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HOMEAWAY INC - 10-Q - : Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Safe Harbor Cautionary Statement This quarterly report on Form 10-Q contains forward-looking statements that are based on our management's beliefs and assumptions and on information currently available to our management. The statements contained in this quarterly report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may be signified by terms such as "anticipates," "believes," "could," "seeks," "estimates," "expects," "intends," "may," "plans," "potential," "predicts," "projects," "should," "will," "would" or similar expressions and the negatives of those terms. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in other documents we file with the Securities and Exchange Commission. Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management's beliefs and assumptions only as of the date of this quarterly report on Form 10-Q. You should read this quarterly report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. The following discussion should be read in conjunction with our interim condensed consolidated financial statements contained elsewhere in this quarterly report on Form 10-Q and in our other Securities and Exchange Commission, or SEC, filings including our Annual Report on Form 10-K for the year ended December 31, 2013 and subsequent reports on Form 8-K, which discuss our business in greater detail. Overview We operate the world's largest online marketplace for the vacation rental industry. Our marketplace brings together millions of travelers seeking vacation rentals online with hundreds of thousands of property owners and managers of vacation rental properties located in 190 countries around the world. Our portfolio includes leading vacation rental websites in Australia, Brazil, France, Germany, New Zealand, Singapore, Spain, the United Kingdom and the United States. During the three and six months ended June 30, 2014, according to our internal metrics, our websites attracted approximately 230 million and 475 million website visits, respectively, and as of June 30, 2014, our global marketplace included over one million paid listings. In the second quarter of 2014, consistent with our stated strategy, we focused our efforts on providing the largest selection of properties to travelers and the most qualified inquiries and bookings to property owners and managers. We added over 265,000 paid listings, net of non-renewals, to our network from June 30, 2013 to June 30, 2014, representing a 34.2% growth rate over the comparable prior year period. Historically, property owners and managers have paid us to list on our marketplace by paying for a subscription that generally is for an annual period. Our listing business, which is made up largely of subscription listings, comprises the majority of our revenues at 82.7% for both the three and six months ended June 30, 2014, as compared to 84.8% and 84.5% for the three and six months ended June 30, 2013, respectively. We continued to improve monetization of our paid listing base from pricing and product changes through continued adoption of our tiered pricing structure, where available, and from an increase in purchases by property owners and managers of bundled listings products. This improved monetization can be seen in the increase of our average revenue per subscription listing from $416 in the second quarter of 2013 to $473 in the second quarter of 2014. For the three and six months ended June 30, 2014, average revenue per subscription listing, excluding the impact of foreign exchange rates, increased by 11.5% and 11.1% as compared to the three and six months ended June 30, 2013, respectively. Tiered pricing allows property owners and managers with paid subscriptions to improve their position in search results by purchasing a higher subscription level or tier. We believe property owners and managers increasingly will elect to purchase higher tiers, which would increase average revenue per subscription listing in future periods. At the same time, by keeping base prices low, we believe the number of paid listings can continue to grow. Although we plan to launch tiered pricing on our other websites as well, we may use different strategies as we enter new markets and geographies or attempt to further penetrate the professional property manager market, which could result in lower average revenue per listing. Enablement of e-commerce on our websites has been and will continue to be a focus for our Company. In the second quarter of 2014, we continued to see adoption of our online payments platform, which is currently available on HomeAway.com and VRBO.com in the United States, HomeAway.co.uk in the United Kingdom, Abritel.fr in France and HomeAway.de in Germany. Subscribers are encouraged but not required to use the platform. Those owners and managers who are not fully integrated with our websites, who elect 27-------------------------------------------------------------------------------- Table of Contents to pay by commission, are required to accept bookings and payments online via the platform. Using this platform enables property owners and managers to respond to and manage inquiries, prepare and send rental quotes and payment invoices. It also allows travelers to book online, including via online rental agreements and to process online payments via credit card or eCheck. Additionally in some countries, property owners and managers can make value-added products available for purchase. We believe that adoption and increased use of our payments platform over time will allow us to earn more revenue from ancillary products while providing a more secure and efficient payment mechanism for travelers. We plan to introduce new products and services for travelers, property owners and managers, which we believe will provide further opportunities to generate revenue through our marketplace. We believe that bringing travelers to our online marketplace is necessary to attract and retain vacation rental owners and managers. It is also critical for us to increase the rate at which travelers book vacation rentals with our property owners and managers. To meet these challenges, which are even more important with the increase in performance-based listings, we are focused on a combination of marketing tactics, including pay-per-click advertising, search engine optimization, and display advertising, with a goal of driving more travelers and bookings to our websites as well as increasing the exposure of the vacation rental category. We are also investing in product enhancements to make it easier for travelers visiting our websites to search and find the right property, to inquire and to book their stay. Online booking enables travelers to reserve a vacation rental directly on any of our listing websites that utilize our platform, rather than requiring correspondence with a property owner or manager to reserve a vacation rental. Key Financial Highlights We have achieved significant growth since our commercial launch in 2005. Our revenue growth is attributable to our acquisitions of other online listings businesses, the organic growth in the number of listings that property owners and managers purchase from us, increases in the average revenue we receive per listing due to additional features and price increases, and the introduction of additional products and services related to our marketplace. We view our market opportunity as global and have historically generated strong cash flows. Additionally, we have had predictable financial results because of our advance payment, subscription-based model and our high annual listing renewal rates. Key financial highlights for the three months ended June 30, 2014 include the following: • Total revenue was $114.3 million compared to $86.6 million in the second quarter of 2013, or an increase of 31.9%; • Percentage of total revenue from outside the United States was 42.7% in the second quarter, compared to 39.2% in the second quarter of 2013; total revenue from outside the United States in the second quarter of 2014 included 35.2% from Europe and 7.5% from South America and the Asia Pacific region; • Listing revenue was $94.5 million compared to $73.4 million in the second quarter of 2013 and contributed 82.7% of total revenue compared to 84.8% in the second quarter of 2013; • Net income attributable to HomeAway, Inc. was $3.9 million compared to $5.5 million in the second quarter of 2013, or a decrease of 29.3%; • Cash from operating activities was $45.9 million compared to $21.8 million in the second quarter of 2013, or an increase of 110.5%, which includes a positive impact from an excess tax expense as a result of stock-based compensation of $2.4 million compared to a negative impact for an excess tax benefit of $2.9 million in the second quarter of 2013; • Adjusted EBITDA was $33.0 million compared to $24.8 million in the second quarter of 2013, or an increase of 32.7%; Adjusted EBITDA as a percentage of revenue was 28.8%, an increase of approximately 10 basis points from 28.7% in the second quarter of 2013; • Free cash flow was $35.0 million compared to $19.2 million in the second quarter of 2013, or an increase of 82.5%; on a trailing twelve month basis, free cash flow increased 24.7% to $114.2 million from $91.6 million in the comparable trailing twelve month period for the prior year; • Non-GAAP net income was $14.3 million, or $0.15 per diluted share, compared to non-GAAP net income of $14.0 million, or $0.16 per diluted share, in the second quarter of 2013; and • Cash, cash equivalents and short-term investments as of June 30, 2014 were $792.5 million. For further discussion regarding Adjusted EBITDA, free cash flow and non-GAAP net income, along with reconciliations of such numbers to the most directly comparable financial measures calculated and presented in accordance with GAAP, please see the information under the caption "Discussion of Non-GAAP Financial Measures" in Item 2 of this Quarterly Report on Form 10-Q. 28-------------------------------------------------------------------------------- Table of Contents Acquisitions Since our inception, we have acquired 22 businesses as part of our growth strategy. Each of these acquisitions has been accounted for using the acquisition method of accounting. Accordingly, the financial statements for these businesses have been included in our consolidated financial results since the applicable acquisition dates. The most recent acquisition was in March 2014, when we acquired Glad to Have You, Inc. Glad To Have You is the creator of a mobile guest management solution that is designed for property managers and homeowners to improve the way they manage and communicate with guests during their vacation rental stay. We believe that this acquisition will enable us to enhance our travelers' vacation rental stay experience and provide our owners and managers with additional tools to help them manage their vacation rentals. Our acquisitions have presented, and certain of them continue to present, significant integration challenges. They have required us to integrate new operations, offices and employees and to formulate and execute on marketing, product and technology strategies associated with the acquired businesses. In some cases, we continue to manage multiple brands and technology platforms of the acquired businesses, which has increased our cost of operations. Challenges of this nature are likely to arise if we acquire businesses in the future. Growth Opportunities and Trends Our ability to continue to grow our revenue will depend largely on increasing the number of paid listings, increasing revenue per listing and increasing revenue from other products and services through our marketplace. This includes our ability to successfully enable e-commerce transactions on our websites, including allowing for online payments and online booking, and commission-based revenue streams for vacation rental listings including pay-per-booking listings. We continually assess opportunities for strategic acquisitions. We also use direct and indirect marketing as well as telesales to reach owners, professional property managers and travelers. We have seen other companies launch online businesses offering vacation rentals or other alternatives to hotels. We believe that the growing awareness of vacation rentals, as a favorable alternative to hotels, has and will continue to support growth of our business. In the future, we believe it will be important for us to not only use marketing to grow the industry, but to also support our brand. Expenses Our expenses are primarily composed of salaries and related expenses, marketing and professional fees. Our expenses from year to year may fluctuate due to timing of specific events or projects. We will continue to increase expenses across the organization on an annual basis to support our growth and expect our cost of revenue to grow in absolute dollars but remain consistent as a percentage of revenue in 2014. We expect to incur higher expenses for product development as we record a full year impact of personnel hired in 2013 and as we hire additional personnel to develop new features and products and expect product development expenses to increase as a percentage of revenue in 2014. We expect to incur higher expenses in both absolute dollars and as a percentage of revenue in 2014 for sales and marketing as we continue to build our sales team to address the professional property managers, increase our marketing activities to generate additional traveler demand to support both subscription and performance based listings and continue to build brand and category awareness. The level of increased expenses related to demand driven marketing activities during 2014 will be determined based on the results of those activities. We expect to incur higher expenses in absolute dollars and remain relatively flat as a percentage of revenue in 2014 for general and administrative expenses as we support the growth of our business internationally and the requirements of being a publicly traded company. We plan for additional capital investments in 2014 to support the growth of our business and expect our investment in capital expenditures to increase as a percentage of revenue as compared to 2013, primarily due to the expansion of our office facilities in Austin, Texas. We believe that the reorganization of our global corporate structure will lower our tax expense over the longer term, and we are continuously seeking to optimize tax expense in line with our global expansion plans. Key Business Metrics In addition to traditional financial and operational metrics, we use the following business metrics to monitor and evaluate results. Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Paid listings, end of period 1,040,547 775,232 1,040,547 775,232 Average revenue per subscription listing $ 473 $ 416 $ 459 $ 407 Renewal rate, end of period 72.8 % 72.4 % 72.8 % 72.4 % Visits to websites (in millions) 230 201 475 408 29 -------------------------------------------------------------------------------- Table of Contents Following the migration of VRBO.com to our global technology platform in 2012, property owners and managers that have listings on both HomeAway.com and VRBO.com are able to consolidate their listings into one listing that is displayed on both websites. Additionally, the platform consolidation allows property owners and managers to purchase bundled listings that include display on both HomeAway.com and VRBO.com. As a result, we now count each of these bundled listings as one listing. This impacts the comparability of our current period reported metrics to our previously reported historical metrics for paid listings, renewal rate and average revenue per listing. As it has been over one year since the migration of VRBO.com to our global platform, a majority of customers who had listings on both VRBO.com and HomeAway.com, have consolidated their listings. However, some customers still have listings on both websites. As a result, further consolidations will continue to impact the comparability of our results. In the three months ended June 30, 2014, we migrated Homelidays.com to our global technology platform and expect to see consolidation of subscription listings in the coming year. Furthermore, we expect that there will be future platform migrations for certain of our websites, such as the future migration of Stayz.com.au to our global technology platform. When this occurs, property owners and managers who have purchased subscriptions on the website being migrated as well as other HomeAway websites will be given the opportunity to consolidate their listings through the purchase of a bundled listing. We expect these migrations will also impact comparability of our operating metrics. We will disclose and discuss the trends of the business resulting from these consolidated listings when there is a significant impact to the operating metrics. As a result of consolidated listings and bundled listings, our paid listing counts will be lower since these listings previously would have been counted as two paid listings had they been purchased on both websites. In the future, as property owners and managers renew their subscriptions into a bundled listing, we will count these as one listing. The lower paid listing counts from consolidations and bundles will in turn lower our reported renewal rate. Additionally, our bundled listing products generally have a higher overall price and will increase our average revenue per listing. Paid Listings. In the three months ended June 30, 2014 and 2013, 82.7% and 84.8%, respectively, of our revenue was derived from paid listings. We regularly track paid listings as a key revenue growth indicator and to identify trends in our business and industry. From June 30, 2013 to June 30, 2014, paid listings increased by 34.2%, contributing to listing revenue growth of 28.7%. The growth in paid listings is due to our marketing and selling new and additional listings to property owners and managers, the introduction of pay-per-booking listings, listings acquired in acquisitions and organic growth from property owners and managers who become aware of our websites and choose to market their properties. From June 30, 2013 to June 30, 2014, we reduced the number of pay-per-lead listings and added a significant number of pay-per-booking listings, resulting in a net impact of 328.5% ending listing growth from performance-based listings. A portion of the growth in listings came from 2013 acquisitions of travelmob Pte. Ltd. ("travelmob"), Bookabach Limited ("Bookabach") and Stayz, which added approximately 73,000 paid listings to our network, most of which are performance-based listings. Growth in new listings is partially offset by loss of listings through attrition and through consolidations. Adjusting for the impact of consolidated listings and new bundled listings, we estimate that our paid listing growth would have been approximately 36.3% from June 30, 2013 to June 30, 2014. We do not expect these changes to have any negative impact on the number of unique properties on our websites. As the number of paid listings increases, we believe that we will generate additional revenue while also expanding the value of the marketplace to travelers, thus increasing the likelihood that travelers will find a property that is suitable to their needs. It is possible that a specific property may be listed on more than one of our websites without indicating that the multiple listings refer to the same property. Average Revenue per Subscription Listing. We believe that trends in total revenue per listing, over an extended period, are important to understanding the value we bring to property owners and managers, and the overall health of our marketplace. As the majority of our listing business is generated from subscriptions, we use trends in revenue per subscription listing, as well as trends in paid listings, in order to formulate financial projections and make strategic business decisions. At a consolidated level, increases in revenue per subscription listing may increase our earnings or may be used for future investment. The average revenue per subscription listing may fluctuate based on the timing and nature of acquisitions, changes in our pricing, the impact of consolidated and bundled listing products, uptake of listing enhancements, changes in the pricing of enhancements, seasonality, changes in brand and listing type mix, and the impact of foreign exchange rates on our listing revenue outside of the United States. For the three and six months ended June 30, 2014, average revenue per subscription listing was $473 and $459, respectively, an increase of 13.7% and 12.8% compared to the three and six months ended June 30, 2013, respectively. Excluding the impact of foreign exchange rates, average revenue per subscription listing would have been $464 and $452 in the three and six months ended June 30, 2014, respectively, an increase of 11.5% and 11.1% compared to the three and six months ended June 30, 2013 respectively. 30-------------------------------------------------------------------------------- Table of Contents Adjusting for the impact of consolidated listings and new bundled listings on the number of paid listings, our average revenue per subscription listing would have been $437 and $425 in the three and six months ended June 30, 2014, respectively, or an increase of 9.3% and 7.9% as compared to the three and six months ended June 30, 2013, respectively. We compute average revenue per subscription listing as annualized subscription listing revenue divided by the average of paid subscription listings at the beginning and end of the period. Our paid listings included in the calculation only include subscription listings. The price of subscription listings varies by website and can include various additional fees associated with listing enhancements. In order to increase revenue per subscription listing, we rely on increases in base pricing, increases in adoption of tiered pricing alternatives as well as bundled listings for our property owners and managers. We began offering tiered pricing on HomeAway.com in the United States in 2011, which allows our property owners and managers to purchase a higher subscription level to increase the position of their listings in search results. In 2012, we migrated VRBO.com in the United States to the same tiered pricing structure. Also in 2012, we launched tiered pricing on HomeAway.com.uk in the United Kingdom, Abritel.fr in France and HomeAway.de in Germany. In 2013, tiered pricing was launched on HomeAway.es in Spain, HomeAway.it in Italy and AlugueTemporada.com.br in Brazil. In 2014, tiered pricing was launched on Homelidays.com in France upon the migration of that brand to the global network. As we continue to implement tiered pricing on other websites, or change the prices or structure of tiered pricing, we may see an impact on listing sales in the current period and on revenue during the length of the subscription period. Renewal Rate. Renewal of paid subscription listings is a key driver of revenue for our business. We track renewal rate in order to understand and improve property owners' and managers' satisfaction and to help us more accurately estimate our future revenue and cash flows. Our overall renewal rate increased from 72.4% at June 30, 2013 to 72.8% at June 30, 2014. This increase of 0.4% is primarily due to increased renewals in the United Kingdom and the United States. After adjusting for consolidated listings, our renewal rate as of June 30, 2014 is estimated to be 74.3%, or a decrease of 0.2% as compared to June 30, 2013. We expect continued product improvements, demand generation for property owners and managers and the resulting increases in customer satisfaction to result in long-term improvements in renewal rates. Our renewal rate is impacted by the level of traveler demand our websites deliver to listed properties. In addition, several other factors as affect renewal rates including our property owners' and managers' ability to consolidate their listings, their ability to purchase geographic bundled listings and our use of promotional pricing to attract new subscribers. Additionally, our paid subscription listing renewal rate could be impacted by property owners and managers who elect to list their properties through our recently launched pay-per-booking commission offering, rather than paying a subscription fee. The renewal rate for our subscription listings at the end of any period is defined as the percentage of those paid listings that were active at the end of the period ended twelve months prior that are still active as of the end of the reported period. Unique property subscription listings that are removed from property managers' accounts and subsequently replaced with new subscription listings within the same property manager's account listings are not considered as renewals in our renewal rate calculation. We include most brands in our calculation of renewal rate with the exception of BedandBreakfast.com, Toprural.com, and Bookabach.co.nz, which will remain excluded until we can further develop our database system. However, based on our review of other internal renewal rate data, we do not believe that the exclusion of these brands from the renewal rate calculation materially impacts the result. Property owners' and managers' satisfaction with our solutions is the primary driver of our renewal rate. We believe that property owners and managers measure their satisfaction with our websites based largely on the number of inquiries and rental bookings that they receive from travelers. When the underlying vacation properties are sold or taken off the market, the owner or manager has no further need for the listings, and this attrition is a natural and ongoing component of non-renewal of listings. We exclude pay-for-performance listings from our renewal rate analysis since they are not sold on a subscription basis. Visits to Websites. We view visits to websites as a key indicator of growth in our brand awareness among users and our ability to provide our property owners and managers with inquiries and bookings from travelers. Growth in visits to websites will be driven by our marketing strategies and has a direct impact on our financial performance. We use a variety of tools to measure visits to our websites. These tools include solutions from third parties such as Omniture and Google Analytics. We also review third-party published reports to measure our results against comparable companies; however, these reports are frequently inconsistent with our internal measurements. Growth in visits was 14.2% in the second quarter of 2014 as compared to the second quarter of 2013. We believe that certain quality initiatives aimed at reducing the number of visits required to secure a booking may have an impact on growth in visits. These initiatives include online booking, quotable rates, and continuous improvements to our search functionality to help travelers locate appropriate properties more quickly. 31-------------------------------------------------------------------------------- Table of Contents Key Components of Our Results of Operations Revenue We derive most of our revenue from paid subscription listings. Our customers generally pay for their subscription listings at the beginning of the listing term, and revenue is recognized monthly over the term of the listing, which is generally one year. We offer pay-for-performance listings to property owners and professional managers, which represented 5.5% and 6.1% of our revenue in the three and six months ended June 30, 2014, respectively. This offering allows the customer to list a property with no initial upfront fees and, instead, pay us fees based on traveler inquiries or commissions on bookings. A major source of new property listings has been the introduction of pay-for-performance listings and the use of our inside sales organization which targets larger professional managers. We also generate new listings from search engines such as Google, where property owners and managers search to find vacation rental listings websites. In addition, word-of-mouth referrals are another source for new listings. We believe that in order to grow our revenue in the future, it will be important to introduce new features and functionality for our property owners and managers, which will allow us to keep prices low while offering expanded distribution and search placement for additional fees. It will also be important for us to continually improve the functionality of our websites to attract a large audience of travelers to help ensure our property owners and managers receive sufficient inquiries and bookings. Deferred revenue consists of payments received from listings in excess of the revenue that we have recognized from the same listings, sales from hosted software solutions for which the estimated period of the hosting relationship is longer than one year and sales of gift cards for which revenue is recognized over a period commensurate with the use of the gift card. Deferred revenue increases as a result of new and renewed listings and decreases as a result of the recognition each month of the pro-rata share of revenue from cash collected in previous periods. We expect an increase in deferred revenue on an annual basis as we grow our core listing business, but may experience seasonal decreases in deferred revenue in quarters with fewer new listings and renewals, as is discussed in more detail in the "Management's Discussion and Analysis of Financial Condition and Results of Operations-Seasonality and Quarterly Results" section of this Quarterly Report on Form 10-Q. As with other balance sheet line items, deferred revenue is reflected at the current month-end exchange rate, and the change in deferred revenue may therefore be impacted by movements in foreign currency. We earn revenue from the sales of Internet display-based advertising on our websites, property management software licenses and related maintenance, gift cards and commissions for online reservations. We also offer other services to property owners, managers and travelers that result in revenue and royalties. Costs and Expenses A large component of our costs and expenses consists of personnel costs. Personnel costs include salaries, benefits, bonuses and related expenses, including stock-based compensation. We grew from 1,408 employees at June 30, 2013 to 1,705 at June 30, 2014. We expect that personnel costs will be higher in absolute dollars in 2014 than in 2013 based on an expected increase in the number of employees in 2014. Cost of Revenue. Cost of revenue consists of salaries, benefits and related expenses and stock-based compensation of our customer service and web-hosting personnel, merchant fees charged by credit card processors, costs associated with the hosting of our websites, costs associated with payments and reserves from our Carefree Rental Guarantee, and allocated facility expenses and depreciation costs. Personnel costs include salaries, benefits, bonuses and related expenses, including stock-based compensation. To the extent that the number of paid listings on our marketplace grows and as we add more features to our websites, we intend to invest additional resources in customer service systems and personnel. Our customer service personnel help our property owners and managers use our websites to list their properties, answer their questions, and perform listing reviews and other processes as a part of our efforts to ensure quality, trust and security. Our customer service personnel also help travelers use our websites to book their travel and answer their questions. As more property owners and travelers utilize our e-commerce products and services, such as our online booking functionality on our websites, we believe that more travelers will require help from our customer service personnel. Our merchant fees are based on a contractual rate per transaction and will increase in absolute dollars as sales of listings increase, but for 2014 we expect our merchant fees to remain relatively constant and commensurate with 2013 levels, as a percentage of revenue. In general, as we add more features and functionality to our websites and anticipate an increase in the number of travelers accessing our websites, we will increase our spending on hardware and software required for hosting. We expect these additional costs to cause our cost of revenue expenses to increase in absolute dollars but remain consistent as a percentage of revenue in 2014 as compared to 2013. 32-------------------------------------------------------------------------------- Table of Contents We view the operation of our websites as a foundation upon which different revenue streams are generated. Cost of revenue, as described above, which includes the cost of customer service personnel, web hosting and merchant fees, directly supports our listing revenue, and was 15.3% and 16.0% of total revenue in the three months ended June 30, 2014 and 2013, respectively and 15.2% and 16.3% of total revenue in the six months ended June 30, 2014 and 2013, respectively. These same expenses support the overall operation of our websites and therefore our other revenue. There are no other material distinct costs of revenue for any period presented. The reporting of cost of revenue as one category in our consolidated financial statements is consistent with the manner in which we manage our business. Product Development. Product development expenses consist of personnel costs, third-party contracting and consulting fees associated with our research and development, costs associated with improvements to, and maintenance of, existing services, and allocated facility expenses and depreciation costs. We have historically focused our product development efforts on increasing the functionality and enhancing the ease of use of our websites, both for property owners and managers and for travelers. We intend to increase our technology and product resources by hiring additional personnel in future periods as we anticipate an increase in the number of listings and develop new features and products. We expect these additional investments to cause our product development expenses to increase both in absolute dollars and as a percentage of revenue in 2014 as compared to 2013. Sales and Marketing. Sales and marketing expenses consist of pay-per-click costs, online display advertising, broad reach advertising, personnel costs for our marketing, search engine optimization ("SEO"), sales staff, consulting and other services firms' fees, expenses associated with email marketing programs and public relations expenses, and allocated facility expenses and depreciation costs. We utilize pay-per-click advertising primarily to increase the number of travelers to our websites who are seeking properties in specific geographical areas in order to increase the number of inquiries and bookings. Our sales and marketing team also focuses on increasing the placement of our websites in search rankings on Google, Bing and other search engines, which results in owner, manager and traveler acquisition at relatively little incremental expense. We intend to increase our sales expense to drive additional listing sales to professional property managers and increase marketing efforts to support our new products, increase the traffic to our websites and increase overall brand awareness. It will be particularly important for us to increase bookings to our pay-for-performance customers while also continuing to deliver bookings for our subscription-based customers. Therefore, we expect to build and enhance our internal team of marketing professionals to manage this area. We expect our sales and marketing expenses to increase both in absolute dollars and as a percentage of revenue in 2014 as compared to 2013. General and Administrative. General and administrative expenses consist of personnel costs for our executive, finance and accounting, and management information systems personnel, professional fees for legal, audit, and other consulting services, allocated facility expenses, depreciation and other corporate overhead expenses. We expect to increase headcount to support our anticipated growth and international expansion, which will result in an increase in other expenses, such as facilities and travel. We also expect to continue to incur costs associated with operating as a public company, including increases in our finance, accounting and legal personnel, additional consulting, legal and audit fees, insurance costs, board of directors' compensation, and costs associated with compliance with the Sarbanes-Oxley Act and other requirements. As a result, we expect our general and administrative expenses to increase in absolute dollars and remain relatively flat as a percentage of revenue in 2014 as compared to 2013. Depreciation Property and equipment, office tenant improvements and software licenses are recorded at cost and are depreciated using the straight-line method over their estimated useful lives. Equipment and computer hardware are generally depreciated over three years and furniture and fixtures over five to ten years. Leasehold improvements are recorded at cost and depreciated over the shorter of the contractual lease period or their estimated useful life. We allocate depreciation to expense categories based on the relative number of employees in each category. Based on our current estimated level of capital expenditures, we expect our depreciation expense to increase in absolute dollars but remain relatively consistent as a percentage of revenue in 2014 as compared to 2013. Amortization Due to our historical acquisitions, we have recorded identifiable intangible assets, which are being amortized over their estimated useful lives. As a result, our amortization expense has grown as we have made acquisitions. We perform annual impairment testing of goodwill and indefinite-lived intangible assets, or when events or circumstances indicate that impairment may have occurred. We expect our amortization expenses to increase in absolute dollars in 2014 as compared to 2013 but decrease as a percentage of revenue in 2014. Amortization expense will depend on our future acquisition activity. 33-------------------------------------------------------------------------------- Table of Contents Other Income (Expense) Other income (expense) includes interest expense associated with the Notes, net of interest income earned on our excess cash, which is invested in short-term instruments. At June 30, 2014, we had operations in Australia, Brazil, Colombia, France, Germany, Italy, the Netherlands, New Zealand, Singapore, Spain, Switzerland, Thailand, the United Kingdom and the United States. As a result of operating in multiple countries, we incur gains and losses on foreign currency transactions, primarily related to the valuation of intercompany loans and short-term advances, which are included as other income (expense). Due to the issuance of the Notes in March of 2014, we expect interest expense to increase significantly in 2014 as compared to 2013. This increase will result from both cash payments related to coupon interest rates as well as non-cash amortization of the recorded debt discount over the term of the Notes. Income Taxes We accrue federal, state, and foreign income taxes at the applicable statutory rates adjusted for certain items, including non-deductible expenses, the most significant of which is stock-based compensation, and changes in our reserves for uncertain tax positions and deferred tax asset valuation allowance. Significant judgment is required in evaluating any uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate due to additional information. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which the determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as any related net interest and penalties. Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, reversals of existing taxable temporary differences and the feasibility of tax planning. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which the determination is made. Historically, we have generated most of our current taxable income outside of the United States due to net operating loss carryforwards and stock option deductions available for utilization in the United States. However, in 2014 we expect to utilize most of our available U.S. net operating loss carryforward. In 2014, we expect to pay corporate income taxes associated with our operations in Brazil, Colombia, France, Germany, the Netherlands, New Zealand, Spain, Switzerland and the United Kingdom, as well as certain states within the United States. We will continue to expand our business outside of the United States, in which case, we will become subject to further taxation based on foreign statutory tax rates in those jurisdictions where we operate, and our effective tax rate may fluctuate as a result. In prior periods, we have benefited from the tax credit incentives under the U.S. research and experimentation tax credit extended to taxpayers engaged in qualified research and experimental activities. The tax credit expired on December 31, 2013, and as such, no benefit is reflected in our income tax expense in the six months ended June 30, 2014. If this credit is renewed under similar terms as in prior years, the result could benefit our effective tax rate. Critical Accounting Policies and Estimates Our consolidated financial statements include the accounts of our U.S.-based operations and our Australia, Brazil, Colombia, France, Germany, Italy, Netherlands, New Zealand, Singapore, Spain, Switzerland, Thailand and United Kingdom-based subsidiaries. Our consolidated results are prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. To the extent there are material differences between these estimates and our actual results, our consolidated financial statements will be affected. 34-------------------------------------------------------------------------------- Table of Contents Our significant accounting policies are described in Note 2 to the accompanying condensed consolidated financial statements included, and, of those policies, we believe that the accounting policies listed below involve the greatest degree of complexity and exercise of judgment by our management. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on our results of operations particularly in the areas of business combination and taxes. Accordingly, we believe the policies listed below are the most critical for understanding and evaluating our financial condition and results of operations. These critical accounting policies are: • Revenue recognition; • Business combinations; • Stock-based compensation; and • Income taxes. A description of our critical accounting policies that involve significant management judgments appears in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 26, 2014 under "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates." Results of Operations The following table presents our operating results and our operating results as a percentage of revenue for the periods indicated: Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (in thousands, except per share data) Consolidated Statements of Operations Data: Revenue: Listing $ 94,526 $ 73,432 $ 181,858 $ 140,377 Other 19,730 13,176 38,080 25,695 Total revenue 114,256 86,608 219,938 166,072 Costs and expenses: Cost of revenue (exclusive of amortization shown separately below) 17,428 13,845 33,365 27,126 Product development 18,427 14,441 36,740 26,840 Sales and marketing 39,400 28,867 75,017 55,234 General and administrative 22,846 18,069 46,472 34,118 Amortization expense 3,492 2,995 6,766 6,175 Total costs and expenses 101,593 78,217 198,360 149,493 Operating income 12,663 8,391 21,578 16,579 Other income (expense): Interest expense (4,469 ) - (4,469 ) - Interest income 401 299 565 542 Other income (expense) (2,483 ) 66 (5,018 ) (1,525 ) Total other income (expense) (6,551 ) 365 (8,922 ) (983 ) Income before income taxes 6,112 8,756 12,656 15,596 Income tax expense (2,676 ) (3,286 ) (5,064 ) (4,831 ) Net income 3,436 5,470 7,592 10,765 Less: Net loss attributable to noncontrolling interests (431 ) - (718 ) - Net income attributable to HomeAway, Inc. $ 3,867 $ 5,470 $ 8,310 $ 10,765 Net income per share attributable to HomeAway, Inc.: Basic $ 0.04 $ 0.06 $ 0.09 $ 0.13 Diluted $ 0.04 $ 0.06 $ 0.09 $ 0.12 Weighted average number of shares outstanding Basic 93,671 84,920 93,188 84,482 Diluted 96,011 87,647 96,202 87,183 35 -------------------------------------------------------------------------------- Table of Contents |