BLUCORA, INC. 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2006
For the transition period from to
Commission File Number 0-25131
(Exact name of registrant as specified in its charter)
601 108th Avenue NE, Suite 1200, Bellevue, Washington 98004
(Address of principal executive offices) (Zip code)
Registrants telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $.0001 per share
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant outstanding as of June 30, 2006, based upon the closing price of Common Stock on June 30, 2006 as reported by Nasdaq, was $575.0 million. Shares of voting stock held by each officer and director and by each person who owns 5% or more of the outstanding voting stock (as publicly reported by such persons pursuant to Section 13 and Section 16 of the Securities Exchange Act of 1934) have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
As of February 16, 2007, 31,469,062 shares of the registrants Common Stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates certain information by reference from the definitive proxy statement for the Annual Meeting of Stockholders tentatively scheduled for May 14, 2007 (the Proxy Statement).
TABLE OF CONTENTS
This report contains forward-looking statements that involve risks and uncertainties. You should not rely on forward-looking statements. The statements in this report that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. We use words such as anticipate, believe, plan, expect, future, intend, may, will, should, estimate, predict, potential, continue, and similar expressions to identify such forward-looking statements. These forward-looking statements include, but are not limited to:
Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause our results, levels of activity, performance, achievements and prospects, and those of the wireless and Internet industries generally, to be materially different from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among others, those identified under Item 1A, Risk Factors and elsewhere in this report.
InfoSpace, Inc. (InfoSpace, Our or We) is a developer of tools and technologies that assist consumers with finding content and information on the Internet or mobile phone. We use our technology, including metasearch, to power our own branded Web sites and provide private-label online search and directory services to distribution partners. In addition, our mobile applications provide programming and sales opportunities to our mobile carrier partners, while providing consumers with relevant mobile functionality and mobile media content, including ringtones, graphics, and games. We were founded in 1996 and are incorporated in the state of Delaware. Our principal corporate offices are located in Bellevue, Washington. We also have facilities in Los Angeles, California; Westborough, Massachusetts; Woking and Eastleigh, United Kingdom; and Papendrecht, The Netherlands. Our common stock is listed on the Nasdaq Stock Market under the symbol INSP.
In September 2006, we announced that we had been informed by one of our carrier partners that it intended to develop direct relationships for mobile ringtone content with the major record labels beginning in 2007. We anticipated that such direct relationships between the carrier and content providers would have a material negative impact on our revenues and operating results. As a result, during September 2006, we committed to a plan to make operational changes to our business to align operational focus and costs with expected future revenues. The plan included a reduction in our workforce and consolidation of our facilities. We also suspended investment in mobile media content initiatives and, accordingly, intend to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007 by eliminating certain products including, but not limited to, ringtones, graphics and games. We will continue to operate our two business units: Online, comprised of our search and directory properties as well as our private label distribution service and Mobile services, including portal, storefront, messaging, and mobile search.
Company Internet Site and Availability of SEC Filings. Our corporate Internet site is located at www.infospaceinc.com. We make available on that site our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as well as any amendments to those filings, and other filings we make electronically with the U.S. Securities and Exchange Commission (the SEC). The filings can be found in the Investor Relations section of our site and are available free of charge. Information on our Internet site is not part of this Form 10-K. The SEC maintains an Internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding us and other issuers that file electronically with the SEC.
Our Online search and directory services enable Internet users to locate information, merchants, individuals and products online. We offer search and directory services through our branded Web sites, Dogpile.com, Switchboard.com, InfoSpace.com, Webcrawler.com, MetaCrawler.com, and Zoo.com, as well as through the Web properties of distribution partners. Partner versions of our search and directory services are generally private-labeled and delivered with each distribution partners unique requirements. See Note 10Business Unit Disclosures in the Notes to Consolidated Financial Statements (Item 8, of Part II of this Report) for further discussion.
Our search offerings differ from most other mainstream search services in that they provide metasearch technology that selects results from several search engines, including Google and Yahoo!, among others. We offer search services through our own Web sites, as well as through the Web properties of distribution partners including Akarl, Cablevision, Info.com, Verizon Online, WhenU, and others.
Our directory services include online yellow and white pages services. InfoSpace directory properties help Internet users find local and national merchants and individuals in North America. We offer directory services through our branded Web sites, such as Switchboard.com and InfoSpace.com, as well as through distribution partner relationships. We obtain the underlying directory listings primarily through our relationships with Yellowpages.com and Verizon.
We compete against other providers of Web search services, major Internet portals and Web-based directories. We also compete against more traditional advertising media, including radio, network and cable television, newspaper, magazines, Internet, direct mail and others for a share of the U.S. advertising media market.
Our Mobile business delivers data technology solutions, consulting and management services for the mobile operator market, including portal, storefront, search and messaging solutions. Additionally, we provide mobile media content products, including ringtones, graphics and games, to subscribers of our Mobile customers. However, we plan to substantially reduce, through various initiatives, our mobile media content product offerings
by mid-2007. Through our products, content and service offerings, our mobile operator partners are able to aggregate, configure and customize the services they offer under their own brand and deliver them to their subscribers. As of December 31, 2006, we had relationships with many leading mobile operators, including Cingular Wireless, T-Mobile, Virgin Mobile US, Verizon Wireless, and Virgin Mobile UK. See Note 10Business Unit Disclosures in the Notes to Consolidated Financial Statements (Item 8, of Part II of this Report) for further discussion.
Competitors include mobile application providers, mobile application aggregators, mobile application enablers, entertainment and other digital media companies, and the mobile operators themselves.
Our online search and directory services are affected by seasonal fluctuations in Internet usage, which generally declines in the summer months. Our mobile products and services may also be subject to seasonality based on the timing of consumer product cycles and other factors, such as the timing of new mobile phone sales.
We currently maintain facilities in the United States, the United Kingdom, and The Netherlands.
We have historically generated most of our revenues from customers in the United States. Revenue generated in the United States accounted for 96% in 2006, 93% in 2005, and 93% in 2004 of our total revenues in those years.
Our revenues are derived from products and services delivered to our customers and distribution partners across our two businesses, Online and Mobile. We derive a significant portion of our revenue from a small number of customers and we expect that this concentration will continue in the foreseeable future. Cingular Wireless, Google, and Yahoo! each accounted for more than 10% of our revenues in 2006.
Online Revenue: We generate revenues from our Web search and directory services when an end user of our services generates a paid search at our Web site. We also generate revenues from paid searches through a distribution partners Web property. Revenues are recognized in the period in which a paid search occurs and are based on the amounts earned and remitted to us by our customer content providers. We also generate advertising revenues by selling banner, button and text-link advertisements based on cost per search or page view, which are recognized when the services are delivered.
Mobile Revenue: We earn revenues typically through agreements with mobile operators for various services, which include subscriber usage, hosting and maintenance services, and professional services, as well as for the delivery of mobile media content products, such as ringtones, graphics and games. We recognize subscriber usage revenues based on a fee per user or per usage by the end user. We recognize revenue from hosting services and maintenance of such services in the period in which the service is provided. We sometimes earn one-time user set-up fees, which are generally amortized over the term of the customer contract. We recognize revenues from professional services in the period in which the work is completed and accepted by the customer. We recognize revenue from our mobile media content product when it is delivered.
We believe that our technology is essential to successfully implement our strategy of expanding and enhancing our products and services and maintaining the attractiveness and competitiveness of our products and
services. Product development expenses were $46.3 million in the year ended December 31, 2006, $31.2 million in the year ended December 31, 2005, and $23.1 million in the year ended December 31, 2004.
Our success depends significantly upon our technology. To protect our rights, we rely on a combination of copyright and trademark laws, patents, trade secrets, confidentiality agreements with employees and third parties and protective contractual provisions. Most of our employees have executed confidentiality and non-use agreements that contain provisions prohibiting the unauthorized disclosure and use of our confidential and proprietary information and that transfer to us any rights they may have in copyrightable works or patentable technologies that they may develop while under our employ. In addition, prior to entering into discussions with third parties regarding our business and technologies, we generally require that such parties enter into nondisclosure agreements with us. If these discussions result in a license or other business relationship, we also generally require that the agreement setting forth the parties respective rights and obligations include provisions for the protection of our intellectual property rights. For example, the standard language in our agreements with distribution partners provides that we retain ownership of all patents and copyrights in our technologies and requires them to display our patent, copyright and trademark notices.
We hold over 50 U.S. registered trademarks and over 100 foreign trademarks registered in various countries. We also have applied for registration of certain service marks and trademarks in the United States and in other countries, and will seek to register additional marks in the U.S. and foreign countries, as appropriate. We may not be successful in obtaining registration for the service marks and trademarks for which we have applied.
We hold over 30 U.S. and foreign patents. Our issued patents relate to our online directory, advertisement and location services, among others. We are currently pursuing certain pending U.S. and foreign patent applications that relate to various aspects of our technology. We anticipate on-going patent application activity in the future. However, patent claims may not be issued and, if issued, may be challenged or invalidated by third parties. In addition, issued patents may not provide us with any competitive advantages.
Despite our efforts to protect our rights, unauthorized parties may copy aspects of our products or services or obtain and use information that we regard as proprietary. The laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. In addition, others could independently develop substantially equivalent intellectual property. If we do not effectively protect our intellectual property, our business could suffer.
Companies and individuals in the arts and entertainment industry, as well as in the Internet software and application services industry, have frequently resorted to litigation regarding intellectual property rights. We may have to litigate to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of others proprietary rights which are sometimes not clear or may change. From time to time, we have received, and may receive in the future, notice of claims of infringement of others proprietary rights. Responding to any such claims could be time-consuming, result in costly litigation, divert managements attention, cause product or service release delays, require us to redesign our products or services or require us to enter into royalty or licensing agreements. If a successful claim of infringement were made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could suffer.
MetaCrawler License Agreement. We hold an exclusive, perpetual worldwide license, subject to certain limited exceptions, to the MetaCrawler intellectual property and related search technology from the University of Washington, which we use in our web search services.
We operate in the online search and directory markets and mobile services and media markets, which are extremely competitive and rapidly changing. Our current and prospective competitors include many large
companies that have substantially greater resources than we have. We believe that the primary competitive factors in the market for online and mobile services are:
Although we believe that no one competitor offers all of the products and services we do, our primary offerings face competition from various sources. We compete, directly or indirectly, in the following ways, among others:
We expect that in the future we will experience competition from other Internet application and mobile services companies, as well as from content providers. Some of these companies are currently customers, distribution partners or content providers of ours, the loss of which could harm our business.
Many of our current customers have established relationships with some of our current and potential future competitors. Some of our customers are also our competitors. If our competitors develop software and application services that are superior to ours, or that achieve greater market acceptance than ours, our business will suffer.
Because of the increasing use of the Internet and wireless devices, U.S. and foreign governments have adopted or may in the future adopt laws and regulations relating to the Internet or use of wireless devices, addressing issues such as consumer protection, user privacy, security, pricing, age verification, content, taxation, copyrights and other intellectual property, distribution, advertising and product and services quality.
Recent concerns regarding Internet and wireless device user privacy have led to the introduction of U.S. federal and state legislation to protect user privacy and data security. Existing federal laws regarding user privacy that we may be subject to include the Childrens Online Privacy Protection Act, which regulates the online and,
Countries outside of the United States may have more restrictive privacy laws. The European Union, for example, strictly regulates the collection, use and transfer of personal information of European residents. Further, information lawfully collected in the European Union may not be transferred for processing outside Europe to a country that lacks adequate protections. The European Union has deemed the U.S. to lack such protections and transfers of personal information gathered in Europe to the United States are only permitted under limited circumstances. Other countries such as Canada follow models similar to the European Union albeit without express prohibitions on data export. These and similar restrictions may limit our ability to collect and use information regarding Internet users in those countries.
We may be subject to provisions of the Federal Trade Commission Act and similar state laws that regulate consumer protection and advertising in all media, including the Internet, and require advertisers to substantiate advertising claims before disseminating advertising. The FTC and various state attorneys general have recently brought actions charging deceptive advertising via the Internet and may actively monitor Internet advertising. The United States and various individual states have also enacted restrictions on advertising through other media. For example, in the United States, the Telephone Consumer Protection Act, Do Not Call legislation and similar state laws regulate the manner in which we may advertise goods and services via telephones and facsimiles. Also, with respect to our tournament games, most states regulate the provision of prizes for mobile games or other contests, and other states may adopt similar regulations.
We may also be subject to the provisions of the Child Online Protection Act, which restricts the distribution of certain materials deemed harmful to children. The Act is also designed to restrict access to such materials by children, and accordingly, the provisions of this Act may apply to certain Internet and wireless product and service providers even though such companies are not engaged in the business of distributing the harmful materials. Although some court decisions have cast doubt on the constitutionality of the Act, and we have instituted processes for voluntary compliance with provisions of the Act that may be relevant to our business, the Act could subject us to liability.
These or other laws or regulations that may be enacted in the future could have adverse effects on our business, including higher regulatory compliance costs, limitations on our ability to provide some services in some countries, and liabilities which might be incurred through lawsuits or regulatory penalties. For example, numerous states now require that companies notify individuals of security breaches that may result in third parties gaining unauthorized access to certain types of personal information. We believe we take reasonable steps to protect the security and confidentiality of the information we collect and store but there is no guarantee that third parties will not gain unauthorized access despite our efforts or that we will not incur costs in complying with our notification obligations under such circumstances.
As of January 31, 2007, we had approximately 530 employees. None of our employees are represented by a labor union and we consider employee relations to be positive. There is significant competition for qualified personnel in our industry, particularly for software development and other technical staff. We believe that our future success will depend in part on our continued ability to hire and retain qualified personnel.
Executive Officers and Directors of the Registrant
The following table sets forth certain information as of February 16, 2007 with respect to our executive officers and directors:
James F. Voelker has served as our Chairman and Chief Executive Officer since December 2002, and also as President since December 2005. He also held the title of President from December 2002 to April 2003. He has served as a director since July 2002. Mr. Voelker served as President and a director of NEXTLINK Communications, Inc. (now XO Communications, Inc.), a broadband communications company, from inception in 1994 through 1998.
Allen M. Hsieh was appointed Chief Financial Officer in November 2006, after serving as interim Chief Financial Officer from April 2006 to October 2006. Mr. Hsieh joined us in June 2003 as Chief Accounting Officer and Vice President Financial Operations. From February 2000 to March 2003, he served as Vice President Finance at Terabeam Corp., a provider of fiberless optics communications. Prior to Terabeam he served in various positions at PricewaterhouseCoopers LLP, a big four accounting firm, from July 1985 to February 2000, the last two years as a partner in their accounting and auditing practice.
Brian T. McManus was appointed Executive Vice PresidentOnline in October 2006, after serving as Executive Vice President Sales and Business Development from January 2006 to October 2006. He also served as Executive Vice President, Search and Directory from April 2003 to January 2006. From April 2000 to October 2002, he served as Vice President of Corporate Development at Internet service provider Epoch Internet.
Steven L. Elfman was appointed Executive Vice PresidentMobile in October 2006, after serving as Executive Vice President, Technology and Operations and Managing Director of Europe from August 2005 to October 2006. He also served as Vice President-Mobile Operations from November 2004 to July 2005, and as Chief Technology Officer and Vice President-Engineering and Operations from July 2003 to November 2004. From May 2003 to July 2003, he was a consultant at Accenture Ltd., a consulting company. From September 2001 to May 2003, Mr. Elfman served as Executive Vice President of Operations at Terabeam Corp., a provider of fiberless optics communications.
R. Bruce Easter, Jr. joined us in December 2006 as Senior Vice President, General Counsel and Secretary. From February 2003 to December 2006, he served as General Counsel for Seattle Northwest Securities Corporation, an investment banking firm. From January 1995 through December 1999, he served as Vice President and General Counsel at NEXTLINK Communications.
John E. Cunningham, IV has served as a director of InfoSpace since July 1998. Mr. Cunningham has been a general partner of Clear Fir Partners, L.P., a private equity investment partnership, since February 1998. Since January 2004, he has served as a board member of Citel Technologies, Inc., a telecommunications company, and also served as its non-executive chairman from January 2004 to July 2006. From April 1995 until February 2003, he served as President of Kellett Investment Corporation, an investment fund for private companies.
Jules Haimovitz was appointed as a director in October 2005. Since July 2002, Mr. Haimovitz has served as Vice Chairman and Managing Partner of Dick Clark Productions Inc., a producer of programming for television, cable networks and syndicators. From June 1999 to July 2004, Mr. Haimovitz served in various capacities at Metro Goldwyn Mayer Inc., including President of MGM Networks Inc., a wholly-owned subsidiary, Executive Consultant to the CEO, and Chair of the Library Task Force. Mr. Haimovitz is a director of Blockbuster, Inc., a provider of in-home movie and game entertainment.
Richard D. Hearney has served as a director since September 2001. General Hearney served as President and Chief Executive Officer of Business Executives for National Security, an organization focusing on national security policy, from December 2000 to April 2002.
Lewis M. Taffer has served as a director since June 2001. Since March, 2006, Mr. Taffer has served as an Operating Advisor at Pegasus Capital Advisors. Since May 2006, he has served as a director and Senior Vice President at iGPS Company LLC, a provider of RFID (radio frequency identification)-tagged plastic pallet rental systems and an affiliate of Pegasus Capital Advisors. Since January 2005, he has been an independent management consultant. From January 2004 to January 2005, Mr. Taffer served as Executive Vice President, Acquisition Marketing of America Online. From May 2001 through December 2003, Mr. Taffer was an independent consultant specializing in marketing, business development and strategic partnerships.
George M. Tronsrue, III was appointed as a director in February 2003. Since March 2004, Mr. Tronsrue has served as Co-Manager of Jericho Fund, LLC, an investment and consulting company. From January 2000 to March 2004, Mr. Tronsrue served as Chairman and Chief Executive Officer of Monet Mobile Networks Inc., a wireless Internet service provider. Monet Mobile filed for Chapter 11 bankruptcy protection in March 2004.
Vanessa A. Wittman was appointed as a director in April 2003. From March 2003 to December 2006, Ms. Wittman served as Executive Vice President and Chief Financial Officer of Adelphia Communications Corporation, a cable television company. From February 2000 to March 2003, Ms. Wittman served as Chief Financial Officer of broadband network services provider 360networks, Inc.
ITEM 1A. Risk Factors
RISKS RELATED TO OUR BUSINESS
A substantial portion of our revenues is dependent on our relationships with a small number of distribution partners who distribute our products and services, the loss of which would have a material adverse effect on our financial results.
We rely on our relationships with distribution partners, including mobile operators, Web portals and software application providers, for distribution of our products and services. We generated approximately 51% of our total revenues through relationships with our top five distribution partners for the year ended December 31, 2006. We cannot assure you that these relationships will continue or result in benefits to us that outweigh the cost of the relationships. One of our challenges is providing our distribution partners with relevant products and services at competitive prices in rapidly evolving markets. In September 2006, we announced that one of our major mobile customers plans to develop direct licensing relationships with the major record labels beginning in 2007. We anticipate that the direct relationships to be developed by this mobile customer and our substantial reduction of our mobile media content product offerings will have a material negative impact on our revenues. In addition, other distribution partners, including our other mobile distribution partners, may create their own products and services or also seek to license products and services from others that compete with or replace the products and services that we provide. Also, many of our search distribution partners are developing companies with limited operating histories and evolving business models that may prove unsuccessful even if our products and services are relevant and our prices competitive. If we are not able to maintain our relationships with our distribution partners, our financial results would be materially adversely affected.
Our mobile operator distribution partner agreements generally come up for renewal on an annual basis, and our agreements with most of our online search and directory distribution partners come up for renewal in 2007 and 2008. Such agreements may be terminated or may not be renewed or replaced on favorable terms, which could adversely impact our financial results. In particular, we are experiencing pricing pressure in our mobile business, and competition is increasing for consumer traffic in the search and directory markets. We anticipate that the cost of our content for our revenue sharing arrangements with our search distribution partners will increase as revenues grow and may increase on a relative basis compared to revenues to the extent that there are changes to existing arrangements or we enter into new arrangements on less favorable terms.
Failure by us or our search distribution partners to comply with the requirements imposed by our search content providers relating to the distribution of content may require us to modify, terminate or not enter into certain distribution relationships, may cause the content provider to terminate its agreement with us, and may expose us to liability.
If our search distribution partners or we fail to meet the requirements and guidelines promulgated by our major search content providers, we may not be able to continue to provide content to such distribution partners, we may be liable to such content providers for certain damages they may suffer, and the content provider may terminate its agreement with us. In the past, certain of our search content providers had notified us that we were not in compliance with respect to our use of their content or the redistribution of their content by our distribution partners. We have been able to cure such breaches, however, there can be no assurance that if we breach our agreements in the future we will be able to cure the breach. Our agreements with some of our major content providers give such content providers the ability to terminate their agreements with us immediately in the case of certain breaches, regardless of whether such breaches could be cured.
Additionally, agreements with our search content providers may be amended from time to time by both parties or may be subject to different interpretation by either party, which may require the rights we grant to our search distribution partners to be modified to comply with such amendments or interpretations. The agreements with our search distribution partners generally provide that we may modify the rights we grant to them to avoid being in conflict with the agreements with our search content providers. For example, recent changes by some of
our search content providers such as Google and Yahoo! to their approval processes and guidelines with respect to downloadable applications through which content is provided to end users have resulted in some of our search distribution partners changing the manner in which they distribute their downloadable applications to end users to meet the new approval processes and guidelines. Other distribution partners have not been able to meet the new guidelines, and as a result we no longer provide the applicable content or any content, as the case may be, to such distribution partners or certain of their downloadable applications. Also, our search content providers have approval processes with respect to the redistribution of their content by our distribution partners. Some of our distribution partners that redistribute such content have not complied with such approval processes, and we no longer provide the applicable content to such partners or such partners no longer redistribute the content. If our search content providers impose additional restrictions, some of our distribution partners may be required to make changes to the manner in which they distribute their downloadable applications or may be required to cease redistributing the content. If such distribution partners are unable to meet the new restrictions, we may need to terminate our agreement with such distribution partners or no longer provide the applicable content to such partners.
The loss or reduction of content that we can make available to our distribution partners, as well as the termination of distribution or content provider agreements, as described above, could have a material adverse effect on our financial results.
A substantial portion of our revenues is attributable to a small number of customers, the loss of any one of which would harm our financial results.
We derive a substantial portion of our revenues from a small number of customers. We expect that concentration will continue in the foreseeable future. Our top five customers represented approximately 85%, 81%, and 82% of our revenues in 2006, 2005, and 2004, respectively. Cingular Wireless, Google and Yahoo! each accounted for more than 10% of our revenues in 2006. Our principal agreements with these customers expire in 2007, 2009 and 2008, respectively. Also, some of these customers are competitors of each other, and the way we do business with one of them may not be acceptable to one or some of their competitors with whom we also do business, which may result in such competitors not renewing their agreements with us on favorable terms.
If any of our top customers significantly reduces or eliminates the content or services it receives from us under our existing contracts, or we are unable to renew the contracts on favorable terms, or any of these customers are unwilling to pay us amounts that they owe us, or dispute amounts they owe us or have paid to us, our financial results would materially suffer. For example, in September 2006, we announced that one of our mobile customers plans to develop direct licensing relationships with the major record labels beginning in 2007. Although this mobile customer can continue to receive, or reduce further, the mobile content and services it receives from us under our existing agreements, we expect that the loss of the labeltones content portion will have a material negative impact on our revenues.
If our content providers or distribution partners disagree with our estimate of our royalty liability, it could expose us to significant liability and adversely impact our financial results.
Under our agreements with content providers, we calculate our royalty liability based on inputs from various sources of data and have been and are continuously subject to audits by our content providers and distribution partners. If our content providers disagree with the royalty amounts we have calculated that are due to them and we are unable to resolve those disagreements amicably, it may subject us to potential litigation and substantial costs even if it is found that the amounts we determined were due to them were accurate. If a content provider or distribution partner prevails in showing that the royalty amount due to it was not what was intended under our agreement with them and our estimate of the royalty liability was significantly different, it could subject us to significant liability to the affected content provider or distribution partner and have an adverse effect on our financial results. As we announced in January 2007, one of our content providers, EMI Entertainment World, Inc.
(EMI), recently instituted litigation against us due to a disagreement, among other things, over the amount of royalties due to them from the content they provide. Although we believe that EMIs claims are without merit and that we have meritorious defenses to them and intend to vigorously defend the suit, there can be no assurance that we will prevail or that other content providers will not also disagree with the royalty amount due to them and initiate their own litigation, which could have a material adverse effect on our financial results.
Our agreements with some of our major customers contain minimum performance commitments or minimum service level requirements that we must meet in order to avoid reduction in payments from such customers.
Under our agreements with some of our major customers, we are required to generate a minimum amount of revenue. If we do not reach these minimums, we may receive reduced revenues from our customers or we may be required to compensate our customer for the difference between the minimum and the shortfall. If such shortfall is substantial, it could have a material adverse effect on our financial results.
Furthermore, we have entered into service level agreements with most of our mobile operator customers and certain other customers. These agreements generally call for specific system up times and 24/7 support and include penalties for non-performance. We may be unable to fulfill these commitments, which could subject us to substantial penalties under those agreements, harm our reputation and result in the loss of customers and distribution partners, which would have an adverse effect on our financial results.
Our strategic direction is evolving, including through our restructuring, which could negatively affect our future results.
Since inception, our business model has evolved and is likely to continue to evolve as we refine our product offerings and market focus. Since 2003, we have focused on our search, directory, and mobile products and services. We continue to evaluate opportunities in a rapidly evolving market. In September 2006, we announced that one of our mobile customers plans to develop direct licensing relationships with the major record labels beginning in 2007. In light of that announcement, we plan to continue building on our foundations in mobile technology and services and online discovery, including leveraging our search and directory technology and applications for mobile devices. However, we have suspended investments in developing or obtaining more mobile content and certain new mobile distribution channels, including our direct to consumer online web site, Moviso.com, and we plan to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007. These changes to our business may not prove successful in the short or long term due to a variety of factors, including competition, consumer adoption and demand for products and services, and other factors described in this section, and may have a material negative impact on our financial results.
In addition, we have in the past and may in the future find it advisable to streamline operations and reduce expenses, including, without limitation, such measures as reductions in the workforce, discretionary spending, and/or capital expenditures as well as other steps to reduce expenses. In September 2006, we announced a restructuring plan that includes the elimination of approximately 250 positions taking place through mid-2007 and the recording of restructuring charges of $62.3 million as part of our effort to align costs with expected future revenues. Effecting this or any such restructuring will likely place significant strains on management, our employees, and our operational, financial, and other resources. In addition, any such restructuring could impair our development, marketing, sales and customer support efforts or alter our product development plans. Our suspension of investment in developing or obtaining new content and our ongoing process of substantially reducing our mobile media content product offerings may also negatively impact our relationships with our mobile operator distribution partners who may decide, prior to our product offering reduction, to obtain content or services from other sources offering a more complete mobile content and services package. Such effects could have a more immediate negative impact on our financial results.
We have identified a material weakness in our internal controls as of December 31, 2006 that, if not properly remediated, could result in material misstatements in our financial statements in future periods.
Based on an evaluation of our disclosure controls and procedures as of December 31, 2006, our management has concluded that such disclosure controls and procedures were not effective as of such date due to the existence of a deficiency in the operation of our internal accounting controls, which constituted a material weakness in our internal control over financial reporting. As defined in Public Company Accounting Oversight Board Auditing Standard No. 2, a material weakness is a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The identified deficiency pertained to controls which were not adequately designed to ensure proper accounting and disclosure of deferred income taxes. These ineffective controls resulted in adjustments to our previously reported unaudited financial results as of, and for the quarter and full year ended, December 31, 2006.
Because of this material weakness, there is risk that a material misstatement of our annual or quarterly financial statements will not be prevented or detected. We are currently in the process of designing and implementing control procedures to remediate the material weakness. We cannot guarantee, however, that such remediation efforts will correct the material weakness such that our internal control over financial reporting will be effective. In the event that we do not adequately remedy this material weakness, or if we fail to maintain effective internal controls in future periods, our operating results, financial position and stock price could be adversely affected.
We have a history of incurring net losses, we may incur net losses in the future, and we may not be able to regain or sustain profitability on a quarterly or annual basis.
While we achieved profitability in each of the twelve fiscal quarters ending on June 30, 2006, in the fourth quarter of 2006, and on an annual basis for the years ended December 31, 2005 and 2004, we incurred net losses on an annual basis in 2006 and from our inception through December 31, 2003 and in the third quarter of 2006. For the year ended December 31, 2006, we recorded a loss of $15.1 million. As of December 31, 2006, we had an accumulated deficit of $1.0 billion. We may incur net losses in the future including from our operations, the impairment of goodwill or other intangible assets, losses from acquisitions, restructuring charges or expense related to stock-based compensation and other equity awards. There can be no assurance that we will be able to regain profitability on a quarterly or annual basis or, if regained, to sustain it.
Our financial results are likely to continue to fluctuate, which could cause our stock price to be volatile or decline.
Our financial results have varied on a quarterly basis and are likely to fluctuate in the future. These fluctuations could cause our stock price to be volatile or decline. Several factors could cause our quarterly results to fluctuate materially, including:
For these reasons, among others, you should not rely on period-to-period comparisons of our financial results to forecast our future performance. Furthermore, our fluctuating operating results may fall below the expectations of securities analysts or investors, which could cause the trading price of our stock to decline.
If advertisers perceive that they are not receiving quality traffic to their sites through their paid-per-click advertisements, they may reduce or eliminate their advertising through the Internet, which could have a negative material impact on our financial results.
Most of our revenues from our search and directory business are based on the number of paid clicks on commercial search results served on our own Web sites or our distribution partners Web properties. Generally, each time a user clicks on a commercial search result, the content provider that provided the commercial search result receives a fee from the advertiser who paid for such commercial click and the content provider pays us a portion of that fee. If the click originated from one of our distribution partners Web properties, we share a portion of the fee we receive with such partner. If an advertiser receives what it perceives to be a large percentage of clicks for which it needs to pay, but that do not result in the intended objectives of such advertiser, the advertiser may reduce or eliminate its advertisements through the content provider that provided the commercial search result to us. This leads to a loss of revenue to our content providers and consequently to fewer fees paid to us. The content provider may also suspend or terminate our ability to provide its content through such distribution partners. The payment of fewer fees paid to us or the inability to provide content through such distribution partners could have a material negative effect on our financial results.
We operate in new and rapidly evolving markets, and our business model continues to evolve, which makes it difficult to evaluate our future prospects.
Our potential for future profitability must be considered in the light of the risks, uncertainties, and difficulties encountered by companies that are in new and rapidly evolving markets and continuing to innovate with new and unproven technologies or services, as well as undergoing significant change. Our search, directory and mobile products and services are in young industries that have undergone rapid and dramatic changes in their short history. In addition to the other risks we describe in this section, some of these risks relate to our potential inability to:
If we do not effectively address the risks we face, we may not be able to achieve profitability.
We depend on third parties for content, and the loss of access to or increased cost of this content could cause us to reduce our product offerings to customers and could negatively impact our financial results.
We currently create only a relatively small portion of our content. In most cases, we acquire rights to content from numerous third-party content providers, and our future success is highly dependent upon our ability to maintain relationships with these content providers and enter into new relationships with other content providers.
We typically license content under arrangements that require us to pay usage or fixed monthly fees for the use of the content or require us to pay under a revenue-sharing arrangement. In the future, some of our content providers may not give us access to important content or may increase the royalties, fees or percentages that they charge us for their content, which could have a material negative effect on our operating results. If we fail to enter into or maintain satisfactory arrangements with content providers, particularly with our major content providers, our ability to provide a variety of products and services to our customers could be severely limited, which would have a material negative effect on our operating results. Also, even if we maintain agreements with our major content partners, such partners may directly contract with our distribution partners as well, reducing the demand by our distribution partners for content coming through us. Additionally, our content license and royalty fees will increase to the extent that our revenues related to such products and services increase and may increase as a percent of revenues as a result of price competition and carrier demand for our products and services and the mix of our product sales.
Further, our musical composition and other media licenses for the creation of mobile content consisting of ringtones generally require royalty payments on a most favored nation basis, which requires us to pay the highest royalty paid to any licensor to all such licensors. Also, our agreements with the four major record labels for ringtones, which comprise a significant portion of our mobile business revenues, typically have terms of one year or less. As part of our September 2006 restructuring plans, however, we intend to substantially reduce our role as a provider of mobile content; accordingly, these content agreements are expected to have less of an impact on our financial results going forward.
If we fail to detect invalid click activity, we could lose the confidence of advertisers and of our content providers, which could cause our business to suffer.
Poor quality traffic may be a result of invalid click activity. Such invalid click activity occurs, for example, when a person or automated click generation program clicks on a commercial search result to generate fees for the Web property displaying the commercial search result rather than to view the Web page underlying the commercial search result or when a competitor of the advertiser clicks on the advertisers search result to increase the advertising expense of the advertiser. Some of this invalid click activity is sometimes referred to as
click fraud. When such invalid click activity is detected, content providers may refund the fee paid by the advertiser for such invalid clicks. When such invalid click activity is detected as coming from one of our distribution partners Web properties or our own Web sites, our content providers may refund the fees paid by the advertisers for such invalid clicks, which in turn reduces the amount of fees the content provider pays us. If we or our content providers are unable to effectively detect and stop invalid click activity, advertisers may see a reduced return on their advertising investment with the content provider because such invalid clicks do not generate quality traffic to such advertisers, which could lead such advertisers to reduce or terminate their investment in such ads. This could also lead to a loss of advertisers and revenue to our content providers and consequently to fewer fees paid to us. Additionally, if we are unable to detect and stop invalid click activity that may originate from our own Web sites or the Web properties of our distribution partners, our content providers may impose restrictions on our ability to provide their commercial search results on our own Web sites or to our current and future distribution partners, which could have a material negative impact on our financial results.
Although we and our content providers have in place certain systems to assist with the detection of invalid clicks, these systems may not detect all such invalid click activity, including new types of invalid click activity that may appear. From time to time, some of our search content providers may notify us that poor quality traffic may be originating from one of our distribution partners. Although the poor quality traffic may be due to factors other than invalid click activity, if we are unable to resolve or determine what factor may be creating the poor quality traffic, we may terminate our agreement with such distribution partner or stop providing content to such distribution partner from the partner that notified us of such traffic in an attempt to maintain the confidence of our content provider and their advertisers in the overall quality of our traffic.
Our financial and operating results will suffer if we are unsuccessful at integrating acquired technologies and businesses.
We have acquired a number of technologies and businesses in the past and may engage in further acquisitions in the future. Acquisitions may involve use of cash, potentially dilutive issuances of stock, the potential incurrence of debt and contingent liabilities or amortization expenses related to certain intangible assets. In the past, our financial results have suffered significantly due to impairment charges of goodwill and other intangible assets related to prior acquisitions. Acquisitions also involve numerous risks which could materially and adversely affect our results of operations or stock price, including:
The success of the operations of companies that we have acquired will often depend on the continued efforts of the management and key employees of those acquired companies. Accordingly, we have typically attempted to retain key employees and members of existing management of acquired companies under the overall supervision
of our senior management. We have, however, not always been successful in these attempts at retention. Failure to retain key employees of an acquired company may make it more difficult to integrate or manage the business of the acquired company, may reduce the anticipated benefits of the acquisition by increasing costs, causing delays, or otherwise and may expose us to additional competition from companies these employees may join or form.
Our stock price has been and is likely to continue to be highly volatile.
The trading price of our common stock has been highly volatile. Since we began trading on December 15, 1998, our stock price has ranged from $3.70 to $1,385.00 (as adjusted for stock splits). On February 16, 2007, the closing price of our common stock was $23.19. Our stock price could decline or be subject to wide fluctuations in response to factors such as the other risks discussed in this section and the following, among others:
In addition, the stock market in general, and the Nasdaq Stock Market and the market for Internet and technology company securities in particular, have experienced extreme price and volume fluctuations. These broad market and industry factors and general economic conditions may materially and adversely affect our stock price. Our stock has been subject to such price and volume fluctuations in the recent past. Often, class action litigation has been instituted against companies after periods of volatility in the overall market and the price of such companies stock. If such litigation were to be instituted against us, even if we were to prevail, it could result in substantial cost and diversion of managements attention and resources.
If we are unable to retain our key employees, we may not be able to successfully manage our business.
Our business and operations are substantially dependent on the performance of our executive officers and key employees, all of whom, except our chief executive officer, are employed on an at-will basis. If we lose the services of one or more of our executive officers or key employees and are unable to recruit and retain a suitable successor(s), we may not be able to successfully manage our business or achieve our business objectives. Additionally, our recently announced reduction of approximately 250 positions, to occur through mid-2007 and related to our restructuring, could place significant strain on many of the remaining employees, including key employees, as well as create uncertainty about their and our future prospects. We recently instituted a restricted stock unit program aimed at retaining employees who were not scheduled for termination. However, there can be no assurance that this or any other retention program we initiate will be successful at retaining employees, including key employees. Also, some employees scheduled to be terminated may decide to terminate their employment before their scheduled termination by us, creating additional strain and uncertainty on the remaining employees. If we are unable to retain the services of the remaining key employees, or if employees who are key during some aspects of the restructuring but who are scheduled to be terminated leave before their scheduled termination by us, it could increase the potential effects of the restructuring on our development, sales and customer support efforts or alter our product development plans.
Unless we are able to hire, retain and motivate highly qualified employees, we will be unable to execute our business strategy.
Our future success depends on our ability to identify, attract, hire, retain and motivate highly skilled technical, managerial, sales and marketing, and corporate development personnel. Our services and the industries to which we provide our services are relatively new. Qualified personnel with experience relevant to our business are scarce and competition to recruit them is intense. If we fail to successfully hire and retain a sufficient number of highly qualified employees, we may have difficulties in supporting our customers or expanding our business. Realignments of resources, reductions in workforce, including our recently announced reduction in workforce of approximately 250 positions to occur through mid-2007, or other operational decisions have created and could continue to create an unstable work environment and may have a negative effect on our ability to hire, retain and motivate employees.
In light of current market and regulatory conditions, the value of stock options granted to employees may cease to provide sufficient incentive to our employees.
Like many technology companies, we use stock options and other equity-based awards to recruit technology professionals and senior level employees. Our stock options, which typically vest over a two-, three- or four-year period, are one of the means by which we have historically attempted to motivate long-term employee performance. Beginning in 2006, the accounting treatment of options required us to expense the fair value of our employee stock options, which may make it difficult or overly expensive for us to issue stock options to our employees in the future. We also face a significant challenge in retaining our employees if the value of these stock options is either not substantial enough or so substantial that the employees leave after their stock options have vested. If our stock price does not increase significantly above the prices of our options, or option programs become impracticable, we may need to issue new options or other equity incentives or increase other forms of compensation to motivate and retain our employees. We recently instituted a restricted stock unit program in lieu of issuing stock options to employees, other than executives, because stock options were not currently seen as providing enough incentive to attract or retain employees. We may undertake or seek stockholder approval to undertake other equity-based programs to retain our employees, which may be viewed as dilutive to our stockholders or may increase our compensation costs. Additionally, there can be no assurance that any such programs, including the restricted stock unit awards, we undertake will be successful in motivating and retaining our employees.
Our search and directory products and services may expose us to claims relating to how the content was obtained or distributed.
Our search and directory services link users, either directly through our Web sites or indirectly through the Web properties of our distribution partners, to third party Web pages and content in response to search queries. These services could expose us to legal liability from claims relating to such third-party content and sites, the manner in which these services are distributed by us or our distribution partners, or how the content provided by our third-party content providers was obtained or provided by our content providers. Such claims could include the following: infringement of copyright, trademark, trade secret or other proprietary rights; violation of privacy and publicity rights; unfair competition; defamation; providing false or misleading information; obscenity; and illegal gambling. Regardless of the legal merits of any such claims, they could result in costly litigation, be time consuming to defend and divert managements attention and resources. If there were a determination that we had violated third-party rights or applicable law, we could incur substantial monetary liability, be required to enter into costly royalty or licensing arrangements (if available), or be required to change our business practices. We may also have obligations to indemnify and hold harmless certain of our content or distribution partners for damages they suffer for such violations under our contracts with them. Implementing measures to reduce our exposure to such claims could require us to expend substantial resources and limit the attractiveness of our products and services to our customers. As a result, these claims could result in material harm to our business.
Recently, there have been legal actions brought or threatened against distributors of downloadable applications deemed to be adware or spyware. Additionally, certain bills are pending and some laws have
been passed in certain jurisdictions setting forth requirements that must be met before a downloadable application is downloaded to an end users computer. We partner with some distribution partners that provide adware to their users if the partners adhere to our strict guidelines requiring them, among other things, to disclose to the user what the adware does and to obtain the consent of the user before the application is downloaded. The adware must also be easy to uninstall. We also review the application the partner proposes to use before we distribute our results to them. We also have the right to audit our partners, and if we find that they are not following our guidelines, we can terminate our agreement with them or cease providing content to that downloadable application. Some partners have not been able to meet the new guidelines imposed by us or some of our content providers, and we no longer provide the applicable content or any content, as the case may be, to such partners or certain of their downloadable applications. We work closely with some of our major content providers to try to identify potential distribution partners that do not meet our guidelines or are in breach of our distribution agreements and we work with our distribution partners to ensure they deliver quality traffic. However, there can be no assurance that the measures we implement to reduce our exposure to claims that certain ways in which the content is distributed violate legal requirements will be successful. As stated above, these claims could result in material harm to our business.
Our efforts to increase our presence in markets outside the United States may be unsuccessful and could result in losses.
We plan to expand our mobile and search offerings internationally, particularly in Europe. We have limited experience in marketing and operating our products and services in international markets, and we may not be able to successfully execute our business model in these markets. Our success in these markets will be directly linked to the success of relationships with our distribution and content partners and other third parties.
As the international markets in which we operate continue to grow, competition in these markets will intensify. Local companies may have a substantial competitive advantage because of their greater understanding of and focus on the local markets. Some of our domestic competitors who have substantially greater resources than we do may be able to more quickly and comprehensively develop and grow in the international markets. International expansion may also require significant financial investment including, among other things, the expense of developing localized products, the costs of acquiring foreign companies and the integration of such companies with our operations, expenditure of resources in developing distribution and content relationships and the increased costs of supporting remote operations. Although our revenues from our European offerings have increased in absolute dollars, they have declined as a percentage of our overall revenues.
Other risks of doing business in international markets include the increased risks and burdens of complying with different legal and regulatory standards, difficulties in managing and staffing foreign operations, limitations on the repatriation of funds and fluctuations of foreign exchange rates, varying levels of Internet technology adoption and infrastructure, and ability to enforce our contracts in foreign jurisdictions. In addition, our success in international expansion could be limited by barriers to international expansion such as tariffs, adverse tax consequences, and technology export controls. If we cannot manage these risks effectively, the costs of doing business in some international markets may be prohibitive or our costs may increase disproportionately to our revenues.
We have implemented anti-takeover provisions that could make it more difficult to acquire us.
Our certificate of incorporation, bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors, even if the transaction would be beneficial to our stockholders. Provisions of our charter documents which could have an anti-takeover effect include:
On July 19, 2002, our board of directors adopted a stockholder rights plan, pursuant to which we declared and paid a dividend of one right for each share of common stock held by stockholders of record as of August 9, 2002. Unless redeemed by us prior to the time the rights are exercised, upon the occurrence of certain events, the rights will entitle the holders to receive shares of our preferred stock, or shares of an acquiring entity. The issuance of the rights would make the acquisition of InfoSpace more expensive to the acquirer and could delay or discourage third parties from acquiring InfoSpace without the approval of our board of directors.
Our systems could fail or become unavailable, which could harm our reputation, result in a loss of current and potential customers and cause us to breach agreements with our partners.
Our success depends, in part, on the performance, reliability and availability of our services. We have data centers in Seattle and Bellevue, Washington; Los Angeles, California; Waltham, Massachusetts; and Papendrecht, The Netherlands. Although we have completed our disaster and redundancy planning for certain of our business-critical systems so that some are now redundant across two physical locations, we have not yet completed our disaster recovery and redundancy planning for others. Our systems and operations could be damaged or interrupted by fire, flood, power loss, telecommunications failure, Internet breakdown, break-in, earthquake or similar events. We would face significant damage as a result of these events, and our business interruption insurance may not be adequate to compensate us for all the losses that may occur. In addition, our systems use sophisticated software that may contain bugs that could interrupt service. For these reasons, we may be unable to develop or successfully manage the infrastructure necessary to meet current or future demands for reliability and scalability of our systems.
If the volume of traffic to our products and services increases substantially, we must respond in a timely fashion by expanding our systems, which may entail upgrading our technology and network infrastructure. Due to the number of our customers and the products and services that we offer, we could experience periodic capacity constraints which may cause temporary unanticipated system disruptions, slower response times and lower levels of customer service. Our business could be harmed if we are unable to accurately project the rate or timing of increases, if any, in the use of our products and application services or expand and upgrade our systems and infrastructure to accommodate these increases in a timely manner.
The security measures we have implemented to secure information we collect and store may be breached, which could cause us to breach agreements with our partners and expose us to potential investigation and penalties by authorities and potential claims by persons whose information was disclosed.
We take reasonable steps to protect the security, integrity and confidentiality of the information we collect and store but there is no guarantee that inadvertent or unauthorized disclosure will not occur or that third parties will not gain unauthorized access despite our efforts. If such unauthorized disclosure or access does occur, we may be required to notify persons whose information was disclosed or accessed under existing and proposed laws. We also may be subject to claims of breach of contract for such disclosure, investigation and penalties by regulatory authorities and potential claims by persons whose information was disclosed.
We may be subject to liability for our use or distribution of information that we gather or receive from third parties.
We obtain content and commerce information from third parties. When we distribute this information, we may be liable for the data that is contained in that content. This could subject us to legal liability for such things
as defamation, negligence, intellectual property infringement, violation of privacy or publicity rights and product or service liability, among others. Laws or regulations of certain jurisdictions may also deem some content illegal, which may expose us to legal liability as well. We also gather personal information from users in order to provide personalized services. Gathering and processing this personal information may subject us to legal liability for, among other things, negligence, defamation, invasion of privacy or product or service liability. We are also subject to laws and regulations, both in the United States and abroad, regarding the collection and use of end user information. If we do not comply with these laws and regulations, we may be exposed to legal liability.
Many of the agreements by which we obtain content do not contain indemnity provisions in favor of us. Even if a given contract does contain indemnity provisions, these provisions may not cover a particular claim or type of claim or the party giving the indemnity may not have the financial resources to cover the claim. Our insurance coverage may be inadequate to cover fully the amounts or types of claims that might be made against us. Any liability that we incur as a result of content we receive from third parties could harm our financial results.
If others claim that our products infringe their intellectual property rights, we may be forced to seek expensive licenses, reengineer our products, engage in expensive and time-consuming litigation or stop marketing and licensing our products.
We attempt to avoid infringing known proprietary rights of third parties in our product development efforts. However, we do not regularly conduct patent searches to determine whether the technology used in our products infringes patents held by third parties. Patent searches generally return only a fraction of the issued patents that may be deemed relevant to a particular product or service. It is therefore nearly impossible to determine, with any level of certainty, whether a particular product or service may be construed as infringing a U.S. or foreign patent. Because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed by third parties that relate to our products. In addition, other companies, as well as research and academic institutions, have conducted research for many years in the search and directory and mobile and wireless technology fields, and this research could lead to the filing of further patent applications.
In addition to patent claims, third parties have in the past and may in the future make claims against us alleging infringement of copyrights, trademark rights, trade secret rights or other proprietary rights, or alleging unfair competition or violations of privacy or publicity rights. In some cases, the ownership or scope of an entitys or persons rights is unclear and may also change over time, including through changes in U.S. or international intellectual property laws or regulations or through court decisions or decisions by agencies or regulatory boards that manage such rights.
If we were to discover that our products violated or potentially violated third-party proprietary rights, including those third-party proprietary rights that came about due to decisions and other changes regarding a persons or entitys proprietary rights discussed above, we might be required to obtain licenses that are costly or contain terms unfavorable to us, or expend substantial resources to reengineer those products so that they would not violate such third party rights. Any reengineering effort may not be successful, and we cannot be certain that any such licenses would be available on commercially reasonable terms. Any third-party infringement claims against us could result in costly litigation or liability and be time consuming to defend, divert managements attention and resources, cause product and service delays or require us to enter into royalty and licensing agreements.
We rely heavily on our technology, but we may be unable to adequately or cost-effectively protect or enforce our intellectual property rights, thus weakening our competitive position and negatively impacting our financial results.
To protect our rights in our products and technology, we rely on a combination of copyright and trademark laws, patents, trade secrets, and confidentiality agreements with employees and third parties and protective contractual provisions. We also rely on the law pertaining to trademarks and domain names to protect the value of our corporate brands and reputation. Despite our efforts to protect our proprietary rights, unauthorized parties
may copy aspects of our products or services or obtain and use information that we regard as proprietary, or infringe our trademarks. In addition, it is possible that others could independently develop substantially equivalent intellectual property. If we do not effectively protect our intellectual property, we could lose our competitive position.
Effectively policing the unauthorized use of our products and trademarks is time-consuming and costly, and there can be no assurance that the steps taken by us will prevent misappropriation of our technology or trademarks. Our intellectual property may be subject to even greater risk in foreign jurisdictions, as protection is not sought or obtained in every country in which our services are available. Also, the laws of many countries do not protect proprietary rights to the same extent as the laws of the United States. If we cannot adequately protect our intellectual property, our competitive position in markets abroad may suffer.
RISKS RELATED TO THE INDUSTRIES IN WHICH WE OPERATE
Intense competition in the mobile, search and directory markets could prevent us from increasing distribution of our services in those markets or cause us to lose market share.
Our current business model depends on distribution of our products and services into the mobile, search and directory markets, which are extremely competitive and rapidly changing. Many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, more developed infrastructures, greater name recognition or more established relationships in the industry than we have. Our competitors may be able to adopt more aggressive pricing policies, develop and expand their service offerings more rapidly, adapt to new or emerging technologies and changes in customer requirements more quickly, take advantage of acquisitions and other opportunities more readily, achieve greater economies of scale, and devote greater resources to the marketing and sale of their services than we can. Because of these competitive factors and due to our relatively small size and financial resources, we may be unable to compete successfully.
Some of the companies we compete with are currently customers of ours, the loss of which could harm our business. Many of our customers have established relationships with some of our competitors. If these competitors develop products and services that compete with ours, we could lose market share and our revenues could decrease. Additionally, our financial results could be adversely affected as well if our distribution partners create their own products and services that compete or replace the products and services we provide.
Consolidation in the industries in which we operate could lead to increased competition and loss of customers.
The Internet industry (including the search and directory segments) and the wireless industry have experienced substantial consolidation. We expect this consolidation to continue. These acquisitions could adversely affect our business and results of operations in a number of ways, including the following:
Security breaches may pose risks to the uninterrupted operation of our systems.
Our networks may be vulnerable to unauthorized access by hackers or others, computer viruses and other disruptive problems. Someone who is able to circumvent security measures could misappropriate our proprietary
information or cause interruptions in our operations. Subscribers to some of our services are required to provide information in order to utilize the service that may be considered to be personally identifiable or private information. Unauthorized access to, and abuse of, this information could subject us to a risk of loss or litigation and liability.
We may need to expend significant capital or other resources protecting against the threat of security breaches or alleviating problems caused by breaches. Although we intend to continue to implement and improve our security measures, persons may be able to circumvent the measures that we implement in the future. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to users accessing our services, any of which could harm our business.
Governmental regulation and the application of existing laws may slow business growth, increase our costs of doing business and create potential liability.
The growth and development of the Internet and wireless communication have led to new laws and regulations, as well as the application of existing laws to wireless communications and the Internet. Application of these laws can be unclear. The costs of complying or failure to comply with these laws and regulations could limit our ability to operate in our markets, expose us to compliance costs and substantial liability and result in costly and time-consuming litigation.
Several federal or state laws could impact our business. Federal laws include those designed to restrict the online distribution of certain materials deemed harmful to children and impose additional restrictions or obligations for online services when dealing with minors. Such legislation may impose significant additional costs on our business or subject us to additional liabilities. The application to advertising in our industries of existing laws regulating or requiring licenses for certain businesses can be unclear. Such regulated businesses may include, for example, gambling; distribution of pharmaceuticals, alcohol, tobacco or firearms; or insurance, securities brokerage and legal services. Additionally, certain bills are pending and some laws have been passed in certain jurisdictions setting forth requirements that must be met before a downloadable application is downloaded to an end users computer. Moreover, regulations by the Federal Communications Commission regarding unsolicited commercial email to wireless devices have created new requirements that could adversely affect our business by limiting our ability to communicate with users and increasing our burden of disclosure.
We post our privacy policies and practices concerning the use and disclosure of user data. Any failure by us to comply with our posted privacy policies, FTC requirements or other privacy-related laws and regulations could result in proceedings by the FTC or others, including potential class action litigation, which could potentially have an adverse effect on our business, results of operations and financial condition. In this regard, there are a large number of legislative proposals before the United States Congress and various state legislative bodies regarding privacy and data protection issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registrations and revenues. This could be caused by, among other possible provisions, the required use of disclaimers or other requirements before users can utilize our services.
The FTC has recommended to search engine providers that paid-ranking search results be delineated from non-paid results. To the extent that the FTC may in the future issue specific requirements regarding the nature of such delineation, which would require modifications to the presentation of search results, revenue from the affected search engines could be negatively impacted.
Due to the nature of the Internet, it is possible that the governments of states and foreign countries might attempt to regulate Internet transmissions, through data protection laws amongst others, or institute proceedings for violations of their laws. We might unintentionally violate such laws, such laws may be modified and new laws may be enacted in the future. Any such developments (or developments stemming from enactment or modification of other laws) could increase the costs of regulatory compliance for us or force us to change our business practices.
We rely on the infrastructure of the Internet and of wireless networks, over which we have no control and the failure of which could substantially undermine our operations.
Our success depends, in large part, on other companies maintaining the Internet system infrastructure and mobile operators who distribute our mobile content and services to maintain their proprietary wireless networks. In particular, with respect to the Internet, we rely on other companies to maintain a reliable network backbone that provides adequate speed, data capacity and security and to develop products that enable reliable Internet access and services. With respect to wireless networks, we depend on mobile operators to maintain their wireless networks so as to provide adequate speed, data capacity and security and that enable reliable mobile access to our products and services.
As the Internet and usage of mobile services continues to experience growth in the number of users, frequency of use and amount of data transmitted, the Internet system infrastructure and the wireless networks of mobile operators may be unable to support the demands placed on them, and the Internets and mobile operators networks performance or reliability may suffer as a result of this continued growth. Some of the companies that we rely upon to maintain network infrastructure may lack sufficient capital to support their long-term operations. The failure of the internet infrastructure or wireless networks would substantially undermine our operations and may have a material adverse effect on our financial results.
Not applicable with respect to the current reporting period.
ITEM 2. Properties
Our principal corporate office is located in Bellevue, Washington, and we have business operations in: Los Angeles, California, Waltham and Westborough, Massachusetts, Woking and Eastleigh, United Kingdom, and Papendrecht, The Netherlands. Our Bellevue and Woking facilities are utilized by both our Online and Mobile businesses; our Westborough facilities are utilized by our Online business; and our Los Angeles, Eastleigh, and Papendrecht facilities are utilized by our Mobile business. We have data centers in Bellevue and Seattle, Washington, Los Angeles, California, Waltham, Massachusetts, and Papendrecht, The Netherlands. All of our facilities are leased. We believe our properties are suitable and adequate for our present and anticipated near term needs.
ITEM 3. Legal Proceedings
See Note 7Commitments and Contingencies of the Notes to Consolidated Financial Statements (Item 8, of Part II of this Report) for information regarding legal proceedings.
ITEM 4. Submission of Matters to a Vote of Security Holders
Not applicable with respect to the current reporting period.
Market for Our Common Stock
Our common stock has been traded on the Nasdaq Stock Market under the symbol INSP since December 15, 1998, the date of our initial public offering. Prior to that time, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as reported by the Nasdaq Stock Market.
On February 16, 2007, the last reported sale price for our common stock on the Nasdaq Stock Market was $23.19 per share. As of February 16, 2007, there were 958 holders of record of our common stock.
We have never declared, nor have we paid, any cash dividends on our common stock. We currently intend to retain our earnings to finance future growth and, therefore, do not anticipate paying any cash dividends on our common stock in the foreseeable future. Please see Part III, Item 12 of this report for disclosure relating to our equity compensation plans. Such information is incorporated by reference from our Proxy Statement.
The information contained in the performance graph shall not be deemed to be soliciting material or to be filed with the SEC, and such information shall not be incorporated by reference into any future filing under the Securities Act or Exchange Act, except to the extent that InfoSpace specifically incorporates it by reference into such filing.
Set forth below is a line graph comparing the cumulative return of (i) the Nasdaq U.S. Index and (ii) the Nasdaq Computer Index for the five-year period ending on December 31, 2006.
ITEM 6. Selected Consolidated Financial Data
The following selected consolidated financial data should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations, our consolidated financial statements and notes thereto and other financial information included elsewhere in this report. The selected consolidated statements of operations data for the years ended December 31, 2006, 2005, 2004, 2003, and 2002 are derived from our audited consolidated financial statements.
You should read the following discussion and analysis in conjunction with Selected Consolidated Financial Data and our consolidated financial statements and notes thereto included elsewhere in this report.
InfoSpace, Inc. (InfoSpace, Our or We) is a developer of tools and technologies that assist consumers with finding content and information on the Internet or mobile phone. We use our metasearch technology to power our own branded Web sites and provide private-label online search and directory services to distribution partners. In addition, our mobile applications provide programming and sales opportunities to our carrier partners, while providing consumers with relevant mobile functionality and mobile media content, including ringtones, graphics, and games. We were founded in 1996 and are incorporated in the state of Delaware. Our principal corporate office is located in Bellevue, Washington. We also have facilities in Los Angeles, California; Westborough, Massachusetts; Woking and Eastleigh, United Kingdom; and Papendrecht, The Netherlands. Our common stock is listed on the Nasdaq Stock Market under the symbol INSP.
Our Online search and directory services enable Internet users to locate information, merchants, individuals, and products online. We offer search and directory services through our branded Web sites, Dogpile.com, Switchboard.com, InfoSpace.com, Webcrawler.com, MetaCrawler.com, and Zoo.com, as well as through the Web properties of distribution partners. Partner versions of our search and directory services are generally private-labeled and delivered with each distribution partners unique requirements.
Our Mobile business delivers data technology solutions, consulting and management services for the mobile operator market, including portal, storefront, search and messaging solutions. Additionally, we provide mobile media content, including ringtones, graphics and games, to subscribers of our Mobile customers. However, we plan to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007. Through our products, content and service offerings, our mobile operator partners are able to aggregate, configure and customize the services they offer under their own brand and deliver them to their subscribers.
Overview of 2006 Operating Results
The following is an overview of our operating results for the year ended December 31, 2006. A more detailed discussion of our operating results, comparing our operating results for the years ended December 31, 2006, 2005, and 2004, is included under the heading Historical Results of Operations in this Managements Discussion and Analysis of Financial Condition and Results of Operations.
In September 2006, we announced that we had been informed by one of our carrier partners that it intended to develop direct relationships for mobile ringtone content with the major record labels beginning in 2007. We anticipated that such direct relationships between the carrier and content providers would have a material negative impact on our revenues and operating results. As a result, during September 2006, we committed to a plan to make operational changes to our business to align operational focus and costs with expected future revenues. The plan included a reduction in our workforce and consolidation of our facilities. We also suspended investment in mobile media content initiatives and, accordingly, intend to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007 by eliminating certain products including but not limited to ringtones, graphics and games. We will continue to operate our two business units: Online, comprised of our search and directory properties as well as our private label distribution service and Mobile services, including portal, storefront, messaging, and mobile search. Additionally, in 2006 we announced the closing of our office in Hamburg, Germany. As a result of these operational changes, in 2006 we recorded an aggregate $62.3 million restructuring charge, which includes impairment for goodwill and other intangible assets, employee separation costs, losses on contractual commitments and costs to consolidate facilities.
Revenues for 2006 increased to $371.7 million from $340.0 million in 2005. Revenues from our Online business increased to $186.9 million in 2006 from $182.6 million in 2005. This increase was primarily due to better monetization of our paid searches. During 2006, approximately 60% of our search revenues came from our search distribution partners. Revenues from our Mobile business increased to $184.8 million in 2006 from $157.4 million in 2005, primarily attributable to an increase in sales of our media download products, such as ringtones and graphics. Mobile revenues are expected to decrease in the near term as we substantially reduce our mobile media content product offerings.
Content and distribution costs for 2006 increased to $178.3 million from $145.4 million in 2005. Total segment gross profit, comprised of revenues net of content and distribution costs, decreased to $193.4 million in 2006 from $194.6 million in 2005. Segment gross profit from our Online business increased to $120.2 million from $114.5 million in 2005, due to better monetization of our paid searches, primarily from our own branded Web sites. Segment gross profit for our Mobile segment decreased to $73.2 million in 2006 from $80.1 million in 2005, primarily attributable to an increase in content costs associated with our media downloads and the loss of a service agreement at the end of 2005. Mobile content costs, as a percentage of revenue, increased at a greater rate as a result of an increase in content costs and the shift of the mix of products and services we provide. In particular, sales of our labeltone or true tone (MP3-like quality) ringtones, that have a greater cost as a percentage of revenue than our other media download products, represented a larger share of our Mobile revenues in 2006.
Other operating expenses for 2006, excluding the restructuring charge of $62.3 million recorded in the second half of 2006, were $204.1 million, an increase of $55.9 million from $148.2 million in 2005. Other operating expenses include expenses related to systems and network operations, product development, sales and marketing, general and administrative, depreciation and amortization of intangible assets. The increase from 2005 was primarily attributable to spending on certain business initiatives, general growth in our operations, and the effect of expensing stock options and other equity-based awards as required under Statement of Financial Accounting Standard (SFAS) No. 123(R), Share-Based Payment, which we adopted on January 1, 2006. Increased operating costs related to our initiatives and growth in our business primarily relate to increases in personnel costs, including salaries, benefits and other employee costs, and costs of temporary help from contractors to augment our staffing needs, as well as increases in marketing and promotional costs and depreciation expense. In light of our restructuring described above, we have suspended investments in developing or obtaining new Mobile content and certain Mobile distribution channels, including our direct to consumer online web site, Moviso.com.
Additionally, interest income increased in 2006 to $19.6 million compared to interest income in 2005 of $11.3 million and was primarily attributable to an increase in interest rates and, to a lesser extent, more available cash and marketable investments on hand to invest. In 2005, we recognized a gain, net of legal costs, of $79.3 million in connection with the settlement of certain litigation matters, including the Dreiling v. Jain, et al. derivative lawsuit and the Dreiling v. Jain, et. al. Section 16(b) case. We also recognized an income tax benefit of $28.6 million from the realization of a deferred tax asset related to a portion of our net operating loss carryforward, an increase of $3.6 million from our realization of a similar deferred tax asset in 2005. Additionally, we recorded a net tax benefit of $9.9 million from our operations in 2006 as compared to a net expense of $1.5 million from our operations in 2005.
Net loss for 2006 was $15.1 million compared to net income of $159.4 million in 2005. The net loss in 2006 was primarily attributable to the items noted above.
Critical Accounting Policies and Estimates
The Managements Discussion and Analysis of Financial Condition and Results of Operations, as well as disclosures included elsewhere in this Form 10-K, are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and disclosures of contingencies.
The Securities and Exchange Commission (SEC) has defined a companys most critical accounting policies as the ones that are the most important to the portrayal of the companys financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. On an ongoing basis, we evaluate the estimates used, including those related to impairment of goodwill and other intangible assets, useful lives of other intangible assets, purchase accounting, other-than-temporary impairment of investments, revenue recognition, the estimated allowance for sales returns and doubtful accounts, restructuring-related liabilities, accrued contingencies and valuation allowance for our deferred tax assets. We base our estimates on historical experience, current conditions and on various other assumptions that we believe to be reasonable under the circumstances and, based on information available to us at that time, we make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identify and assess our accounting treatment with respect to commitments and contingencies. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our consolidated financial statements. We also have other accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results. For additional information see Item 8 of Part II Financial Statements and Supplementary DataNote 1: Summary of Significant Accounting Policies to our Consolidated Financial Statements.
Our revenues are derived from products and services delivered to our customers across our two businesses, Online and Mobile. In general, we recognize revenues in the period in which the services are performed, products are delivered or transaction occurs. In certain arrangements, we record deferred revenue for amounts received from customers in advance of the performance of services or upon execution of an agreement and recognize revenues ratably over the term of the agreement or expected customer life. We generally record revenue on a gross basis in accordance with Emerging Issues Task Force Issue 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. For distribution partner arrangements in our Online business we record revenue on a gross basis and the corresponding revenue sharing payments as a content and distribution expense. For mobile operator customers in which we license the content, we record revenue on a gross basis and the corresponding licensing expense as content and distribution expense. In the event the mobile operator customer directly licenses the content, we record as revenue the service fees we earn. See Item 8 of Part II Financial Statements and Supplementary DataNote 1: Summary of Significant Accounting Policies to our Consolidated Financial Statements for a description of products and services and the related revenue recognition policy for each of our business units.
We account for income taxes under the asset and liability method, under which deferred tax assets, including net operating loss carryforwards, and liabilities are determined based on temporary differences between the book and tax basis of assets and liabilities. We periodically evaluate the likelihood of the realization of deferred tax assets, and reduce the carrying amount of the deferred tax assets by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available to us for tax reporting purposes, and other relevant factors. The range of possible judgments relating to the valuation of our deferred tax assets is wide.
During the year ended December 31, 2006, based on the weight of available evidence, we determined that it was more likely than not that a portion of our deferred tax asset would be realized and, at December 31, 2006, our deferred tax asset, net of the valuation allowance, is $104.0 million. See discussion in our Results of Operations for the Years Ended December 31, 2006, 2005, and 2004. Significant judgment is required in making
this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of our deferred tax assets are realizable.
During the evaluation of our disclosure controls and procedures as of December 31, 2006, our management identified a deficiency in our internal control over financial reporting which constituted a material weakness. Specifically, the deficiency pertained to our controls which were ineffective and not properly designed to ensure proper accounting and disclosure of our deferred income tax benefit and related income tax asset. We have and are continuing to take steps to address this material weakness, including the recent hiring of a senior tax director and implementing a more rigorous review process involving appropriate internal accounting staff and an external accounting firm. Additional review, evaluation and oversight were undertaken in order to ensure our consolidated financial statements were prepared in accordance with generally accepted accounting principles and, as a result, we concluded that the consolidated financial statements in this Form 10-K fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented.
In 2006, we committed to a plan to make operational changes to our business, which included a reduction in our workforce and, as part of the workforce reduction, consolidation of our facilities. Charges associated with this restructuring plan are accounted for in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. In determining the restructuring charges that we recorded in 2006 we relied on certain assumptions, including planned employee separation dates and estimated income for facilities that we plan to sublease. Changing business conditions may affect the assumptions related to the timing and extent of restructuring activities. We will review the status of these activities on a quarterly basis and, if appropriate, record changes based on updated estimates.
Accounting for Goodwill and Certain Other Intangible Assets
SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill and intangible assets with indefinite lives be tested for impairment on an annual basis and between annual tests in certain circumstances. Certain circumstance may include testing for impairment in conjunction with restructuring in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. On a quarterly basis, we assess whether business conditions indicate that our goodwill and other intangible assets may not be recoverable, and, as a result of the restructuring plan we committed to in 2006, we tested our goodwill and certain other intangible assets for impairment.
Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment.) Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit.
Other intangible assets are tested for impairment by comparing their carrying amounts to their fair values. We measure the fair value of such assets by estimating the future undiscounted cash flows attributable to them, and recognize an impairment if their carrying amounts exceeded the estimated fair values. Such evaluations rely on various assumptions, including the timing of future events and market conditions.
During 2006, based upon our analysis, we recorded impairments for goodwill of $31.9 million and intangible assets of $12.6 million associated with changes in our Mobile business and our 2006 restructuring plan. As of December 31, 2006 we have $104.4 million of goodwill and $19.6 million of other intangible assets on our balance sheet.
Business combinations accounted for under the purchase method of accounting require management to estimate the fair value of the assets and liabilities acquired. The allocation of the purchase price based on the estimated fair value of assets and liabilities acquired may be subject to adjustments during the year following the date of acquisition.
Allowances for Sales and Doubtful Accounts
Our management must make estimates of potential future sales allowances related to current period revenues for our products and services. We analyze historical adjustments, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales allowances. Estimates must be made and used in connection with establishing the sales allowance in any accounting period.
The allowance for doubtful accounts is a management estimate that considers actual facts and circumstances of individual customers and other debtors, such as financial condition and historical payment trends. We evaluate the adequacy of the allowance utilizing a combination of specific identification of potentially problematic accounts and identification of accounts that have exceeded payment terms.
On January 1, 2006, we adopted SFAS No. 123(R), Stock-Based Compensation, which requires companies to record stock compensation expense for equity-based awards granted, including stock options and restricted stock unit grants, for which expense will be recognized over the service period of the equity-based award based on the fair value of the award at the date of grant. During 2006, we recognized $16.9 million of stock compensation expense.
Calculating stock-based compensation expense relies upon certain assumptions, including the expected term of the stock-based awards, stock price volatility, expected interest rate, number and types of stock-based awards and the pre-vesting forfeiture rate. If we use different assumptions due to changes in our business or other factors, our stock-based compensation expense could materially vary in the future.
Through December 31, 2005, we accounted for stock-based compensation under the intrinsic method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Under the intrinsic method, we did not record any expenses when we granted stock options because they were priced at the fair market value of our stock at the date of grant.
On December 14, 2005, we accelerated vesting of certain unvested and out-of-the-money stock options with exercise prices equal to or greater than $34.00 per share that were previously awarded under our equity compensation plans to our employees. These options were accelerated to avoid recording future compensation expense with respect to such options. We believe that because such options had exercise prices in excess of the current market value of our stock, the options were not achieving their original objective. The acceleration of vesting was effective for stock options outstanding as of December 14, 2005. Options to purchase 2.4 million shares of common stock were subject to the acceleration and the weighted average exercise price of the options subject to the acceleration was $40.51. Due to this acceleration, an additional $29.3 million is included in the pro forma stock-based compensation expense for the year ended December 31, 2005.
We are subject to various legal proceedings and claims and tax matters, the outcomes of which are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is
required if there is at least a reasonable possibility that a loss has been incurred. We evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results of operations. See Item 8 of Part II Financial Statements and Supplementary DataNote 7: Commitments and Contingencies to our Consolidated Financial Statements for further information regarding contingencies.
Historical Results of Operations
For the year ending December 31, 2006, our net loss totaled $15.1 million, which includes restructuring expense of $62.3 million related to our plan to make operational changes. While we achieved profitability for each of the quarters since the third quarter of 2003, with the exception of the third quarter of 2006, and for the years ended December 31, 2004 and 2005, prior to that we had incurred losses since our inception, and as of December 31, 2006, we had an accumulated deficit of $1.0 billion.
In light of the rapidly evolving nature of our business and overall market conditions, we believe that period-to-period comparisons of our revenues and operating results are not necessarily meaningful, and you should not necessarily rely solely upon them as indications of future performance.
The following table sets forth the historical results of our operations (in thousands and as percent of revenues).
Results of Operations for the Years Ended December 31, 2006, 2005, and 2004
Revenues. Revenues are derived from deploying our services and products to customers via the Internet and mobile phones. Under many of our agreements, we earn revenues from a combination of our products and services delivered to customers. Revenues for the years ended December 31, 2006, 2005, and 2004 are presented below (in thousands):
The increase in revenue for Online products and services for 2006 as compared to 2005 was primarily due to the growth in our online search services, in particular, better monetization for paid searches, and, to a lesser extent, directory revenues related to a contract we entered into in June 2005. These increases were partially offset by a decline in revenue due to one of our top customers, Verizon, not renewing certain key provisions of our subscription agreement for yellow pages listings in June 2005. In 2006, approximately 60% of our search revenues came from our search distribution partners.
The absolute dollar increase in Online revenue from 2004 to 2005 was primarily due to growth in our paid search services from both our search and directory businesses, in particular, paid searches from our distribution partners Web properties and greater revenue per paid search, and directory revenues related to our acquisition of an online directory business in June 2004. In 2005, search revenues from distribution partners were over 60% of total search revenues.
We expect that search revenue from our distribution partners will continue to be a significant share of our search revenues.
The increase in revenue for our Mobile products and services for 2006 as compared to 2005 was primarily due to increased revenues from the sales of our media download products, primarily sales of our labeltone or true tone (MP3-like quality) ringtones. Partially offsetting the increase in revenue for Mobile products and services was the loss of a service agreement at the end of 2005. We expect that there will be a decline in our Mobile revenue in 2007 due to one of our carrier partners developing direct licensing relationships with the major record labels and as result of our plan to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007, focusing instead on our core Mobile services, which generated approximately $37 million in revenues in 2006.
The absolute dollar increase in Mobile revenue from 2004 to 2005 was primarily due to an increase in sales of our media download products, including our labeltones or MP3-like quality ringtones and, to a lesser extent, graphics and games.
Content and Distribution Expenses. Content and distribution expenses consist principally of costs related to royalty and license fees related to our Mobile products for items such as ringtones, graphics and games, and other content or data licenses, and revenue sharing arrangements with our Online distribution partners, as well as online content and data licenses. Content and distribution expenses in total dollars (in thousands) and as a percent of revenue for the years ended December 31, 2006, 2005, and 2004 are presented below:
Content and distribution expenses increased by $33.0 million to $178.3 million in 2006 as compared to $145.4 million in 2005. The cost as a percent of revenues decrease for Online content and distribution expense was primarily due to better monetization of our paid searches, primarily from our own branded Web sites. We anticipate that our Online content and distribution costs will continue to increase in absolute dollars if revenues increase through growth from existing arrangements with our Online distribution partners or we add new Online distribution partners. If Online revenue generated from our distribution partners increases at a greater rate than revenues generated from our own branded Web sites, content and distribution costs as a percent of revenue will increase.
The absolute dollar and cost as a percent of revenues increase for Mobile content and distribution expense was primarily attributable to revenue growth from sales of our content and media products to our Mobile customers, in particular, sales of our labeltone or true tone (MP3-like quality) ringtones, for which our costs as a percentage of revenues were greater than our other media download products. We expect that there will be a
decline in our content and distribution costs related to our Mobile business in 2007 due to the loss of revenue from one of our carrier partners developing direct licensing relationships with the major record labels and our substantially reducing our mobile media content product offerings.
Content and distribution expenses increased by $52.7 million to $145.4 million in 2005 as compared to $92.7 million in 2004. The absolute dollar and percent of revenue increase was attributable to the growth from sales of our content and media download products to our mobile customers, including our higher cost labeltones or MP3-like quality ringtones, which require licensing and royalty payments to third parties and, to a lesser extent, revenue growth from our online search and directory distribution partners in which we have revenue sharing arrangements where we private label our search products for our partners to offer on their own Web properties.
Systems and Network Operations Expenses. Systems and network operations consists of expenses associated with the delivery, maintenance and support of our products, services and infrastructure, including personnel expenses, which include salaries, benefits and other employee related costs, stock-based compensation, and temporary help and contractors to augment our staffing, communication costs, equipment repair and maintenance, and professional service fees. Systems and network operations expenses in total dollars (in thousands) and as a percent of revenue for the years ended December 31, 2006, 2005, and 2004 are presented below:
Systems and network operations expenses increased by $9.8 million to $31.2 million for the year ended December 31, 2006 as compared to $21.4 million for the year ended December 31, 2005. The absolute dollar increase for 2006 as compared to 2005 was primarily attributable to an increase in facilities, software, equipment expense, and communication costs of $4.1 million related to increased costs of operating the East Coast data center and our new Puget Sound data center, an increase of $3.6 million in personnel expenses and contractors to augment our staffing, stock-based compensation expense of $1.6 million, and a $1.0 million increase in professional service fees related to growth in our business.
Systems and network operations expenses increased by $7.2 million to $21.4 million for the year ended December 31, 2005 as compared to $14.2 million for the year ended December 31, 2004. The increase in absolute dollars was primarily attributable to an increase of $6.0 million in personnel expenses, including employee salaries and benefits and temporary help and contractors to augment our staffing and also related to our acquisitions of an online directory business and three mobile gaming companies. Additionally, there was an increase of over $1.0 million in facilities, software and equipment expenses to support the additional headcount and the operation of our East Coast data center. Partially offsetting these increases was a decrease in communications costs of $514,000 related to the renegotiation of certain contracts.
Product Development Expenses. Product development expenses consist principally of personnel expenses, which include salaries, benefits and other employee related costs, stock-based compensation, and temporary help and contractors to augment our staffing, for research, development, support and ongoing enhancements of our products and services. Product development expenses in total dollars (in thousands) and as a percent of revenue for the years ended December 31, 2006, 2005, and 2004 are presented below:
Product development expenses increased by $15.1 million to $46.3 million in 2006 as compared to $31.2 million in 2005. The absolute dollar increase from the prior year was primarily attributable to an increase of
$13.0 million in personnel related expenses and contractors to augment our staffing, as we continued to invest in the development and enhancement of our products and services, and stock-based compensation of $2.7 million.
Product development expenses increased by $8.1 million to $31.2 million in 2005 as compared to $23.1 million in 2004. The increase in absolute dollars was primarily due to an increase of $7.5 million in personnel expenses, including employee salaries and benefits and temporary help and contractors to augment our staffing, as we continued to invest in the development and enhancement of our products and services and also as a result of additional headcount related to our acquisitions of an online directory business and three mobile gaming companies.
Product development costs may not be consistent with changes in revenues as they represent key costs to develop and enhance our product and service offerings. We believe that investments in technology are necessary to remain competitive, and we anticipate that we will continue to invest in our products and services.
Sales and Marketing Expenses. Sales and marketing expenses consist principally of personnel costs, which include salaries, benefits and other employee related costs, stock-based compensation, and temporary help and contractors to augment our staffing, and advertising, market research and promotion expenses. Sales and marketing expenses in total dollars (in thousands) and as a percent of revenue for the years ended December 31, 2006, 2005, and 2004 are presented below:
Sales and marketing expenses increased by $15.5 million to $46.5 million in 2006 as compared to $31.1 million in 2005. The absolute dollar increase was primarily attributable to an increase in personnel expenses totaling $7.3 million, an increase of $3.8 million in marketing and promotional expense due to our new products and services initiatives, growth in content and new distribution channels, as well as $4.8 million of stock-based compensation. These increases were partially offset by a decrease in professional service fees of $563,000.
Sales and marketing expenses increased by $7.6 million to $31.1 million in 2005 as compared to $23.5 million in 2004. The increase in absolute dollars was primarily attributable to an increase of $4.1 million in advertising and promotion expense and an increase of $3.4 million in personnel expenses, including salaries and benefits and temporary help and contractors to augment our staffing, as we continued to grow our business, and also as a result of our acquisitions of an online directory business and three mobile gaming companies.
We will continue to invest in marketing initiatives, sales promotions, and new distribution channels, while we expect that sales and marketing expenses will decline in 2007 due to our suspension of investment in our Mobile media products and services.
General and Administrative Expenses. General and administrative expenses consist primarily of personnel expenses, which include salaries, benefits and other employee related costs, stock-based compensation, professional service fees, which include legal fees, audit fees, SEC compliance costs, which include costs related to compliance with the Sarbanes-Oxley Act of 2002, occupancy and general office expenses, and general business development and management expenses. General and administrative expenses in total dollars (in thousands) and as a percent of revenue for the years ended December 31, 2006, 2005, and 2004 are presented below:
General and administrative expenses increased by $11.5 million to $51.7 million in 2006 as compared to $40.2 million in 2005. The absolute dollar increase was primarily attributable to stock-based compensation expense of $7.8 million, $2.2 million related to certain arbitration and litigation settlements, an increase in facilities expenses totaling $1.5 million, an increase in personnel related expenses totaling $1.2 million, and an increase in professional fees of $1.1 million. These increases were partially offset by reductions in business taxes of $2.6 million due to changes in existing tax laws.
General and administrative expenses increased by $3.9 million to $40.2 million in 2005 as compared to $36.3 million in 2004. The increase in absolute dollars was primarily attributable to an increase in facilities costs of $2.4 million to expand facilities and build our East Coast data center, an increase of $1.2 million in personnel costs and temporary help and contractors, to augment our staffing, as a result of our acquisitions of an online directory business and three gaming companies, and growth in operations, and an increase of $1.4 million in professional services fees, which include tax and consulting fees. Partially offsetting these increases were reductions in legal fees of $1.9 million and insurance costs of $929,000.
Restructuring: Restructuring charges reflect actual and estimated costs associated with the reductions in workforce and costs associated with the consolidation and closures of certain of our facilities. Restructuring charges for the years ended December 31, 2006, 2005, and 2004 are presented below (in thousands):
In September 2006, we announced that one of our carrier partners plans to develop direct licensing relationships with the major record labels beginning in 2007. We anticipated that such direct relationships between the carrier and content providers would have a material negative impact on our revenues and operating results. As a result, during September 2006, we committed to a plan to make operational changes to our business to align operational focus and costs with expected future revenues. The plan included a reduction in our workforce and consolidation of our facilities. We also suspended investment in mobile media content initiatives and, accordingly intend to substantially reduce, through various initiatives, our mobile media content product offerings by mid-2007. The restructuring plan is expected to be completed by mid-2007. Also during September 2006, we initiated a plan to close our office in Hamburg, Germany. In future periods, adjustments and additions are expected to be made to the amounts recorded as of December 31, 2006. Salaries and other costs are expected to decline in the future as a result of the reduction in our workforce.
We recorded no restructuring charges in 2005.
The restructuring charge in 2004 was attributable to an adjustment of our estimated reserves for the restructuring in 2003 primarily related to the payment of lease termination costs.
Depreciation. Depreciation of property and equipment includes depreciation of network servers and data center equipment, computers, software, office equipment and fixtures, and leasehold improvements. Depreciation expenses for the years ended December 31, 2006, 2005, and 2004 are presented below (in thousands):
The $7.0 million increase from 2005 to 2006 was primarily a result of property and equipment recently placed in service related to our East Coast and Puget Sound data centers. The $2.1 million increase from 2004 to 2005 was primarily a result of property and equipment recently placed in service related to our East Coast data center and those acquired with our acquisitions of an online directory business and the three mobile gaming companies, partially offset by a decrease in depreciation expenses of older property and equipment reaching the end of their depreciable lives.
Amortization of Other Intangible Assets. Amortization of definite-lived intangible assets includes amortization of core technology, customer and content relationships, customer lists and other intangible assets. Definite-lived intangible assets are amortized over their estimated life, ranging from one to five years. Amortization of other intangible assets is presented below for the years ended December 31, 2006, 2005, and 2004 (in thousands):
The $3.1 million absolute dollar decrease from 2005 to 2006 was primarily attributable to the impairment $12.6 million of definite-lived intangible assets related to our Mobile business.
The $5.3 million absolute dollar increase from 2004 to 2005 was primarily attributable to intangible assets that were acquired in the acquisitions of an online directory business and the three mobile gaming companies.
Assuming we do not acquire businesses or intangible assets in the future, the amortization of intangible assets will be $4.0 million in 2007.
Other, Net. Other, net consists of costs, charges, refunds or gains that are not directly associated with other revenue or operating expense classifications. Other, net for the years ended December 31, 2006, 2005, and 2004 is presented below (in thousands):
During 2004, we recorded other charges, net for a gain of $3.2 million. We settled a litigation matter concerning promissory notes due from a former officer, resulting in a gain of $3.9 million. Additionally, we recorded a charge of $1.2 million related to the separation of a former executive officer, and we received a final assessment from the Internal Revenue Service (the IRS) for a payroll tax settlement regarding certain aspects of our payroll tax returns for the year 2000 that included penalties and estimated interest, and, accordingly, we paid the IRS. The interest charges were less than originally estimated and, as a result, we reversed previously recognized interest charges of $266,000 upon our payment of the final assessment.
Gain on Equity Investments. Gain on equity investments consists of gains from changes in the fair value of derivative instruments held by us and the other-than-temporary impairment of equity investments. Gain on equity investments is comprised of the following for the years ended December 31, 2006, 2005, and 2004 (in thousands):
Other-than-temporary investment impairment: We have equity investments in privately-held companies and periodically evaluate whether the decline in fair value of an investment is other-than-temporary. During 2004, we concluded that there had been an other-than-temporary impairment of certain equity investments and we recorded an impairment charge related to those specific investments.
Gains in fair value of warrants: In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, we adjust our derivative instruments to fair value and recognize the change in the recorded fair value in earnings. We hold warrants to purchase stock in other companies, which qualify as derivatives, and therefore gains or losses are based on the fair value. In 2004, a company in which we held warrants to purchase shares of stock announced that it was being acquired and that any outstanding warrants to purchase shares of the company would also be purchased. We recognized a gain and proceeds of $1.4 million in 2004 based on the estimated fair value of the warrant. The warrant was subsequently purchased for $1.5 million and we received the final payment and recorded a gain of $154,000 in 2005.
Other Income, Net. Other income, net, primarily consists of interest income, litigation settlements and foreign currency gain (loss).
Interest income increased primarily due to increased interest rates in 2006 compared to 2005. Interest income more than doubled primarily due to increased interest rates in 2005 compared to 2004. In 2005, we received proceeds of $83.2 million from the settlement of several outstanding litigation matters. We recognized a gain of $79.3 million comprised of the settlement proceeds and interest, less $3.9 million in legal fees.
In 2005, we acquired elkware GmbH, a mobile gaming company, at a cost of 20.0 million euros in cash. The purchase price in U.S dollars was $26.4 million plus acquisition costs. In December 2004, due to the significant fluctuations in the exchange rate of the U.S. dollar to the euro, we entered into a forward exchange contract to mitigate our foreign currency exposure. At December 31, 2004, the exchange rate of the U.S. dollar had declined relative to the euro and a $456,000 gain on the forward exchange contract was recorded in 2004. Subsequently, in January 2005 when the acquisition was consummated, the U.S. dollar had strengthened against the euro and a $934,000 loss was recorded in 2005 at the settlement of that foreign exchange contract.
Income Tax Benefit. During the years ended December 31, 2006, 2005, and 2004, we have recorded an income tax benefit of $38.5 million, $23.5 million, and $29,000, respectively. The 2006 income tax benefit of $38.5 million is primarily due to a $28.6 million benefit from the realization of deferred tax assets related to an additional portion of our net operating loss carryforwards and a net tax benefit of $10.2 million from current year operations, partially offset by tax expense for federal alternative minimum, state and international taxes, as more fully discussed below. The 2005 income tax benefit of $23.5 million is primarily due to a $25.0 million benefit from the realization of deferred tax assets related to a portion of our net operating loss carryforwards, partially offset by tax expense for federal alternative minimum, state and international taxes.
At December 31, 2006, our net deferred tax assets are $104.0 million out of total deferred tax assets of $441.4 million, primarily comprised of $381.2 million of accumulated net operating loss carryforwards, net of a $337.4 million valuation allowance. In 2006, we determined it was more likely than not that an additional portion of our operating assets would be realizable in the foreseeable future. Accordingly, we reduced the valuation allowance related to our operating deferred tax assets and recognized a $28.6 million deferred tax benefit. As of December 31, 2006, we continue to have a $337.4 million valuation allowance against our deferred tax assets
primarily related to net operating loss carryforwards. Due to the size of our net operating loss carryforwards, their expiration beginning in 2020, and our recent level of annualized profitability, we believe that sufficient uncertainty exists regarding the realizability of the remaining balance of our deferred tax assets. If in the future, we determine that the realization of the remaining deferred tax assets is more likely than not to be realized, we will record a benefit to the income statement or make an adjustment to additional paid-in-capital.
To the extent we are profitable and we record a tax expense, the actual payment may be offset against the accumulated net operating loss carryforwards
Income from Discontinued Operations and Gain on Sale of Discontinued Operation. In 2004, we completed the sale of our Payment Solutions business and have reflected income from Payment Solutions as income from discontinued operations. For 2004, we recorded a gain on the sale of Payment Solutions of $29.1 million and income, net of taxes, from the operating results of Payment Solutions of $2.3 million for the year ended December 31, 2004. Income from discontinued operations includes previously unallocated depreciation, amortization, corporate expenses, and income taxes that were attributed to Payment Solutions.
Liquidity and Capital Resources
Our principal source of liquidity is our cash and cash equivalents, short-term investments and long-term investments, initially generated from proceeds from private placements and our initial and follow-on public offerings. In addition, more recently we have generated cash from operations. In 2005, we received proceeds of $83.2 million from the settlement of certain litigation matters and, in 2004, we received proceeds of $82.0 million from the sale of our Payment Solutions business unit.
As of December 31, 2006, we had cash and marketable investments of $401.9 million, consisting of cash and cash equivalents of $163.5 million and short-term investments available-for-sale of $238.4 million. We invest our excess cash in high quality marketable investments. These investments include securities issued by U.S. government agencies, certificates of deposit, money market funds, and taxable municipal bonds.
Commitments and Pledged Funds
The following are our contractual commitments associated with our operating lease obligations (in thousands):
We have no significant purchase commitments at December 31, 2006. We have pledged a portion of our cash as collateral for standby letters of credit and bank guaranties for certain of our property leases and banking arrangements. At December 31, 2006, the total amount of collateral pledged under these agreements was $4.4 million.
Net cash provided by operating activities consists of net income (loss) offset by certain adjustments not affecting current-period cash flows and the effect of changes in our operating assets and liabilities. Adjustments to net income (loss) to determine cash flow from operations include certain restructuring charges, depreciation and amortization, stock-based compensation expense, and deferred taxes. Net cash used by investing activities consists of net cash used to acquire businesses, transactions related to our investments, purchases of property and equipment, and proceeds from the sale of certain assets. Net cash provided (used) by financing activities consists
of proceeds from the issuance of stock through the exercise of stock options or warrants and our employee stock purchase plan, and cash used to repurchase outstanding stock.
Our net cash flows are comprised of the following for the years ended December 31, 2006, 2005, and 2004 (in thousands):
Net cash provided by operating activities was $43.5 million in 2006, consisting of our net loss of $15.1 million, cash provided by changes in our operating assets and liabilities of $5.8 million, consisting of decreases in other receivables and prepaid expenses and other current assets, increases in deferred revenue and accounts payable, and adjustments not affecting cash flows provided by operating activities of $107.7 million, primarily consisting of restructuring, depreciation and amortization and stock-based compensation. Partially offsetting the increase are changes in our operating assets and liabilities of $15.9 million, primarily consisting of increases in our accounts receivable and other long-term assets and a decrease in our accrued expenses and other current and long-term liabilities, and adjustments not affecting cash flows provided by operating activities of $38.8 million, consisting of increases in our deferred tax assets.
Net cash provided by operating activities was $157.6 million in 2005, consisting of our net income of $159.4 million, cash provided by changes in our operating assets and liabilities of $25.0 million, consisting of a decrease in notes and other receivables, an increase in accrued expenses and accounts payable, and adjustments not affecting cash flows provided by operating activities of $24.8 million, primarily consisting of depreciation and amortization. Partially offsetting the increase are changes in our operating assets and liabilities of $24.7 million, primarily consisting of increases in our accounts receivable, prepaid expenses and other current assets and other long-term assets and a decrease in our deferred revenue, and adjustments not affecting cash flows provided by operating activities of $26.9 million, primarily consisting of the benefit from the reversal of the deferred tax asset valuation allowance.
Net cash provided by operating activities was $51.1 million in 2004, consisting of our net income of $82.4 million, cash provided by changes in our operating assets and liabilities of $17.6 million, consisting of an increase in our accrued expenses, deferred revenues and a decrease in prepaid expenses and adjustments not affecting cash flows provided by operating activities of $18.4 million, primarily consisting of depreciation and amortization, stock-based compensation and bad debt expense, and non-cash restructuring charges. Partially offsetting the increase are cash used by changes in our operating assets and liabilities of $35.0 million, primarily consisting of increases in our accounts receivable, notes and other receivables, other long-term assets and a decrease in our accounts payable, and adjustments not affecting cash flows provided by operating activities of $32.3 million, primarily consisting of income and the gain on sale of our Payment Solutions business of $31.4 million, accounted for as a discontinued operation, and gains from our equity investments.
Net cash used by investing activities was $38.5 million in 2006, primarily from the purchase of $313.9 million of marketable investments, $22.6 million of property and equipment purchases, and the purchase of $320,000 of intangible assets. Partially offsetting cash used in investing activities were proceeds from the sale or maturity of our marketable investments of $298.3 million and proceeds of $35,000 from the sale of assets.
Net cash used by investing activities was $33.6 million in 2005, primarily from the purchase of $189.0 million of marketable investments, the use of $26.4 million for business acquisitions, net of cash acquired, increase of long-term assets of $4.5 million and $17.0 million of property and equipment purchases. Partially
offsetting cash used in investing activities were proceeds from the sale or maturity of our marketable investments of $202.9 million, proceeds of $139,000 from the sale of assets and proceeds of $154,000 upon the final settlement of warrants sold in 2004.
Net cash used by investing activities was $109.5 million in 2004, primarily from the purchase of $499.2 million of marketable investments, the use of $130.6 million for business acquisitions, net of cash acquired, and $10.4 million of property and equipment purchases. Partially offsetting cash used in investing activities were proceeds from the sale or maturity of our marketable investments of $446.4 million, proceeds of $82.0 million from the sale of our Payment Solutions business, and proceeds of $2.3 million from the sale of equity investments and our non-core services.
Net cash provided by financing activities in 2006 was $5.4 million, which resulted from the exercise of stock options and from the sale of shares through our employee stock purchase plan.
Net cash used by financing activities in 2005 was $56.3 million, primarily from the repurchase of 2.6 million shares of common stock for $70.4 million, including commissions. Partially offsetting cash used in financing activities were proceeds of $14.1 million from the exercise of stock options and from the sale of shares through our employee stock purchase plan.
Net cash provided by financing activities in 2004 was $32.7 million, which resulted from the exercise of stock options and from the sale of shares through our employee stock purchase plan.
We plan to use our cash to fund operations, develop technology, advertise, market and distribute our products and services, and continue the enhancement of our network infrastructure. We may use a portion of our cash for acquisitions or for common stock repurchases.
We believe that existing cash balances, cash equivalents, short term investments and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, the underlying assumed levels of revenues and expenses may not prove to be accurate. Our anticipated cash needs exclude any payments for pending or future litigation matters. In addition, we evaluate acquisitions of businesses, products or technologies that complement our business from time to time. Any such transactions, if consummated, may use a significant portion of our cash balances and marketable investments. We may seek additional funding through public or private financings or other arrangements prior to such time. Adequate funds may not be available when needed or may not be available on favorable terms. If we raise additional funds by issuing equity securities, dilution to existing stockholders will result. If funding is insufficient at any time in the future, we may be unable to develop or enhance our products or services, take advantage of business opportunities or respond to competitive pressures, any of which could harm our business.
Market Sensitive Derivatives and Financial Instruments
On December 15, 2004, we entered into a definitive agreement to acquire the outstanding stock of elkware GmbH, a German mobile games company. The purchase price was denominated in euros in the amount of 20.0 million euros. Due to significant changes in the exchange rate and the continued devaluation of the U.S. dollar to the euro, on December 22, 2004 we entered into a forward exchange contract to minimize any further exposure of the U.S. dollar weakening relative to the euro, which locked the exchange rate at 1.3416 for each dollar per euro. The acquisition was completed on January 7, 2005 and the forward contract was settled.
Summary of Our Acquisitions
elkware GmbH. On January 7, 2005, we acquired elkware GmbH, a German mobile games company, for 20.0 million euros, which approximated $26.4 million in cash, excluding acquisition costs and liabilities assumed. In addition, the purchase agreement required that 5.0 million euros of the purchase price be placed in escrow to provide security for certain indemnification obligations set forth in the purchase agreement. The operations were combined with our United Kingdom games operations and the office in Germany was closed in 2006.
IOMO Limited. In December 2004, we acquired the outstanding stock of IOMO Limited, a designer and publisher of mobile games, for 8.0 million British pounds, which approximated $15.4 million in cash, excluding acquisition costs and liabilities assumed. In addition, the purchase agreement required that 1.1 million British pounds of the purchase price be placed in escrow to provide security for certain indemnification obligations set forth in the purchase agreement.
Atlas Mobile, Inc. In July 2004, we acquired the assets of Atlas Mobile, a provider of mobile multi-player tournament games, for $6.3 million. We sold these assets in January 2007 for $1.5 million.
Switchboard Incorporated. In June 2004, we acquired the outstanding stock of Switchboard Incorporated, a provider of local online advertising and Internet based yellow pages, for $159.4 million in cash, which excludes transaction fees of $6.0 million and liabilities assumed. As of the acquisition date, Switchboard had $56.4 million in cash.
Stock Repurchase Program
On May 30, 2006, our Board of Directors approved a stock repurchase plan whereby we are authorized to purchase up to $100 million of our common stock during the succeeding twelve month period. Repurchased shares will be retired and resume the status of authorized but unissued shares of common stock. We did not purchase any shares during the year ended December 31, 2006. Under a previous repurchase plan authorized on May 13, 2005, which expired May 12, 2006, we purchased 2,633,002 shares in open-market transactions during 2005 at a total cost, exclusive of purchase and administrative costs, of $70.2 million, at an average price of $26.66 per share.
Quarterly Results of Operations (Unaudited)
The following table presents a summary of our unaudited consolidated results of operations for the eight quarters ended December 31, 2006. The information for each of these quarters has been prepared on a basis consistent with our audited consolidated financial statements. You should read this information in conjunction with our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. The operating results for any quarter are not necessarily indicative of results for any future period.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standard Board (FASB) issued Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for our first fiscal year beginning January 1, 2007. We are currently evaluating the provisions of FIN No. 48 to determine what effect its adoption will have on our financial position, cash flows, and results of operations, however we do not believe that there will be any material effect of adoption of FIN No. 48.
In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB No. 108 requires registrants to quantify misstatements using both an income statement (rollover) and balance sheet (iron curtain) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB No. 108 was effective for 2006. The application of SAB No. 108 did not have an effect on our financial position, cash flows, or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently evaluating the provisions of SFAS No. 157 to determine what effect its adoption on January 1, 2008 will have on our financial position, cash flows, and results of operations.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks, including changes in interest rates, foreign currency fluctuations, and changes in the market values of our investments.
Interest Rate Risk. We invest our available cash in investment-grade debt instruments of corporate issuers and in debt instruments of the U.S. Government and its agencies. By policy, we limit our credit exposure to any one issuer. We do not have any derivative instruments in our investment portfolio. We protect and preserve invested funds by limiting default, market and reinvestment risk. Investments in both fixed-rate and floating-rate interest earning instruments carry a degree of interest rate risk. Fixed-rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating-rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if we are forced to sell securities which have declined in market value due to changes in interest rates. At December 31, 2006, our short-term investment balances were $238.4 million.
The following table provides information about our cash equivalent and marketable fixed-income securities, including principal cash flows for 2006 and the related weighted average interest rates. Amounts are presented in U.S. dollar equivalents, which is our reporting currency.
Principal amounts by expected year of maturity in U.S. dollars as of December 31, 2006 are as follows (in thousands, except percentages):
Foreign Currency Risk: Our earnings and cash flows are subject to fluctuations due to changes in the exchange rates of the principal currency of countries that we operate in (Canada and countries in Europe) versus the U.S. dollar. We are exposed to these exchange rate fluctuations as the financial results of our non-U.S. based subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, those results, when translated, may vary from expectations and adversely impact our results. The cumulative translation effects for subsidiaries using functional currencies other than the U.S. dollar are included in accumulated other comprehensive income in stockholders equity. We do not currently use derivative instruments to manage our exposure to changes in foreign currency exchange rates as this exposure has had an immaterial impact on our past financial results.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
We have audited the accompanying consolidated balance sheets of InfoSpace, Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income (loss), changes in stockholders equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of InfoSpace, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation upon adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Companys internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 21, 2007 expressed an unqualified opinion on managements assessment of the effectiveness of the Companys internal control over financial reporting and an adverse opinion on the effectiveness of the Companys internal control over financial reporting because of a material weakness.
DELOITTE & TOUCHE LLP
February 21, 2007
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share data)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(amounts in thousands, except per share data)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY
Years Ended December 31, 2006, 2005, and 2004
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005, and 2004
Note 1: Summary of Significant Accounting Policies
Description of the business: InfoSpace, Inc. (the Company or InfoSpace) uses its technology, including metasearch, to power its branded Web sites and provide private-label online search and directory services to its distribution partners. The Company also is a provider and publisher of mobile content, products and services assisting consumers with finding information, personalization and entertainment on the mobile phone.
Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Basis of presentation: On March 31, 2004, the Company completed the sale of its Payment Solutions business to Lightbridge, Inc., for $82.0 million in cash. The operating results of the Payment Solutions business have been presented as a discontinued operation in the Consolidated Statements of Operations for all years presented.
Business combinations: Business combinations accounted for under the purchase method of accounting include the results of operations of the acquired business from the date of acquisition. Net assets of the business acquired are recorded at their fair value at the date of acquisition.
Cash and cash equivalents: The Company considers all highly liquid debt instruments with an original maturity of 90 days or less to be Cash equivalents. Cash and cash equivalents are carried at cost, which approximates market value.
Short-term and long-term investments: The Company principally invests its available cash in investment-grade debt instruments of corporate issuers and in debt instruments of the U.S. Government and its agencies. Auction Rate Securities and all debt instruments with original maturities greater than three months up to one year from the balance sheet date are considered Short-term investments. Other investments maturing after one year from the balance sheet date are considered Long-term investments. The Company accounts for investments in accordance with Statement of Financial Accounting Standard (SFAS) No. 115, Accou