UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

 

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(Mark One)

 

For the quarterly period ended March 31, 2015

 

OR

 

 

For the transition period from                    to                    

 

Commission file number 001-35048

 

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DEMAND MEDIA, INC.

(Exact name of registrant as specified in its charter)

 

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(310) 394-6400

(Registrant’s telephone number, including area code)

 

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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 ☒  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. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company’ 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 Exchange Act). Yes ☐  No ☒ 

As of May 1, 2015, there were 19,803,540 shares of the registrant’s common stock, $0.0001 par value, outstanding.

 

 

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DEMAND MEDIA, INC.

INDEX TO FORM 10-Q

 

 

 

 

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Part I.       FINANCIAL INFORMATION

 

Item 1.      CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)  

Demand Media, Inc. and Subsidiaries 

Condensed Consolidated Balance Sheets  

(In thousands)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Demand Media, Inc. and Subsidiaries 

Condensed Consolidated Statements of Operations  

(In thousands, except per share amounts)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Demand Media, Inc. and Subsidiaries 

Condensed Consolidated Statements of Comprehensive Income (Loss)  

(In thousands)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Demand Media, Inc. and Subsidiaries

Condensed Consolidated Statements of Stockholders’ Equity  

(In thousands)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Demand Media, Inc. and Subsidiaries 

Condensed Consolidated Statements of Cash Flows  

(In thousands)

(Unaudited)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Demand Media, Inc. and Subsidiaries 

Notes to Condensed Consolidated Financial Statements  

(Unaudited)

1. Company Background and Overview

Demand Media, Inc. (“Demand Media” and, together with its consolidated subsidiaries, the “Company,” “our,” “we,” or “us”) is a Delaware corporation headquartered in Santa Monica, California. We are a diversified Internet company that builds platforms across our media and marketplace properties to enable communities of creators to reach passionate audiences in large and growing lifestyle categories. Our business is comprised of two service offerings, Content & Media and Marketplaces.

On August 1, 2014, we completed the separation of Rightside Group, Ltd. (“Rightside”) from Demand Media, Inc., resulting in two independent, publicly traded companies (hereinafter referred to as the “Separation”). Following the Separation, Rightside operates our former domain name services business, while we continue to own and operate our Content & Media and Marketplaces businesses. The Separation was structured as a pro rata tax-free dividend involving the distribution of all outstanding shares of Rightside common stock to holders of Demand Media common stock as of the August 1, 2014 record date (the “Distribution”). Immediately following the Distribution, we completed a 1-for-5 reverse stock split with respect to all of our outstanding shares of common stock, including shares held in treasury, which is reflected retrospectively throughout the consolidated financial statements.

Content & Media

Our Content & Media service offering includes a leading online content creation platform that publishes content to our owned and operated online properties as well as to online properties operated by our customers. Through our innovative content creation platform, DemandStudios.com, a large community of qualified freelance professionals utilizes proprietary technology and automated workflow processes to identify valuable topics and then create high-quality content in text, video, photography and designed visual formats. This content is published to our leading owned and operated online properties across several key categories, including eHow.com, a how-to reference destination, and Livestrong.com, a health and healthy living destination. We also own and operate Cracked.com, a humor site offering original and engaging comedy-driven text articles, video series and blogs created by our in-house editorial staff, comedians and a community of website enthusiasts. Our content creation studio also produces content for our Content Solutions business, which develops and executes custom content marketing strategies for third-party brands, publishers and advertisers.

Marketplaces

Through our Marketplaces service offering, we operate two leading artist marketplaces where large communities of artists can market and sell original artwork or original designs printed on a wide variety of products. Society6.com (“Society6”), which we acquired in June 2013, provides artists with an online commerce platform to feature and sell their original designs on art prints, phone and tablet cases, t-shirts, throw pillows and other consumer products. Saatchi Online, which operates SaatchiArt.com (“Saatchi Art”), and which we acquired in August 2014, is an online art gallery featuring a wide selection of original paintings, drawings, sculptures and photography that provides a global community of artists a curated environment in which to exhibit and sell their work directly to consumers around the world.

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2. Basis of Presentation and Summary of Significant Accounting Policies

A summary of the significant accounting policies consistently applied in the preparation of the accompanying condensed consolidated financial statements follows.

Basis of Presentation

The accompanying interim condensed consolidated balance sheet as of March 31, 2015, the condensed consolidated statements of operations and condensed consolidated statements of comprehensive income (loss) for the three month periods ended March 31, 2015 and 2014, the condensed consolidated statements of cash flows for the three month periods ended March 31, 2015 and 2014 and the condensed consolidated statement of stockholders’ equity for the three month period ended March 31, 2015 are unaudited.

In the opinion of management, the unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair statement of our statement of financial position as of March 31, 2015 and our results of operations for the three month periods ended March 31, 2015 and 2014 and our cash flows for the three month periods ended March 31, 2015 and 2014. The results for the three month period ended March 31, 2015 are not necessarily indicative of the results expected for the full year. The consolidated balance sheet as of December 31, 2014 has been derived from our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2014.

The interim unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States, for interim financial information and with the instructions to the U.S. Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of Regulation S-X. They do not include all of the information and footnotes required by GAAP for complete financial statements. Therefore, these condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2014 filed with the SEC.

Our common stock share information and related per share amounts included in the condensed consolidated financial statements have been adjusted retroactively for all periods presented to reflect the 1-for-5 reverse stock split with respect to all of our outstanding shares of common stock, including shares held in treasury, that was effected on August 1, 2014.

The financial results of Rightside are presented as discontinued operations in our condensed consolidated statements of operations for the three months ended March 31, 2014. For additional information relating to our previous domain name services business, please refer to our Annual Report on Form 10-K for the year ended December 31, 2013.

Principles of Consolidation

The consolidated financial statements include the accounts of Demand Media and its wholly owned subsidiaries. Acquisitions are included in our consolidated financial statements from the date of the acquisition. Our purchase accounting resulted in all assets and liabilities of acquired businesses being recorded at their estimated fair values on the acquisition dates. All significant intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant items subject to such estimates and assumptions include revenue, allowance for doubtful accounts, investments in equity interests, the assigned value of acquired assets and assumed liabilities in business combinations, useful lives and impairment of property and equipment, intangible assets, goodwill and other assets, the

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fair value of equity-based compensation awards, and deferred income tax assets and liabilities. Actual results could differ materially from those estimates. On an ongoing basis, we evaluate our estimates compared to historical experience and trends, which form the basis for making judgments about the carrying value of our assets and liabilities.

Investments in Equity

We account for investments in companies that we do not control or account for under the equity method of accounting either at fair value or using the cost method of accounting, as applicable. Investments in equity securities are carried at fair value if the fair value of the security is readily determinable. Equity investments carried at fair value are classified as marketable securities available-for-sale. Realized gains and losses for marketable securities available-for-sale are included in other income (expense), net in our consolidated statements of operations. Unrealized gains and losses, net of taxes, on marketable securities available-for-sale are included in our consolidated financial statements as a component of other comprehensive income (loss) and accumulated other comprehensive income (loss) (“AOCI”), until realized.

Investments in companies that we do not control or account for under the equity method, and for which we do not have readily determinable fair values, are accounted for under the cost method. Cost method investments are originally recorded at cost. In determining whether other-than-temporary impairment exists for equity securities, management considers: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer and (3) our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

The cost of marketable securities sold is based upon the specific accounting method used. Any realized gains or losses on the sale of equity investments are reflected as a component of interest income or expense. During the first quarter of 2014, we sold all of these marketable securities, resulting in a reclassification from other comprehensive income of $0.9 million of unrealized gains on marketable securities, which is currently recorded in discontinued operations. The sale of our marketable securities resulted in total realized gains of $1.4 million related to the sale of our marketable securities, which are included in discontinued operations.

We classify marketable securities as current or non-current based upon whether such assets are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.

Revenue Recognition

We recognize revenue when four basic criteria are met: persuasive evidence of a sales arrangement exists; performance of services has occurred; the sales price is fixed or determinable; and collectability is reasonably assured. We consider persuasive evidence of a sales arrangement to be the receipt of a signed contract. Collectability is assessed based on a number of factors, including transaction history and the credit worthiness of a customer. If it is determined that collection is not reasonably assured, revenue is not recognized until collection becomes reasonably assured, which is generally upon receipt of cash. We record cash received in advance of revenue recognition as deferred revenue.

For arrangements with multiple deliverables, we allocate revenue to each deliverable if the delivered item(s) has value to the customer on a standalone basis and, if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in our control. The fair value of the selling price for a deliverable is determined using a hierarchy of (1) company-specific objective and reliable evidence, then (2) third-party evidence, then (3) best estimate of selling price. We allocate any arrangement fee to each of the elements based on their relative selling prices.

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Our revenue is principally derived from the following services and products:

Service Revenue

Content & Media

Advertising Revenue. We generate revenue from advertisements displayed alongside our content on our online properties and certain of our customers’ online properties. Articles, videos and other forms of content generate advertising revenue from a diverse mix of advertising methods including performance-based cost-per-click advertising, in which an advertiser pays only when a visitor clicks on an advertisement; display advertisements, where revenue is dependent upon the number of advertising impressions delivered; and sponsored content or advertising links. In determining whether an arrangement exists, we ensure that a binding arrangement is in place, such as a standard insertion order or a fully executed customer-specific agreement. Obligations pursuant to our advertising revenue arrangements typically include a minimum number of impressions or the satisfaction of other performance criteria. Revenue from performance-based arrangements is recognized as the related performance criteria are met. We assess whether performance criteria have been met and whether the fees are fixed or determinable based on a reconciliation of the performance criteria and an analysis of the payment terms associated with the transaction. The reconciliation of the performance criteria generally includes a comparison of third-party performance data to the contractual performance obligation and to internal or customer performance data in circumstances where that data is available.

Where we enter into revenue-sharing arrangements with our customers, such as those relating to our advertiser network, and when we are considered the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record these revenue-sharing payments to our customers in service costs.

Social Media Services. Prior to the sale of our Pluck social media business in February 2015, we configured, hosted, and maintained our platform social media services under private-labeled versions of software for commercial customers. We earned revenue from our social media services through recurring management support fees, overage fees in excess of standard usage terms, outside consulting fees and initial set-up fees. Due to the fact that social media services customers had no contractual right to take possession of our private-labeled software, we accounted for our social media services revenue as service arrangements. Social media services revenue was recognized when persuasive evidence of an arrangement exists, delivery of the service has occurred and no significant obligations remain, the selling price is fixed or determinable, and collectability is reasonably assured. In February 2015, we sold our Pluck social media business and we no longer provide any social media services. The consideration we received for Pluck was a $3.8 million cash payment after working capital adjustments, resulting in a gain of $2.9 million, which is recorded in other income (expense), net.

Content Sales and Licensing Revenue. We also generate revenue from the sale or license of media content, including the creation and distribution of content for third party brands, publishers and advertisers through our Content Solutions service. Revenue from the sale or perpetual license of media content is recognized when the content has been delivered and the contractual performance obligations have been fulfilled. Revenue from the license of media content is recognized over the period of the license as content is delivered or when other related performance criteria are fulfilled. In circumstances where we distribute our content on third-party properties and the customer acts as the primary obligor, we recognize revenue on a net basis.

Marketplaces

Art Commissions Revenue. We generate service revenue from commissions we receive from facilitating the sale of original art by artists to customers through Saatchi Art. We recognize service revenue arising from the sale of original art net of amounts paid to the artist because we are not the primary obligor in the transaction, we do not have inventory risk, and we do not establish the prices for the art sold. We also recognize this service revenue net of any sales allowances. Revenue is recognized after the original art has been delivered and the return period has expired. Payments received in advance of delivery and completion of the return period are included in deferred revenue in the accompanying condensed consolidated balance sheets. We periodically provide incentive offers to customers to encourage purchases, including percentage discounts off current purchases, free shipping and other offers. Value-added

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taxes (“VAT’), sales and other taxes are not included in revenue because we are a pass-through conduit for collecting and remitting any such taxes.

Product Revenue

Marketplaces

We recognize product revenue from sales of Society6 products upon delivery, net of estimated returns based on historical experience. We recognize product revenue from the sale of prints through Saatchi Art when the prints are delivered and the return period has expired. Payments received in advance of delivery and, with respect to the Saatchi Art prints, prior to completion of the return period are included in deferred revenue in the accompanying condensed consolidated balance sheets. Revenue is recorded at the gross amount due to the following factors: we are the primary obligor in a transaction, we have inventory and credit risk, and we have latitude in establishing prices and selecting suppliers. Product revenue is recognized net of sales allowances and return allowances. We periodically provide incentive offers to customers to encourage purchases, including percentage discounts off current purchases, free shipping and other offers. VAT, sales and other taxes are not included in revenue, as we are a pass-through conduit for collecting and remitting any such taxes.

Service Costs

Service costs consist of payments relating to our Internet connection and co-location charges and other platform operating expenses, including depreciation of the systems and hardware used to build and operate our content creation and distribution platform; expenses related to creating, rewriting, or auditing certain content units; and personnel costs relating to in-house editorial, customer service, information technology, as well as revenue-sharing arrangements, such as content creator revenue-sharing arrangements.

Product Costs

Product costs consist of outsourced product manufacturing costs, artist royalties and personnel costs.

Shipping and Handling

Shipping and handling charged to customers is recorded in service revenue or product revenue. Associated costs are recorded in service costs or product costs.

Deferred Revenue

Deferred revenue consists of amounts received from customers before we have met all four criteria for the recognition of revenue. Deferred revenue includes payments received from sales of our products on Society6 prior to delivery of such products; payments made for original art and prints sold via Saatchi Art that are collected prior to the completion of the return period; and amounts received from customers of our social media services in advance of our performance of such services. Deferred revenue for social media services is recognized as revenue on a systematic basis that is proportionate to the services that have been rendered.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Computer equipment is amortized over two to five years, software is amortized over two to three years, and furniture and fixtures are amortized over seven to ten years. Leasehold improvements are amortized straight-line over the shorter of the remaining lease term or the estimated useful lives of the improvements ranging from one to ten years. Upon the sale or retirement of property or equipment, the cost and related accumulated depreciation or amortization is removed from our financial statements with the resulting gain or loss reflected in our results of operations. Repairs and maintenance costs are expensed as incurred. In the event that property and equipment is no longer in use, we will record a loss on disposal of the property and equipment, which is

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computed as the difference between the sales price, if any, and the net remaining value (gross amount of property and equipment less accumulated depreciation expense) of the related equipment at the date of disposal.

Intangible Assets—Media Content

We capitalize the direct costs incurred to acquire our media content that is determined to embody a probable future economic benefit. Costs are recognized as finite-lived intangible assets based on their acquisition cost to us. Direct content costs primarily represent amounts paid to unrelated third parties for completed content units, and to a lesser extent, specifically identifiable internal direct labor costs incurred to enhance the value of specific content units acquired prior to their publication. Internal costs not directly attributable to the enhancement of an individual content unit acquired are expensed as incurred. All costs incurred to deploy and publish content are expensed as incurred, including the costs incurred for the ongoing maintenance of our properties on which our content is published.

Capitalized media content is amortized on a straight-line basis over its useful life, which is typically five years, representing our estimate of when the underlying economic benefits are expected to be realized and based on our estimates of the projected cash flows from advertising revenue expected to be generated by the deployment of such content. These estimates are based on our plans and projections, comparison of the economic returns generated by our content with content of comparable quality and an analysis of historical cash flows generated by that content to date. Amortization of media content is included in amortization of intangible assets in the accompanying condensed consolidated statements of operations and the acquisition costs are included in purchases of intangible assets within cash flows from investing activities in the accompanying condensed consolidated statements of cash flows.

Google, Yahoo! and Bing, the largest providers of search engine referrals to the majority of our online properties, regularly deploy changes to their search engine algorithm. To date, the overall impact of these changes on search referrals to our owned and operated online properties has been negative primarily due to a decline in traffic to eHow.com, our largest website. In response to changes in search engine algorithms since 2011, we have performed evaluations of our existing content library to identify potential improvements in our content creation and distribution platform. As a result of these evaluations, we elected to remove certain content units from our content library, resulting in $18.1 million of related accelerated amortization expense since 2011. We expect to remove additional content over the next year, which may result in significant additional accelerated amortization expense in the periods such actions occur.

Intangible Assets—Acquired in Business Combinations

We perform valuations of assets acquired and liabilities assumed on each acquisition accounted for as a business combination and allocate the purchase price of each acquired business to our respective net tangible and intangible assets. Acquired intangible assets include: trade names, non-compete agreements, owned website names, artist relationships, customer relationships, technology, media content, and content publisher relationships. We determine the appropriate useful life by performing an analysis of expected cash flows based on historical experience of the acquired businesses. Intangible assets are amortized over their estimated useful lives using the straight-line method which approximates the pattern in which the economic benefits are consumed.

Long-lived Assets

We evaluate the recoverability of our long-lived tangible and intangible assets with finite useful lives for impairment when events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Such trigger events or changes in circumstances may include: a significant decrease in the market price of a long-lived asset, a significant adverse change in the extent or manner in which a long-lived asset is being used, a significant adverse change in legal factors or in the business climate, including those resulting from technology advancements in the industry, the impact of competition or other factors that could affect the value of a long-lived asset, a significant adverse deterioration in the amount of revenue or cash flows we expect to generate from an asset group, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or development of a long-lived asset, current or future operating or cash flow losses that demonstrate continuing losses associated with the use of a long-lived asset, or a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. We perform impairment testing at the

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asset group level that represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable and the expected undiscounted future cash flows attributable to the asset group are less than the carrying amount of the asset group, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. Fair value is determined based upon estimated discounted future cash flows. Assets to be disposed of would be separately presented on the balance sheets and reported at the lower of their carrying amount or fair value less costs to sell, and would no longer be depreciated or amortized.

Goodwill

Goodwill represents the excess of the cost of an acquired entity over the fair value of the acquired net assets. Goodwill is tested for impairment annually during the fourth quarter of our fiscal year or when events or circumstances change in a manner that indicates goodwill might be impaired. Events or circumstances that could trigger an impairment review include, but are not limited to, a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key personnel, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, significant negative industry or economic trends, a decline in our stock price leading to an extended period when our market capitalization is less than the book value of our net assets or significant underperformance relative to expected historical or projected future results of operations.

Goodwill is tested for impairment at the reporting unit level, which is one level below or the same as an operating segment. As of March 31, 2015, we determined that we have two reporting units. When testing goodwill for impairment, we first perform a qualitative assessment to determine whether it is necessary to perform step one of a two-step goodwill impairment test for each reporting unit. We are required to perform step one only if we conclude that it is more likely than not that a reporting unit’s fair value is less than the carrying value of its assets. Should this be the case, the first step of the two-step process is to identify whether a potential impairment exists by comparing the estimated fair values of our reporting units with their respective carrying values, including goodwill. If the estimated fair value of a reporting unit exceeds the carrying value, goodwill is not considered to be impaired and no additional steps are necessary. If, however, the fair value of a reporting unit is less than its carrying value, then a second step is performed to measure the amount of the impairment loss, if any. The amount of the impairment loss is the excess of the carrying amount of the goodwill over its implied fair value. The estimate of implied fair value of goodwill is primarily based on an estimate of the discounted cash flows expected to result from that reporting unit, but may require valuations of certain internally generated and unrecognized intangible assets such as our software, technology, patents and trademarks.

Stock-Based Compensation

We measure and recognize compensation expense for all stock-based payment awards made to employees, non-employees and directors based on the grant date fair values of the awards. The fair value of restricted stock units (“RSU”) is measured based on the fair market value of the underlying stock on the date of grant. The fair value of stock options with service based vesting conditions is estimated using the Black-Scholes-Merton option pricing model. The fair value of premium-priced stock options with service based vesting conditions is estimated using the Hull-White model. We recognize stock-based compensation expense on a straight-line basis (net of estimated forfeitures) over the requisite service period. Stock-based compensation expense is classified in the consolidated statement of operations based on the department to which the related employee provides service.

The Black-Scholes-Merton and Hull-White option pricing models require management to make assumptions and to apply judgment in determining the fair value of our awards. The most significant assumptions and judgments include the expected volatility, expected term of the award and estimated forfeiture rates. We estimated the expected volatility of our awards from the historical volatility of selected public companies with comparable characteristics to Demand Media, including similarity in size, lines of business, market capitalization, revenue and financial leverage. The weighted average expected life of options was calculated using the simplified method as prescribed under guidance by the SEC. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury notes with terms approximately equal to the expected life of the option. The expected dividend rate is zero as we currently have no history or expectation of paying cash dividends on our common stock. The forfeiture rate is established based on applicable historical forfeiture patterns adjusted for any expected changes in future periods.

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We use the Black-Scholes-Merton option pricing model to determine the fair value of shares issued pursuant to the Demand Media, Inc. 2010 Employee Stock Purchase Plan (“ESPP”), and we recognize the fair value straight-line over the total offering period.

Stock Repurchases

Under a stock repurchase plan, shares repurchased by us are accounted for when the transaction is settled. Repurchased shares held for future issuance are classified as treasury stock. Shares formally or constructively retired are deducted from common stock at par value and from additional paid in capital for the excess over par value. If additional paid in capital has been exhausted, the excess over par value is deducted from retained earnings. Direct costs incurred to acquire the shares are included in the total cost of the repurchased shares.

Income Taxes

Deferred income taxes are recognized for differences between financial reporting and tax bases of assets and liabilities at the enacted statutory tax rates in effect for the years in which the temporary differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate the realizability of deferred tax assets and recognize a valuation allowance for our deferred tax assets when it is more likely than not that a future benefit on such deferred tax assets will not be realized.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. We recognize interest and penalties accrued related to unrecognized tax benefits in our income tax (benefit) provision in the accompanying condensed consolidated statements of operations.

Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period. Net income (loss) attributable to common stockholders is increased for any cumulative preferred stock dividends earned during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted average common shares outstanding plus potentially dilutive common shares. RSUs and other restricted awards are considered outstanding common shares and included in the computation of basic income (loss) per share as of the date that all necessary conditions of vesting are satisfied. RSUs, stock options and stock issued pursuant to the ESPP are excluded from the diluted net income (loss) per share calculation when their impact is antidilutive.

Fair Value of Financial Instruments

We report certain financial assets and liabilities at their carrying amounts. The carrying amounts of our financial instruments, including cash and cash equivalents, accounts receivable, restricted cash, accounts payable, accrued liabilities and customer deposits approximate fair value because of their short maturities. For our term loans and revolving loan facility, which were repaid in full in November 2014, the carrying amounts approximate fair value because they bore interest at variable rates that approximate fair value. Our investments in marketable securities are recorded at fair value. Certain assets, including equity investments, investments held at cost, goodwill and intangible assets are also subject to measurement at fair value on a nonrecurring basis, if they are deemed to be impaired as the result of an impairment review.

Assets Held-For-Sale

We report a business as held-for-sale when management has approved or received approval to sell the business and is committed to a formal plan, the business is available for immediate sale, the business is being actively marketed, the sale is probable and anticipated to occur during the ensuing year and certain other specified criteria are met. A business

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classified as held-for-sale is recorded at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Depreciation is not recorded on long-lived assets of a business classified as held-for-sale. Assets and liabilities related to a business classified as held-for-sale are segregated in the unaudited consolidated balance sheet and major classes are separately disclosed in the notes to the unaudited consolidated financial statements commencing in the period in which the business is classified as held-for-sale.

Discontinued Operations

 

We report the results of operations of a business as discontinued operations if the disposal of a component represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results. The results of discontinued operations are reported in net income (loss) from discontinued operations in the unaudited condensed consolidated statements of operations for current and prior periods commencing in the period in which the business meets the criteria of a discontinued operation, and include any gain or loss recognized on closing or adjustment of the carrying amount to fair value less cost to sell.

3. Property and Equipment

Property and equipment consisted of the following (in thousands):

 

Depreciation and software amortization expense, which includes losses on disposal of property and equipment of approximately $0.3 million and $0.9 million for the three months ended March 31, 2015 and 2014, respectively, is shown by classification below (in thousands):

 

 

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4. Intangible Assets

Intangible assets consisted of the following (in thousands):

 

 

 

Identifiable finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives commencing on the date that the asset is available for its intended use.

Total amortization expense for the periods shown is classified as shown below (in thousands):

 

Service costs include accelerated amortization charges that were less than $0.1 million for the three months ended March 31, 2015 and $1.5 million for the three months ended March 31, 2014 as a result of removing certain assets from service.

 

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5. Other Assets

Other assets consisted of the following (in thousands):

 

 

6. Other Balance Sheet Items

 

Accrued expenses and other current liabilities consisted of the following (in thousands):

 

 

 

 

7. Debt

In November 2014, we repaid all amounts outstanding under our credit agreement, dated August 29, 2013, with Silicon Valley Bank, as administrative agent, and the lenders and other agents party thereto (the “Credit Agreement”) and terminated the Credit Agreement and the related Guarantee and Collateral Agreement. The Credit Agreement had provided for a $100.0 million senior secured term loan facility and a $125.0 million senior secured revolving loan facility. Under the Credit Agreement, loans bore interest, at our option, at an annual rate based on LIBOR or a base rate. Loans based on LIBOR bore interest at a rate between LIBOR plus 2.00% and LIBOR plus 3.00%, depending on our consolidated leverage ratio. Loans based on the base rate bore interest at the base rate plus an applicable margin of 1.00% or 2.00%, depending on our consolidated leverage ratio. We were also required to pay a commitment fee between 0.20% and 0.40% per annum, depending on our consolidated leverage ratio, on the undrawn portion available under the credit facility.

In connection with entering into the Credit Agreement in August 2013, we incurred debt issuance costs of $1.9 million. Debt issuance costs are capitalized and amortized into interest expense over the term of the underlying debt. During the three months ended March 31, 2014 we amortized $0.1 million of deferred debt issuance costs.

8. Commitments and Contingencies

Leases

We conduct our operations utilizing leased office facilities in various locations and lease certain equipment under non-cancelable operating and capital leases. Our leases expire between December 2015 and February 2020.

Litigation

On November 5, 2014, Charles Saatchi filed a lawsuit against our wholly owned subsidiary, Saatchi Online, Inc. (“Saatchi Art”), in the High Court of Justice, Chancery Division (United Kingdom) relating to an intellectual property licensing agreement (the “IP Agreement”) between Charles Saatchi and Saatchi Art, dated February 18, 2010. Mr. Saatchi alleges that Saatchi Art committed a repudiatory breach of the IP Agreement, effectively terminating it, and that Saatchi Art must cease using the “Saatchi” name. Mr. Saatchi is seeking a permanent injunction restricting Saatchi Art from continuing to use the “Saatchi” name, a declaration that the IP Agreement has been validly terminated, a disgorgement of any profits

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derived from Saatchi Art’s use of the name since the alleged termination date and unspecified monetary damages. We do not believe that the conduct alleged by Mr. Saatchi constitutes a repudiatory breach of the IP Agreement and intend to vigorously defend the lawsuit. We have filed an Application for Summary Judgment, or Strike Out of Claimant’s Claim, with the High Court of Justice, Chancery Division (United Kingdom). The litigation is in its early stages.

On December 30, 2014, Charles Saatchi and Robert Norton, common stockholders of Saatchi Art prior to its acquisition by Demand Media, filed a lawsuit in the Delaware Chancery Court against the former directors, certain former officers and certain former preferred stockholders of Saatchi Art, and Saatchi Art itself. Messrs. Saatchi and Norton allege that, in connection with Demand Media’s acquisition of Saatchi Art, (i) the former directors and officers named in the lawsuit breached their fiduciary duties to the common stockholders; (ii) certain preferred stockholders of Saatchi Art breached their fiduciary duties to the common stockholders, aided and abetted the former officers’ and directors’ breach of their fiduciary duties and violated a Saatchi Art voting agreement by breaching the implied covenant of good faith and fair dealing; and (iii) Saatchi Art violated the voting agreement by breaching the implied covenant of good faith and fair dealing. The complaint seeks rescissory damages, a constructive trust over the acquisition proceeds, disgorgement of all profits related thereto, and unspecified compensatory damages, costs and fees. We believe that we are entitled to indemnification with respect to any losses incurred by us related to these claims under the terms of the merger agreement, although there can be no assurance that we will be successful in recovering such losses, if any. The litigation is in its early stages.

In addition, from time to time we are a party to various legal matters incidental to the conduct of our businesses. Certain of our outstanding legal matters include speculative claims for indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. Based on our current knowledge, we do not believe that there is a reasonable possibility that the final outcome of the pending or threatened legal proceedings to which we are a party, either individually or in the aggregate, will have a material adverse effect on our future financial results. However, the outcome of such legal matters is subject to significant uncertainties.

Taxes

From time to time, various federal, state and other jurisdictional tax authorities undertake review of us and our filings. In evaluating the exposure associated with various tax filing positions, we accrue charges for possible exposures. The Company’s 2012 federal income tax return is currently under Internal revenue service (“IRS”) audit. We believe any adjustments that may ultimately be required as a result of any of these reviews will not be material to our consolidated financial statements.

Indemnification

In the normal course of business, we have provided certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These indemnities include intellectual property indemnities to our customers, indemnities to our directors and officers to the maximum extent permitted under the laws of the State of Delaware, indemnifications related to our lease agreements and indemnifications to sellers or buyers in connection with acquisitions and dispositions, respectively. In addition, our advertiser and distribution partner agreements contain certain indemnification provisions which are generally consistent with those prevalent in our industry. We have not incurred significant obligations under indemnification provisions historically and do not expect to incur significant obligations in the future. Accordingly, we have not recorded any liability for these indemnities, commitments and guarantees in the accompanying condensed consolidated balance sheets. 

9. Income Taxes

Our effective tax rate differs from the statutory rate primarily as a result of state taxes, foreign taxes, nondeductible stock option expenses and changes in our valuation allowance.

Income tax expense for the three months ended March 31, 2015, decreased by $2.4 million to less than $0.1 million compared to $2.4 million in the same period in 2014. The decrease is primarily due to the impairment of goodwill which

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allowed for the reversal of the deferred tax liability related to the tax amortization of goodwill and a full valuation allowance. 

We reduce our deferred tax assets resulting from future tax benefits by a valuation allowance if, based on the weight of the available evidence, it is more likely than not that some portion or all of these deferred taxes will not be realized. The timing of the reversal of deferred tax liabilities associated with tax deductible goodwill is not certain and thus not available to assure the realization of deferred tax assets. Due to the limitation associated with deferred tax liabilities from tax deductible goodwill, we have deferred tax assets in excess of deferred tax liabilities before application of a valuation allowance for the periods presented. As we have insufficient history of generating book income, the ultimate future realization of these excess deferred tax assets is not more likely than not and is thus subject to a valuation allowance. Accordingly, we have established a full valuation allowance against our deferred tax assets.

We are subject to the accounting guidance for uncertain income tax positions. We believe that our income tax positions and deductions will be sustained on audit and do not anticipate any adjustments will result in a material adverse effect on our financial condition, results of operations, or cash flow. We acquired a $0.1 million uncertain tax position as a result of a business acquisition during 2011.

Our policy for recording interest and penalties associated with audits and uncertain tax positions is to record such items as a component of income tax expense, and amounts recognized to date are insignificant. No uncertain income tax positions were recorded during the three months ended March 31, 2015 or 2014 other than the acquired uncertain tax position, and we do not expect our uncertain tax position to change materially during the next twelve months. We file a U.S. federal and many state tax returns as well as tax returns in multiple foreign jurisdictions. All tax years since our incorporation remain subject to examination by the IRS and various state authorities.  The IRS is currently conducting an audit of our 2012 tax return.

10. Employee Benefit Plan

We have a defined contribution plan (the “401(k) Plan”) under Section 401(k) of the Internal Revenue Code of 1986, as amended  covering all full-time employees who meet certain eligibility requirements. Eligible employees may defer up to 90% of their pre-tax eligible compensation, up to the annual maximum allowed by the IRS. Under the 401(k) Plan, we may, but are not obligated to, match a portion of the employee contributions up to a defined maximum. During the three months ended March 31, 2015 and 2014, we incurred approximately $0.3 million and $0.6 million, respectively, in employer contributions under the 401(k) Plan, and we expect to incur approximately $0.9 million for the remainder of the current fiscal year. 

11. Stock-based Compensation Plans and Awards

Stock-based Compensation Expense

Stock-based compensation expense related to all employee and non-employee stock-based awards recognized in the condensed consolidated statements of operations was as follows (in thousands):

 

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Award Activity

Stock Options

Stock option activity is as follows (in thousands):

 

Restricted Stock Units

Restricted stock unit activity is as follows (in thousands):

 

Employee Stock Purchase Plan

 

In 2010, we established our ESPP, which allows eligible employees to purchase, through payroll deductions, a limited amount of our common stock at a discounted price. The ESPP provides up to a 24-month offering period which is comprised of four consecutive six-month purchase periods commencing in May and November. We commenced our first offering period in May 2011 and our most recent offering period in November 2014. Under the ESPP, participants can purchase our common stock at a 15% discount to the lower of our common stock’s market price as of the beginning or ending of the relevant offering period. Participants can authorize payroll deductions for amounts up to the lesser of 15% of their qualifying wages or the statutory limit under the U.S. Internal Revenue Code. A maximum of 750 shares of common stock may be purchased by each participant during each purchase period. The fair value of the shares issued pursuant to the ESPP is determined using a Black-Scholes-Merton model and is amortized over the remaining life of the 24-month offering period of the ESPP. The Black-Scholes-Merton model included an assumption for expected volatility of between 58% and 60% for each of the four purchase periods during the current offering period. During the three months ended March 31, 2015, we recognized $0.1 million of expense in relation to the ESPP and there were approximately 1.8 million shares of common stock remaining authorized for issuance under the ESPP at March 31, 2015. As of March 31, 2015 there was approximately $0.4 million of unrecognized compensation cost related to the ESPP which is expected to be recognized on a straight line basis over the remainder of the offering period.

12. Stockholders’ Equity

Reverse Stock Split

On August 1, 2014, immediately following the Distribution, we enacted a 1-for-5 reverse stock split with respect to all of our outstanding shares of common stock, including shares held in treasury, which is reflected retrospectively throughout the condensed consolidated financial statements.

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Stock Repurchases

Under our February 8, 2012 stock repurchase plan, as amended, we are authorized to repurchase up to $50.0 million of our common stock from time to time. Since April 2013, we have not repurchased any shares of common stock. Approximately $19.2 million remains available under the repurchase plan at March 31, 2015. The timing and actual number of shares repurchased will depend on various factors including price, corporate and regulatory requirements, debt covenant requirements, alternative investment opportunities and other market conditions.

Shares repurchased by us are accounted for when the transaction is settled. As of March 31, 2015, there were no unsettled share repurchases. The par value of shares repurchased and retired is deducted from common stock and any excess over par value is deducted from additional paid in capital. Direct costs incurred to repurchase the shares are included in the total cost of the shares.

Other

Each share of common stock has the right to one vote per share.

13. Business Segments

We operate in one operating segment. Our chief operating decision maker (the “CODM”) manages our operations on a consolidated basis for purposes of evaluating financial performance and allocating resources. The CODM reviews separate revenue information for its Content & Media and Marketplace offerings. All other financial information is reviewed by the CODM on a consolidated basis. All of our principal operations and assets are located in the United States.

Revenue derived from our Content & Media and Marketplaces service offerings is as follows (in thousands):

 

 

Revenue by geographic region, as determined based on the location of our customers or anticipated destination of use, was as follows:

 

 

 

 

 

14. Fair Value

Fair value represents the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We measure our financial assets and liabilities in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

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In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible and consider counterparty credit risk in our assessment of fair value.

For financial assets that utilize Level 1 and Level 2 inputs, we utilize both direct and indirect observable price quotes, including quoted market prices (Level 1 inputs) or inputs that are derived principally from or corroborated by observable market data (Level 2 inputs). For financial assets that utilize Level 3 inputs, we derive the fair value based on company assumptions and information obtained from brokers based on the indicated market values.

We report certain financial assets and liabilities at their carrying amounts. The carrying amounts of our financial instruments, which include cash and cash equivalents, accounts receivable, restricted cash, accounts payable, accrued liabilities and customer deposits, approximate fair value because of their short maturities. The carrying amount for amounts that were outstanding under our terminated credit facility approximates fair value because the loans bore interest at variable rates that approximated fair value. Our investments in marketable securities are recorded at fair value. Certain assets, including equity investments, investments held at cost, goodwill and intangible assets, are also subject to measurement at fair value on a nonrecurring basis, if they are deemed to be impaired as the result of an impairment review.

Financial assets measured at fair value on a recurring basis were as follows (in thousands):

 

 

 

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(1) Comprises money market funds which are included in Cash and cash equivalents in the accompanying condensed consolidated balance sheet. 

During the three months ended March 31, 2015, we increased the fair value of the promissory note by $0.1 million to its current estimated fair value.

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15. Net Loss Per Share

The following table sets forth the computation of basic and diluted net loss per share of common stock (in thousands, except per share data):

 

For each of the three months ended March 31, 2015 and 2014 we excluded 0.1 million shares from the calculation of diluted weighted average common shares outstanding, as their inclusion would have been antidilutive.

16. Discontinued Operations

On August 1, 2014, we completed the Separation of Rightside from Demand Media. As a result of the Separation, the financial results of Rightside are presented as discontinued operations in our consolidated statements of operations for the three months ended March 31, 2014. Following the Separation, the following activity in our statement of operations was reclassified from continuing operations to discontinued operations:

 

 

 

 

 

 

 

 

 

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Item 2.       MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  

As used herein, “Demand Media,” the “Company,” “our,” “we,” or “us” and similar terms include Demand Media, Inc. and its subsidiaries, unless the context indicates otherwise. “Demand Media” and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our 2014 Annual Report on Form 10-K. 

Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy and plans and our objectives for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “predict,” “plan” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements are so identified. You should not rely upon forward-looking statements as guarantees of future performance. We have based these forward-looking statements largely on our estimates of our financial results and our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, as well as those discussed in other documents we file with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2014 (the “2014 Annual Report”), which was filed with the SEC on March 16, 2015, and the factors described in the section entitled “Risk Factors” in Part I. Item 1A of the 2014 Annual Report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason after the date of this Quarterly Report on Form 10-Q, except as required by law.

You should read this Quarterly Report on Form 10-Q and the documents that we reference in this Quarterly Report on Form 10-Q and have filed with the Securities and Exchange Commission (the “SEC”) with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect.

Overview

We are a diversified Internet company that builds platforms across our media and marketplace properties to enable communities of creators to reach passionate audiences in large and growing lifestyle categories. Our business is comprised of two service offerings: Content & Media and Marketplaces.

Content & Media

Our Content & Media service offering includes a leading online content creation platform that publishes content to our owned and operated online properties as well as to online properties operated by our customers. Through our innovative content creation platform, DemandStudios.com, a large community of qualified freelance professionals

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utilizes proprietary technology and automated workflow processes to identify valuable topics and then create high-quality content in text, video, photography and designed visual formats. This content is published to our leading owned and operated online properties across several key categories, including eHow.com, a how-to reference destination, and Livestrong.com, a health and healthy living destination. We also own and operate Cracked.com, a humor site offering original and engaging comedy-driven text articles, video series and blogs created by our in-house editorial staff, comedians and a community of website enthusiasts. Our content creation studio also produces content for our Content Solutions business, which develops and executes custom content marketing strategies for third-party brands, publishers and advertisers.

Our Content & Media service offering derives the majority of its revenue from the sale of advertising on our owned and operated online properties. Our advertising revenue is principally dependent on the number of visits to our properties and the corresponding ad unit rates.  Since 2011, the number of visits to our properties, particularly eHow.com, has substantially declined due to lower search engine referrals resulting from ongoing changes to search engine algorithms by Google, Yahoo! and Bing. In addition, visits across our owned and operated online properties continue to shift from desktop to mobile, with ad unit rates for mobile generally lower than desktop, and we have recently experienced declines in ad unit rates for both desktop and mobile, resulting in lower advertising revenue. As a result of the traffic declines and lower ad unit rates, our revenue derived from eHow for the three months ended March 31, 2015 dropped to 28% of our total revenue, as compared to 43% and 56% for the years ended December 31, 2014 and 2013, respectively, after giving effect to the Separation. Future changes to search engine algorithms that negatively impact the volume of referral traffic, additional declines in ad unit rates or a continuing reduction in eHow’s performance could result in a material adverse effect to our business and results of operations.

However, we believe that there are opportunities to increase the number of visits, both from search engine referrals and direct visits by users, by improving the user experience and engagement on our online properties. Such improvements include redesigning our websites; refining our content library through select removals, rewrites and additions; reducing the number of advertisements per page; and developing a greater variety of content formats, particularly formats better suited for mobile devices. These changes will likely negatively impact revenue and significantly increase our operating expenses in the near term, but we believe that by providing consumers with an improved user and content experience, we will be able to increase the number of visits and revenue in a sustained fashion over the long-term. However, if the ad unit rates we receive continue to decline, we could experience lower advertising revenue even if the number of visits to our properties increases.

The majority of our advertising revenue currently is, and historically has been, generated by our relationship with Google. Google also serves as one of the principal technology platform partners for our programmatic ad sales offering. Any change in the type of services that Google provides to us, or to the terms of our agreements with Google, could adversely impact our results of operations.

Marketplaces

Through our Marketplaces service offering, we operate two leading artist marketplaces where large communities of artists can market and sell original artwork or original designs printed on a wide variety of products. Society6.com (“Society6”) provides artists with an online commerce platform to feature and sell their original designs on art prints, phone and tablet cases, t-shirts, throw pillows and other consumer products. SaatchiArt.com (“Saatchi Art”) is an online art gallery featuring a wide selection of original paintings, drawings, sculptures and photography that provides a global community of artists a curated environment in which to exhibit and sell their work directly to consumers around the world.

Our Marketplaces service offering generates revenue from the sale of products and services through our online artist marketplaces.  On Society6, revenue is generated from the sale of print-on-demand products. Saatchi Art primarily generates revenue through commissions on the final sale price of original works of art. Our Marketplaces service offering is principally dependent on the number of transactions and average revenue per transaction generated by the sale of products and services through our online marketplaces, both of which increased for the three months ended March 31, 2015 as compared to the prior year period. We believe there are opportunities to further increase the number of transactions and the average revenue per transaction by attracting new visitors to our marketplaces via diverse online and

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offline marketing, improving conversion of visitors to purchasing customers, introducing new products, and offering product bundling and other promotions.

The revenue generated by our Marketplaces service offering has higher costs associated with it as compared to our Content & Media service offering due to variable product costs, including outsourced product manufacturing costs, artist royalties, and shipping and handling costs. During the three months ended March 31, 2015, a higher percentage of our total revenue was generated by our Marketplaces service offering as compared to the prior year period. If our revenue sources continue to shift from our Content & Media service offering to our Marketplaces service offering, our total costs relative to our revenue will be negatively impacted.

On August 1, 2014, we completed the separation of Rightside Group, Ltd. (“Rightside”) from Demand Media, Inc., resulting in two independent, publicly traded companies (hereinafter referred to as the “Separation”). Following the Separation, Rightside operates our former domain name services business, while we continue to own and operate our Content & Media and Marketplaces businesses. The Separation was structured as a pro rata tax-free dividend involving the distribution of all outstanding shares of Rightside common stock to holders of Demand Media common stock as of the August 1, 2014 record date (the “Distribution”). Immediately following the Distribution, we completed a 1-for-5 reverse stock split with respect to all of our outstanding shares of common stock, including shares held in treasury. The financial results of Rightside are presented as discontinued operations in our condensed consolidated statements of operations for the three months ended March 31, 2014. Unless it is disclosed, all financial results represent continuing operations.

For the three months ended March 31, 2015 and 2014, we reported revenue of $33.2 million and $45.1 million, respectively. For the three months ended March 31, 2015 and 2014, Content & Media revenue accounted for 68% and 85% of our total revenue, respectively, and Marketplaces revenue accounted for 32% and 15% of our total revenue, respectively.

 

Key Business Metrics

We regularly review a number of business metrics, including the following key metrics, to evaluate our business, measure the performance of our business model, identify trends impacting our business, determine resource allocations, formulate financial projections and make strategic business decisions. Measures which we believe are the primary indicators of our performance are as follows:

Content & Media Metrics

Marketplaces Metrics

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The following table sets forth our key business metrics for the periods presented:

 

Basis of Presentation

Revenue

Our revenue is derived from sales of advertising and from products and services sold through our online marketplaces and other offerings.

Service Revenue

Content & Media

We generate Content & Media service revenue primarily from advertisements displayed alongside our content on our online properties and certain of our customers’ online properties. Articles, videos and other forms of content generate advertising revenue from a diverse mix of advertising methods including performance-based cost-per-click advertising, in which an advertiser pays only when a visitor clicks on an advertisement; display advertisements, where revenue is dependent upon the number of advertising impressions delivered; and sponsored content or advertising links. Where we enter into revenue-sharing arrangements with our customers, such as those relating to our advertiser network, and when we are considered the primary obligor, we report the underlying revenue on a gross basis in our consolidated statements of operations, and record these revenue-sharing payments to our customers in service costs.

We also generate Content & Media service revenue from the sale or license of media content, including the creation and distribution of content for third-party brands, publishers and advertisers through our Content Solutions service. In circumstances where we distribute our content on third-party properties and the customer acts as the primary obligor we recognize revenue on a net basis. In addition, we have previously generated Content & Media service revenue through social media services from recurring management support fees, overage fees in excess of standard usage terms, outside consulting fees and initial set-up fees. As of February 2015, we no longer provide social media services.

Marketplaces

We generate service revenue from commissions we receive from facilitating the sale of original art by artists to customers through Saatchi Art. We recognize service revenue arising from the sale of original art net of amounts paid to the artist because we are not the primary obligor in the transaction, we do not have inventory risk, and we do not establish the prices for the art sold. We also recognize this service revenue net of any sales allowances. Revenue is recognized after the original art has been delivered and the return period has expired. Payments received in advance of delivery and completion of the return period are included in deferred revenue in the accompanying consolidated balance sheets. We periodically provide incentive offers to customers to encourage purchases, including percentage discounts off current purchases, free shipping and other offers. Value-added taxes (“VAT”), sales and other taxes are not included in Marketplaces service revenue because we are a pass-through conduit for collecting and remitting any such taxes.

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Product Revenue

Marketplaces

We recognize product revenue from sales of Society6 products upon delivery, net of estimated returns based on historical experience. We recognize product revenue from the sale of prints through Saatchi Art when the prints are delivered and the return period has expired. Payments received in advance of delivery and, with respect to the Saatchi Art prints, prior to completion of the return period are included in deferred revenue in the accompanying consolidated balance sheets. Product revenue is recorded at the gross amount due to the following factors: we are the primary obligor in a transaction, we have inventory and credit risk, and we have latitude in establishing prices and selecting suppliers. Product revenue is recognized net of sales allowances and return allowances. We periodically provide incentive offers to customers to encourage purchases, including percentage discounts off current purchases, free shipping and other offers. VAT, sales and other taxes are not included in product revenue because we are a pass-through conduit for collecting and remitting any such taxes. Substantially all of our product revenue is currently generated through Society6.

Service Costs

Service costs consist of payments relating to our Internet connection and co-location charges and other platform operating expenses, including depreciation of the systems and hardware used to build and operate our content creation and distribution platform; expenses related to creating, rewriting, or auditing certain content units; personnel costs related to in-house editorial, customer service and information technology; and revenue-sharing arrangements, such as content creator revenue-sharing arrangements. In the near term, we expect increases in service costs associated with our investment in new business initiatives that we believe will support future growth, including refining, auditing and consolidating our content library.

Product Costs

Product costs consist of outsourced product manufacturing costs, artist royalties, and personnel costs. In the near term, we expect our product costs to increase as our product revenue continues to grow.

Shipping and Handling

Shipping and handling charged to customers is recorded in service revenue or product revenue. Associated costs are recorded in service costs or product costs.

Sales and Marketing

Sales and marketing expenses consist primarily of sales and marketing personnel costs, sales support, public relations, advertising, marketing and general promotional expenditures. Fluctuations in our sales and marketing expenses are generally the result of our efforts to drive growth in our product and service offerings. We currently anticipate that our sales and marketing expenses will slightly increase in the near term as a percentage of revenue as we grow our marketing activities to support our Content Solutions and Marketplaces offerings.

Product Development

Product development expenses consist primarily of expenses incurred in our software engineering, product development and web design activities and related personnel costs. Fluctuations in our product development expenses are generally the result of hiring personnel to support and develop our platforms, including the costs to improve our owned and operated websites and related mobile applications and further develop our content algorithms, as well as the costs to develop future product and service offerings. We currently anticipate that our product development expenses will slightly increase in the near term as a percentage of revenue as we continue to invest in product development personnel to support the growth of our businesses.

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General and Administrative

General and administrative expenses consist primarily of personnel costs from our executive, legal, finance, human resources and information technology organizations and facilities related expenditures, as well as third-party professional fees and insurance. Professional fees are largely comprised of outside legal, audit and information technology consulting. We currently anticipate that general and administrative expenses will remain relatively flat in the near term.

Amortization of Intangible Assets

We capitalize certain costs (i) allocated to the purchase price of certain identifiable intangible assets acquired in connection with business combinations and (ii) incurred to develop media content that our algorithms indicate have a probable economic benefit. We amortize these costs on a straight-line basis over the related expected useful lives of these assets. We determine the appropriate useful life of intangible assets by performing an analysis of expected cash flows based on our historical experience of intangible assets of similar quality and value. We expect amortization expense related to business combinations to decrease due to fewer acquisitions in the near term as compared to prior years, as well as a decrease in intangible assets as a result of recent dispositions including our Creativebug, CoveritLive and Pluck businesses. Further remediation of our content in future periods may result in significant additional accelerated amortization expense related to capitalized media content in the periods such actions occur. Amortization as a percentage of revenue will depend upon a variety of factors, such as the amounts and mix of our investments in content and identifiable intangible assets acquired in business combinations.

Goodwill

We test goodwill for impairment in the fourth quarter of each year unless there are interim indicators that suggest that it is more likely than not that goodwill may be impaired.

Stock-based Compensation

Included in operating expenses are expenses associated with stock-based compensation, which are allocated and included in service costs, sales and marketing, product development and general and administrative expenses. Stock-based compensation expense is largely comprised of costs associated with stock options, restricted stock units and restricted stock granted to employees, directors and non-employees, and expenses relating to our Employee Stock Purchase Plan. We record the fair value of these equity-based awards and expenses at their cost ratably over related vesting periods.

Interest Income (Expense), Net

Interest expense principally consists of interest on outstanding debt and amortization of debt issuance costs associated with our credit facility, which was fully repaid in November 2014, resulting in lower interest expense in the first quarter of 2015 than in the prior year period. We expect interest expense to decrease in 2015 because we currently have no debt outstanding. Interest income consists of interest earned on cash balances and short-term investments. We expect interest income to increase in 2015 as compared to 2014 due to the promissory note we received in July 2014 as part of the consideration for the sale of CoveritLive. We typically invest our available cash balances in money market funds and short-term United States Treasury obligations.

Other Income (Expense), Net

Other income (expense), net consists primarily of transaction gains and losses on foreign currency-denominated assets and liabilities and gain or loss on sale of businesses. We expect our transaction gains and losses will vary depending upon movements in underlying currency exchange rates and whether we dispose of any businesses.

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Provision for Income Taxes

Since our inception, we have been subject to income taxes principally in the United States, and certain other countries where we have a legal presence, including the United Kingdom, the Netherlands, Canada, Australia and Argentina. We may in the future become subject to taxation in additional countries based on the foreign statutory rates and our effective tax rate could fluctuate accordingly.

Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

We currently believe that based on the available information, it is more likely than not that our deferred tax assets will not be realized, and accordingly we have taken a full valuation allowance against all of our United States federal and certain state and foreign deferred tax assets. Federal and state laws impose substantial restrictions on the utilization of net operating loss and tax credit carry-forwards in the event of an “ownership change,” as defined in Section 382 of the Code. Currently, we do not expect the utilization of our net operating loss and tax credit carry-forwards in the near term to be materially affected as no significant limitations are expected to be placed on these carry-forwards as a result of our previous ownership changes.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates.

We believe that the assumptions and estimates associated with our revenue recognition, accounts receivable and allowance for doubtful accounts, goodwill, capitalization and useful lives associated with our intangible assets, income taxes, stock-based compensation, the recoverability of our long-lived assets, including our media portfolio, and discontinued operations have the greatest potential impact on our condensed consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates and have discussed these in our 2014 Annual Report. There have been no material changes to our critical accounting policies and estimates since the date of our 2014 Annual Report. The following discussion includes any specific activity related to these accounting policies and estimates for the three months ended March 31, 2015, as well as any additional accounting policies and estimates that had a significant impact on our consolidated financial statements for the three months ended March 31, 2015.

Discontinued Operations

 

We report the results of operations of a business as discontinued operations if the disposal of a component represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results. The results of discontinued operations are reported in discontinued operations in the condensed unaudited consolidated statements of operations for current and prior periods commencing in the period in which the business meets the criteria of a discontinued operation, and include any gain or loss recognized on closing or adjustment of the carrying amount to fair value less cost to sell.

 

On August 1, 2014, we completed the Separation of Rightside from Demand Media, resulting in two independent, publicly traded companies. Following the Separation, Rightside operates our former domain name services business, while we continue to own and operate our Content & Media and Marketplaces businesses. The financial results of

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Rightside are presented as discontinued operations in our condensed consolidated statements of operations for the three months ended March 31, 2014.

 

 

 

 

 

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Results of Operations

The following tables set forth our results of operations for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of future results.

 

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As a percentage of revenue:

 

Revenue

Revenue by service offering was as follows (in thousands):

 

Content & Media Revenue

Content & Media revenue decreased by $15.8 million, a 41% decline to $22.5 million for the three months ended March 31, 2015, as compared to $38.3 million for the same period in 2014. Visits decreased by 5% to 943 million visits in the three months ended March 31, 2015 from 989 million visits in the three months ended March 31, 2014 driven by significant declines in desktop visits across most of our online properties, partially offset by significant mobile visit growth across most of our online properties, as well as desktop visit growth from Livestrong.com and customer web pages hosted by our content services. RPV decreased by 38%, to $23.87 in the three months ended March 31, 2015 from $38.77 in the three months ended March 31, 2014, primarily due to lower ad monetization yields from our cost-per-click advertising, our strategic reduction in higher yielding direct sold display advertising and the impact from selling our CoveritLive and Pluck social media businesses.

Marketplaces Revenue

Marketplaces revenue increased by $4.0 million, a 59% increase to $10.7 million for the three months ended March 31, 2015, as compared to $6.7 million for the same period in 2014. The number of transactions increased 31% to

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182,179 in the three months ended March 31, 2015 from 138,886 in the 2014 period, as a result of new product introductions, increased traffic and increased conversion of visits to purchases on Society6, as well as the addition of Saatchi Art. Marketplaces average revenue per transaction increased by 21% year-over-year, from $48.46 to $58.65, driven primarily by a mix shift towards higher-priced items on Society6, as well as the addition of Saatchi Art, which has significantly higher average revenue per transaction.

Costs and Expenses

Operating costs and expenses were as follows (in thousands):

 

Service Costs

Service costs for the three months ended March 31, 2015 decreased by approximately $0.7 million, or 6%, to $10 million compared to $10.7 million in the same period in 2014. The decrease was primarily due to a decrease of $0.4 million in depreciation expense, $0.4 million in information technology expense, $0.3 million in new content expense, $0.3 million in traffic acquisition cost (“TAC”), $0.2 million in ad serving costs, and $0.1 million in consulting and other costs. These factors were partially offset by an increase of $0.4 million in content renovation costs, $0.3 million in service sales related costs, and $0.3 million in personnel and related costs.

Product Costs

Product costs for the three months ended March 31, 2015 increased by approximately $1.9 million, or 38%, to $6.8 million, as compared to $5.0 million in the same period in 2014. The increase was primarily due to increased costs related to the higher volume of products sold on Society6.

Sales and Marketing

Sales and marketing expenses decreased by approximately $1.5 million, or 25%, to $4.6 million for the three months ended March 31, 2015 from $6.1 million for the same period in 2014. The decrease was primarily driven by a $1.6 million decrease in personnel and related costs due to our strategic shift away from direct advertising sales.

Product Development

Product development expenses decreased by approximately $0.9 million, or 12%, to $6.4 million during the three months ended March 31, 2015 compared to $7.2 million in the same period in 2014, primarily as a result of a decrease of $0.9 million in personnel and related costs, net of internal costs capitalized as internal software development.

General and Administrative

General and administrative expenses decreased by approximately $1.5 million, or 13%, to $10.4 million during the three months ended March 31, 2015 compared to $11.8 million in the same period in 2014. The decrease was primarily due to a decrease of $0.4 million in facilities and related costs, $2.0 million in personnel and related costs, and $0.1

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million in depreciation expense. These factors were partially offset by increases of $0.4 million in legal and audit fees, $0.3 million in realignment costs, $0.2 million in consulting costs, and $0.1 million in taxes and insurance costs.

Amortization of Intangible Assets  

Amortization expense for the three months ended March 31, 2015 decreased by approximately $5.2 million, or 53%, to $4.7 million compared to $9.9 million in the same period in 2014. The decrease is primarily due to the removal of content from our media properties in the fourth quarter of 2014, as well as lower amortization related to intangibles disposed of in connection with the sales of our Creativebug and CoveritLive businesses in the third quarter of 2014.

Interest Income (Expense), Net

Interest income, net for the three months ended March 31, 2015 was $0.1 million from the promissory note that we received in July 2014 as part of the consideration for the sale of CoveritLive. For the three months ended March 31, 2014 interest expense was $0.8 million due to our former outstanding debt. We did not incur any interest expense for the three months ended March 31, 2015 because we did not have any debt outstanding during the period.

Other Income (Expense), Net

Other income (expense), net for the three months ended March 31, 2015 was $2.9 million, primarily due to the gain on sale of our Pluck business.

Income Tax Expense

Income tax expense for continuing operations for the three months ended March 31, 2015 decreased by $2.4 million to less than $0.1 million compared to $2.4 million in the same period in 2014. The decrease is primarily due to the impact from the impairment of goodwill during the third quarter of 2014, which allowed for the reversal of the deferred tax liability related to the tax amortization of goodwill and a full valuation allowance as compared to the same period in 2014.

Non-GAAP Financial Measures

To provide investors and others with additional information regarding our financial results, we have disclosed in the table below adjusted earnings before interest, taxes, depreciation and amortization expense, or Adjusted EBITDA. We have provided a reconciliation of this non-GAAP financial measure to net income (loss), the most directly comparable GAAP financial measure. Our Adjusted EBITDA financial measure differs from GAAP net income (loss) in that it excludes net income (loss) from discontinued operations, as well as net interest expense, income tax expense (benefit), and certain other non-cash and non-recurring items impacting net income (loss) from time to time, principally comprised of depreciation and amortization and stock-based compensation. 

Adjusted EBITDA is one of the primary measures used by our management and board of directors to understand and evaluate our financial performance and operating trends, including period-to-period comparisons, because it excludes certain expenses that management believes are not indicative of our core operating results. Management believes that the exclusion of these expenses provides a useful measure for period-to-period comparisons of our underlying recurring revenue and operating costs that is focused more closely on the current costs necessary to utilize previously acquired long-lived assets and reflects our ongoing business in a manner that allows for meaningful analysis of trends. In addition, management believes that excluding certain non-cash charges can be useful because the amount of such expenses is the result of long-term investment decisions in previous periods rather than day-to-day operating decisions. Adjusted EBITDA is also one of the primary measures management uses to prepare and update the Company’s short and long term financial and operational plan, including evaluating investment decisions. We also frequently use Adjusted EBITDA in our discussions with investors, commercial bankers and other users of our financial statements.

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Accordingly, we believe that Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our consolidated revenue and operating results in the same manner as our management and in comparing financial results across accounting periods and to those of our peer companies. However, the use of non-GAAP financial measures has certain limitations because they do not reflect all items of income and expense that affect our operations. We compensate for these limitations by reconciling non-GAAP financial measures to the most comparable GAAP financial measures. Further, non-GAAP financial measures do not have standardized meanings, and therefore other companies, including peer companies, may use the same or similarly named measures but exclude different items or use different computations, so comparability may be limited. Non-GAAP financial measures should be considered in addition to, and not as a substitute for, measures prepared in accordance with GAAP. We encourage investors and others to review our financial information in its entirety and not rely on a single financial measure.

The following table presents a reconciliation of Adjusted EBITDA for each of the periods presented (in thousands):

 

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Liquidity and Capital Resources

As of March 31, 2015, we had $47.3 million of cash and cash equivalents. Our principal sources of liquidity are our cash and cash equivalents, as well as the cash we generate from our operations. Historically, we have principally financed our operations from the issuance of stock, net cash provided by our operating activities and borrowings under our previous credit facilities. In November 2014, we repaid all outstanding amounts under our previous credit facility and terminated that facility, and we do not currently have a line of credit available. We believe that our existing cash and cash equivalents and our cash flows from operating activities will be sufficient to fund our operations for at least the next 12 months. However, in order to fund our operations, make potential acquisitions, pursue new business opportunities and invest in our existing businesses, platforms and technologies, we may need to raise additional funds by entering into a new credit facility or through the issuance of equity, equity-related or debt securities. We currently have a shelf registration statement on file with the SEC that is effective through October 2015 which we may use to offer and sell debt or equity securities with an aggregate offering price not to exceed $100.0 million.

Since our inception, we have used significant cash to make strategic acquisitions to grow our business, including the acquisitions of Society6 in June 2013 and Saatchi Art in August 2014. We acquired Saatchi Art for total consideration, after giving effect to working capital adjustments as of the closing date, of approximately $4.8 million in

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cash and 1,049,959 shares of our common stock, in addition to certain liabilities that we assumed in the merger. In July 2014, we sold our Creativebug business for $10.0 million in cash, of which $1.0 million is being held in escrow until the first anniversary of the Creativebug closing, and our CoveritLive business for $4.5 million in cash and a promissory note with a principal amount of $5.6 million. In addition, in February 2015 we sold our Pluck social media business for $3.8 million in cash after working capital adjustments. We may make further acquisitions and dispositions in the future.

Our cash flows from operating activities are significantly affected by our cash-based investments in operations, including working capital, and corporate infrastructure to support our ability to generate revenue and conduct operations. Cash used in investing activities has historically been, and is expected to be, impacted by our ongoing investments in our platforms, company infrastructure and equipment. The following table sets forth our major sources and (uses) of cash for each of the periods presented (in thousands):

 

Cash Flow from Operating Activities

Three months ended March 31, 2015

Net cash used in our operating activities was $2.4 million. Our net loss during the period was $6.7 million, which included non-cash charges of $9.8 million related to depreciation, amortization and stock-based compensation, partially offset by gain on disposals of $2.9 million. The remainder of our uses of net cash flow from operating activities was from changes in our working capital, including changes in accounts payable, accrued expenses and other liabilities, prepaid expenses and other assets and deferred revenue of $5.4 million, offset in part by changes in accounts receivable of $2.9 million. The decrease in accrued expenses, accounts payable and accounts receivable was primarily due to the timing of payments and collections.

Three months ended March 31, 2014

Net cash inflows from our operating activities was $5.7 million. Our net loss during the period was $11.0 million, which included non-cash charges of $25.0 million for depreciation, amortization, deferred income taxes, and stock-based compensation, partially offset by gain on other assets and other of $6.4 million. The remainder of our sources of net cash flow from operating activities was from changes in our working capital, driven by a $9.5 million increase resulting from changes in deferred revenue and accounts receivable, offset by changes in deferred registration costs, accrued expenses and prepaid and other assets, totaling $11.3 million. The increase in our deferred revenue was primarily due to growth in the registrar services offered during the period, while the decrease in our accrued liabilities was primarily due to timing of payments.

Cash Flow from Investing Activities

Three months ended March 31, 2015 and 2014

Net cash provided by investing activities was $2.2 million during the three months ended March 31, 2015, compared to net cash used in investing activities of $0.2 million during the same period in 2014. Cash flows from investing activities for the three months ended March 31, 2015 primarily consisted of cash inflows of $3.8 million from the sale of our Pluck business, partially offset by investments in property and equipment of $1.8 million. Cash flows from investing activities for the three months ended March 31, 2014 primarily included cash used to purchase property and equipment of $2.8 million, investments in intangible assets primarily comprised of media content of $3.3 million, and net payments for generic Top Level Domain (“gTLD”) applications in connection with our former domain name business of $0.4 million, offset by proceeds of $5.1 million from the withdrawals of our interest in certain gTLD

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applications relating to our former domain name business and cash inflows from the sale of marketable securities of $1.4 million. Investments in property and equipment in both periods were primarily comprised of investments in servers, IT equipment and internally developed software.

Cash Flow from Financing Activities

Three months ended March 31, 2015 and 2014

Net cash used in financing activities was $0.3 million and $5.0 million during the three months ended March 31, 2015 and 2014, respectively. Cash used in financing activities for the three months ended March 31, 2014, primarily consists of repayments of $3.8 million under our former credit facility. We also used $0.5 million during the three months ended March 31, 2014 to fund an acquisition holdback related to a prior acquisition. During the three months ended March 31, 2015 and 2014, we paid $0.3 million and $0.8 million, respectively, of costs related to net taxes paid on employee stock options exercises and restricted stock units vesting.

Off Balance Sheet Arrangements

As of March 31, 2015, we did not have any off balance sheet arrangements.

Capital Expenditures

For the three months ended March 31, 2015 and 2014, we used $1.8 million and $2.8 million, respectively, in cash to fund capital expenditures to create internally developed software and purchase property and equipment. The decrease is primarily due to lower internally developed software and lower capital expenditures relating to the registry infrastructure for our former domain name business. We currently anticipate making capital expenditures of between $4.0 million and $8.0 million during the remainder of the year ending December 31, 2015.

Item 3.       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  

We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate, foreign currency exchange, inflation, and concentration of credit risk. To reduce and manage these risks, we assess the financial condition of our large advertising network providers, large direct advertisers and their agencies, and other large customers when we enter into or amend agreements with them and limit credit risk by collecting in advance when possible and setting and adjusting credit limits where we deem appropriate. In addition, our recent investment strategy has been to invest in high credit quality financial instruments, which are highly liquid, readily convertible into cash and mature within three months from the date of purchase.

Foreign Currency Exchange Risk

While relatively small, we have operations and generate revenue from sources outside the United States. We have foreign currency exchange risks related to our revenue being denominated in currencies other than the U.S. dollar, principally in the Euro and British Pound Sterling and a relatively smaller percentage of our expenses being denominated in such currencies. We do not believe movements in the foreign currencies in which we transact will significantly affect future net earnings or losses. Foreign currency exchange risk can be quantified by estimating the change in cash flows resulting from a hypothetical 10% adverse change in foreign exchange rates. We believe such a change would not currently have a material impact on our results of operations. However, as our international operations grow, our risks associated with fluctuation in currency rates will become greater, and we intend to continue to assess our approach to managing this risk.

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Inflation Risk

We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

Concentrations of Credit Risk

As of March 31, 2015, our cash and cash equivalents were maintained primarily with five major U.S. financial institutions and three foreign banks. We also maintained cash balances with two Internet payment processor. Deposits with these institutions at times exceed the federally insured limits, which potentially subject us to concentration of credit risk. Historically, we have not experienced any losses related to these balances and believe that there is minimal risk of expected future losses. However, there can be no assurance that there will not be losses on these deposits.

Components of our consolidated accounts receivable balance comprising more than 10% were as follows:

 

 

Item 4.       CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. In accordance with Rule 13a-15(b) of the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of its disclosure controls and procedures. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures, as of the end of the period covered by this Quarterly Report on Form 10-Q, were effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to our management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION  

Item  1.       LEGAL PROCEEDINGS

On November 5, 2014, Charles Saatchi filed a lawsuit against our wholly owned subsidiary, Saatchi Online, Inc. (“Saatchi Art”), in the High Court of Justice, Chancery Division (United Kingdom) relating to an intellectual property licensing agreement (the “IP Agreement”) between Charles Saatchi and Saatchi Art, dated February 18, 2010. Mr. Saatchi alleges that Saatchi Art committed a repudiatory breach of the IP Agreement, effectively terminating it, and that Saatchi Art must cease using the “Saatchi” name. Mr. Saatchi is seeking a permanent injunction restricting Saatchi Art from continuing to use the “Saatchi” name, a declaration that the IP Agreement has been validly terminated, a

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disgorgement of any profits derived from Saatchi Art’s use of the name since the alleged termination date and unspecified monetary damages. We do not believe that the conduct alleged by Mr. Saatchi constitutes a repudiatory breach of the IP Agreement and intend to vigorously defend the lawsuit. We have filed an Application for Summary Judgment, or Strike Out of Claimant’s Claim, with the High Court of Justice, Chancery Division (United Kingdom). The litigation is in its early stages.

On December 30, 2014, Charles Saatchi and Robert Norton, common stockholders of Saatchi Art prior to its acquisition by Demand Media, filed a lawsuit in the Delaware Chancery Court against the former directors, certain former officers and certain former preferred stockholders of Saatchi Art, and Saatchi Art itself. Messrs. Saatchi and Norton allege that, in connection with Demand Media’s acquisition of Saatchi Art, (i) the former directors and officers named in the lawsuit breached their fiduciary duties to the common stockholders; (ii) certain preferred stockholders of Saatchi Art breached their fiduciary duties to the common stockholders, aided and abetted the former officers’ and directors’ breach of their fiduciary duties and violated a Saatchi Art voting agreement by breaching the implied covenant of good faith and fair dealing; and (iii) Saatchi Art violated the voting agreement by breaching the implied covenant of good faith and fair dealing. The complaint seeks rescissory damages, a constructive trust over the acquisition proceeds, disgorgement of all profits related thereto, and unspecified compensatory damages, costs and fees. We believe that we are entitled to indemnification with respect to any losses incurred by us related to these claims under the terms of the merger agreement, although there can be no assurance that we will be successful in recovering such losses, if any. The litigation is in its early stages.

In addition, from time to time we are a party to various legal matters incidental to the conduct of our businesses. Certain of our outstanding legal matters include speculative claims for indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. Based on our current knowledge, we do not believe that there is a reasonable possibility that the final outcome of the pending or threatened legal proceedings to which we are a party, either individually or in the aggregate, will have a material adverse effect on our future financial results. However, the outcome of such legal matters is subject to significant uncertainties.

Item 1A.RISK FACTORS

There are certain risks and uncertainties in our business that could cause our actual results to differ materially from those anticipated.  A detailed discussion of our risk factors was included in Part I, Item 1A, “Risk Factors” of our 2014 Annual Report, which is available at www.sec.gov and at ir.demandmedia.com.  These risk factors should be read carefully in connection with evaluating our business and in connection with the forward-looking statements and other information contained in this Quarterly Report on Form 10-Q. Any of the risks described in the 2014 Annual Report could materially affect our business, financial condition and/or future results.  The risk factors described in the 2014 Annual Report are not the only risks facing us. Additional risks and uncertainties not currently known to us, or that are currently deemed to be immaterial, could also materially adversely affect our business, financial condition and/or future results. There have been no material changes to the risk factors set forth in the 2014 Annual Report. 

Item  2.       UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS  

Unregistered Sales of Equity Securities

None.

Repurchases of our Common Stock

We did not repurchase any of our common stock during the three months ended March 31, 2015.

Item 3.      DEFAULTS UPON SENIOR SECURITIES  

None.

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Item 4.       MINE SAFETY DISCLOSURES  

Not applicable.

Item 5.       OTHER INFORMATION  

None.

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Item 6.       EXHIBITS  

 

 

 

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SIGNATURES 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

Date: May 7, 2015