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SYNCHRONOSS TECHNOLOGIES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the information set forth in our consolidated financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and in our annual report Form 10-K for the year ended December 31, 2013. This report contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management as of the date hereof based on information currently available to our management. Use of words such as "believes," "expects," "anticipates," "intends," "plans," "hopes," "should," "continues," "seeks," "likely" or similar expressions, indicate a forward-looking statement. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions. Actual results may differ materially from the forward-looking statements we make. We caution investors not to place substantial reliance on the forward-looking statements included in this report. These statements speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments. All numbers are expressed in thousands unless otherwise stated. Overview We are a mobile innovation company that provides cloud solutions and software-based activation for connected devices globally. Such services include intelligent connectivity management and content synchronization, backup and sharing, as well as device and service procurement, provisioning, activation, and support, that enable communications service providers ("CSPs"), cable operators/multi-services operators ("MSOs"), original equipment manufacturers ("OEMs") with embedded connectivity (e.g. smartphones, laptops, tablets and mobile Internet devices, such as automobiles, wearables for personal health and wellness, and connected homes), multi-channel retailers and other customers to accelerate and monetize their go-to-market strategies for connected devices. This includes automating subscriber activation, order management, upgrades, service provisioning and connectivity and content management from any sales channel to any communication service (wireless or wireline), across any connected device type and managing the content transfer, synchronization and share. Our global solutions touch all aspects of connected devices on the mobile Internet. Our Synchronoss Personal Cloud™ solution targets individual consumers while our Synchronoss WorkSpace™ solution focuses on providing a secure, integrated file sharing and collaboration solution for small and medium businesses. In addition, our Integrated Life™ platform is specifically designed to power the activation of the devices and technologies that seamlessly connect today's consumer and leverage our cloud assets to manage these devices and contents associated with them. The Integrated Life™ platform enables us to drive a natural extension of our mobile activations and cloud services with leading wireless networks around the world to link other non-traditional devices (i.e., automobiles, wearables for personal health and wellness, and connected homes). Our Activation Services, Synchronoss Personal Cloud™, Synchronoss WorkSpace™, and Synchronoss Integrated Life™ platforms provide end-to-end seamless integration between customer-facing channels/applications, communication services, or devices and "back-office" infrastructure-related systems and processes. Our customers rely on our solutions and technology to automate the process of activation and content and settings management for their customers' devices while delivering additional communication services. Our Synchronoss Integrated Life™ platform brings together the capabilities of device/service activation with content and settings management to provide a seamless experience of activating and managing non-traditional devices. Our platforms also support automated customer care processes through use of accurate and effective speech processing technology and enable our customers to offer their subscribers the ability to store in and retrieve from the Cloud their personal and work content and data to their connected mobile devices, such as personal computers, smartphones and tablets. Our platforms are designed to be carrier-grade, high availability, flexible and scalable to enable multiple converged communication services to be managed across multiple distribution channels, including e-commerce, m-commerce, telesales, customer stores, indirect and other retail outlets, allowing us to meet the rapidly changing and converging services and connected devices offered by our customers. We enable our customers to acquire, retain and service subscribers quickly, reliably and cost-effectively by enabling backup, restore, synchronization and sharing of subscriber content. Through the use of our platforms, our customers can simplify the processes associated with managing the customer experience for procuring, activating, connecting, backing-up, synchronizing and social media and enterprise-wide sharing/collaboration connected devices and contents from these devices and associated services. The extensibility, scalability, reliability and relevance of our platforms enable new revenue streams and retention opportunities for our customers through new subscriber acquisitions, sale of new devices, accessories and new value-added service offerings in the Cloud, while optimizing their cost of operations and enhancing customer experience. We currently operate in and market our solutions and services directly through our sales organizations in North America, Europe and Asia-Pacific. Our industry-leading customers include Tier 1 mobile service providers such as AT&T Inc., Verizon Wireless, Vodafone, Orange, Sprint, Telstra and U.S. Cellular, Tier 1 cable operators/MSOs and wireline operators like AT&T Inc., Comcast, Cablevision, Charter, 15 -------------------------------------------------------------------------------- CenturyLink, Mediacom and Level 3 Communications, and large OEMs such as Apple and Ericsson. These customers utilize our platforms, technology and services to service both consumer and business customers. Revenues We generate a substantial portion of our revenues on a per-transaction or subscription basis, which is derived from contracts that extend up to 60 months from execution. For the three months ended September 30, 2014 and 2013, we derived approximately 80% and 77%, respectively, of our revenues from transactions processed and subscription arrangements. This increase is a result of new subscription arrangements with our existing customers and increased transaction volumes. The remainder of our revenues were generated from professional services and licenses. Historically, our revenues have been directly impacted by the number of transactions processed. The future success of our business depends on the continued growth of consumer and business transactions and, as such, the volume of transactions that we process could fluctuate on a quarterly basis. See "Current Trends Affecting Our Results of Operations" for certain matters regarding future results of operations. Most of our revenues are recorded in U.S. dollars but as we continue to expand our footprint with international carriers and increase the extent of recording our international activities in local currencies, we will become subject to currency translation risk that could affect our future net sales. Each of AT&T and Verizon Wireless accounted for more than 10% of our revenues for the three months ended September 30, 2014 and 2013. AT&T and Verizon Wireless in the aggregate accounted for 75% and 68% of our revenues for the three months ended September 30, 2014 and 2013, respectively. See "Risk Factors" for certain matters bearing risks on our future results of operations. Costs and Expenses Our costs and expenses consist of cost of services, research and development, selling, general and administrative, depreciation and amortization, change in contingent consideration and interest and other expense. Cost of services includes all direct materials, direct labor, cost of facilities and those indirect costs related to revenues such as indirect labor, materials and supplies. Our primary cost of services is related to our information technology and systems department, including colocation fees, network costs, data center maintenance, database management and data processing costs, as well as personnel costs associated with service implementation, customer deployment and customer care. Also included in cost of services are costs associated with our exception handling centers and the maintenance of those centers. Currently, we utilize a combination of employees and third-party providers to process transactions through these centers. Research and development costs are expensed as incurred unless they meet U.S. Generally Accepted Accounting Principles ("GAAP") criteria for deferral and amortization. Software development costs incurred prior to the establishment of technological feasibility do not meet these criteria, and are expensed as incurred. Research and development expense consists primarily of costs related to personnel, including salaries and other personnel-related expenses, consulting fees and the cost of facilities, computer and support services used in service technology development. We also expense costs relating to developing modifications and minor enhancements of our existing technology and services. Selling, general and administrative expense consists of personnel costs including salaries, sales commissions, sales operations and other personnel-related expenses, travel and related expenses, trade shows, costs of communications equipment and support services, facilities costs, consulting fees, costs of marketing programs, such as internet and print and other overhead costs. Net change in contingent consideration obligation consists of the changes to the fair value estimate of the obligation to the former equity holders which resulted from our acquisitions. The estimate is based on the weighted probability of achieving certain financial targets and milestones. The contingent consideration obligation earn-out periods are no longer than 12 months in duration. As such, we recognize the changes in fair value over that period. Final determination of the payment is done up to 90 days after the earn-out period. Depreciation relates to our property and equipment and includes our network infrastructure and facilities. Amortization primarily relates to trademarks, customer lists and technology acquired and internally developed software. Interest expense consists primarily of interest on our lease financing obligations and our convertible senior notes. 16 --------------------------------------------------------------------------------Current Trends Affecting Our Results of Operations Business from our Activation and Cloud Solutions has been driven by the unprecedented growth in mobile devices globally. Certain industry trends, such as Next programs from AT&T, have resulted in faster device upgrade cycles increasing device order transactions and activations. With mobile devices becoming content rich and starting to act as a replacement for other traditional devices like PC's, the need to securely back up content from mobile devices, sync it with other devices and share it with others in their community of family, friends and business associates have become essential needs. The major Tier 1 carriers are also publicly discussing achieving 500% penetration (multiple connected devices per user) by enabling connectivity to non-traditional devices. Such devices include connected cars, health and wellness devices, connected home and health care. The need for these devices to be activated, managed and the contents from them to be stored in a common cloud are also expected to be drivers of our businesses in the long term. Bring Your Own Technology is impacting the work environment for Small and Medium Businesses, which find themselves in a position where they need to offer their employees a safe environment to share and collaborate on their work documents and files via mobile devices. Leveraging our Synchronoss Personal Cloud™ solution infrastructure and technology to build our Synchronoss WorkSpace™ solution for this purpose is enabling us to serve a completely new market, which we believe will also contribute to our growth. To support our expected growth driven by the favorable industry trends mentioned above, we continue to look for opportunities to improve our operating efficiencies, such as the utilization of offshore technical and non-technical resources for our exception handling center management as well as routine software maintenance activities. We also leverage modular components from our existing software platforms to build new products. We believe that these opportunities will continue to provide future benefits and position us to support revenue growth. In addition, we anticipate further automation of the transactions generated by our more mature customers and additional transaction types. Our cost of services can fluctuate from period to period based upon the level of automation and the on-boarding of new transaction and service types. We are also making investments in new research and development for development of products designed to enable us to grow rapidly in the mobile wireless market. Our purchase of capital assets and equipment may also increase based on aggressive deployment, subscriber growth and promotional offers for storage incentives by our major Tier 1 carrier customers. We continue to advance our plans for the expansion of our platforms' footprint with broadband carriers and international mobile carriers to support connected devices and multiple networks through our focus on transaction management and cloud-based services for back up, synchronization and sharing of content. Our initiatives with AT&T, Verizon Wireless, Vodafone and other CSPs continue to grow both with our current businesses as well as new products. We are also exploring additional opportunities through merger and acquisition activities to support our customer, product and geographic diversification strategies. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements in accordance with GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during a fiscal period. The Securities and Exchange Commission ("SEC") considers an accounting policy to be critical if it is important to a company's financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. We have discussed the selection and development of the critical accounting policies with the audit committee of our Board of Directors, and the audit committee has reviewed our related disclosures in this Form 10-Q. Although we believe that our judgments and estimates are appropriate, correct and reasonable under the circumstances, actual results may differ from those estimates. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected. See "Risk Factors" for certain matters bearing risks on our future results of operations. 17 -------------------------------------------------------------------------------- We believe that of our significant accounting policies, which are described in Note 2 in our Annual Report on Form 10-K for the year ended December 31, 2013, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies which we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations: · Revenue Recognition and Deferred Revenue · Allowance for Doubtful Accounts · Income Taxes · Goodwill and Impairment of Long-Lived Assets · Business Combinations · Stock-Based Compensation There were no significant changes in our critical accounting policies and estimates discussed in our Form 10-K during the nine months ended September 30, 2014. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2013 for a more complete discussion of our critical accounting policies and estimates. Acquisitions On July 11, 2014, the Company acquired all outstanding shares of Vox, a French company, for $25.1 million, net of cash acquired and liabilities assumed, subject to certain working capital adjustments. The Company believes that this acquisition will enable its position as the leading provider of personal cloud solutions to the world's largest mobile operators. On July 2, 2014, the Company acquired certain assets, liabilities and workforce from Clarity, an Australian company, for cash consideration of $6.6 million net of liabilities assumed. The Company believes that the assets and customer contracts acquired from Clarity will assist the Company's access to new markets in the Asia Pacific region. On May 12, 2014, the Company acquired certain assets and workforce from Digi-Data, a U.S. company, for total consideration of $6.3 million. The Company believes that the assets and workforce acquired from Digi-Data will expedite the Company's integration of broadband technologies into the Company's wireless cloud offerings. Results of Operations Three months ended September 30, 2014 compared to the three months ended September 30, 2013 The following table presents an overview of our results of operations for the three months ended September 30, 2014 and 2013: Three Months Ended September 30, 2014 2013 2014 vs 2013 $ % of Revenue $ % of Revenue $ Change % Change (in thousands) Net revenues $ 125,175 100.0 % $ 89,716 100.0 % $ 35,459 39.5 % Cost of services* 50,496 40.3 % 38,133 42.5 % 12,363 32.4 % Research and development 21,056 16.8 % 16,554 18.5 % 4,502 27.2 % Selling, general and administrative 21,382 17.1 % 15,562 17.3 % 5,820 37.4 % Net change in contingent consideration obligation 355 0.3 % 500 0.6 % (145) (29.0) % Depreciation and amortization 16,268 13.0 % 10,213 11.4 % 6,055 59.3 % Total costs and expenses 109,557 87.5 % 80,962 90.2 % 28,595 35.3 % Income from operations $ 15,618 12.5 % $ 8,754 9.8 % $ 6,864 78.4 % * Cost of services excludes depreciation and amortization which is shown separately. Net Revenues. Net revenues increased $35.5 million to $125.2 million for the three months ended September 30, 2014, compared to the same period in 2013. This increase was due primarily to the expansion of our services provided to our customers. Transaction and subscription revenues as a percentage of sales were 80% or $100.3 million for the three months ended September 30, 2014 compared to 77% or $69.4 million for the same period in 2013. The increase in transaction and subscription revenue is primarily due 18 --------------------------------------------------------------------------------to new subscription arrangements with our existing customers and increased transaction volumes. Professional service and license revenues as a percentage of sales were 20% or $24.9 million for the three months ended September 30, 2014, compared to 23% or $20.3 million for the same period in 2013. Net revenues related to Activation Services increased $4.5 million to $67.4 million for the three months ended September 30, 2014 compared to the same period in 2013. Net revenues related to Activation Services represented 54% for the three months ended September 30, 2014, compared to 70% for the same period in 2013. Net revenues related to our Cloud Services increased by $31.0 million to $57.8 million for the three months ended September 30, 2014 compared to the same period in 2013. Net revenues related to our Cloud Services represented 46% for the three months ended September 30, 2014, compared to 30% for the same period in 2013. The increase in our Cloud Service performance was a result of a strong adoption of our cloud offerings across our customer base. Expenses Cost of Services. Cost of services increased $12.4 million to $50.5 million for the three months ended September 30, 2014, compared to the same period in 2013, due primarily to an increase of $5.9 million in colocation costs related to the expansion of our hosting and storage offerings. There was also an increase of $2.6 million in outside consulting expense, due to our increased use of third party exception handling vendors. Additionally, our personnel and related costs increased $4.1 million as a result of our continued growth in existing and new programs with our customers. As a result of increased revenues, cost of services as a percentage of revenues decreased to 40.3% for the three months ended September 30, 2014, as compared to 42.5% for the same period in 2013. Research and Development. Research and development expense increased $4.5 million to $21.1 million for the three months ended September 30, 2014, compared to the same period in 2013 primarily due to an increase of $1.6 million in outside consultants and $3.1 million in personnel and related costs, as a result of our acquisitions and our continued growth as we further expand the capabilities of our offerings. Research and development expense as a percentage of revenues decreased to 16.8% for the three months ended September 30, 2014 as compared to 18.5% for the same period in 2013. Selling, General and Administrative. Selling, general and administrative expense increased $5.8 million to $21.4 million for the three months ended September 30, 2014, compared to the same period in 2013. This was primarily driven by an increase of $2.7 million in personnel and related costs and an increase of $2.2 million in merger and acquisition related expenses. The increase in personnel and related costs primarily related to increased headcount as a result of our international expansion as well as the earn-out compensation due to the former owners and employees of Strumsoft. Additionally, there was an increase in merger and acquisition expense related to the recent acquisitions of Vox and Clarity. As a result of increased revenues, selling, general and administrative expense as a percentage of revenues decreased to 17.1% for the three months ended September 30, 2014, compared to 17.3% for the same period in 2013. Net change in contingent consideration obligation. The net change in contingent consideration obligation resulted in a $145 thousand decrease for the three months ended September 30, 2014. The contingent consideration associated with the Strumsoft acquisition increased $355 thousand due to changes in the fair value estimates related to the weighted probability of achieving revenue milestones. The contingent consideration associated with the SpeechCycle, Inc. and Spatial Systems Nominees PTY Limited acquisitions decreased $500 thousand due to the completion of their earn-out periods. Depreciation and amortization. Depreciation and amortization expense increased $6.1 million to $16.3 million for the three months ended September 30, 2014, compared to the same period in 2013. This was primarily related to the increase in depreciable fixed assets necessary for the continued expansion of our platforms and amortization of our newly acquired intangible assets related to our recent acquisitions. Depreciation and amortization expense as a percentage of revenues increased to 13.0% for the three months ended September 30, 2014, as compared to 11.4% for the three months ended September 30, 2013. Income from Operations. Income from operations increased $6.9 million to $15.6 million for the three months ended September 30, 2014, compared to the same period in 2013. This was primarily due to increased revenues, offset by the additional costs associated with our acquired operations, increased depreciation for data center deployments and amortization related to acquisitions. Income from operations as a percentage of revenues increased to 12.5% for the three months ended September 30, 2014, as compared to 9.8% for the three months ended September 30, 2013. Interest income. Interest income increased $177 thousand to $326 thousand for the three months ended September 30, 2014, compared to the same period in 2013, as a result of interest income earned on our larger cash and marketable securities balances. Interest expense. Interest expense increased $897 thousand to $1.1 million for the three months ended September 30, 2014, compared to the same period in 2013 due primarily to an increase of approximately $267 thousand related to our $40 million borrowing on our revolving credit facility, which was drawn in July and subsequently repaid in September, and an additional $392 thousand related to the convertible debt. 19 -------------------------------------------------------------------------------- Other income (expense). Other income (expense) increased $372 thousand to $3 thousand for the three months ended September 30, 2014, compared to the same period in 2013. Other income (expense) increased primarily due foreign currency exchange rate fluctuations. Income Tax. We recognized approximately $5.5 million and $4.7 million in related income tax expense during the three months ended September 30, 2014 and 2013, respectively. Our effective tax rate was approximately 37.0% for the three months ended September 30, 2014, which was higher than our U.S. federal statutory rate primarily due to an unfavorable impact of the change in fair market value for the contingent consideration obligation related to our Strumsoft earn-out, offset by a favorable impact of profit mix in foreign jurisdictions, which have lower tax rates. Our effective tax rate was approximately 56.7% for the three months ended September 30, 2013, which was higher than our U.S. federal statutory rate primarily due to an unfavorable impact of the change in fair market value for the contingent consideration obligation related to the Spatial earn-out and higher state taxes. We review the expected annual effective income tax rate and make changes on a quarterly basis as necessary based on certain factors such as changes in forecasted annual operating income, changes to the actual and forecasted permanent book-to-tax differences, and changes resulting from the impact of tax law changes. Nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 The following table presents an overview of our results of operations for the nine months ended September 30, 2014 and 2013: Nine Months Ended September 30, 2014 2013 2014 vs 2013 $ % of Revenue $ % of Revenue $ Change % Change (in thousands) Net revenues $ 327,103 100.0 % $ 251,840 100.0 % $ 75,263 29.9 % Cost of services* 131,766 40.3 % 105,791 42.0 % 25,975 24.6 % Research and development 53,902 16.5 % 49,630 19.7 % 4,272 8.6 % Selling, general and administrative 55,656 17.0 % 45,157 17.9 % 10,499 23.2 % Net change in contingent consideration obligation 1,680 0.5 % 2,676 1.1 % (996) (37.2) % Restructuring charges - - % 5,172 2.1 % (5,172) (100.0) % Depreciation and amortization 42,292 12.9 % 28,792 11.4 % 13,500 46.9 % Total costs and expenses 285,296 87.2 % 237,218 94.2 % 48,078 20.3 % Income from operations $ 41,807 12.8 % $ 14,622 5.8 % $ 27,185 185.9 % * Cost of services excludes depreciation and amortization which is shown separately. Net Revenues. Net revenues increased $75.3 million to $327.1 million for the nine months ended September 30, 2014, compared to the same period in 2013. This increase was due primarily to the expansion of our services provided to our customers. Transaction and subscription revenues as a percentage of sales were 76% or $248.0 million for the nine months ended September 30, 2014 compared to 70% or $175.3 million for the same period in 2013. The increase in transaction and subscription revenue was primarily due to new subscription arrangements with our existing customers and increased transaction volumes. Professional service and license revenues as a percentage of sales were 24% or $79.1 million for the nine months ended September 30, 2014, compared to 30% or $76.5 million for the same period in 2013. Net revenues related to Activation Services increased $3.8 million to $179.0 million for the nine months ended September 30, 2014 compared to the same period in 2013. Net revenues related to Activation Services represented 55% for the nine months ended September 30, 2014, compared to 70% for the same period in 2013. Net revenues related to our Cloud Services increased by $71.5 million to $148.1 million of our revenues for the nine months ended September 30, 2014 compared to the same period in 2013. Net revenues related to our Cloud Services represented 45% for the nine months ended September 30, 2014, compared to 30% for the same period in 2013. The increase in our Cloud Service performance was a result of a strong adoption of our cloud offerings across our customer base. 20 -------------------------------------------------------------------------------- Expenses Cost of Services. Cost of services increased $26.0 million to $131.8 million for the nine months ended September 30, 2014, compared to the same period in 2013, due primarily to an increase of $14.7 million in colocation costs related to the expansion of our hosting and storage offerings. There was also an increase of $5.3 million in outside consulting expense, due to our increased use of third party exception handling vendors as a result of increased call volume. Additionally, our personnel and related costs increased $6.6 million as a result of our continued growth in existing and new programs with our customers. As a result of increased revenues, cost of services as a percentage of revenues decreased to 40.3% for the nine months ended September 30, 2014, as compared to 42.0% for the same period in 2013. Research and Development. Research and development expense increased $4.3 million to $53.9 million for the nine months ended September 30, 2014, compared to the same period in 2013 primarily due to an increase of $2.5 million in outside consultants and $2.2 million in personnel and related costs, as a result of our acquisitions and our continued growth as we further expand the capabilities of our offerings. Research and development expense as a percentage of revenues decreased to 16.5% for the nine months ended September 30, 2014 as compared to 19.7% for the same period in 2013. Selling, General and Administrative. Selling, general and administrative expense increased $10.5 million to $55.7 million for the nine months ended September 30, 2014, compared to the same period in 2013. There was an increase of $4.7 million in personnel and related costs and an increase of $1.9 million in stock-based compensation. The increase in personnel and related costs primarily related to increased headcount as a result of our international expansion as well as the earn-out compensation due to the former owners and employees of Strumsoft. There was also an increase of $1.6 million in merger and acquisition expense related to the recent acquisitions of Digi-Data, Vox and Clarity. Our marketing expense increase of $1.3 million related to our expanded marketing activities associated with rebranding and the launch of our new products. The remaining increase of $1.2 million related to telecommunication and facility costs that were impacted by the common area maintenance cost increase and an increase in outside consultant's costs supporting various strategic projects. These increases were partially offset by a $1.3 million decrease in selling costs and some professional fees. As a result of increased revenues, selling, general and administrative expense as a percentage of revenues decreased to 17.0% for the nine months ended September 30, 2014, compared to 17.9% for the same period in 2013. Net change in contingent consideration obligation. The net change in contingent consideration obligation resulted in a $996 thousand decrease for the nine months ended September 30, 2014. The contingent consideration associated with the Strumsoft acquisition increased $1.7 million due to changes in the fair value estimates related to the weighted probability of achieving revenue milestones. The contingent consideration associated with the SpeechCycle, Inc. and Spatial Systems Nominees PTY Limited acquisitions decreased $2.7 million due to the completion of their earn-out periods. Restructuring charges. There were no restructuring charges recorded for the nine months ended September 30, 2014. Restructuring charges were $5.2 million for the nine months ended September 30, 2013, as a result of the January 2013 work-force reduction plan to reduce costs and align our resources with our key strategic priorities. Depreciation and amortization. Depreciation and amortization expense increased $13.5 million to $42.3 million for the nine months ended September 30, 2014, compared to the same period in 2013, primarily related to the increase in depreciable fixed assets necessary for the continued expansion of our platforms and amortization of our newly acquired intangible assets related to our Strumsoft, Digi-Data, Clarity and Vox acquisitions. Depreciation and amortization expense as a percentage of revenues increased to 12.9% for the nine months ended September 30, 2014, as compared to 11.4% for the nine months ended September 30, 2013. Income from Operations. Income from operations increased $27.2 million to $41.8 million for the nine months ended September 30, 2014, compared to the same period in 2013 This was primarily due to increased revenues offset by the additional costs associated with our acquired operations, increased depreciation for data center deployments and amortization related to acquisitions. Income from operations as a percentage of revenues increased to 12.8% for the nine months ended September 30, 2014, as compared to 5.8% for the nine months ended September 30, 2013. Interest income. Interest income increased $8 thousand to $440 thousand for the nine months ended September 30, 2014, compared to the same period in 2013. Interest expense. Interest expense increased $1.1 million to $1.8 million for the nine months ended September 30, 2014, compared to the same period in 2013 due to an increase of approximately $373 thousand related to related to our $40 million borrowing on our revolving credit facility, which was drawn in July and subsequently repaid in September, and an additional $392 thousand related to the convertible debt. Other income (expense). Other income (expense) increased $1.4 million to $1.1 million for the nine months ended September 30, 2014, compared to the same period in 2013. Other income (expense) increased primarily due to an increase in New York state 21 --------------------------------------------------------------------------------refundable research and development tax credits domestically, upon the state's completion of its audit, and foreign currency exchange rate fluctuations. Income Tax. We recognized approximately $16.2 million and $6.5 million in related income tax expense during the nine months ended September 30, 2014 and 2013, respectively. Our effective tax rate was approximately 39.0% for the nine months ended September 30, 2014, which was higher than our U.S. federal statutory rate primarily due to an unfavorable impact of the change in fair market value of our contingent consideration obligation related to the Strumsoft earn-out, offset by a favorable impact of profit mix in foreign jurisdictions, which have lower tax rates. Our effective tax rate was approximately 46.6% for the nine months ended September 30, 2013, higher than our U.S. federal statutory rate primarily due to an unfavorable impact of the change in fair market value of our contingent consideration obligation related to the Spatial earn-out and higher state taxes. We review the expected annual effective income tax rate and make changes on a quarterly basis as necessary based on certain factors such as changes in forecasted annual operating income, changes to the actual and forecasted permanent book-to-tax differences, and changes resulting from the impact of tax law changes. Liquidity and Capital Resources Our principal source of liquidity has been cash provided by operations. Our cash, cash equivalents and marketable securities balance was $305.0 million at September 30, 2014, an increase of $227.4 million as compared to the balance at December 31, 2013. This increase was primarily due to $223 million of cash received from the issuance of our convertible senior notes, $45.0 million cash generated from operations and $20.7 million of cash received from the exercise of stock options offset by $24.8 million related to purchases of fixed assets and $38.1 million for the acquisition of Digi-Data, Clarity and Vox. We anticipate that our principal uses of cash in the future will be to fund the expansion of our business through both organic growth as well as possible acquisition activities and the expansion of our customer base internationally. Uses of cash will also include facility and technology expansion, capital expenditures, and working capital. On August 12, 2014, we issued $230.0 million aggregate principal amount of 0.75% Convertible Senior Notes due in 2019 (the "2019 Notes"). The 2019 Notes mature on August 15, 2019, and bear interest at a rate of 0.75% per annum payable semi-annually in arrears on February 15 and August 15 of each year. We accounted for the $230 million face value of the debt as a liability and capitalized approximately $7.1 million of financing fees, related to the issuance. The 2019 Notes are senior, unsecured obligations and are convertible into shares of common stock based on a conversion rate of 18.8072 shares per $1,000 principal amount of 2019 Notes which is equivalent to an initial conversion price of approximately $53.17 per share. We will satisfy any conversion of the 2019 Notes with shares of our common stock. The 2019 Notes are convertible at the note holders' option prior to their maturity and if specified corporate transactions occur. The issue price of the 2019 Notes was equal to their face amount. Holders of the 2019 Notes who convert their notes in connection with a qualifying fundamental change, as defined in the related indenture, may be entitled to a make-whole premium in the form of an increase in the conversion rate. Additionally, following the occurrence of a fundamental change, holders may require that we repurchase some or all of the 2019 Notes for cash at a repurchase price equal to 100% of the principal amount of the notes being repurchased, plus accrued and unpaid interest, if any. As of September 30, 2014, none of these conditions existed with respect to the 2019 Notes and as a result, the 2019 Notes are classified as long term. The 2019 Notes are the Company's direct senior unsecured obligations and rank equal in right of payment to all of the Company's existing and future unsecured and unsubordinated indebtedness. At September 30, 2014, the carrying amount of the liability and the outstanding principal of the 2019 Notes was $230.0 million, with an effective interest rate of approximately 1.36%. The fair value of the 2019 Notes was $263.5 million at September 30, 2014. The interest expense of the Company's 2019 Notes related to the contractual interest coupon was $216 thousand for the three and nine months ended September 30, 2014. There was no interest expense related to the 2019 Notes for the three and nine months ended September 30, 2013. In September 2013, we entered into a Credit Agreement (the "Credit Facility") with JP Morgan Chase Bank, N.A., as the administrative agent, Wells Fargo Bank, National Association, as the syndication agent and Capital One, National Association and KeyBank National Association, as co-documentation agents. The Credit Facility, which can be used for general corporate purposes, is a $100 million unsecured revolving line of credit that matures on September 27, 2018. We pay a commitment fee of 25 basis points on the undrawn balance of the revolving credit facility under the Credit Agreement. Commitment fees totaled approximately $46 thousand during the three months ended September 30, 2014 and $171 thousand during the nine months ended September 30, 2014. We have the right to request an increase in the aggregate principal amount of the Credit Facility to $150 million. 22 -------------------------------------------------------------------------------- On July 2, 2014 we borrowed $40 million under the Credit Facility to fund the acquisitions of Digi-Data, Vox and Clarity. Interest on the borrowing is based upon LIBOR plus a 175 basis point margin. On September 4, 2014, we repaid the full amount borrowed under the Credit Facility plus interest of approximately $136 thousand. The Credit Facility is subject to certain financial covenants. As of September 30, 2014, we were in compliance with all required covenants and there were no outstanding balances on the Credit Facility. At September 30, 2014, our non-U.S. subsidiaries held approximately $5.8 million of cash and cash equivalents that are available for use by all of our operations around the world. At this time, we believe these funds will be permanently reinvested. However, if these funds were repatriated to the U.S. or used for U.S. operations, certain amounts could be subject to U.S. tax for the incremental amount in excess of the foreign tax paid. Due to the timing and circumstances of repatriation of such earnings, if any, it is not practical to determine the unrecognized deferred tax liability related to the amount. Discussion of Cash Flows Cash flows from operations. Net cash provided by operating activities for the nine months ended September 30, 2014 was $45.0 million, as compared to $33.4 million provided for the same period in 2013. Cash flows from operations increased by approximately $11.6 million. The operating cash flows for the nine months ended September 30, 2014 benefited from the increase in net income and non-cash items by $27.9 million compared to the same period in 2013. This was offset by a decrease in the changes in working capital for the nine months ended September 30, 2014, of approximately $21.8 million. Among the changes in working capital, the accounts receivable increase accounted for most of the change. Cash flows from investing. Net cash used in investing activities for the nine months ended September 30, 2014 was $88.5 million, as compared to $48.3 million used for the same period in 2013. The increase in net cash used in investing activities for the nine months ended September 30, 2014 of $40.3 million compared to 2013 was primarily due to the recent acquisitions of Digi, Clarity and Vox and purchases of marketable securities. Cash flows from financing. Net cash provided by financing activities for the nine months ended September 30, 2014 was $245.5 million, as compared to $17.6 million provided by financing activities for the same period in 2013. The increase in net cash provided by financing activities for the nine months ended September 30, 2014 of $227.8 million as compared to 2013 was primarily due the issuance of the convertible notes and an increase in proceeds from the exercises of stock options. We believe that our existing cash and cash equivalents, cash generated from our existing operations, our available credit facilities and other available sources of financing will be sufficient to fund our operations for the next twelve months based on our current business plans. Effect of Inflation Although inflation generally affects us by increasing our cost of labor and equipment, we do not believe that inflation has had any material effect on our results of operations for nine months ended September 30, 2014 or 2013. Impact of Recently Issued Accounting Standards In August 2014 the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-15 Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. Management of public and private companies will be required to evaluate whether there are conditions and events that raise substantial doubt about the entity's ability to continue as a going concern within one year after the financial statements are issued (or available to be issued when applicable) and, if so, disclose that fact. Management will be required to make this evaluation for both annual and interim reporting periods, if applicable. The standard is effective for annual periods ending after December 15, 2016 and interim periods ending after December 15, 2016. Early adoption is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. Management does not expect adoption of this ASU to significantly impact its consolidated financial statements. In May 2014, the FASB and the International Accounting Standards Board ("IASB") (collectively, the "Boards") jointly issued a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance under US GAAP and IFRS. The standard's core principle (issued as ASU 2014-09 by the FASB and as IFRS 15 by the IASB), is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The new guidance must be adopted using either a full retrospective approach for all periods 23 -------------------------------------------------------------------------------- presented in the period of adoption or a modified retrospective approach. The effective date is fiscal years beginning after December 15, 2016. Early application is not permitted. Management is currently evaluating the methods of adoption and the impact that ASU 2014-09 will have on our consolidated financial statements. Off-Balance Sheet Arrangements We had no off-balance sheet arrangements as of September 30, 2014 and December 31, 2013, that have or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to our interests. |