCom Network Services, Inc., regarding the valueof services provided by UUNET, with UUNET claiming in excess of $1.0 millionand Juno claiming less than $0.3 million. On April 25, 2003, Juno, theCommittee of Unsecured Creditors, WorldCom and UUNET (allegedly the largestsecured creditor) entered into a Stipulation of Settlement, which provided forthe payment by Juno of $5.5 million in final settlement of all claims againstJuno. On September 11, 2003, the court issued an order approving theStipulation of Settlement. On September 12, 2005, the Second Circuit Courtof Appeals vacated the judgment of the bankruptcy court and remanded the caseto the bankruptcy court. Discovery in the adversary proceeding in the bankruptcycourt has commenced. No trial date has been set. At December 31, 2005, theCompany had liabilities recorded of approximately $5.5 million in respect ofthis matter.

On April 27, 2004, plaintiff MyMail Ltd. filed alawsuit in the United States District Court for the Eastern District of Texasagainst NetZero, Juno, NetBrands, America Online, Inc., AT&T,EarthLink, Inc., SBC Communications, Inc., and Verizon Communications, Inc.alleging infringement of plaintiff’s patent which purports to cover user accessto a computer network. On October 28, 2005, the court issued an ordergranting defendants’ motions for summary judgment of non-infringement of thepatent. MyMail has filed a notice of appeal of the trial court’s ruling.

The pending lawsuits involve complex questions of factand law and may require the expenditure of significant funds and the diversionof other resources to defend. Although the Company does not believe the outcomeof the above outstanding legal proceedings, claims and litigation will have amaterial adverse effect on its business, financial position, results ofoperations or cash flows, the results of litigation are inherently uncertainand the Company can provide no assurance that it will not be materially andadversely impacted by the results of such proceedings. The Company hasestablished a reserve for the Freewwweb 

F-39

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matter discussed above andsuch reserve is reflected in the consolidated financial statements, though theCompany can provide no assurance that such reserves will be adequate.

The Company is subject tovarious other legal proceedings and claims that arise in the ordinary course ofbusiness. Management believes the amount and ultimate liability, if any, withrespect to these actions will not materially affect the Company’s business,financial position, results of operations or cash flows. There can be noassurance, however, that such actions will not be material or adversely affectthe Company’s business, financial position, results of operations or cashflows.

**10. TRANSITIONPERIOD COMPARATIVE DATA**

Thefollowing table presents certain financial information for the six months endedDecember 31, 2003 and 2002, respectively (in thousands, except per shareamounts):

| ** **                                             | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **2003**                                          | ** ** | **2002** | ** ** |
| ** **                                             | ** ** | ** **                                        | ** ** | **(unaudited)** | ** ** |
| Revenues                                               |       | $                                                 | 185,738    |   |   | $ | 123,868 |   |   |
| Income before  income taxes                            |       | $                                                 | 35,046     |   |   | $ | 6,928 |   |   |
| Provision for  income taxes                            |       | $                                                 | 1,719      |   |   | $ | 692 |   |   |
| Net income                                             |       | $                                                 | 33,327     |   |   | $ | 6,236 |   |   |
| Net income per  share—basic                       |       | $                                                 | 0.52       |   |   | $ | 0.10 |   |   |
| Net income per  share—diluted                     |       | $                                                 | 0.48       |   |   | $ | 0.09 |   |   |
| Shares used to  calculate basic net income per share   |       | 64,163                                            |       |   | 60,830 |   |   |
| Shares used to calculate  diluted net income per share |       | 69,504                                            |       |   | 66,179 |   |   |

 

**11. QUARTERLYFINANCIAL DATA (UNAUDITED) (in thousands, except per share data)**

Yearended December 31, 2005:

| ** **                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **December 31,**  | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| Revenues                           |       |                   | $          | 130,232 |   |   |   | $ | 132,778 |   |   | $ | 131,520 |   | $ | 130,531 |   |
| Operating income                   |       |                   | $          | 22,082 |   |   |   | $ | 22,634 |   |   | $ | 20,859 |   | $ | 20,985 |   |
| Net income                         |       |                   | $          | 12,374 |   |   |   | $ | 12,594 |   |   | $ | 10,672 |   | $ | 11,487 |   |
| Net income per  share—basic   |       |                   | $          | 0.20 |   |   |   | $ | 0.21 |   |   | $ | 0.18 |   | $ | 0.19 |   |
| Net income per  share—diluted |       |                   | $          | 0.19 |   |   |   | $ | 0.20 |   |   | $ | 0.17 |   | $ | 0.18 |   |

 

Yearended December 31, 2004:

| ** **                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **December 31,**  | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| Revenues                           |       |                   | $          | 119,620 |   |   |   | $ | 110,704 |   |   | $ | 110,618 |   | $ | 107,675 |   |
| Operating income                   |       |                   | $          | 19,036 |   |   |   | $ | 20,516 |   |   | $ | 20,011 |   | $ | 19,930 |   |
| Net income                         |       |                   | $          | 80,189 |   |   |   | $ | 12,620 |   |   | $ | 12,310 |   | $ | 12,361 |   |
| Net income per  share—basic   |       |                   | $          | 1.33 |   |   |   | $ | 0.21 |   |   | $ | 0.20 |   | $ | 0.20 |   |
| Net income per  share—diluted |       |                   | $          | 1.27 |   |   |   | $ | 0.19 |   |   | $ | 0.19 |   | $ | 0.18 |   |

 

F-40

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**UNITED ONLINE, INC.SCHEDULE II—VALUATIONAND QUALIFYING ACCOUNTS(in thousands)**

| ** **                                        | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged/  (Credited) to  Expense** | ** ** | **Charged  to Other  Accounts** | ** ** | **Charges  Utilized/  Writeoffs** | ** ** | **Balance at End  of Period** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|----------------------------------------------|------------|
| **Allowance for doubtful accounts:**              |       |                                           |       |                                      |       |                                 |       |                              |       |                                         |       |   |   |   |   |   |   |
| Year ended  December 31, 2005                |       |                                           | $          | 647                                       |       |                                 |       | $                                 | 678        |                                         |       | $ | — |   | $ | — |   |   | $ | 1,325 |   |   |
| Year ended  December 31, 2004                |       |                                           | 288        |                                      |       |                                 | 75         |                              |       | 284                                          | (b)        | — |   |   | 647 |   |   |
| Six months ended  December 31, 2003          |       |                                           | 288        |                                      |       |                                 | —     |                              |       | —                                       |       | — |   |   | 288 |   |   |
| Year ended  June 30, 2003                    |       |                                           | 333        |                                      |       |                                 | —     |                              |       | —                                       |       | 45 | (a) |   | 288 |   |   |
| **Valuation allowance for  deferred tax assets:** |       |                                           |       |                                      |       |                                 |       |                              |       |                                         |       |   |   |   |   |   |   |
| Year ended  December 31, 2005                |       |                                           | $          | 1,938                                     |       |                                 |       | $                                 | 2,732      | (c)                                          |       | $ | — |   | $ | — |   |   | $ | 4,670 |   |   |
| Year ended  December 31, 2004                |       |                                           | 87,212     |                                      |       |                                 | (67,478    | )(d)                              |       | (20,783                                      | )(e)       | (2,987 | )(f) |   | 1,938 |   |   |
| Six months ended  December 31, 2003          |       |                                           | 95,423     |                                      |       |                                 | (12,292    | )(d)                              |       | (16,408                                      | )(e)       | (20,489 | )(g) |   | 87,212 |   |   |
| Year ended June 30,  2003                    |       |                                           | 110,360    |                                      |       |                                 | (12,207    | )(d)                              |       | (3,720                                       | )(e)       | (990 | )(f) |   | 95,423 |   |   |

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(a)           Represents specific amountswritten off that were considered to be uncollectible.

(b)          Represents allowance fordoubtful accounts acquired in connection with the acquisition of Classmates.

(c)           Represents the increasein valuation allowance primarily due to executive compensation that is limitedunder Section 162(m) of the Code and foreign losses, the benefit ofwhich is not currently recognizable.

(d)          Represents the releaseof valuation allowance primarily to recognize the actual and future taxbenefits of deferred tax assets.

(e)           Represents the releaseof valuation allowance primarily to recognize the future tax benefits for stockoption deductions and net operating losses acquired in the Merger.

(f)             Represents netadjustments to the valuation allowance primarily related to the Merger.

(g)           Represents the increaseto the valuation allowance primarily due to stock option deductions andacquired net operating loss carryforwards in connection with the Mergerpursuant to IRS Notice 2003-65.

F-41

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