ZipRealty 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended March 31, 2010
Commission file number: 000-51002
(Exact name of registrant as specified in its charter)
(Registrants telephone number)
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of accelerated filer, large accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
We had 20,508,472 shares of common stock outstanding at April 30, 2010.
TABLE OF CONTENTS
Statement regarding forward-looking statements
This report includes forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. All statements other than statements of historical facts contained in this report, including statements regarding our future financial position, business strategy and operations, and plans and objectives of management, are forward-looking statements. The words believe, may, will, should, could, estimate, continue, anticipate, intend, expect, plan, potential, predict, project, designed, provides, facilitates, assists, helps and similar expressions, as they relate to us, are intended to identify forward-looking statements. Forward-looking statements contained in this report include, but are not limited to, statements relating to:
We have based these forward-looking statements principally on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. No forward-looking statement is a guarantee of future performance and you should not place undue reliance on any forward-looking statement.
These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in Risk Factors in Item 1A of Part I of our annual report on Form 10-K for our fiscal year ended December 31, 2009, as such disclosure may be revised under Risk Factors in Item 1A of Part II of this report. Readers should carefully review such cautionary statements as they identify certain important factors that could cause actual results to differ materially from those in the forward-looking statements and from historical trends. Those cautionary statements are not exclusive and are in addition to other factors discussed elsewhere in this report or in materials incorporated herein by reference.
In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Except as otherwise required by law, we do not intend to update or revise any forward-looking statement contained in this report.
ZipRealty, ZipAgent, ZipNotify, and Your home is where our heart is are some of our registered trademarks in the United States. We also own the rights to the domain name www.Real-Estate.com. REALTOR and REALTORS are registered trademarks of the National Association of REALTORS®. All other trademarks, trade names and service marks appearing in this report are the property of their respective owners.
Our Internet address is www.ziprealty.com. We make publicly available free of charge on our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Information contained on our website is not a part of this report.
Where you can find additional information
You may review a copy of this report, including exhibits and any schedule filed therewith, and obtain copies of such materials at prescribed rates, at the Securities and Exchange Commissions Public Reference at 100 F Street NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, such as ZipRealty, that file electronically with the Securities and Exchange Commission.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
1. BACKGROUND AND BASIS OF PRESENTATION
The accompanying unaudited interim condensed consolidated financial statements as of March 31, 2010 and 2009 and for the three months then ended have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by Generally Accepted Accounting Principles (GAAP) for annual financial statements. In the opinion of the Companys management, the unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Companys financial position for the periods presented. The results for the three months ended March 31, 2010 are not necessarily indicative of the results to be expected for the year ending December 31, 2010, or any other period. The unaudited condensed consolidated balance sheet at December 31, 2009 has been derived from the audited consolidated balance sheet at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements and notes should be read in conjunction with the audited financial statements and notes thereto included in the Companys annual report on Form 10-K for the year ended December 31, 2009.
Principles of consolidation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries and reflect the elimination of intercompany accounts and transactions.
The Companys net transaction revenues and income (loss) from operations have historically varied from quarter to quarter. Such variations are principally attributable to variations in home sales activity over the course of the calendar year. The Company has historically experienced lower net transaction revenues during the first quarter because holidays and adverse weather conditions in certain regions typically reduce the level of sales activity and listings inventories between the Thanksgiving and Presidents Day holidays. Net transaction revenues during the three months ended March 31, 2009 and 2008 accounted for approximately 17.7% and 19.1% of annual net transaction revenues in 2009 and 2008, respectively.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In January 2010, the FASB issued new accounting guidance related to the disclosure requirements for fair value measurements and provides clarification for existing disclosures requirements, which amends the use of the fair value measures and the related disclosures. This new guidance requires new disclosures for transfers in and out of Level 1 and Level 2 fair value measurements. The Company adopted the provisions of this new guidance during the three months ended March 31, 2010 and its adoption did not have any significant impact on the Companys consolidated financial position, results of operations and cash flows.
3. SHORT-TERM INVESTMENTS AND FAIR VALUE MEASUREMENTS
At March 31, 2010, short-term investments were classified as available-for-sale securities, except for restricted cash, and were reported at fair value as follows:
At March 31, 2010 the fair value of the Companys investments that had been in an unrealized loss position for over twelve months was $1.9 million and the related unrealized loss was approximately $86,000. The Company evaluates its investments periodically for possible other-than-temporary impairment and records impairment charges equal to the amount that the carrying value of its available-for-sale securities exceeds the estimated fair market value of the securities as of the evaluation date, if appropriate. The Company considers various factors such as the length of time and extent to which fair value has been below cost basis and the financial condition of the issuer. The Company has no requirement or intent to sell the securities and expects to recover up to (or beyond) the initial cost of the investment. The evaluation of asset and mortgage backed securities involves many factors including, but not limited to, lien position, loan to value ratios, fixed vs. variable rate, amount of collateralization, delinquency rates, credit support, and servicer and originator quality. Based on its evaluation, the Company has determined that the unrealized loss is temporary and, accordingly, no impairment charge on investments has been recorded in the three months ended March 31, 2010. The factors evaluated in this determination may change and an impairment charge may be recorded in the future.
The estimated fair value of short-term investments classified by date of contractual maturity at March 31, 2010 was as follows:
Fair Value Measurements
The Company follows the accounting standards establishing a fair value hierarchy to prioritize the inputs used in valuation techniques. There are three broad levels to the fair value hierarchy of inputs to fair value; Level 1 is the highest priority and Level 3 is the lowest priority. The three levels of the fair value hierarchy and are as follows:
The Company measures and reports certain financial assets at fair value on a recurring basis, including its investments in money market funds and available-for-sale securities. At March 31, 2010 there were no liabilities within the scope of the accounting standards.
At March 31, 2010, our available-for-sale short-term investments, measured at fair value on a recurring basis, by level within the fair value hierarchy were as follows:
The fair value of the Companys investments in money market funds, included within money market securities, approximates their face value and has been included in cash and cash equivalents.
4. NET INCOME (LOSS) PER SHARE
The following table sets forth the computation of basic and dilutive net income (loss) per share for the periods indicated:
The following weighted-average outstanding options, warrants and non-vested common shares were excluded in the computation of diluted net loss per share for the periods presented because including them would be anti-dilutive:
5. STOCK-BASED COMPENSATION EXPENSE
Valuation assumptions and stock-based compensation expense
The Company estimates the fair value of stock options on the day of grant using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the Companys common stock and consideration of other relevant factors such as the volatility of guideline companies. The expected life of options granted during the three months ended March 31, 2010 and 2009 was estimated by taking the average of the vesting term and the contractual term of the option. The risk-free interest rate estimate is based upon U.S. Treasury bond rates appropriate for the expected life of the options.
The assumptions used and the resulting estimates of weighted average fair value per share of options granted were as follows:
Stock-based compensation expense was as follows:
The accounting standards require forfeitures to be estimated at the time of grant and revised, if necessary in subsequent periods if actual forfeitures differ from those estimates. The Company estimated expected forfeitures based on various factors including employee class and historical experience. The amount of stock-based compensation expense has been reduced for estimated forfeitures. As of March 31, 2010, there was $5.3 million of unrecorded stock-based compensation, after estimated forfeitures, related to unvested stock options. That cost is expected to be recognized over a weighted average remaining recognition period of 2.7 years. As of March 31, 2010, there was $0.8 million of unrecorded stock-based compensation related to unvested restricted stock. That cost is expected to be recognized over a weighted average remaining recognition period of 1.0 years.
Stock option activity
A summary of the Companys stock option activity for the period indicated was as follows:
Options generally vest over a four-year period with one-fourth (1/4) of the shares vesting one year after the vesting commencement date, and an additional one-forty eighth (1/48) of the shares vesting on the first day of each calendar month thereafter until all such shares are exercisable. Options generally expire after ten years. Options issued pursuant to the Companys voluntary stock option exchange program, completed in July 2009, vest ratably over a 36 month period and expire after seven years.
Aggregate intrinsic value represents the difference between the Companys closing stock price on the last trading day of the fiscal period, which was $4.90 on March 31, 2010, and the exercise price for the options that were in-the-money at March 31, 2010. The total number of in-the-money options exercisable as of March 31, 2010 was 935,000. Total intrinsic value of options exercised was $57,000 and zero for the three months ended March 31, 2010 and 2009, respectively.
The Company settles employee stock option exercises with newly issued common shares.
The Company expenses the cost of restricted stock awards, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restriction lapse. Stock-based compensation expense related to restricted stock for the three months ended March 31, 2010 and 2009 was $184,000, and $214,000, respectively.
A summary of the Companys nonvested restricted stock for the period indicated was as follows:
6. INCOME TAXES
At the end of each interim period, the Company calculates an effective tax rate based on the Companys best estimate of the tax provision (benefit) that will be provided for the full year, stated as a percentage of estimated annual pre-tax income (loss). The tax provision (benefit) for the interim period is determined using this estimated annual effective tax rate.
The Company maintains that a full valuation allowance should be accounted for against its net deferred tax assets at March 31, 2010. The Company considers its ongoing performance, recent historical losses and expectations for the foreseeable future, among other things, in determining the need for a valuation allowance.
Based on the full valuation allowance and the taxable loss for the three months ended March 31, 2010, the Company has not recorded a tax provision or benefit.
7. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) includes net income (loss) and unrealized gains (losses) on investments. Comprehensive income (loss) for the periods indicated is comprised of the following:
8. COMMITMENTS AND CONTINGENCIES
The Company leases office space under non-cancelable operating leases with various expiration dates through June 2016.
Future minimum lease payments under non-cancelable operating leases at March 31, 2010 were as follows, in thousands:
On March 26, 2010, the Company was named as one of fourteen defendants in a law suit filed in United States District Court for the District of Delaware, Smarter Agent LLC v. Boopsie, Inc., et al., by plaintiff, Smarter Agent LLC. The complaint alleges that the defendants have each infringed on patents owned by Smarter Agent relating to mobile device application technology and seeks unspecified damages and injunctive relief. Company is in the initial stages of investigating this matter, but does not currently believe that it has infringed on any patent, or that it has any liability for the claims alleged and thus, intends to vigorously defend against this lawsuit.
On January 22, 2010, the Company was named in a class action lawsuit filed in the Superior Court of California, County of Alameda, Elizabeth Williams v. ZipRealty, Inc., et al., by a former employee agent of the Company. The complaint sought monetary relief and alleged, among other things, that the Companys practice of classifying agents as exempt employees pursuant to the outside salesperson exemption under California law, and compensating agents accordingly, violates applicable law regarding the payment of minimum wages and overtime. The Company filed a counter claim against Plaintiff Elizabeth Williams alleging, among other things, that Ms. Williams engaged in conduct violating her employment agreement with the Company. On March 16, 2010, the parties entered into a settlement of these claims whereby each party agreed to dismiss its claim against the other. The parties have each filed dismissals of their claims.
The Company is not currently subject to any other material legal proceedings. From time to time, the Company has been, and it currently is, a party to litigation and subject to claims incidental to the ordinary course of the business. The amounts in dispute in these matters are not material to the Company, and management believes that the resolution of these proceedings will not have a material adverse effect on the Companys business, consolidated financial position, results of operations or cash flows.
The Company has entered into various indemnification agreements in the ordinary course of our business. Pursuant to these agreements, the Company has agreed to indemnify, hold harmless and reimburse the indemnified parties, which include certain of our service providers as well as others, in connection with certain occurrences. In addition, the corporate charter documents require the Company to provide indemnification rights to the Companys directors and officers to the fullest extent permitted by the Delaware General Corporation Law, and permit the Company to provide indemnification rights to our other employees and agents, for certain events that occur while these persons are serving in these capacities. The Companys charter documents also protect each of its directors, to the fullest extent permitted by the Delaware General Corporation Law, from personal liability to the Company and its stockholders from monetary damages for a breach of fiduciary duty as a director. The Company has also entered into indemnification agreements with the Companys directors and each of our officers with a title of Vice President or higher. Further, the underwriting agreement for the Companys initial public offering requires the Company to indemnify the underwriters and certain of their affiliates and agents for certain liabilities arising from the offering and the related registration statement.
The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unspecified. The Company is not aware of any material indemnification liabilities for actions, events or occurrences that have occurred to date. The Company maintains insurance on some of the liabilities the Company has agreed to indemnify, including liabilities incurred by the Companys directors and officers while acting in these capacities, subject to certain exclusions and limitations of coverage.
The following discussion should be read together with our financial statements and related notes appearing elsewhere in this report. This discussion contains forward-looking statements based upon current expectations that involve numerous risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including but not limited to those described under Risk Factors in Item 1A of Part I of our annual report on Form 10-K for our fiscal year ended December 31, 2009, as such disclosure may be revised under Risk Factors in Item 1A of Part II of this report. Those reasons include, without limitation, those described at the beginning of this report under Statement regarding forward-looking statements, as well as those that may be set forth elsewhere in this report. Except as otherwise required by law, we do not intend to update any information contained in these forward-looking statements.
We are a leading full-service residential real estate brokerage that uses an innovative combination of a comprehensive online presence, robust proprietary technology and knowledgeable local agents in the field to offer our clients fast, responsive and transparent service. Our award-winning, user-friendly website gives our users access to comprehensive local Multiple Listing Services home listings data, as well as other relevant market and neighborhood information and tools. Our proprietary technology, including our agent platform and customer relationship tools, helps us to enhance customer service while increasing agent efficiency and reducing costs, allowing us to pass on significant savings to consumers as permitted by law.
We have grown our business rapidly since our inception in 1999. In 2009, we ranked as the 5th largest residential real estate brokerage in the nation as ranked by closed transaction sides, accordingly to REAL Trends. Also in 2009, our website received more traffic than any other residential real estate brokerage in the nation, according to Hitwise. As of May 1, 2010, we operated in 35 major markets serviced by our team of over 3,000 local, licensed sales agents, and we had approximately 2.6 million active registered users who had accessed our website within the last year. All of our markets were opened prior to 2009 with the exception of Portland, which we opened in April 2009. Depending on market conditions and other criteria, we may consider entering additional markets in the future.
We typically share a portion of our commissions with our buyer clients in the form of a cash rebate, and typically represent our seller clients at fees below those offered by most traditional brokerage companies in our markets. Generally, our seller clients pay a total brokerage fee of 4.5% to 5.0% of the transaction value, of which 2.5% to 3.0% is paid to agents representing buyers. In the Oregon portion of our Portland market (which serves portions of both Oregon and Washington), the payment of cash rebates is not currently permitted by law, so we have adjusted our value proposition for our buyer clients by offering an enhanced client satisfaction guarantee.
Our agents show properties to our buyers, list and market properties for our sellers, negotiate transactions and handle closing details. In most of our markets, our agents are employees to whom we provide training, marketing support, technology, customer leads and other employee benefits not typically provided by most residential real estate brokerages. However, in February 2010, we ceased to employ agents in New York, and instead engaged agents as independent contractors in that state. We plan to do likewise in Nevada beginning in June 2010. Through our modified business models in those states, we hope to deliver excellent customer service and enable independent contractor agents to be productive and efficient with minimal management oversight. We currently do not have plans to make a similar change in other markets, although we continually evaluate all aspects of our business and operational model and could make similar or different changes in other markets in the future.
Our net revenues are composed primarily of commissions earned as agents for buyers and sellers in residential real estate transactions, and we operate in one reportable segment. We record commission revenues net of any rebate, commission discount or transaction fee adjustment. Our net revenues are principally driven by the number of transactions we close and the average net revenue per transaction. Average net revenue per transaction is a function of the home sales price and percentage commission we receive on each transaction and varies significantly by market. We also receive revenues from certain marketing arrangements, such as with mortgage lenders to whom we provide access through the mortgage center on our website, who pay us a flat marketing fee that is established on a periodic basis, as well as from relationships with advertisers. Generally, non-commission revenues represent less than 5% of our net revenues during any period. We routinely explore options for entering into additional marketing and other business arrangements for offering services related to the purchase, sale and ownership of a home.
We believe that customer acquisition is one of our core competencies, and although the difficulty of acquiring a sufficient number of leads online could increase over time, we expect that we can mitigate some of that impact with repeat and referral business, as well as by increasing our visibility and credibility to potential clients over time. Because our aggregate transaction volume market share in our markets has averaged less than 1% historically, we believe that there is an opportunity to increase our market share and grow our business, even if the overall level of sales do not grow due to macroeconomic conditions.
Market conditions and trends in our business
Macroeconomic forces. For the past few years, the residential real estate market has been negatively impacted by macroeconomic conditions. We perceive that conditions such as tight lending criteria, high numbers of distressed properties, and high unemployment continue to exert negative pressure on the residential real estate market, and may continue to do so for some time. Although the federal government, state governments and related agencies have acted repeatedly to address the decline in the residential real estate market and the availability of home mortgage credit, there can be no assurance that these activities will have a positive, meaningful and lasting impact. In addition, as these activities end, including the federal governments wind-down of its program to purchase troubled assets from financial institutions, the availability of credit and interest rates could be negatively affected. For 2010, we currently believe that the health of the residential housing market will be significantly affected by the availability of credit, shadow inventory levels, and interest rates, all of which could be negatively impacted by high unemployment levels.
Current residential real estate market conditions. Although the residential real estate market has begun to show some signs of price stabilization, it remains volatile and unpredictable both nationally and regionally. Federal tax credit programs designed to encourage home buyers have been extended into 2010, but the expiration of these programs, and any future rise in interest rates in keeping with our current expectations, could deter future home buyers.
Current indicators of national market conditions include the following:
Fluctuations in quarterly profitability. We have experienced fluctuations in profitability from period to period. Our profitability has been impacted by various factors including seasonality, new market expansion, legal settlements, government activism and ongoing market challenges, including changes in the availability of home mortgage credit.
For example, in 2009, the federal government introduced a program to provide a tax credit of up to $8,000 to first-time home buyers, meaning, for this purpose, buyers who had not owned a home in the preceding three years. That program had been set to expire on November 30, 2009. We believe many first-time home buyers chose to accelerate their home purchases to take advantage of the credit before it expired, which may have bolstered sales volume in the fourth quarter of 2009 and then reduced sales volume after the planned expiration date for the program.
In November 2009, before the tax credit program expired, the federal government extended and expanded the program. In its current form, the program offers a credit of $8,000 to first-time home buyers and up to $6,500 to repeat home buyers who have lived in their current home for five consecutive years in the past eight years. To take advantage of the current program, buyers must have entered into a home purchase contract by April 30, 2010, and complete the purchase by June 30, 2010. Once again, we expect that this program may have a positive effect on our home sales volume in the first half of 2010, particularly in the second quarter, but may also result in fewer sales than we otherwise would have closed in the second half of 2010.
Industry seasonality and cyclicality. The residential real estate brokerage market is influenced both by seasonal factors and by overall economic cycles. While individual markets vary, transaction volume nationally tends to progressively increase from January through the summer months, then gradually slow over the last three to four months of the calendar year. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing for traditional home purchases. For non-traditional sales, the time lag from contract execution to closing can be longer. We have been, and believe we will continue to be, influenced by overall market activity and seasonal forces. We generally experience the most significant impact in the first and fourth quarters of each year, when our revenues are typically lower relative to the second and third quarters as a result of traditionally slower home sales activity and reduced listings inventory between Thanksgiving and Presidents Day.
The impact of seasonality can be masked by the general health of the residential real estate market at any given point in time, whether affected by macroeconomic events, periodic business cycles or other factors. Generally, when economic times are fair or good, the housing market tends to perform well. If the economy is weak, if interest rates dramatically increase, if mortgage lending standards tighten, or if there are disturbances such as terrorist attacks or threats, the outbreak of war or geopolitical uncertainties, the housing market likely would be negatively impacted.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Accordingly, our actual results may differ from these estimates under different assumptions or conditions.
Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements contained in our 10-K for the year ended December 31, 2009, and of those policies, we believe that the following accounting policies are the most critical to understand and evaluate our financial condition and results of operations.
We derive the majority of our revenues from commissions earned as agents for buyers and sellers in residential real estate transactions. We recognize commission revenues upon closing of a sale and purchase transaction, net of any rebate, commission discount or transaction fee adjustment, as evidenced when the escrow or similar account has closed and funds have been disbursed to all appropriate parties. We recognize non-commission revenues from our other business relationships, including marketing agreements, advertising, referral and other income, as the fees are earned from the other party. We recognize revenue only when there is persuasive evidence an arrangement exists, the sales price is fixed or determinable, the transaction has been completed and collectability of the resulting receivable is reasonably assured.
Internal-use software and website development costs
We account for internal-use software and website development costs, including the development of our ZipAgent Platform (ZAP) in accordance with the guidance set forth in the related accounting standards. We capitalize internal costs consisting of payroll and direct payroll-related costs of employees who devote time to the development of internal-use software, as well as any external direct costs. We amortize these costs over their estimated useful lives, which typically range between 15 to 24 months. Our judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the estimated useful lives over which the costs are amortized. The estimated life is based on managements judgment as to the product life cycle.
We follow the provisions of accounting standards for share-based payments, which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases, based on estimated fair values. Under the fair value recognition provisions of the accounting standards, stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense using the straight-line method over the requisite service period of the award.
We estimate the fair value of stock options using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of our common stock and consideration of other relevant factors such as the volatility of guideline companies. The expected life of options is estimated by taking the average of the vesting term and the contractual term of the option. We estimate expected forfeitures based on various factors including employee class and historical experience. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period the estimates are revised.
Deferred tax assets and liabilities arise from the differences between the tax basis of an asset or liability and its reported amount in the financial statements as well as from net operating loss and tax credit carry forwards. Deferred tax amounts are determined by using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided under current tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense or benefit is the tax payable or refundable, respectively, for the period adjusted for the change during the period in deferred tax assets and liabilities.
The accounting standard for income taxes requires that deferred tax assets be evaluated for future realization and reduced 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 historical results and our expectations for the future. Historically, we have recorded a valuation allowance on our deferred tax assets, the majority of which relate to net operating loss carryforwards and we maintain that a full valuation allowance should be accounted for against our net deferred tax assets at March 31, 2010.
Recently issued accounting pronouncements
See Note 2 titled Recent Accounting Pronouncements of our Notes to Unaudited Condensed Consolidated Financial Statements for a full description of recent accounting pronouncements including the respective expected dates of adoption.
RESULTS OF OPERATIONS
The following table summarizes certain financial data related to our operations for the periods indicated:
The following table presents our operating results as a percentage of net revenues for the periods indicated:
Comparison of the three months ended March 31, 2010 and 2009
Other operating data
Net transaction revenues
Net transaction revenues consist primarily of commissions earned as agents to buyers and sellers on the purchase or sale of real estate transactions, net of any rebate, commission discount or transaction fee adjustment.
The increase in net transaction revenues of $3.5 million or 16.3% was driven primarily by an increase in the number of transactions closed during the period of 732 or 17.5%, offset by a decrease in average net revenue per transaction of $52 or 1.0%. The year over year increase in the number of transactions closed was partially attributable to an increase of 159 or 73.3% sell side transactions as these seller representation transactions increased to 7.7% of total transactions closed from 5.2% in the quarter ended March 31, 2009. The year over year decrease in average net revenue per transaction for the quarter ended March 31, 2009 was $1,328 or 20.6%. We believe year over year decreases in average net revenue per transaction have moderated because of a combination of factors. Foreclosure, bank real estate owned (REO) and short sale transactions, which are typically transacted at reduced sales prices, declined to 37% of transactions in the quarter ended March 31, 2010 from 53% in the quarter ended March 31, 2009. Overall decreases in housing prices continue as well as ongoing tightening in the availability of consumer mortgage financing particularly impacting the sale of higher priced housing.
We expect our net transaction revenues will increase for 2010 driven by an increase in the overall number of transactions in our markets partially offset by a continued decrease in net revenue per transaction. The decrease in net revenue per transaction year over year is expected to result from a continuation of the factors impacting the period ended March 31, 2010: overall decreases in housing prices, the number of foreclosure, bank REO and short sale transactions, typically at further reduced sales prices, and ongoing pressure on the availability of consumer mortgage financing particularly impacting the sale of higher priced housing. We expect foreclosure, bank REO and, particularly, short sales to increase as a percentage of transactions closed during the remainder of 2010 which will continue to contribute to the expected decrease in net revenue per transaction.
Marketing and other revenues
Marketing and other revenues consist primarily of market transaction referrals and corporate marketing agreements and advertising.
The increase in corporate marketing and other revenues for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2009 was primarily attributable to fees from a mortgage services marketing agreement with Bank of America, which commenced in June 2009.
We expect our marketing and other income will increase for 2010 attributable to full year results from the Bank of America agreement and as we explore our options for other marketing agreements, advertising and sources of residential real estate related services.
Cost of revenues
Our cost of revenues consists principally of commissions, payroll taxes, benefits including health insurance, performance and tenure based award programs, agent expense reimbursements and amortization of internal-use software and website development costs which relate primarily to our ZAP technology. Agent commissions are generally paid on market net revenues which include net transaction revenues plus referral and other revenues generated by our ZipAgents.
The increase in cost of revenues for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2009 was primarily related to the overall increase in net revenues on which we pay agent commissions. Agent commissions and payroll taxes increased by $2.0 million or 19.0% primarily attributable to the mix of agent commissions paid and the increase in the net revenues on which these costs are based. Agent performance and tenure based programs, benefits and expense reimbursements decreased by approximately $0.6 million or 19.0% primarily attributable to a decrease in the number of qualifying agents. Overall, cost of revenues as a percentage of market net revenues decreased by about 3.1 percentage points.
We expect our cost of revenues for 2010 will increase in absolute dollars and decrease as a percentage of net revenues over the remainder of the year. The first quarter of each calendar year is typically the seasonally slowest quarter of the year with the highest cost of revenue percentage primarily attributable to the relatively fixed costs of agent performance and tenure based programs, benefits and expense reimbursements as well as higher payroll taxes due to resets of limits at the beginning of the year.
Product development expenses include our information technology costs relating to the maintenance of our website, proprietary technology platforms and system infrastructure. These costs consist primarily of compensation and benefits for our product development and infrastructure personnel, depreciation of software and equipment and infrastructure costs consisting primarily of facilities, communications and other operating expenses.
The increase in product development expenses for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2009 was due primarily to supporting higher website volume and fulfilling product requirements for our website and ZAP system and consisted primarily of increases in salaries and benefits of $0.1 million and infrastructure costs of $0.1 million partially offset by a decrease in depreciation expense of $0.1 million. As a percentage of net revenues, product development expenses decreased by 1.2 percentage points for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2009.
We expect our product development expenses to increase in 2010 in absolute dollars and to decrease as a percentage of net revenues over the remainder of the year. The first quarter of each calendar year is typically the seasonally slowest period of the year with all operating expenses representing a higher percentage of net revenues than full year results are expected to reflect.
Sales and marketing
Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in sales, sales support and customer service as well as promotional, advertising and client acquisition costs. These expenses have been categorized below between those incurred in our market offices and those expenses which are incurred by the regional and corporate support functions.
Sales and marketing expenses increased in our markets by approximately $0.6 million or 7.4% principally attributable to increases in salaries and benefits of $0.3 million and customer acquisition and marketing costs of $0.3 million. As a percentage of market net revenues, market sales and marketing expenses were 35.2% in the current year compared to 38.1% in the prior year.
Regional/corporate sales support and marketing expenses increased by approximately $0.2 million or 12.4% and consisted primarily of general operating expenses including sales incentive and management meetings. As a percentage of net revenues, regional sales support and marketing expenses were approximately 7.7% in the current year compared to 8.1% in the prior year.
We expect our market level and regional/corporate sales and marketing expenses for 2010 will increase in absolute dollars but will decrease as a percentage of net revenues over the remainder of the year. The first quarter of each calendar year is typically the seasonally slowest period of the year with all operating expenses representing a higher percentage of net revenues than full year results are expected to reflect.
General and administrative
General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resources, facilities and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit and tax services.
The increase in general and administrative expenses for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2009 was principally due to an increase in salaries and benefits of $0.1 million. As a percentage of net revenues, general and administrative expenses were 14.0% for the current year compared to 16.0% in the prior year.
We expect our general and administrative expenses for 2010 will increase in absolute dollars but will decrease as a percentage of net revenues over the remainder of the year. The first quarter of each calendar year is typically the seasonally slowest period of the year with all operating expenses representing a higher percentage of net revenues than full year results are expected to reflect.
Interest income relates to interest we earn on our money market deposits and short-term investments.
Interest income fluctuates as our cash equivalents and short-term investment balances change and applicable interest rates increase or decrease. The decrease in interest income for the quarter ended March 31, 2010 compared to the quarter ended March 31, 2008 was due primarily to lower interest rates earned on lower average balances. The lower interest rates were primarily attributable to overall decreases in market interest rates combined with maintaining higher money market account balances yielding lower interest rates as we decreased our short-term investments positions. The lower average balances were primarily attributable cash used in our operating activities as a result of the losses incurred since March 31, 2009.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity for 2010 are our cash, cash equivalents and short-term investments. As of March 31, 2010, we had cash, cash equivalents and short-term investments at fair value of $38.1 million and no bank debt, line of credit or equipment facilities.
Our operating activities used cash in the amount of $5.2 and $4.0 million in the three months ended March 31, 2010 and 2009, respectively. Cash used in the quarter ended March 31, 2010 resulted primarily from a net loss of $6.2 million increased by net changes in operating assets and liabilities of $0.5 million and decreased by non-cash adjustments. The non-cash adjustments resulted primarily from $0.6 million of depreciation and amortization and $0.7 million of stock-based compensation expense. The increase in cash used attributable to the net changes in operating assets and liabilities was mainly driven by timing differences in accounts receivable, accounts payable and accrued expenses relating to agent compensation, bonuses, and customer acquisition expenses. Cash used in the quarter ended March 31, 2009 resulted primarily from a net loss of $7.5 million decreased by non-cash adjustments including $0.6 million of depreciation and amortization and $1.0 million of stock-based compensation expense.
Our primary source of operating cash flow is the collection of our net commission income from escrow companies or similar intermediaries in the real estate transaction closing process offset by cash payments for ZipAgent costs; commissions, payroll taxes, benefits, award programs and expense reimbursements, as well as for product development, sales and marketing and general and administrative costs including employee compensation, benefits, client acquisition costs and other operating expenses. Due to the structure of our commission arrangements, our accounts receivable are settled in cash on a short-term basis and our accounts receivable balances at period end have historically been significantly less than one months net revenues.
Our investing activities provided cash of $0.4 million and $14.2 million in the three months ended March 31, 2010 and 2009, respectively. Cash provided for in the three months ended March 31, 2010 primarily represents the proceeds from the sale and maturity of short-term investments of $0.9 million less the purchase of property and equipment, including amounts for website development and internal use software. Cash provided for the three months ended March 31, 2009 represent the net proceeds from the sales and maturity of short-term investments of $14.6 million less the purchase of property and equipment, including amounts for website development and internal use software.
We typically maintain a minimum amount of cash and cash equivalents for operational purposes and invest the remaining amount of our cash in investment grade, highly liquid interest-bearing securities which allows for flexibility in the event our cash needs change.
Currently, we expect our remaining 2010 capital expenditures to be approximately $2.2 million primarily attributable to amounts capitalized for internal-use software and website development as well as expenditures for increased server capacity and software. In the future, our ability to make significant capital investments may depend on our ability to generate cash flow from operations and to obtain adequate financing, if necessary and available.
Our financing activities used $0.1 million in the three months ended March 31, 2010 and were not significant in the three months ended March 31, 2009. The use of cash for the three months ended March 31, 2010 represents primarily the repurchase of shares of our common stock in connection with the payment of withholding and payroll taxes due upon vesting of employee restricted stock awards partially offset by the proceeds from stock option exercises.
As of March 31, 2010, we had one warrant outstanding for the purchase of an aggregate of 3,284 shares of our common stock at an exercise price of $18.27 per share; that warrant is currently exercisable at the option of the holder and expires in August 2010.
We believe that our current cash, cash equivalents and short-term investments will be sufficient to fund cash used in our operations and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors, including our level of investment in technology and advertising initiatives, our rate of growth into new geographic markets and possible repurchases of our common stock. In addition, if the current macroeconomic environment and depressed state of the residential real estate market continues or worsens, we may have a greater need to fund our business by using our cash reserves, which could not continue indefinitely without our raising additional capital.
We routinely explore our options for offering services relating to the purchase, sale and ownership of a home, including services related to title insurance, escrow, mortgage, home warranty insurance and property and casualty insurance (including auto insurance), which we refer to as core services. We expect that some of our core services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or promoted through marketing arrangements with independent third parties, such as title companies, banks and insurance companies. We may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing.
We currently have no bank debt or line of credit facilities. In the event that additional financing is required, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operations and results will likely suffer.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
We lease office space under non-cancelable operating leases with various expiration dates through June 2016. The following table provides summary information concerning our future contractual obligations and commitments at March 31, 2010.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off balance-sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.
The table below shows the trend of Adjusted EBITDA as a percentage of revenue for the periods indicated:
We present Adjusted EBITDA, a non-GAAP financial measure, as a supplemental measure of our performance. We believe Adjusted EDITDA provides useful information regarding the operating results of our core business activity and prospects for the future. We define Adjusted EBITDA as net income (loss) less interest income plus interest expense, provision for income taxes, depreciation and amortization expense, stock-based compensation and further adjusted to eliminate the impact of certain items that we do not consider reflective of our ongoing core operating performance.
We present Adjusted EBITDA because we believe it assists investors and analysts in comparing our operating performance across reporting periods on a consistent basis by excluding items that we do not believe are reflective of our core operating performance. In addition, we use Adjusted EBITDA to evaluate our financial results and business strategies, develop budgets, manage expenditures and as a factor in evaluating managements performance when determining incentive compensation.
Our use of Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:
Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. When evaluating our performance, Adjusted EBITDA should be considered alongside other financial measures, including net income and our other GAAP results.
The following is a reconciliation of Adjusted EBITDA to the most comparable GAAP measure, net loss for the three months ended March 31, 2010 and 2009:
Interest rate sensitivity
Our investment policy requires us to invest funds in excess of current operating requirements. The principal objectives of our investment activities are to preserve principal, provide liquidity and maximize income consistent with minimizing risk of material loss. We believe this investment policy is prudent, and helps to reduce, but does not prevent, loss of principal, and results in minimal interest rate exposure on our investments.
As of March 31, 2010 and 2009, our cash and cash equivalents consisted primarily of money market funds and our short-term investments consisted primarily of investment grade, highly liquid interest-bearing securities. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities and short-term investments are carried at fair value. The amount of credit exposure to any one issue, issuer and type of instrument is limited. Our interest income is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our investments are fixed income investments. If market interest rates were to increase or decrease immediately and uniformly by 10% from levels at March 31, 2010 and 2009, there would be a negligible increase or decline in fair market value of the portfolio.
Exchange rate sensitivity
We consider our exposure to foreign currency exchange rate fluctuations to be minimal, as we do not have any sales denominated in foreign currencies. We have not engaged in any hedging or other derivative transactions to date.
(a) Disclosure controls and procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such items are defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as of the end of the period covered by this Quarterly Report are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
(b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting during the quarter ended March 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II OTHER INFORMATION
On March 26, 2010, we were named as one of fourteen defendants in a law suit filed in United States District Court for the District of Delaware, Smarter Agent LLC v. Boopsie, Inc., et al., by plaintiff, Smarter Agent LLC. The complaint alleges that the defendants have each infringed on patents owned by Smarter Agent relating to mobile device application technology and seeks unspecified damages and injunctive relief. We are in the initial stages of investigating this matter, but do not currently believe that we have infringed on any patent, or that we have any liability for the claims alleged and thus, intends to vigorously defend against this lawsuit.
On January 22, 2010, we were named in a class action lawsuit filed in the Superior Court of California, County of Alameda, Elizabeth Williams v. ZipRealty, Inc., et al., by a former employee agent of the Company. The complaint sought monetary relief and alleged, among other things, that our practice of classifying agents as exempt employees pursuant to the outside salesperson exemption under California law, and compensating agents accordingly, violates applicable law regarding the payment of minimum wages and overtime. We filed a counter claim against Plaintiff Elizabeth Williams alleging, among other things, that Ms. Williams engaged in conduct violating her employment agreement with us. On March 16, 2010, the parties entered into a settlement of these claims whereby each party agreed to dismiss their claim against the other. The parties have each filed dismissals of their claims.
We are not currently subject to any other material legal proceedings. From time to time we have been, and we currently are, a party to litigation and subject to claims incident to the ordinary course of the business. The amounts in dispute in these matters are not material to us, and we believe that the resolution of these proceedings will not have a material adverse effect on the business, financial position, results of operations or cash flows
Our business is subject to a number of risks and uncertainties. Because of risks and uncertainties affecting our operating results and financial condition, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods. You should consider carefully the risk factors described under Risk Factors in Item 1A of Part I of our annual report on Form 10-K for our fiscal year ended December 31, 2009. At this time, we are not aware of any material changes to the nature of those risk factors. We intend to set forth material changes to the nature of those risk factors in our future reports on Form 10-Q as required by Item 1A of Part II thereof. For business, market and other developments in the quarter ended March 31, 2010, please see Item 2 of Part I of this report, Managements Discussion and Analysis of Financial Condition and Results of Operations.
Our Insider Trading Compliance Program allows directors, officers and other employees covered under the program to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, written programs that permit automatic trading of our stock or trading of our stock by an independent person (such as an investment bank) who is not aware of material inside information at the time of the trade. As of the filing date of this report, none of our directors or executive officers has adopted a Rule 10b5-1 trading plan, but they may do so in the future, and we believe that our additional officers and employees may have established such programs or may do so in the future.
The exhibits listed in the Exhibit Index are filed as a part of this report.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: May 5, 2010