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RIGHTSIDE GROUP, LTD. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) As used herein, "Rightside," the "Company," "our," "we," or "us" and similar terms include Rightside Group, Ltd. and its subsidiaries, unless the context indicates otherwise. "Rightside" and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. We were incorporated as a Delaware corporation on July 11, 2013. Prior to our spin off from Demand Media, Inc. on August 1, 2014 we did not have any material assets or liabilities, nor did we engage in any business or other activities. Our domestic operations have historically been conducted primarily through eNom, Incorporated and its subsidiaries. The following discussion describes our financial condition and results of operations as though we were a separate company as of the dates and for the periods presented, and includes the businesses, assets, and liabilities that comprise Rightside following the spinoff. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited interim condensed combined financial statements and related notes included elsewhere in this report. Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy and plans, in particular with regard to gTLDs, our objectives for future operations, the effect of the spin-off, and competition and changes to the governing rules in the domain name services industry are forward-looking statements. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect," "predict," "plan" and similar expressions are intended to identify forward-looking statements. You should not rely upon forward-looking statements as guarantees of future performance. We have based these forward-looking statements largely on our estimates of our financial results and our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the section entitled "Risk Factors" in Part II. Item 1A of this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in -16- -------------------------------------------------------------------------------- the forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason after the date of this Quarterly Report on Form 10-Q, except as required by law. Separation from Demand Media Prior to August 1, 2014, Rightside was a wholly owned subsidiary of Demand Media. In February 2013, Demand Media announced that its board of directors authorized Demand Media to pursue the separation of its business into two distinct publicly traded companies: Rightside Group, Ltd., focused on domain name services, and Demand Media, Inc., a digital media company. In January 2014, we received a private letter ruling from the Internal Revenue Service ("IRS") confirming that the separation and the distribution of shares of Rightside Group, Ltd. common stock qualifies as a transaction that is tax-free for U.S. federal income tax purposes. On July 15, 2014, Demand Media announced that the SEC had declared the Rightside Group, Ltd. Registration Statement on Form 10 effective and that the board of directors of Demand Media had approved the separation of Rightside from Demand Media in the form of a tax-free dividend involving the distribution of all outstanding shares of Rightside common stock to holders of Demand Media common stock on August 1, 2014. Immediately prior to the separation, the authorized shares of Rightside capital stock were increased from 1,000 shares to 120,000,000 shares, divided into the following classes: 100,000,000 shares of common stock, par value $0.0001 per share, and 20,000,000 shares of preferred stock, par value $0.0001 per share. The 1,000 shares of Rightside common stock, par value $0.0001 per share, that were previously issued and outstanding were automatically reclassified as and became 18,412,985 shares of common stock, par value $0.0001 per share. Upon the separation, holders of Demand Media common stock received one share of Rightside common stock for every five shares of Demand Media common stock held on the record date. Following completion of the separation, Rightside Group, Ltd. became an independent, publicly traded company on the NASDAQ Global Select Market using the symbol: "NAME." In connection with the separation and effective as of July 31, 2014, the following individuals were appointed as officers of Rightside: Taryn J. Naidu as Chief Executive Officer; Tracy Knox as Chief Financial Officer; Wayne M. MacLaurin as Chief Technology Officer; and Rick Danis as General Counsel. Effective on August 1, 2014, David E. Panos, Richard C. Spalding and Robert J. Majteles joined Taryn J. Naidu and James R. Quandt on our board of directors. Effective on August 25, 2014, Shawn J. Colo and Diane M. Irvine were appointed to our board of directors. Credit Facilities On August 1, 2014, we entered into a $30.0 million senior secured revolving credit facility with Silicon Valley Bank, including a subfacility of $15.0 million available for the issuance of letters of credit, which was amended on August 12, 2014 and which matures in August 2017 (see "Liquidity and Capital Resources - Credit Facilities" for further discussion). On August 6, 2014, we entered into a $30.0 million term loan credit facility with certain funds managed by Tennenbaum Capital Partners LLC, which matures in August 2019 (see "Liquidity and Capital Resources - Credit Facilities" for further discussion). Overview We are a leading provider of domain name services that enable businesses and consumers to find, establish, and maintain their digital address-the starting point for connecting with their online audience. Millions of digital destinations and thousands of resellers rely upon our comprehensive platform for the discovery, registration, usage, development, and monetization of domain names. As a result, we are a leader in the multibillion dollar domain name services industry, with a complete suite of services that our customers use as the foundation to build their entire online presence. We are the world's largest wholesale Internet domain name registrar, and the second largest registrar overall, offering domain name registration and other related services to resellers and directly to domain name registrants. Through our eNom brand, we provide infrastructure services that enable a network of more than 20,000 active resellers to offer domain name registration services to their customers. Further, through our retail brands, including Name.com, we directly offer domain name registration services to more than 250,000 customers. As of June 30, 2014, we had more -17- --------------------------------------------------------------------------------than 16 million domain names under management. In addition to domain name registration and related services, we have developed proprietary tools and services that identify and acquire, as well as monetize and sell, domain names, both for our own portfolio of names as well as for our customers. We are also positioned to become a leading domain name registry through our participation in the New gTLD Program. To capitalize on this opportunity, we have made significant organizational and technical investments required to operate a domain name registry. To date, we have launched into the marketplace our first 23 gTLDs, including, .Rocks, .Immobilien, .Attorney and .Ninja. In total, we have secured an interest in active applications or registry operator agreements for approximately 100 new gTLDs. The combination of our existing registrar business and our new registry business will make us one of the largest providers of endtoend domain name services in the world and uniquely positions us to capitalize on the New gTLD Program. We are a Delaware corporation headquartered in Kirkland, Washington. We generate the substantial majority of our revenue through domain name registration subscriptions and related valueadded services. We also generate revenue from advertising on, and from the sale of domain names that are registered to our customers or ourselves. For the six months ended June 30, 2014 and 2013, we reported revenue of $91.2 million and $94.1 million, respectively. Key Business Metrics We review a number of business metrics, including the following key metrics, to evaluate our business, measure the performance of our business model, identify trends impacting our business, determine resource allocations, formulate financial projections and make strategic business decisions. We believe the following measures are the primary indicators of our performance: Domain Name Services · domain: We define a domain as an individual domain name paid for by a third-party customer where the domain name is managed through our registrar service offering and for which we have recognized revenue. · average revenue per domain: We calculate average revenue per domain by dividing domain name services revenue for a period by the average number of domain names registered in that period. The average number of domain names is the simple average of the number of domain names at the beginning and end of the period. The average revenue per domain name for partial year periods is annualized. · renewal rate: We define the renewal rate as the percentage of our domain names that are renewed after expiration of the initial term. The following table sets forth performance highlights of key business metrics for the periods presented: Three months ended Six months ended June 30, % June 30, % 2014 2013 Change 2014 2013 Change Domain Name Services End of period domains (in millions) 15.5 14.0 11 % 15.5 14.0 11 % Average revenue per domain $ 10.30 $ 9.99 3 % $ 10.17 $ 9.91 3 % Renewal rate 71.1 % 67.4 % 73.1 % 69.0 % Opportunities, Challenges and Risks Substantially all of our revenue is derived from domain name registrations and related valueadded service subscriptions from our wholesale and retail customers to our registrar platform. Growth in our revenue is dependent upon our ability to attract wholesale and retail customers to our registrar platform, to sustain those recurring revenue relationships by maintaining consistent domain name registration and valueadded service renewal rates and to grow -18- -------------------------------------------------------------------------------- those relationships through competitive pricing on domain name registrations, differentiated valueadded service and customer service offerings, and bestinclass reseller integration tools. Over the past few years our revenue growth has been driven by the addition of reseller customers with large volumes of domain names as well as the acquisition of Name.com, a leading retail registrar. Certain of these large customers account for a significant portion of our revenue, and from time to time, we enter into multiyear agreements with those customers. For example, our top three customers account for 25% of our combined revenue for the six months ended June 30, 2014. We also generate advertising revenue through our monetization platform for websites or domain names that we or our customers own. The revenue associated with these websites has recently experienced flat to declining trends due to lower traffic and advertising yields in the marketplace, which we expect to continue. Going forward, we are diversifying our service offerings and expect to be a leading platform for offering new gTLDs, which we believe will help us attract new wholesale and retail customers as well as grow domain name registration volumes with existing customers. ICANN has approved a framework for the significant expansion of the number of gTLDs, which ICANN began delegating in the fourth quarter of 2013. We believe that such expansion could result in an increase in the number of domain names registered on our platform. In addition to wholesale and retail customer growth opportunities in our existing registrar business, the New gTLD Program provides us with new revenue opportunities, such as the opportunity to provide the technical infrastructure for new gTLD registries operated by third parties. We also began generating revenue as the exclusive registry operator for our portfolio of new gTLDs in the first quarter of 2014. We incurred approximately $8.4 million and $4.5 million of expenses related to the New gTLD Program for the year ended December 31, 2013 and for the six months ended June 30, 2014, respectively. We paid $3.9 million during the year ended December 31, 2013 and $18.2 million during the year ended December 31, 2012, for certain gTLD applications under the New gTLD Program. Payments for gTLD applications represent amounts paid directly to ICANN and third parties in the pursuit of certain exclusive gTLD operator rights. We capitalized payments made for gTLD applications that are determined to embody a probable economic benefit, and such capitalized payments are included in other longterm assets and intangible assets. As part of the New gTLD Program, we have received partial cash refunds for certain gTLD applications and to the extent we elect to sell or dispose of certain gTLD applications throughout the process, we will continue to incur gains or losses on amounts invested. Gains on the sale of our interest in gTLDs are recognized when realized, while losses are recognized when deemed probable. Upon the delegation of operator rights for each gTLD by ICANN, which commenced in December 2013, gTLD application fees are reclassified as finitelived intangible assets and amortized on a straightline basis over their estimated useful life. We expense as incurred other costs incurred as part of this gTLD initiative and not directly attributable to the acquisition of gTLD operator rights. Our service costs, the largest component of our operating expenses, can vary from period to period, particularly as a percentage of revenue. As a result of our recent growth having largely been driven by reseller customers with large volumes of domain names but from which we realize lower margins, service costs as a percentage of revenue increased in 2014 compared to 2013. Historically, our marketing expense has reflected our wholesale registrar's ability to leverage the existing marketing and customer relationships of its reseller base. We expect marketing investments to grow as we promote our Name.com retail registrar and New gTLD Program. Marketing activity will primarily flow through our sales and marketing expense line item, although to the extent that our registry offers performance incentive rebates or other business incentives to our partners, those incentives will be recognized as a reduction to revenue. We believe that these factors, together with costs associated with our preparation for new gTLDs, which became available for registration in the fourth quarter of 2013, will compress our operating margin in the short term as we increase our investment in new business initiatives to support future growth. However, over the long term, we expect our overall operating margins to increase as the registry business becomes a larger contributor to our overall revenue -19- --------------------------------------------------------------------------------mix, as registryrelated revenue streams are expected to have higher margins over the long term than our existing registrar business. Basis of Presentation The businesses included within Rightside have historically operated as part of Demand Media and not as a separate standalone entity. Our condensed combined financial statements have been prepared on a "carveout" basis from the condensed consolidated financial statements of Demand Media to represent our financial position and operating results as if we had existed on a standalone basis during the periods presented. Our condensed combined financial statements have been derived from the condensed consolidated financial statements and accounting records of Demand Media using the historical results of operations and historical basis of attributed assets and liabilities of Rightside's business. These historical condensed combined financial statements reflect our financial position, results of operations and cash flows in conformity with generally accepted accounting principles ("GAAP"). Our financial statements include certain assets, liabilities, revenue and expenses of Demand Media, which were allocated for certain functions, including general corporate expenses related to finance, legal, information technology, human resources, shared services, insurance, employee benefits and incentives, and stockbased compensation. These attributed assets, liabilities, revenue and expenses have been allocated to us on the basis of direct usage when identifiable, and for resources indirectly used by us, allocations were based on relative headcount, revenue, or other methodology, to reflect estimated usage by the Rightside business. Management considers the allocation methodology and results to be reasonable for all periods presented. However, these allocations may not be indicative of the actual results that we would have incurred as an independent public company or of the results expected to occur in the future. As such, the condensed combined financial statements included herein may not necessarily reflect our results of operations, financial position or cash flows in the future or what its results of operations, financial position or cash flows would have been had we been an independent company during the periods presented. Revenue Our revenue is principally comprised of registration fees charged to businesses and consumers in connection with new, renewed and transferred domain name registrations. In addition, our registrar also generates revenue from the sale of other valueadded services that are designed to help our customers easily build, enhance and protect their domain names, including security services, email accounts and web hosting, and the performance of services for registries. Finally, we generate advertising and domain name sales revenue as part of our aftermarket service offering. We generate this aftermarket revenue on domain names that we own, as well as by providing these services to third parties. Our revenue varies based upon the number of domain names registered or utilizing our aftermarket service offerings, the rates we charge our customers, our ability to sell valueadded services, our ability to sell domain names from our portfolio, and the monetization we are able to achieve through our aftermarket service offerings. Performance incentive rebates and certain other business incentives are recognized as a reduction in revenue. We primarily market our wholesale registration services under our eNom brand, and our retail registration services under our Name.com brand. We began recognizing insignificant revenue from our gTLD Initiative in the fourth quarter of 2013 and began generating revenue from the portfolio of new gTLDs we exclusively operate in the first quarter of 2014. The amount as well as the timing of revenue is uncertain and is dependent upon the timing and number of our backend registry customers' launches of gTLDs, the outcome of our negotiations or auctions to acquire the operating rights for gTLD applications contested with other participants, the demand and level of user adoption of new gTLDs and the continued progress of the overall ICANN New gTLD Program. To the extent that our registry will offer performance incentive rebates or certain other business incentives to our partners, those incentives will be recognized as a reduction to revenue. Costs and Expenses Costs and expenses consist of service costs, sales and marketing, product development, general and administrative, amortization of intangible assets, gain on other assets, net and other income. Included in our costs and expenses are stockbased compensation and depreciation expenses associated with our capital expenditures. -20- -------------------------------------------------------------------------------- Service Costs Service costs primarily consist of fees paid to registries and ICANN associated with domain name registrations, revenuesharing expenses, Internet connection and colocation charges and other platform expenses including depreciation of the systems and hardware used to build and operate our services, and personnel costs related to customer service and information technology. Our service costs are dependent on a number of factors, including the volume of domain name registrations, valueadded services supported by our registrar service and the revenue share agreements we have with our domain name customers utilizing our monetization platform. In the near term, we expect higher overall registration costs as a percentage of revenue due to the recent growth in highervolume, lowermargin customers as well as a mix shift of revenue toward lowermargin domain name services revenue relative to aftermarket service revenue. Sales and Marketing Sales and marketing expenses consist primarily of sales and marketing personnel costs, sales support, advertising, marketing and general promotional expenditures. We currently anticipate that our sales and marketing expenses will continue to increase in the near term as a percent of revenue as we continue to support our sales efforts and invest in the growth of our business including our gTLD Initiative. Product Development Product development expenses consist primarily of expenses incurred in our software engineering and product development and related personnel costs. Fluctuations in our product development expenses are generally the result of hiring personnel to support and develop our platform, including the costs to develop our future service offerings. We currently anticipate that our product development expenses will increase, but remain relatively flat as a percentage of revenue as we continue to hire more product development personnel and further develop our products and offerings to support the growth of our business, including our gTLD Initiative. General and Administrative General and administrative expenses consist primarily of personnel costs from our executive, legal, finance, human resources and information technology organizations and facilitiesrelated expenditures, as well as third party professional fees, insurance and bad debt expenses. Professional fees are largely comprised of outside legal, audit and information technology consulting. In the near term, we expect our general and administrative expenses to remain relatively flat as a percentage of revenue as we start generating revenue from our registry operations. Amortization of Intangibles We capitalize certain costs allocated to the purchase price of certain identifiable intangible assets acquired in connection with business combinations and to acquire domain names, including initial registration costs. We amortize these costs on a straightline basis over the related expected useful lives of these assets, which have a useful life of 320 years on a combined basis as of June 30, 2013. We determine the appropriate useful life of intangible assets by performing an analysis of expected cash flows based on its historical experience of intangible assets of similar quality and value. We capitalize gTLD assets once they become available for their intended use and amortize them on a straightline basis over the remaining contractual period of the registry operator agreement, which is approximately 10 years. We expect intangible amortization expense to increase in the near term as we recognize expenses related to the gTLDs as they are launched into the market. Stockbased Compensation Included in our costs and expenses are expenses associated with stockbased compensation, which are allocated and included in service costs, sales and marketing, product development and general and administrative expenses. Stockbased compensation expense is largely comprised of costs associated with stock options and restricted stock units granted to employees, restricted stock issued to employees and expenses relating to Demand Media's Employee Stock -21- --------------------------------------------------------------------------------Purchase Plan. We record the fair value of these equitybased awards and expense their cost ratably over related vesting periods. Gain on Other Assets, Net Gain on other assets, net represents the gains on withdrawals of our interest in certain gTLD applications. Other Income (Expense), Net Other income (expense), net, consists primarily of realized gains related to the sale of marketable securities, transaction gains and losses on foreign currencydenominated assets and liabilities and interest income and expense. We expect our gains and losses will vary depending upon potential gains or losses resulting from our gTLD applications as well as movements in underlying currency exchange rates, which could become more significant as we continue to expand internationally. Provision for Income Taxes We are subject to income taxes principally in the United States, and certain other countries where we have a legal presence, including Ireland, Canada, Cayman Islands and Australia. We anticipate that as we expand our operations outside the United States, we will become subject to taxation based on the foreign statutory rates, and our effective tax rate could fluctuate accordingly. Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. We recognize the effect on deferred taxes of a change in tax rates on income in the period that includes the enactment date. Results of Operations The following tables set forth our results of operations for the periods presented (in thousands). The periodtoperiod comparison of financial results is not necessarily indicative of future results. Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Revenue $ 46,689 $ 48,217 $ 91,241 $ 94,114 Service costs (exclusive of amortization of intangible assets shown separately below) 39,796 35,793 78,062 71,429 Sales and marketing 2,201 2,861 4,971 5,364 Product development 3,041 2,682 6,925 5,245 General and administrative 5,489 6,540 12,179 12,049 Amortization of intangible assets 1,908 2,191 3,599 4,216 Gain on other assets, net (885) (1,229) (5,745) (1,229) Other (income) expense, net 35 20 (1,297) 19 Loss before income taxes (4,896) (641) (7,453) (2,979) Income tax benefit (expense) 1,406 (40) 42 564 Net loss $ (3,490) $ (681) $ (7,411) $ (2,415) -22- --------------------------------------------------------------------------------Depreciation expense included in the above line items: Service costs $ 1,294 $ 1,363 $ 3,199 $ 2,644 Sales and marketing 17 26 35 53 Product development 43 45 82 92 General and administrative 452 247 1,025 484 Total depreciation and amortization $ 1,806 $ 1,681 $ 4,341 $ 3,273 Stockbased compensation expense included in the above line items: Service costs $ 91 $ 117 $ 183 $ 223 Sales and marketing 173 477 843 833 Product development 314 245 579 480 General and administrative 709 1,598 1,666 3,231 Total stock-based compensation expense $ 1,287 $ 2,437 $ 3,271 $ 4,767 As a percentage of revenue: Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Revenue 100 % 100 % 100 % 100 % Service costs (Exclusive of amortization of intangible assets shown separately below) 85 74 86 76 Sales and marketing 5 6 5 6 Product development 7 6 8 6 General and administrative 11 13 12 13 Amortization of intangible assets 4 5 4 4 Gain on other assets, net (2) (3) (6) (1) Other (Income) expense, net - - (1) - Loss before income taxes (10) (1) (8) (4) Income tax benefit (expense) 3 - - 1 Net loss (7) % (1) % (8) % (3) % Revenue Revenue by service line was as follows (in thousands): Three months ended Six months ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Domain name services $ 39,566 $ 34,862 13 % $ 77,100 $ 68,332 13 % Aftermarket and other 7,123 13,355 (47) % 14,141 25,782 (45) % Total revenue $ 46,689 $ 48,217 (3) % $ 91,241 $ 94,114 (3) % -23- -------------------------------------------------------------------------------- Domain Name Services Domain name services revenue for the three months ended June 30, 2014 increased by $4.7 million, or 13%, to $39.6 million compared to $34.9 million for the same period in 2013. Excluding the acquisition-related benefit associated with Name.com, organic revenue growth was 7%. This growth was primarily due to an increase in domain name registrations associated with the continued onboarding of eNom wholesale partners. Domain name services revenue for the six months ended June 30, 2014 increased by $8.8 million, or 13%, to $77.1 million compared to $68.3 million for the same period in 2013. Excluding the acquisition-related benefit associated with Name.com, organic revenue growth was 7%. This growth was primarily due to an increase in domain name registrations associated with the continued onboarding of eNom wholesale partners. Aftermarket and Other Aftermarket and other revenue for the three months ended June 30, 2014 decreased by $6.3 million, or 47%, to $7.1 million compared to $13.4 million for the same period in 2013. The decrease was primarily due to a $4.5 million decline in domain sales, which decreased from $6.6 million to $2.1 million, primarily from lower sales of domain names in our portfolio. Additionally, our decision to eliminate low quality advertising traffic drove a $1.6 million decrease in advertising revenue. Aftermarket and other revenue for the six months ended June 30, 2014 decreased by $11.7 million, or 45%, to $14.1 million compared to $25.8 million for the same period in 2013. The decrease was primarily due to a $4.8 million decline in domain sales, which decreased from $9.4 million to $4.6 million, primarily from lower sales of domain names in our portfolio. Additionally, our decision to eliminate low quality advertising traffic drove a $3.5 million decrease in advertising revenue while lower advertising yields, as experienced across the industry resulted in a $3.4 million decrease in advertising revenue. Advertising yields have dropped across the industry primarily due to third party advertising providers' reduction in partner revenue shares and their lowered cost per click rates for domain parking ads. Cost and Expenses Costs and expenses were as follows (in thousands): Three months ended Six months ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Service costs (exclusive of amortization of intangible assets shown separately below) $ 39,796 $ 35,793 11 % $ 78,062 $ 71,429 9 % Sales and marketing 2,201 2,861 (23) % 4,971 5,364 (7) % Product development 3,041 2,682 13 % 6,925 5,245 32 % General and administrative 5,489 6,540 (16) % 12,179 12,049 1 % Amortization of intangible assets 1,908 2,191 (13) % 3,599 4,216 (15) % Gain on other assets, net (885) (1,229) (28) % (5,745) (1,229) 367 % Other income, net 35 20 75 % (1,297) 19 (6,926) % Service Costs Service costs for the three months ended June 30, 2014 increased by approximately $4.0 million, or 11%, to $39.8 million compared to $35.8 million in the same period in 2013. The increase was primarily due to a $4.4 million increase in domain name registration costs associated with our growth in registered domain names and related revenue over the same period. Additionally, there was a $0.3 million increase in network infrastructure support costs incurred to operate -24- --------------------------------------------------------------------------------the new registry platform. These increases were partially offset by a $0.8 million decrease in revenue sharing costs paid to our domain name monetization customers. Service costs for the six months ended June 30, 2014 increased by approximately $6.7 million, or 9%, to $78.1 million compared to $71.4 million in the same period in 2013.The increase was primarily due to a $8.3 million increase in domain name registration costs associated with our growth in registered domain names and related revenue over the same period. Additionally, there was a $0.6 million increase in depreciation expense related to network infrastructure assets, a $0.8 million increase in network infrastructure support costs incurred to operate the new registry platform and a $0.2 million increase in personnel costs. These increases were partially offset by a $3.3 million decrease in revenue sharing costs paid to our domain name monetization customers. Sales and Marketing Sales and marketing expenses for the three months ended June 30, 2014 decreased by approximately $0.7 million, or 23%, to $2.2 million compared to $2.9 million in the same period in 2013. The decrease was primarily due to lower stock compensation expense of $0.3 million due to a reduced allocation from Demand Media, lower commissions of $0.2 million as a result of reduced domain name sales, and lower consulting and payroll expenses of $0.4 million, partially offset by incremental expense of $0.4 million for new marketing campaigns. Sales and marketing expenses for the six months ended June 30, 2014 decreased by approximately $0.4 million, or 7%, to $5.0 million compared to $5.4 million in the same period in 2013. The decrease was primarily due to lower commissions of $0.3 million as a result of reduced domain name sales, and lower consulting and payroll expenses of $0.6 million, partially offset by incremental expense of $0.5 million for new marketing campaigns. Product Development Product development expense for the three months ended June 30, 2014 increased by approximately $0.3 million, or 13%, to $3.0 million compared to $2.7 million in the same period in 2013. Product development expense for the six months ended June 30, 2014 increased by approximately $1.7 million, or 32%, to $6.9 million compared to $5.2 million in the same period in 2013. The increase for the three and six months ended June 30, 2014 compared to the prior year periods was primarily due to an increase in personnel costs to support and develop our domain name services and registry platforms. General and Administrative General and administrative expenses for the three months ended June 30, 2014 decreased by approximately $1.1 million, or 16%, to $5.5 million compared to $6.5 million in the same period in 2013. The decrease was primarily due to a $0.9 million decrease in stock compensation expense due to a reduced allocation from Demand Media. General and administrative expenses for the six months ended June 30, 2014 increased by approximately $0.2 million, or 1%, to $12.2 million compared to $12.0 million in the same period in 2013. The increase was primarily due to a $1.1 million increase in payroll and related expenses related to an increase in corporate headcount associated with becoming a separate public entity, a $0.2 million increase in professional services and consulting fees and a $0.5 million increase in depreciation expense, mostly offset by lower stock compensation expense of $1.5 million and a decrease in facility costs of $0.2 million due to a decrease in allocations from Demand Media. Amortization of Intangibles Amortization expense for the three months ended June 30, 2014 decreased by approximately $0.3 million, or 13%, to $1.9 million compared to $2.2 million in the same period in 2013. The decrease was primarily due to a $0.4 million -25- -------------------------------------------------------------------------------- reduction resulting from intangible assets acquired in business acquisitions in prior years being fully amortized partially offset by a $0.2 million increase due to amortization of gTLDs as compared to the same period in 2013. Amortization expense for the six months ended June 30, 2014 decreased by approximately $0.6 million, or 15%, to $3.6 million compared to $4.2 million in the same period in 2013. The decrease was primarily due to a $1.0 million reduction resulting from intangible assets acquired in business acquisitions in prior years being fully amortized partially offset by a $0.5 million increase due to amortization of gTLDs as compared to the same period in 2013. Gain on Other Assets, Net Gain on other assets, net was $0.9 million for the three months ended June 30, 2014 and $5.7 million for the six months ended June 30, 2014 due to payments received in exchange for the withdrawals of our interest in certain gTLD applications. Gain on other assets, net was $1.2 million for the three and six months ended June 30, 2013. Other (Income) Expense, Net Other (income) expense, net was flat for the three months ended June 30, 2014 and increased $1.3 million for the six months ended June 30, 2014 primarily due to a $1.4 million gain on sale of marketable securities during first quarter 2014. Income Tax (Benefit) Provision During the three months ended June 30, 2014, we recorded an income tax benefit of $1.4 million and the income tax expense was immaterial during the same period in 2013, representing an increase of $1.4 million. The increase was primarily due to increased book losses during the period. During the six months ended June 30, 2014, we recorded a an immaterial income tax benefit compared to a $0.6 million income tax benefit during the same period in 2013 primarily due to the reversal of a deferred tax asset as a result of cancelled stock options. Liquidity and Capital Resources Historically, we have principally financed our operations from net cash provided by our operating activities. Our cash flows from operating activities are significantly affected by our cash based investments in operations, including working capital, and corporate infrastructure to support our ability to generate revenue and conduct operations through cost of services, product development, sales and marketing and general and administrative activities. Cash used in investing activities has historically been, and is expected to be, significantly impacted by our ongoing investments in our platform, company infrastructure, equipment for our domain name services and, more recently, our investments in gTLD applications. Our capital expenditures and investments in gTLDs have to date been funded by both cash flow from operations and investment from our parent, Demand Media. As of June 30, 2014 our principal sources of liquidity were our cash and cash equivalents in the amount of $51.9 million. As part of our separation from Demand Media, cash and cash equivalents were allocated between the two companies, resulting in Rightside receiving cash of $26.1 million as of August 1, 2014 and Demand Media assuming all of the existing outstanding debt at the separation date. Subsequent to the separation, we entered into credit facilities designed to increase our liquidity and financial flexibility to pursue our strategic objectives, including the acquisition of additional gTLDs. Credit Facilities On August 1, 2014, we entered into a $30.0 million senior secured revolving credit facility with Silicon Valley Bank ("SVB"), including a subfacility of $15.0 million available for the issuance of letters of credit (the "SVB Credit Facility"), which was amended on August 12, 2014. Upon initial closing, letters of credit with a face amount of approximately $9.8 million that were previously issued under Demand Media's credit agreement were deemed to be issued under the SVB Credit Facility, and we assumed all obligations to SVB related thereto. Borrowings under the SVB Credit Facility bear interest at a rate per year equal to, at our option, either: (1) a base rate determined by reference to the -26- -------------------------------------------------------------------------------- highest of: (a) the prime rate; (b) 0.50% per annum above the federal funds effective rate; and (c) the Eurodollar base rate for an interest period of one month plus 1.00%, plus a margin ranging from 1.00% to 1.50%, depending on our consolidated senior leverage ratio (as determined under the SVB Credit Facility), or (2) a Eurodollar base rate determined by reference to LIBOR for the interest period equivalent to such borrowing adjusted for certain reserve requirements, plus a margin ranging from 2.00% to 2.50%, depending on our consolidated senior leverage ratio (as determined under the SVB Credit Facility). Interest on the revolving loans is payable at the end of the applicable interest period for Eurodollar loans, but at least quarterly, and quarterly for base rate loans. The revolving loans under the SVB Credit Facility may be repaid and reborrowed until the maturity date in August 2017, when all amounts outstanding under the facility must be repaid in full. The outstanding loans under the SVB Credit Facility may be voluntarily prepaid at any time without premium or penalty, other than customary "breakage" costs with respect to LIBOR loans. The SVB Credit Facility allows SVB to require mandatory prepayments of outstanding borrowings from amounts otherwise required to prepay term loans under the Tennenbaum Credit Facility, as described below. The SVB Credit Facility contains financial covenants, including a requirement that we maintain a minimum consolidated fixed charge coverage ratio, a maximum consolidated senior leverage ratio, a maximum consolidated net leverage ratio, and minimum liquidity. The SVB Credit Facility contains customary representations and warranties, events of default and affirmative and negative covenants. Under certain circumstances, a default interest rate will apply on all outstanding obligations during the existence of an event of default at a per annum rate equal to 2.00% above the otherwise applicable interest rate. On August 6, 2014, we entered into a $30.0 million term loan credit facility with certain funds managed by Tennenbaum Capital Partners LLC (the "Tennenbaum Credit Facility"). Upon initial closing, we incurred $10.0 million in term loan borrowings and our Cayman subsidiary, United TLD HoldCo Ltd. ("United"), incurred $20.0 million in term loan borrowings under the Tennenbaum Credit Facility. Term loans under the Tennenbaum Credit Facility bear interest at a rate per year equal to LIBOR (but not less than 0.50% per annum) plus 8.75%. Interest on the term loans is payable quarterly, beginning September 30, 2014. The principal amount of the term loans is scheduled to be repaid in quarterly installments of $375,000, beginning March 31, 2015. Once repaid, term loans may not be reborrowed. All amounts outstanding under the facility are due and payable in full on the maturity date in August 2019. Any outstanding term loans under the Tennenbaum Credit Facility may be voluntarily prepaid by paying an amount equal to the principal amount being prepaid plus a premium of 4.00%, if prepaid in the first year the facility is outstanding, 2.50% in the second year, 1.00% in the third year, and 0.00% thereafter, plus customary "breakage" costs with respect to LIBOR loans. Any such voluntary prepayments will be applied pro rata against the remaining principal installments. The term loans under the Tennenbaum Credit Facility are subject to mandatory prepayments from 50% of excess cash flow (as determined under the Tennenbaum Credit Facility), which will be paid on the first to occur of the maturity, termination or refinancing of the SVB Credit Facility or the acceleration and termination of the SVB Credit Facility, from excess cash flow determined for the period from the closing of the Tennenbaum Credit Facility to the end of the fiscal year ended as of the date 90 days prior to such date, and thereafter annually for excess cash flow determined for each subsequent fiscal year. In addition, mandatory prepayments, to the extent not used to prepay loans and cash collateralize letters of credit and permanently reduce the commitments under the SVB Credit Facility, are required from certain asset sales and insurance and condemnation events, subject to customary reinvestment rights. Mandatory prepayments are also required from the issuances of certain indebtedness. Mandatory prepayments from asset sales and issuances of indebtedness are subject to a prepayment premium that is the same as for voluntary prepayments. Any such mandatory prepayments will be applied in inverse order of maturity against the remaining principal installments. The Tennenbaum Credit Facility contains financial covenants, including a requirement that we maintain a maximum consolidated net leverage ratio and minimum liquidity. The Tennenbaum Credit Facility contains customary representations and warranties, events of default and affirmative and negative covenants. Under certain circumstances, a default interest rate will apply on all outstanding obligations during the existence of an event of default at a per annum rate equal to 2.00% above the otherwise applicable interest rate. In connection with the Tennenbaum Credit Facility, we issued to the lenders warrants to purchase up to an aggregate of 997,710 shares of common stock. The warrants have an exercise price of $15.05 per share and will be exercisable in accordance with their terms at any time on or after February 6, 2015 through August 6, 2019. The warrants contain a "cashless exercise" feature that allows the warrant holders to exercise such warrants by surrendering a number -27- --------------------------------------------------------------------------------of shares underlying the portion of the warrant being exercised with a fair market value equal to the aggregate exercise price payable to us. We believe this capital structure is appropriate for this stage of the Company and is sufficient to grow the business while pursuing our strategic objectives. However, we are participating in a dynamic and emerging environment, and will continuously evaluate our position relative to the opportunities available in the marketplace. We believe that our future cash from operations, together with our ability to access sources of financing, including debt and equity, will provide sufficient resources to fund both short term and long term operating requirements, capital expenditures, acquisitions and new business development activities for at least the next 12 months. Historical Cash Flow Trends The following table sets forth our major sources and (uses) of cash for each period as set forth below (in thousands): Six months ended June 30, 2014 2013 Net cash provided by (used in) operating activities $ (117) $ 7,457 Net cash used in investing activities (7,580) (4,934) Net cash provided by (used in) financing activities (7,220) 5,083 Cash Flows from Operating Activities Net cash used in our operating activities was $0.1 million for the six months ended June 30, 2014 compared to net cash inflows of $7.5 million in the prior year period. Our net loss during the 2014 period was $7.4 million, which included a gain on the withdrawal of gTLD applications of $5.7 million, a gain on the sale of marketable securities of $1.4 million and noncash charges of $12.7 million such as depreciation, amortization, stockbased compensation, and deferred taxes. In addition, changes in our working capital generated $1.9 million. Positive contributions of $14.3 million from movements in deposits with registries, accrued expenses and deferred revenue, were partially offset by our utilizing $12.4 million to fund an increase in deferred registration costs, a reduction in accounts payable and an increase in accounts receivable, and prepaid and other assets. Cash Flows from Investing Activities Net cash used in investing activities for the six months ended June 30, 2014 increased $2.6 million, or 54%, to $7.6 million compared to $4.9 million net cash used in investing activities for the same period in 2013. The increase of cash used in investing activities was primarily due to payments of $11.5 million related to gTLD applications, an increase in restricted cash of $0.3 million, and a decrease in cash flows from other investing activities of $0.3 million. These cash uses were partially offset by an increase in proceeds from gTLD application withdrawals of $4.7 million, $1.4 million from the sale of marketable securities, fewer investments in property and equipment of $2.8 million, and a $0.6 million reduction in intangible asset investments. Cash Flows from Financing Activities Changes in net cash from financing activities for all periods presented are primarily due to transfers to and from our parent, Demand Media. Parent company investment in the condensed combined balance sheets represents Demand Media's historical investment in us, the net effect of cost allocations from transactions with Demand Media and our accumulated earnings. -28- --------------------------------------------------------------------------------OffBalance Sheet Arrangements At June 30, 2014, we were not a party to any offbalance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, revenue or expenses, results of operations, liquidity or capital resources other than those contractual obligations disclosed in the section entitled "Liquidity and Capital Resources." Contractual Obligations and Commitments On August 6, 2014, Rightside entered into a $30.0 million term loan credit facility with certain funds managed by Tennenbaum Capital Partners, LLC, which matures in August 2019. The principal amount of the term loans is scheduled to be repaid in quarterly installments of $375,000, beginning March 31, 2015. Once repaid, term loans may not be reborrowed. All amounts outstanding under the facility are due and payable in full on the maturity date in August 2019. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosure of contingent assets and liabilities, revenue and expenses at the date of the financial statements. Generally, we base our estimates on historical experience and on various other assumptions in accordance with GAAP that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. Critical accounting policies and estimates are those that we consider the most important to the portrayal of our financial condition and results of operations because they require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our critical accounting policies and estimates include those related to: · revenue recognition; · domain name services; · aftermarket and other; · accounts receivable; · goodwill; · capitalization and useful lives associated with our intangible assets, including internal software; · recoverability of long-lived assets; · income taxes; and · stock-based compensation. There have been no material changes in our critical accounting policies and estimates in the preparation of our condensed combined financial statements during the three and six months ended June 30, 2014 compared to those disclosed in our Form 10 as filed with the SEC on July 14, 2014. -29- --------------------------------------------------------------------------------Recent Accounting Pronouncements In February 2013, the FASB issued ASU 2013-2, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income (ASU 2013-2), to improve the reporting of reclassifications out of accumulated other comprehensive income. ASU 2013-2 requires presentation, either on the face of the financial statements or in the notes, of amounts reclassified out of accumulated other comprehensive income by component and by net income line item. ASU 2013-2 is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2012. We adopted ASU 2013-2 in the first quarter of fiscal 2014. The adoption of ASU 2013-2 did not have a significant impact on our condensed combined financial statements, but did require additional disclosures. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (ASU 2014-09). ASU 2014-09 outlines a new, single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The new model will require revenue recognition to depict the transfer of promised goods or services to customers in an amount that reflects the consideration a company expects to receive in exchange for those goods or services. The amendments in ASU 2014-09 are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period and early adoption is not permitted. The standard can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. We are currently assessing the impact that this updated standard will have on our condensed combined financial statements and footnote disclosures. In June 2014, the FASB issued ASU 2014-12, Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide that a Performance Target Could be Achieved after the Requisite Service Period (ASU 2014-12), which requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. We do not anticipate that the adoption of this standard will have a material impact on our condensed combined financial statements. |