UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

ý         QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2004

 

or

 

o         TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                        to                                       

 

Commission file number 1-14355

 

 

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 ý NO o

 

Indicate by check mark whether the registrant is an accelerated filer Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

CLASS		OUTSTANDING AT May 12 , 2004
Common Stock, par value $.01 per share		34,124,045 Shares

 

 

24/7 Real Media, Inc.

March 31, 2004

FORM 10-Q

INDEX

 

Part I.  Financial Information
Item 1.  Consolidated Financial Statements
Consolidated Balance Sheets as of March 31, 2004 (unaudited) and December 31, 2003
Consolidated Statements of Operations for the three months ended March 31, 2004 and  2003 (unaudited)
Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (unaudited)
Notes to Unaudited Interim Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosure about Market Risk
Item 4.  Controls and Procedures
Part II.  Other Information
Item 1.  Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3.  Defaults Upon Senior Securities
Item 4.  Submission of Matters to a Vote of Security Holders
Item 5.  Other Information
Item 6.  Exhibits and Reports on Form 8-K
Signatures

 

 

Open AdStream®, Open AdSystem™, Open Advertiser™, Insight XE™, Insight ACT™ and Insight SE™ are trademarks of 24/7 Real Media, Inc.  All other brand names or trademarks appearing herein are the properties of their respective holders.

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

24/7 REAL MEDIA, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

		March 31,			December 31,
		2004			2003
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	52,829		$	21,645
Accounts receivable, less allowances of $938 and $971, respectively		16,977			11,603
Prepaid expenses and other current assets		1,729			1,669
Total current assets		71,535			34,917
Property and equipment, net		2,889			2,862
Goodwill		18,740			2,621
Intangible assets, net		2,807			3,352
Other assets		7,080			2,428
Total assets		$	103,051		$	46,180
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	11,076		$	6,266
Accrued liabilities		14,451			10,086
Deferred revenue		2,617			2,544
Total current liabilities		28,144			18,896
Subordinated convertible debentures, 2%, due 2006		13,473			13,320
Warrant liability		2,595			3,595
Other long term liabilities		315			332
Total liabilities		44,527			36,143
Commitments and contingencies
Stockholders’ equity:
Preferred stock; $.01 par value; 10,000,000 shares authorized, 713,362 and 828,250 shares issued and outstanding, respectively (liquidation preference of $10 per share)		7			8
Common stock; $.01 par value; 350,000,000 shares authorized; 33,090,299 and 23,367,421 shares issued and outstanding, respectively		331			234
Additional paid-in capital		1,155,535			1,106,984
Deferred stock compensation		(182		)	(257		)
Accumulated other comprehensive income		462			305
Accumulated deficit		(1,097,629		)	(1,097,237		)
Total stockholders’ equity		58,524			10,037
Total liabilities and stockholders’ equity		$	103,051		$	46,180

 

See accompanying notes to unaudited interim consolidated financial statements.

 

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24/7 REAL MEDIA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, expect share and per share data)

 

		Three months ended March 31,
		2004			2003
		(unaudited)			(unaudited)
Revenues:
Integrated media solutions		$	13,039		$	8,343
Technology solutions		4,342			3,481
Total revenues		17,381			11,824
Cost of revenues:
Integrated media solutions		9,441			5,510
Technology solutions		822			1,165
Total cost of revenues		10,263			6,675
Gross profit		7,118			5,149
Operating expenses:
Sales and marketing (exclusive of $24 and $8, respectively, reported below as stock-based compensation)		3,316			3,144
General and administrative (exclusive of $172 and $38, respectively, reported below as stock-based compensation)		2,982			2,922
Product development (exclusive of $3 and $1, respectively, reported below as stock-based compensation)		1,051			588
Amortization of intangible assets and deferred financing costs		788			647
Stock-based compensation		199			47
Total operating expenses		8,336			7,348
Loss from operations		(1,218		)	(2,199		)
Interest expense, net		(182		)	(91		)
Change in fair value of warrant liability		928			—
Other income, net		180			—
Loss before provision for income taxes		(292		)	(2,290		)
Provision for income taxes		100			7
Net loss		(392		)	(2,297		)
Dividends on preferred stock		(118		)	(129		)
Net loss attributable to common stockholders		$	(510	)	$	(2,426	)
Loss per common share - basic and diluted
Net loss		$	(0.02	)	$	(0.18	)
Dividends on preferred stock		(0.00		)	(0.01		)
Net loss attributable to common stockholders		$	(0.02	)	$	(0.19	)
Weighted average shares outstanding		25,618,029			12,894,663

 

See accompanying notes to unaudited interim consolidated financial statements.

 

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24/7 REAL MEDIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		Three months ended March 31,
		2004			2003
		(unaudited)
Cash flows from operating activities:
Net loss		$	(392	)	$	(2,297	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		488			658
Provision for doubtful accounts and sales reserves		175			213
Loss on disposal of fixed assets		—			—
Amortization of intangible assets and deferred financing costs		788			647
Amortization of warrants		153			—
Non-cash compensation		199			47
Accrued interest on notes payable		75			99
Change in fair value of warrant liability		(928		)	—
Changes in operating assets and liabilities, net of effect of acquisitions and dispositions:
Accounts receivable		(478		)	(1,538		)
Prepaid assets and other current assets		(31		)	560
Other assets		(4,553		)	(57		)
Accounts payable and accrued liabilities		3,015			(1,226		)
Deferred revenue		62			334
Net cash used in operating activities		(1,427		)	(2,560		)
Cash flows from investing activities:
Cash paid for acquisitions, net		(1,574		)	(150		)
Capital expenditures, including capitalized software		(345		)	(325		)
Cash paid for investment		—			(50		)
Net cash used in investing activities		(1,919		)	(525		)
Cash flows from financing activities:
Proceeds from issuance of common stock		33,840			—
Proceeds from exercise of stock options and conversion of warrants		545			42
Payment of capital lease obligations		(12		)	(12		)
Net cash provided by financing activities		34,373			30
Net change in cash and cash equivalents		31,027			(3,055		)
Effect of foreign currency on cash		157			(44		)
Cash and cash equivalents at beginning of year		21,645			7,674
Cash and cash equivalents at end of period		$	52,829		$	4,575

 

See accompanying notes to unaudited interim consolidated financial statements.

 

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(1)  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

 

Nature of Operations

 

24/7 Real Media, Inc. (the “Company”) together with its subsidiaries offers a suite of media and technology products for the online advertising needs of Web publishers and advertisers, including Web representation, advertisement serving, analytics and search marketing services.

 

The Company has organized its business in two principal segments: Integrated Media Solutions and Technology Solutions.

 

Integrated Media Solutions consist of the 24/7 Web Alliance, a global alliance of Web sites represented by the Company through which advertisers can place campaign orders directly with the Company, and 24/7 Search, an Internet search marketing service designed to connect advertisers with consumers using search engines to find product information.

 

Technology Solutions are primarily based on the Company’s patent-protected Open AdSystem technology platform for Internet advertisement delivery, management and analytics, and consist of: Open AdStream Local, which the Company licenses to Web publishers to run on their proprietary, local servers; Open AdStream Central, which the Company provides to Web publishers from software hosted centrally on the Company’s servers; Open Advertiser, which the Company provides to advertisers and advertising agencies from software hosted centrally on the Company’s servers; and the Company’s Insight software solutions, which integrate with Open AdStream to offer Web publishers active campaign reporting and marketing intelligence and help advertisers measure, analyze, manage and monetize audiences.

 

Organization and Basis of Presentation

 

(a)  Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of the Company and its majority-owned and controlled subsidiaries from their respective dates of acquisition.  All significant intercompany transactions and balances have been eliminated.

 

The accompanying interim consolidated financial statements are unaudited.  In the Company’s opinion, the unaudited consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the financial position and the results of the operations and cash flows of the Company for the interim periods presented.  The financial statements, financial data and other information disclosed in these notes to the consolidated results are not necessarily indicative of the results expected for the full fiscal year or any future period.

 

The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2003.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations.

 

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(b)  Use of Estimates

 

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, accruals, allowance for doubtful accounts, fair value of acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, among others.  The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

 

(c)  Cash and Cash Equivalents

 

The Company considers all highly liquid securities, with original maturities of three months or less, to be cash equivalents.  Cash and cash equivalents consisted principally of money market accounts.

 

(d)  Concentration of Credit Risk and Significant Customers

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash equivalents and accounts receivable.  Cash equivalents consist of money market funds, which, at times, exceed federally insured limits.  Accounts receivable are typically unsecured and are derived from revenues earned from customers primarily located in the United States, Europe and Korea.  Many of those customers are in the Internet industry.  To appropriately manage credit risk, the Company performs ongoing evaluations of customer credit and limits the amount of credit extended, but generally no collateral is required.  The Company maintains reserves for estimated credit losses and these losses have generally been within management’s expectations.

 

No single customer accounted for greater than 10% of net revenues for the three months ended March 31, 2004 and 2003.

 

(e)  Accounts Receivable

 

Accounts receivable are recorded at the invoiced amount and are non-interest bearing.  The Company maintains an allowance for doubtful accounts to reserve for potentially uncollectible receivables.  Management reviews the accounts receivable by aging category to identify specific customers with known disputes or collectibility issues.  In determining the amount of the reserve, management makes judgments about the creditworthiness of significant customers based on ongoing credit evaluations.  The Company also maintains a sales allowance to reserve for potential credits issued to customers.  The amount of the reserve is determined based on historical credits issued.

 

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(f)  Unbilled Receivables

 

At March 31, 2004 and December 31, 2003, accounts receivable included approximately $6.4 million and $4.4 million, respectively, of earned but unbilled receivables, which are a normal part of the Company’s business, as receivables are usually invoiced in the month following the completion of the earning process.  All unbilled receivables have been subsequently billed.

 

(h)  Capitalized Software; Product Development Costs

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, Accounting for the Costs of Computer Software To Be Sold, Leased, or Otherwise Marketed, the Company requires certain product development costs to be capitalized when a product’s technological feasibility has been established by completion of a working model of the product and ending when a product is available for general release to customers.  Generally, the completion of the working model coincides with general release.  The Company capitalized approximately $1.2 million in connection with the development of its Open Advertiser advertisement serving software product, which is included in property and equipment, net on the consolidated balance sheet.  The product was released in June 2003 and is being amortized using the straight-line method over the estimated useful life of the software, or four years.  Amortization for the three month period ended March 31, 2004 was $0.1 million and accumulated amortization as of March 31, 2004 was $0.2 million.

 

(i)  Revenue Recognition; Cost of Revenues

 

Integrated Media Solutions

 

24/7 Web Alliance revenues are generated by delivering advertising impressions for a fixed fee to third-party Web sites.  24/7 Search revenues are derived from driving valid visitors to client Web sites. E-mail related revenues are derived from delivering advertisements to e-mail lists for advertisers and Web sites.  Agreements are primarily short term and revenues are recognized as services are delivered provided that no significant Company obligations remain outstanding and collection of the resulting receivable is probable.

 

The Company becomes obligated to make payments to third-party Web sites, search engine distribution partners and e-mail lists which have contracted with the Company to be part of the 24/7 Network, in the period the advertising impressions, valid visitors or e-mails are delivered. Such expenses are classified as cost of revenue in the accompanying consolidated statements of operations.

 

7

 

Technology Solutions

 

Technology Solutions revenues are derived primarily from licensing of our software, hosted advertisement serving, and software maintenance and technical support services.  Revenue from software licensing agreements is recognized in accordance with Statements of Position (“SOP”) No. 97-2, Software Revenue Recognition, and Staff Accounting Board (“SAB”) No. 104, Revenue Recognition, upon delivery of the software, which is generally when the software is made available for download, there is persuasive evidence of an arrangement, collection is reasonably assured, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fees to all elements of the arrangement.  Contracts that bundle the software license with maintenance and technical support are recognized ratably over the contract term.  Revenue from advertisement serving is recognized upon delivery.  Revenue from software maintenance and technical support contracts is recognized ratably over the life of the agreement, which typically does not exceed one year.

 

Expenses from the Company’s licensing, software maintenance, technical support and advertisement serving revenues are primarily payroll costs incurred to deliver and support the software.  These expenses are classified as cost of revenues in the accompanying consolidated statements of operations.

 

Deferred Revenue

 

Revenues that are billed in advance of services being completed are deferred until the conclusion of the period of the service for which the advance billing relates.  Deferred revenues are included on the consolidated balance sheet as a current liability until the service is performed and then recognized in the period in which the service is completed.  The Company’s deferred revenues primarily consist of billings in advance for software license subscriptions and software maintenance and technical support services. Deferred revenues at March 31, 2004 and December 31, 2003 were approximately $2.6 million and $2.5 million, respectively.

 

(j)  Warrant Liability

 

In September 2000, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 00-19 (“EITF 00-19”), Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, which requires freestanding contracts that are settled in a Company’s own stock, including common stock warrants, to be designated as an equity instrument, asset or liability.  Under the provisions of EITF 00-19, a contract designated as an asset or liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the consolidated statement of operations.  A contract designated as an equity instrument must be included within equity, and no fair value adjustments are required.  The classification of a contract should be reviewed at each balance sheet date.

 

In connection with the placement of the Company’s preferred stock and subordinated convertible debentures, the Company issued warrants to investors to purchase shares of the Company’s common stock.  The Company agreed to register the shares issuable upon exercise of the warrants and to pay penalties for a delayed filing or a failure to file a registration statement prior to the agreed deadline.  The Company also agreed to pay penalties if the registration statement becomes temporarily or permanently unavailable for use by the warrant holders.  Accordingly, pursuant to EITF 00-19, the Company reflected the value of the warrants as a warrant liability on the consolidated balance sheet and the liability will be reclassified to equity upon exercise or conversion.  The fair value of the outstanding warrants is evaluated at each reporting period with any resulting change in the fair value being reflected in the consolidated statement of operations.  As a result of such evaluation, the Company decreased the warrant liability at March 31, 2004 by

 

8

 

$0.9 million on the consolidated balance sheet and recorded a change in fair value of warrant liability on the consolidated statement of operations.

 

(k)  Stock-Based Compensation

 

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and Financial Accounting Standards Board (“FASB”) interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation – an interpretation of APB Opinion No. 25, and complies with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure.  Under APB No. 25, compensation cost is recognized based on the difference, if any, on the date of grant between the fair value of the Company’s common stock and the amount an employee must pay to acquire the common stock.  SFAS No. 148 requires more prominent and more frequent disclosures in both interim and annual financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results.  We adopted the disclosure provisions of SFAS No. 148 as of December 31, 2002 and continue to apply the measurement provisions of APB No. 25.

 

Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net loss would have been increased to the pro forma amounts indicated below:

 

		For the Three Months Ended March 31,
		2004			2003
		(in thousands, except per share amounts)
Net loss:
As reported		$	(392	)	$	(2,297	)
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax effect		1,768			2,210
Pro forma		$	(2,160	)	$	(4,507	)
Net loss attributable to common stockholders per share:
As reported		$	(0.02	)	$	(0.19	)
Pro forma		(0.09		)	(0.36		)

 

The per share weighted-average fair value of stock options granted for the three months ended March 31, 2004 and 2003 is $4.63 and $0.85, respectively, on the date of grant using the Black-Scholes method with the following weighted-average assumptions:

 

		2004		2003
Expected dividend yield		0	%	0	%
Risk-free interest rate		2.23	%	2.47	%
Expected life (in years)		2.5		4.0
Volatility		131	%	103	%

 

The Company accounts for non-employee stock-based awards in which goods or services are the consideration received for the equity instruments issued based on the fair value of the equity instruments issued in accordance with the EITF No. 96-18, Accounting For Equity Instruments

 

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That Are Issued To Other Than Employees For Acquiring, or in Conjunction With Selling Goods or Services.

 

(l)  Preferred Stock

 

		Shares		Price Per			Conversion			Shares Ouststanding at
Series		Authorized		Share			Rate			March 31, 2004		December 31, 2003
A		800,000		$	10.00		$	1.02675		635,362		750,000
C		718,250		10.00			1.20790			78,000		78,250
										713,362		828,250

 

During the first quarter of 2004, 114,638 shares of Series A and 250 shares of Series C Preferred Stock were converted into 1,116,513 and 2,070 shares of common stock, respectively.  The preferred stock accrues and cumulates dividends at a rate of 6% per year, compounded monthly, payable when, as and if declared by the Company’s Board of Directors.  All accrued dividends must be paid before any dividends may be declared or paid on the common stock, and shall be paid as an increase in the liquidation preference payable upon the sale, merger, liquidation, dissolution or winding up of the Company.  Accrued but unpaid dividends are cancelled upon conversion.  At March 31, 2004, there are approximately $0.6 million of accrued but unpaid dividends.

 

In the event of a liquidation, dissolution or winding up of the Company, the holders of the preferred stock are entitled to a liquidation preference payment per share equal to the purchase price, plus any dividends accrued but unpaid as of such date before any payment to holders of common stock.  After payment of the foregoing preference, the holders of each share of preferred stock would then participate pro rata with the holders of the common stock, on an as converted basis, in the distribution of the proceeds from such a liquidation event to the holders of the common stock until such time as the holders of preferred stock shall have received an amount equal to three times the purchase price (inclusive of their liquidation preference).  A merger, consolidation or sale of the Company will be treated as a liquidation event unless such transaction has been approved by the holders of a majority of the outstanding preferred stock.

 

(m)  Comprehensive Loss

 

Total comprehensive loss for the three months ended March 31, 2004 and 2003 was $(0.2) million and $(2.3) million, respectively.  Comprehensive loss resulted from net losses of $(0.4) million and $(2.3) million, and in 2004 foreign currency translation adjustment of $0.2 million.

 

(n)  Loss Per Share

 

Loss per share is presented in accordance with the provisions of SFAS No. 128, Earnings Per Share (“EPS”).  Basic EPS excludes dilution for potentially dilutive securities and is computed by dividing loss available to common shareholders by the weighted average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock and resulted in the issuance of common stock.  Diluted net loss per share is equal to basic net loss per share since all potentially dilutive securities are anti-dilutive for each of the periods presented.  Diluted net loss per common share for the three months ended March 31, 2004 and 2003 does not include the effects of options to purchase 4.9 million and 3.9 million shares of

 

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common stock, respectively; 0.6 million and 1.1 million common stock warrants, respectively; 1.7 million shares of common stock in 2004 related to subordinated convertible debentures, on an “as if” converted basis; and 6.8 million and 8.0 million shares of preferred stock, respectively, on an “as if” converted basis, as the effect of their inclusion is anti-dilutive during each period.

 

(o)  Reclassifications

 

Certain reclassifications have been made to prior year consolidated financial statements to conform to current year’s presentation.

 

(2)  ACQUISITIONS AND UNAUDITED PRO FORMA SUMMARY

 

(a)  Acquisition of Real Media Korea Co., Ltd (“RMK”)

 

On January 6, 2004, the Company completed the acquisition of Real Media Korea Co., Ltd., by acquiring the approximately 90.4% of the outstanding shares of RMK that the Company did not already own.  The Company paid total consideration of $20.1 million in exchange for the RMK shares, which consisted of $5.0 million in cash, approximately 2.1 million shares of the Company’s common stock valued at $14.6 million and approximately $0.5 million in transaction costs. Approximately 0.9% of the outstanding shares of RMK are held in an employee stock union established under Korean law. The employee shareholders agreed to transfer their RMK shares to the Company upon vesting in accordance with the terms and conditions of the stock union and Korean law.  For accounting purposes the effective date of the acquisition is January 1, 2004.

 

The purchase price in excess of fair value of net tangible assets and liabilities acquired of $16.1 million has been preliminarily allocated to goodwill.  The Company is in the process of obtaining an external valuation.  The acquisition was accounted for as a purchase business combination in accordance with SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets.

 

The net tangible assets acquired consist of the following:

 

 

(b)  Acquisition of Insight First, Inc.

 

On January 21, 2003, the Company acquired certain assets of Insight First, Inc., including specific contracts, intangibles and employee relationships, related to Insight First’s Web analytics solutions, including the intellectual property relating to specific products, in exchange for approximately 0.7 million shares of the Company’s common stock valued at approximately $1.1 million, plus $150,000 in cash.  In addition, the Company has a contingent obligation to pay additional earn-out consideration of up to $1.0 million, in either cash or common stock, at the Company’s discretion, subject to achievement of earn-out targets relating to revenue generated by the acquired business in fiscal year 2004.

 

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The purchase price in excess of fair value of net tangible assets and liabilities acquired of $1.3 million has been allocated to acquired technology.  The acquired technology is being amortized over the expected benefit period of four years.  The acquisition was accounted for as a purchase business combination in accordance with SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets.

 

The net tangible assets acquired consist of the following:

 

 

(c)  Unaudited Pro Forma Summary

 

The following pro forma consolidated amounts give effect to the Company’s RMK and Insight First acquisition accounted for by the purchase method of accounting as if they had occurred at the beginning of the period by consolidating the results of operations of the acquired entities for the three months ended March 31, 2004 and 2003.

 

The pro forma consolidated statements of operations are not necessarily indicative of the operating results that would have been achieved had the transactions been in effect as of the beginning of the periods presented and should not be construed as being representative of future operating results.

 

		Three Months Ended March 31,
		2004			2003
		(in thousands, except per share data)
Total revenues		$	17,381		$	14,262
Net loss		(392		)	(2,338		)
Loss per share		$	(0.02	)	$	(0.15	)
Weighted average shares used in net loss per share calculation (1)		25,758,232			15,185,635

 

(1)  The weighted average shares used to compute pro forma basic and diluted net loss per share for the three months ended March 31, 2004 and 2003 includes the 2.1 million and 0.7 million shares of common stock issued for RMK and Insight First, respectively, as if the shares were issued on January 1, 2003.

 

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(3)  DISPOSAL OF NON-CORE ASSETS

 

Sale of iPromotions, Inc.

 

On January 31, 2003, the Company entered into an Asset Purchase Agreement with iPromotions, Inc., a corporation formed by private investors including some of the Company’s former employees.  Pursuant to the terms of the Asset Purchase Agreement, the Company sold to the investors, specific contracts, equipment, intangibles, and employee relationships related to our iPromotions business, including the intellectual property relating to specific products.  The Company also invested $50,000 in cash in exchange for shares of preferred stock representing a 19.9% interest in iPromotions, Inc. on a converted basis.  Accordingly, the Company effectively sold a majority stake in its iPromotions business.  Prior to the sale, the carrying value of iPromotions was $0, therefore, there was no gain or loss on the transaction.  The cash payment was recorded as an investment.

 

(4)  GOODWILL AND INTANGIBLE ASSETS, NET

 

Pursuant to SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, the Company recorded goodwill and intangible assets when the fair value of the net tangible assets acquired was less than the purchase price of the asset or business acquired.  Effective January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.  SFAS No. 142 eliminates the amortization of goodwill and indefinite-lived intangible assets, addresses the amortization of goodwill and intangible assets with finite lives and addresses the impairment testing and recognition for goodwill and intangible assets.  SFAS No. 144 establishes a single model for the impairment of long-lived assets.

 

On an ongoing basis, management reviews that value and period of amortization of goodwill and intangible assets.  No event occurred or circumstances changed during the first quarter of 2004 that would have, more likely than not, reduced the fair value of goodwill and intangible assets below the amounts reflected in the consolidated balance sheet and accordingly, no impairment charge was recorded for the three month period ended March 31, 2004.

 

(a)  Goodwill

 

The $18.7 million in goodwill at March 31, 2004 relates $16.1 million to RMK, $1.1 million to 24/7 Canada, $1.1 million to Real Media and $0.4 million to 24/7 Search.  The $2.6 million in goodwill at December 31, 2003 relates $1.1 million to 24/7 Canada, $1.1 million to Real Media and $0.4 million to 24/7 Search.

 

(b)  Intangible Assets, Net

 

The $2.8 million in intangible assets, net at March 31, 2004 relates $1.6 million to Real Media, $0.9 million to Insight First and $0.3 million to 24/7 Search.  The $3.4 million in intangible assets, net at December 31, 2003 relates $1.8 million to Real Media, $1.0 million to Insight First and $0.6 million to 24/7 Search.

 

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		March 31,			December 31,			Estimated
		2004			2003			Useful Lives
		(in thousands)
Goodwill (1)		$	18,740		$	2,621
Technology		$	7,263		$	7,263		4
Less accumulated amortization		(4,655		)	(4,142		)
Net Technology		2,608			3,121
Trademark		500			500			4
Less accumulated amortization		(301		)	(269		)
Net Other intangible assets		199			231
Gross Intangible assets		7,763			7,763
Less accumulated amortization		(4,956		)	(4,411		)
Net Intangible assets		$	2,807		$	3,352

 

(1) Goodwill increased $16.1 million due to the acquisition of RMK.

 

(5)  RESTRUCTURING

 

The following sets forth the activities in the Company’s restructuring reserve for the three month period ended March 31, 2004, which is included in accrued liabilities in the consolidated balance sheet (in thousands):

 

		Beginning Balance			Current Year Utilization			Ending Balance
Employee termination benefits		$	470		$	(438	)	$	32
Office closing costs		1,165			(170		)	995
Other exit costs		28			(28		)	—
		$	1,663		$	(636	)	$	1,027

 

(6)  RELATED PARTY TRANSACTIONS

 

The Company had issued three Promissory Notes to PubliGroupe, a significant shareholder, totaling $7.5 million.  Mr. Wuttke, a member of the Company’s board of directors, is an officer of PubliGroupe SA, the parent company of PubliGroupe.  One note for $4.5 million had an interest rate of 4.5% with principal and interest due in October 30, 2006.  Two notes for $1.5 million each had an interest rate of 6% with principal and interest due in January 2005 and May 2005.  On May 23, 2003, PubliGroupe surrendered for cancellation the three Promissory Notes plus accrued interest of approximately $0.5 million in exchange for a cash payment of $1.5 million and approximately 1.0 million shares of the Company’s common stock, valued at $1.8 million.

 

Interest expense related to these notes for the three month period ended March 31, 2003 was approximately $0.1 million.

 

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(7)  2% SUBORDINATED CONVERTIBLE DEBENTURES

 

On September 26, 2003, the Company completed the placement to an institutional accredited investor of $15.0 million of subordinated convertible debentures due September 2006 (“Debentures”).  The Debentures are convertible into shares of the Company’s common stock at $8.75 per share.  Interest on the Debentures at the rate of 2% is due semi-annually starting in January 2004.  The investor also acquired a five-year warrant (the “Warrants”) to purchase 0.4 million shares of the Company’s common stock at $9.5685 per share.

 

The maturity date of the Debentures is subject to extension, and the conversion price is subject to adjustment, on the terms and conditions set forth in the Debentures.  In addition, the Company may elect to pay the principal of and interest on the Debentures in shares of its common stock rather than cash.  If the Company elects to pay the principal amount due under the Debentures at maturity in shares of its common stock, rather than in cash, the maturity date conversion price will be equal to 90% of the average of the daily volume-weighted average prices of the Company’s common stock on the Nasdaq SmallCap Market for the fifteen consecutive trading days immediately preceding the maturity date.  If the Company elects to make interest payments due under the Debentures in shares of its common stock, rather than in cash, the interest conversion price will be equal to 90% of the average of the daily volume-weighted average prices of the Company’s common stock on the Nasdaq SmallCap Market for the five consecutive trading days immediately preceding the interest payment date.

 

Additionally, if the specific conditions set forth in the Debentures are satisfied, the Company may require the holder to convert the Debentures into shares of the Company’s common stock, at the conversion rate then in effect, or the Company may prepay the Debentures prior to the maturity date, for an amount in cash equal to 150% of the amount prepaid.  In addition, if at any time on or after the second anniversary of the initial issuance date, the weighted average price of the common stock is less than $8.75 on any five consecutive trading days after such second anniversary, the holder shall have the right, in its sole discretion, to require that the Company redeem up to $7.5 million principal amount of this Debentures.  The redemption right constitutes an embedded derivative.  The value of this embedded derivative at March 31, 2004 is immaterial to the financial position of the Company.  The Company will continue to review the value of the derivative on a quarterly basis, in accordance with SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.

 

The Company valued the Warrants at $1.8 million using a Black-Scholes pricing model with the following factors: risk free interest rate of 1.48%, volatility of 143%, dividend yield of 0% and a life of 2.5 years.  The aggregate fair market value of the Warrants was reflected as a reduction of the face amount of the Debentures on the consolidated balance sheet and is being amortized over three years, the initial term of the Debentures, using the effective interest method.  Accordingly, the carrying value of the Debentures will be increased over the initial term.

 

In connection with the issuance of the Debentures and Warrants, the Company incurred placement agent fees, legal fees and other expenses of approximately $1.2 million to be paid in cash.  In addition to the placement fees, the Company issued warrants to the placement agent.  The warrants to purchase 86,000 shares of common stock at an exercise price of $10.068 are in the same form and on the same terms and conditions as the Warrants issued to the investor.  The Company included the value of the warrants, $0.4 million, using the factors above, and the cash placement fees of $1.2 million in other assets on the consolidated balance sheet.  Collectively, the debt issuance costs of $1.6 million are being amortized over three years, the initial term of the Debentures.  In 2004, approximately $0.1 million of these costs are included in amortization

 

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expense and at March 31, 2004, the unamortized portion of the debt issuance costs is $1.3 million.

 

(8)  EQUITY INSTRUMENTS

 

PREFERRED STOCK

 

During the quarter, 114,638 shares of Series A and 250 shares of Series C Preferred Stock were converted into 1,116,513 and 2,070 shares of common stock, respectively.

 

COMMON STOCK

 

(a)  Secondary Stock Offering

 

On March 30, 2004, the Company completed a secondary stock offering in which a total of 8.0 million shares of common stock were sold at $6.00 per share.  Of the shares sold, the Company sold 6.0 million shares and selling stockholders sold 2.0 million shares.  The Company and the selling stockholders received proceeds net of underwriting discounts and commission, and before other offering expenses, of $33.8 million and $11.3 million, respectively.  Other offering expenses estimated at approximately $1.0 million were accrued at March 31, 2004.  The Company will pay all offering expenses (including the offering expenses of the selling stockholders).

 

In connection with this offering, the Company and selling stockholders granted to the underwriters an option to purchase up to an additional 1.2 millions shares of common stock at $6.00 per share less underwriter discounts and commissions for the purpose of covering over-allotments.  Of the additional shares offered, approximately 0.8 million shares and 0.4 million shares were offered by the Company and by the selling stockholders, respectively (see note 13).

 

(b)  Reverse Stock Split

 

On February 27, 2004, the Company completed a one-for-five reverse split of its common stock. As a result of the reverse split, every five shares of the Company’s common stock were combined into one share of common stock. The reverse split does not affect the number of shares of preferred stock and warrants outstanding, however, the conversion ratio is adjusted.  All figures relating to common stock, preferred stock, stock options, warrants and other equity-linked instruments have been adjusted in this Form 10-Q to reflect the reverse stock split.

 

(c)  Other Issuances

 

On January 6, 2004, the Company issued approximately 2.1 million shares, valued at $14.6 million, in connection with the acquisition of RMK.

 

On March 17, 2003, the Company issued approximately 0.3 million shares, valued at $0.3 million, to employees in lieu of cash for achieving contractual performance-based 2002 targets bonuses.  The bonuses were accrued at December 31, 2002.

 

On January 21, 2003, the Company issued approximately 0.7 million shares, valued at $1.1 million, in connection with the acquisition of Insight First.

 

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(d)  Additional Paid-in Capital

 

During the three month period ended March 31, 2004, the Company’s additional paid-in capital increased by $48.6 million primarily due to $32.8 million in connection with the Company’s secondary offering of common stock, $14.6 million in connection with the acquisition of RMK, $0.6 million in other stock-based compensation issued to employees and $0.6 million from exercise of stock options and warrants.

 

(9)  STOCK INCENTIVE PLANS

 

For the three month period ended March 31, 2004, the Company granted 1.8 million stock options under the 2002 Stock Incentive Plan to employees at exercise prices based on the fair market value of the Company’s common stock at the respective dates of grant.

 

On January 1, 2004, in accordance with the terms of the 2002 Stock Incentive Plan, shares reserved for issuance under the Plan were increased by 0.6 million.

 

(10)  SUPPLEMENTAL CASH FLOW INFORMATION

 

Cash Paid for Interest

 

For the three months ended March 31, 2004 and 2003, the amount of cash paid for interest was $81,000 and $3,000, respectively.

 

(11)  SEGMENTS

 

The Company’s business is comprised of two reportable segments:  Integrated Media Solutions and Technology Solutions.  The Integrated Media Solutions segment generates the majority of its revenues by delivering advertisements and promotions to affiliated Web sites and search engine traffic delivery and marketing services.  The Technology Solutions segment generates revenue by providing third-party advertisement serving and other technology services.  The Company’s management periodically reviews corporate assets and overhead expenses for each segment.  The summarized segment information as of and for the three months ended March 31, 2004 and 2003, is as follows:

 

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		Three months ended March 31, 2004
		Integrated
		Media			Technology
		Solutions			Solutions			Corporate			Total
		(in thousands)
Revenues		$	13,039		$	4,342		$	—		$	17,381
Depreciation		247			224			17			488
Amortization of intangible assets and deferred financing costs		327			329			132			788
Stock-based compensation		28			—			171			199
Segment income (loss) from operations		(165		)	739			(1,792		)	(1,218		)
Interest income (expense), net		23			—			(205		)	(182		)
Other income (expense), net		(9		)	—			189			180
Income tax expense		(100		)	—			—			(100		)
Segment income (loss)		(251		)	739			(880		)	(392		)

 

		Three months ended March 31, 2003
		Integrated
		Media			Technology
		Solutions			Solutions			Corporate			Total
		(in thousands)
Revenues		$	8,343		$	3,481		$	—		$	11,824
Depreciation		434			193			31			658
Amortization of intangible assets and deferred financing costs		333			314			—			647
Stock-based compensation		20			—			27			47
Segment loss from operations		(492		)	(42		)	(1,665		)	(2,199		)
Interest income (expense), net		1			—			(92		)	(91		)
Income tax expense		(7		)	—			—			(7		)
Segment loss		(497		)	(42		)	(1,758		)	(2,297		)
Total assets:
March 31, 2004		36,159			10,473			56,419			103,051
December 31, 2003		10,381			11,173			24,626			46,180
		US			International			Total
		(in thousands)
Three months ended March 31, 2004
Revenues		$	8,423		$	8,958		$	17,381
Long-lived assets		13,027			18,489			31,516
Three months ended March 31, 2003
Revenues		$	7,440		$	4,384		$	11,824
Long-lived assets at December 31, 2003		9,548			1,715			11,263

 

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(12)  COMMITMENTS AND CONTINGENCIES

 

COMMITMENTS

 

Lycos, Inc. Services Agreements

 

On February 11, 2004, the Company entered into a five-year arrangement with Lycos, Inc. (“Lycos”) to provide media sales, advertisement serving and analytics technology services to Lycos’ U.S. Web properties and to transition personnel and other services from Lycos to the Company.

 

The agreement requires the Company to pay Lycos the greater of 65% of all net advertising sales revenue generated by the Company in respect of Lycos’ U.S. Web properties, or specified minimum required annual payments.  For 2004, the minimum annual payment is $10.0 million and is payable $2.5 million 45 days after each quarter end.  To the extent that Lycos’ 65% revenue share exceeds the quarterly amount of the minimum annual payment, the Company may credit such excess against the next succeeding quarterly payment of the minimum annual payment.  Management believes that the minimums will be met, resulting in no additional expense for the quarter.

 

The Company also will pay Lycos a transition payment of  $4.5 million in equal installments at each quarter end in 2004.  The amount was recorded as an other long-term asset and a current liability.  The asset will be amortized over the term of the agreement or five years.

 

Indemnifications

 

While the Company has various indemnification obligations included in contracts in the normal course of business, these indemnities do not represent significant commitments or contingent liabilities of the indebtedness of others.  Accordingly, the Company has not recorded a liability related to indemnification provisions.

 

LITIGATION

 

aQuantive, Inc. (formerly Avenue A, Inc.)

 

On April 19, 2002, aQuantive, Inc. (formerly Avenue A, Inc.) filed a complaint against the Company seeking a declaratory judgment that U.S. Patent No. 6,206,368 is invalid and not infringed by aQuantive. The complaint also seeks injunctive relief and recovery of attorney’s fees. On May 10, 2002, the Company filed its answer to the complaint, in which the Company denied the material allegations of the complaint and asserted a counterclaim for infringement of the ‘368 patent. On January 2, 2003, aQuantive filed a motion for summary judgment of non-infringement, to which the Company filed papers in opposition on April 28, 2003. On July 3, 2003, the U.S. Federal Court for the Western District of Washington granted partial summary judgment to aQuantive, Inc. and held that, based on the court’s construction of the patent’s claims, aQuantive’s Atlas DMT advertisement serving system does not infringe the ‘368 patent. The Company appealed the court’s ruling to the Court of Appeals for the Federal Circuit and agreed with aQuantive to dismiss the remaining claims in the case to expedite the appeal.  In March 2004, the Federal Circuit Court of Appeals affirmed, without opinion, the decision of the U.S. Federal Court for the Western District of Washington.  The Company filed a request for rehearing before the Federal Court of Appeals which has been denied on May 7, 2004.

 

Brian Anderson

 

On July 5, 2001, Brian Anderson, former Chief Executive of our AwardTrack, Inc. subsidiary, served the Company with notice of a lawsuit filed in Superior Court for the State of California in and for the County of Santa Cruz, alleging breach of contract, fraud,

 

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intentional infliction of emotional distress and breach of fiduciary duty, in connection with the acquisition of AwardTrack and subsequent events. The Company removed the lawsuit to federal court in California and moved to dismiss the complaint in its entirety. The motion was granted in part, with leave to amend, and denied in part. The plaintiff has subsequently refiled the complaint and the Company filed a counterclaim. Discovery has concluded, and the Company has moved for summary judgment to dismiss the complaint in its entirety.

 

chinadotcom Corporation

 

On February 19, 2003, the Company filed a complaint in federal court against chinadotcom Corporation for breach of contract, unjust enrichment, breach of duty of good faith and fair dealing, and promissory estoppel arising out of a certain equity exchange agreement dated August 16, 2000 between chinadotcom and the Company, seeking to enforce the Company’s right to exchange its stake in 24/7 Media-Asia Ltd. for 1.8 million shares of chinadotcom. chinadotcom filed a motion seeking to compel arbitration of the matter, which the court granted on May 12, 2003.

 

On April 29, 2003, chinadotcom filed an action in court in Hong Kong against David Moore, our Chief Executive Officer, alleging, among other things, breach of fiduciary duty by Mr. Moore in connection with his service as a director of chinadotcom and its subsidiary, 24/7 Media-Asia Ltd. On November 24, 2003, the Hong Kong Court dismissed chinadotcom’s complaint against Mr. Moore in its entirety, and Mr. Moore has requested chinadotcom to reimburse him for all of his legal expenses. chinadotcom has appealed the dismissal of its claim and that appeal is pending.  The Company has assumed Mr. Moore’s defense and will indemnify him in the event of any liability.  The Company believes that the claims against Mr. Moore are without merit and that the action was brought solely in retaliation against the Company for asserting its rights in the matter discussed above.

 

On July 22, 2003, chinadotcom filed an arbitration claim with the International Court of Commerce asserting certain alleged breaches of contract in connection with the Media Asia Agreement entered into between the parties as of June 30, 2000.  The claim seeks damages totaling $24.0 million.  The Company believes that chinadotcom’s claims are without merit. The Company has filed an Answer and Counterclaim in the matter and intends to defend itself vigorously against these claims.

 

General

 

The Company is involved in various claims and legal actions arising in the ordinary course of business.  In the opinion of management, the ultimate disposition of these matters will not have a material effect on the Company’s financial position, results of operations or liquidity.

 

(13)           SUBSEQUENT EVENTS

 

Offering of Common Stock – Exercise of Underwriters’ Over-Allotment Option

 

In April 2004, the underwriters exercised the option to purchase an additional 1.2 million shares of our common stock for the purpose of covering over-allotments.  The Company and selling stockholders received additional proceeds of $4.3 million and $2.3 million, respectively, net of underwriting discounts and commissions and before other offering expenses.

 

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

 

This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report are forward looking. We use words such as “anticipates,” “believes,” “expects,” “future” and “intends” and similar expressions to identify forward-looking statements. Forward-looking statements reflect management’s current expectations, plans or projections and are inherently uncertain. Our actual results may differ significantly from management’s expectations, plans or projections. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Certain risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are described in the section entitled “Risk Factors” and elsewhere in this Quarterly Report. We undertake no obligation to publicly release any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Readers are urged, however, to review the risk factors set forth in reports that we file from time to time with the Securities and Exchange Commission. Unless the context requires otherwise in this Quarterly Report the terms “24/7 Real Media,” the “Company,” “we,” “us” and “our” refer to 24/7 Real Media, Inc. and its subsidiaries, and references to “24/7 Search” refer to 24/7 Search, Inc., formerly 24/7 Website Results, Inc., a wholly owned subsidiary of 24/7 Real Media, Inc.

 

GENERAL

 

We offer a comprehensive suite of media and technology products for the online advertising needs of Web publishers and advertisers, including Web representation, advertisement serving, analytics and search services. Our 24/7 Web Alliance of over 800 affiliated Web sites aggregates advertising inventory online and targets audience segments to attract advertisers worldwide. Our Open AdSystem technology helps Web publishers and advertisers target, convert and retain online customers, maintain customer relationships and safeguard the privacy of Web users. Through 24/7 Search, we connect advertisers with consumers who use search engines to find information about products and services.

 

We generate revenue in two business segments:  Integrated Media Solutions and Technology Solutions.

 

Integrated Media Solutions

 

Our Integrated Media Solutions consist of the 24/7 Web Alliance, a global alliance of Web sites represented by us through which advertisers can run campaign orders directly with us, 24/7 Search, an Internet search marketing service designed to connect advertisers with consumers using search engines to find product information, and Other Media Services. Our 24/7 Search solution uses proprietary technology to help advertisers determine the keywords most relevant to their products and services in order to lead users from search engines to the advertisers’ Web sites.

 

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We generate revenue through the 24/7 Web Alliance from fees paid by client advertisers. We typically offer advertisers a pricing model based on cost-per-thousand-impressions (“CPM”) enabling a client advertiser to pay a fee based on the number of times its advertisement is viewed.

 

We share the revenue generated through the 24/7 Web Alliance with Web publishers included in the 24/7 Web Alliance. With respect to our 24/7 Network, a network of hundreds of Web sites offering a variety of content based in the U.S., we generally retain between 40% and 50% of revenues from advertisers depending on, among other things, a Web publisher’s audience size, the number of unique visitors, impressions and page views, and the prominence of the Web publisher’s brand name. With respect to our 24/7 Portfolio, a select global portfolio of brand name Web sites, we generally retain between 20% and 40% depending on similar factors, including geography.

 

The following table shows by quarter the number of paid impressions and the average CPM since January 1, 2002. Metrics prior to 2002 are not comparable due to the acquisition of Real Media.

 

 

24/7 Search provides services necessary for the inclusion of an advertiser’s Web site into both pay-for-placement and algorithmic search engines.  These services are commonly referred to as bidded services and paid inclusion, respectively.  Our 24/7 Search content builders review advertiser Web site content for relevancy to satisfy both advertiser conversion metrics and search engine editorial standards. Our 24/7 Search optimization team produces a content feed for insertion into the databases of our search distribution partners and helps our advertisers select the most relevant Web site landing page for visitors.  Through relationships with our search distribution partners, we submit advertiser content via automated data feeds. The feeds we submit are regularly refreshed by us to maintain relevancy and accuracy.  Our selection of relevant content is intended to help our advertiser Web sites appear within search results for relevant search queries, improve user experience and improve advertiser conversions.  Our services only provide that our client advertisers’ Web site content will be included in our search engine distribution partners’ databases.  We do not guarantee our client advertisers any particular ranking within search results listings displayed by our search engine distribution partners to users.

 

Generally, we offer performance-based pricing for our 24/7 Search services.  Our client advertisers pay a predetermined cost-per-click, or CPC, for each valid visitor delivered to their Web sites.  For our bidded service, which constitutes a larger portion of our 24/7 Search revenue, we agree on a CPC price with our client advertisers and then we place CPC bids for various keywords and phrases with our search engine distribution partners.  We pay the CPC bid price to our distribution partner when a valid visitor links to one of our client advertisers’ Web sites by

 

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clicking a link displayed in the search results for such keywords or phrases.  We generally keep the spread between the CPC price charged to our client advertiser and the CPC bid price paid to our distribution partner.  For our paid inclusion service, we share the revenue generated by our 24/7 Search services with our search engine distribution partners that include our client advertisers’ Web site content in their databases.  We generally retain between 30% and 45% of the revenue depending on the size of our distribution partner, the number of valid visitors, the number of searches conducted and the prominence of our distribution partner’s brand name, among other factors.  To a lesser extent, we provide search management services.  For these clients, we place CPC bids and manage keyword purchases with our distribution partners and charge client advertisers our CPC plus a commission for each valid visitor delivered to the client.

 

The following table shows by quarter the number of valid visitors and the average CPC for our performance-based 24/7 Search services since January 1, 2002.

 

 

Our other media services primarily relate to e-mail list rental. We derive revenue from this service by delivering advertisements to e-mail lists for advertisers, who pay based on a CPM basis. Our revenue share with list providers generally ranges between 25% and 35%.

 

Technology Solutions

 

Our Technology Solutions are primarily based on our patent-protected Open AdSystem technology platform for Internet advertisement delivery, management and analytics, and consist of:

 

•                  Open AdStream Local, which we license to Web publishers to run on their proprietary, local servers;

 

•                  Open AdStream Central, which we provide to Web publishers from software hosted centrally on our servers; and

 

•                  Open Advertiser, which we provide to advertisers and advertising agencies from software hosted centrally on our servers.

 

We designed our Insight software solutions to fully integrate with our Open AdSystem (“OAS”) technology to offer Web publishers active campaign reporting and marketing intelligence and help advertisers measure, analyze and manage online audiences. In addition to our Insight XE solution, which is currently available, we launched two additional analytics products in the first quarter of 2004 that will integrate with OAS. We have designed our Insight ACT solution to

 

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enable a Web publisher to enhance the value of its advertising inventory by identifying and targeting segments of its audience who may be receptive to a specific advertiser’s message. We have designed our Insight SE solution to allow an advertiser to create targeted campaigns using keywords and phrases, and generate performance metrics that track visitors from specific search engines throughout the entire sales cycle, from prospecting by new customers to the final sale. We may provide these solutions, including Insight XE, to our customers from software hosted on our servers or from software hosted on a customer’s server that is administrated by us.

 

We generate revenue from licensing our Open AdStream Local software to Web publishers. Our license agreements typically provide for an upfront license fee and a software maintenance and service fee. We negotiate license fees based on, among other things, the forecasted number of impressions a Web publisher will deliver using our software and several other factors.

 

We generate revenue from our Open AdStream Central and Open Advertiser services from fees paid by Web publishers and advertisers and agencies, respectively. We typically offer Web publishers or advertisers a CPM-based pricing model allowing the Web publisher or advertiser to pay us based on advertising impressions. For these customers, an “impression” includes the delivery by us at their request of any advertising material. Our service revenue is determined by multiplying the CPM rate by the number of impressions delivered and is typically billed on a monthly basis. We have been generating revenue from Open Advertiser in Europe since mid-2001. We launched our Open Advertiser service in the United States in June 2003 but we have not generated significant revenue in the U.S. from this service from our initial beta or commercial customers.

 

We generate revenue from our Insight XE solution from fees paid by Web publishers. We typically offer Web publishers page-view pricing enabling them to pay us based on how many page views are measured. Our revenue is calculated by multiplying the CPM rate by the number of page views delivered.

 

The following table shows by quarter certain metrics for our Technology Solutions since 2002. We believe that metrics for periods prior to 2002 are not comparable because our Technology Solutions then included a different product mix.

 

		OAS Local		OAS Central, OAD and Insight XE
		Number of Active Client Contracts (1)		Number of Active Client Contracts (1)		Number of Paid Impressions / Pageviews(in billions)		Annual Revenue per Contract
Q1 2004		201		170		19.7		46,814
Q4 2003		199		150		14.9		45,009
Q3 2003		219		162		13.3		42,845
Q2 2003		221		156		11.9		40,191
Q1 2003		235		164		10.6		34,897
Q4 2002		258		162		7.5		37,457
Q3 2002		273		159		6.4		30,926
Q2 2002		271		153		5.1		30,660
Q1 2002		274		152		4.9		30,376

 

(1) A client contract may represent multiple clients and Web Sites utilizing Open AdStream products and services.

 

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To a lesser extent, we generate revenue by providing professional services charged at an hourly rate and from fees paid by Web publishers for trafficking their advertisements. Trafficking advertisements refers to entering advertisement creative material and campaign specifications into our Open AdStream software engine.

 

 

RESULTS OF OPERATIONS

 

FACTORS AFFECTING COMPARABILITY OF 2004 TO 2003

 

In January 2004, we acquired Real Media Korea Co., Ltd. (“RMK”), a leader in interactive marketing in Seoul, Korea.  Revenue was approximately $3.2 million in the first quarter of 2004.

 

The following table compares the results of operations for the three month period ended March 31, 2004 to the results of operations for the three month period ended March 31, 2003 (in thousands):

 

		Three months ended March 31,						Dollar			Percentage
		2004			2003			Variance			Variance
					(in thousands)
		(unaudited)			(unaudited)
Revenues:
Integrated media solutions		$	13,039		$	8,343		$	4,696		56.3	%
Technology solutions		4,342			3,481			861			24.7	%
Total revenues		17,381			11,824			5,557			47.0	%
Cost of revenues:
Integrated media solutions		9,441			5,510			3,931			71.3	%
Technology solutions		822			1,165			(343		)	-29.4	%
Total cost of revenues		10,263			6,675			3,588			53.8	%
Gross profit		7,118			5,149			1,969			38.2	%
Operating expenses:
Sales and marketing		3,316			3,144			172			5.5	%
General and administrative		2,982			2,922			60			2.1	%
Product development		1,051			588			463			78.7	%
Amortization of intangible assets and deferred financing costs		788			647			141			21.8	%
Stock-based compensation		199			47			152			323.4	%
Total operating expenses		8,336			7,348			988			13.4	%
Loss from operations		(1,218		)	(2,199		)	981			44.6	%
Interest expense, net		(182		)	(91		)	(91		)	-100.0	%
Change in fair value of warrant liability		928			—			928			100.0	%
Other income, net		180			—			180			100.0	%
Loss before provision for income taxes		(292		)	(2,290		)	1,998			87.2	%
Provision for income taxes		100			7			93			1328.6	%
Net loss		$	(392	)	$	(2,297	)	$	1,905		82.9	%

 

REVENUES

 

INTEGRATED MEDIA SOLUTIONS. Revenue is derived from three sources: 24/7 Web Alliance, 24/7 Search and Other Media Services.  24/7 Web Alliance revenue was $9.7 million and $4.7 million for the three months ended March 31, 2004 and 2003, respectively, an increase of 107.5%.  The increase is primarily due to an increase in impressions sold from 6.1 billion in

 

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2003 to 9.6 billion in 2004.  Excluding RMK, Web Alliance revenue increased $2.0 million or 42.6%.

 

24/7 Search revenue was $3.0 million and $3.1 million for the three months ended March 31, 2004 and 2003, respectively, a decrease of 2.2%.  Historically, we generated a significant portion of our 24/7 Search revenue from relationships with a small number of search engine distribution partners, particularly Inktomi, which accounted for approximately 55.6% of our 24/7 Search revenue in the first quarter of 2003.  Inktomi was acquired by Yahoo! in the first quarter of 2003 and certain changes implemented by Inktomi caused the revenue we generate from Inktomi to decline, and our contract with Inktomi expired in May 2003.  The loss of revenue from Inktomi was partially offset by increased valid visitors from expanded relationships with our other distribution partners and new search relationships.

 

Other Media Services revenue is generated primarily from e-mail.  E-mail revenue decreased from $0.5 million to $0.3 million for the three months ended March 31, 2004 and 2003, respectively.  The decrease was due to less emphasis placed on e-mail as we focus on our core businesses.

 

TECHNOLOGY SOLUTIONS. Our Technology Solutions revenue was $4.3 million and $3.5 million for the three months ended March 31, 2004 and 2003, respectively, representing an increase of 24.7%.  Revenue from products that we host, including Open AdStream Central, Open Advertiser and Insight XE, grew as impressions and pageviews delivered climbed from 10.6 billion to 19.7 billion as we added new customers.  Excluding RMK, our Technology revenues increased $0.7 million or 21.3%.

 

COST OF REVENUE AND GROSS PROFIT

 

INTEGRATED MEDIA SOLUTIONS COST OF REVENUES AND GROSS PROFIT. Our cost of revenues consists primarily of fees paid to affiliates, whether it is a Web site (24/7 Web Alliance), a list provider (for e-mail) or a search engine distribution partner (for 24/7 Search), which is usually calculated as a percentage of revenues.  Cost of revenues also includes advertisement serving costs, which is an intercompany charge from the Technology Solutions segment based on a fixed CPM.  Gross profit margin decreased from 34.0% for the three months ended March 31, 2003 to 27.6% for the three months ended March 31, 2004.  This decrease is due to the addition of RMK, which has a lower gross profit margin than existing businesses, and increased upward pressure on the cost of traffic for 24/7 Search.  In addition, 24/7 Search generated a greater portion of its revenue from bid-for-placement and search management services, which have a lower gross margin than paid inclusion.

 

TECHNOLOGY SOLUTIONS COST OF REVENUES AND GROSS PROFIT. Our cost of technology revenues consists of the costs of operating equipment and broadband bandwidth capacity centrally hosted technology solutions and payroll costs to deliver and support software offset by the portion charged to Integrated Media Solutions for advertisement serving.  Gross margins were 81.1% and 66.5% for the three month periods ended March 31, 2004 and 2003, respectively.  The increase in gross margins is due to declining hosting and bandwidth costs and leveraging the existing support infrastructure over a higher revenue base.

 

SALES AND MARKETING EXPENSES. Sales and marketing expenses consist primarily of sales force salaries and commissions, advertising expenditures and cost of trade shows, conventions and marketing materials.  Sales and marketing expenses were $3.3 million and $3.1 million for the three months ended March 31, 2004 and 2003, respectively.  Sales and marketing expenses decreased as a percentage of revenue from 26.6% for the three month period ended

 

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March 31, 2003 to 19.1% for the three month period ended March 31, 2004 as we were able to gain operating leverage off the existing cost structure.  The number of employees included in sales and marketing increased from 129 at March 31, 2003 to 133 at March 31, 2004, as a result of terminations and the addition of 30 employees from RMK.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of compensation, facilities expenses and other overhead expenses incurred to support the business.  General and administrative expenses were $3.0 million and $2.9 million for the three months ended March 31, 2004 and 2003, respectively.  As a percentage of revenue, the expenses decreased from 24.7% to 17.2% for the three months ended March 31, 2003 and 2004, respectively.  The decrease as a percentage of revenue reflects an increased revenue base with low additional costs.  The number of general and administrative employees at March 31, 2004 and 2003 was 47 and 45, respectively.

 

PRODUCT DEVELOPMENT EXPENSES. Product development expenses consist primarily of compensation and related operating expenses incurred to perform research and development, further enhance and maintain our existing products and provide quality assurance.  Product development expenses were $1.1 million and $0.6 million for the three months ended March 31, 2004 and 2003, respectively.  We capitalized approximately $0.2 million for the three months ended March 31, 2003 and continued to capitalize the costs until Open Advertiser was commercially released in June 2003.  The remaining increase is related to the development of our Insight SE and Insight ACT products and further enhancements to our Insight XE and Open AdStream products.  The number of employees included in product development increased from 31 at March 31, 2003 to 41 at March 31, 2004.

 

AMORTIZATION OF INTANGIBLE ASSETS AND DEFERRED FINANCING COST. Amortization expense relates to intangible assets acquired with 24/7 Search in August 2000, certain assets acquired from Insight First in January 2003, deferred financing costs associated with the subordinated convertible debentures offering in September 2003 and the transition payment to Lycos in February 2004.  Amortization expense increased from $0.6 million for the three months ended March 31, 2003 to $0.8 million for the three months ended March 31, 2004.  Amortization expense for the three months ended March 31, 2004 relates $0.5 million to acquired technology, $0.2 million to deferred financing costs and $0.1 million to the transition payment to Lycos.  Amortization expense for the three months ended March 31, 2003 related $0.6 million to acquired technology.

 

STOCK-BASED COMPENSATION. Stock-based compensation was $0.2 million and $47,000 for the three months ended March 31, 2004 and 2003, respectively.  The expense for the three months ended March 31, 2004 consists of $0.1 million in amortization of deferred compensation for restricted shares issued to certain employees and $0.1 million in discretionary bonuses paid in stock.  The expense for the three months ended March 31, 2003 represents the amortization of deferred compensation for restricted shares issued to certain employees.

 

INTEREST EXPENSE, NET. Interest expense, net relates to our long term debt and capital lease obligations offset by interest income related to our cash and cash equivalents.  Interest expense, net was $0.2 million and $0.1 million for the three months ended March 31, 2004 and 2003, respectively.  Interest expense in 2004 primarily relates to subordinated convertible debt issued in the third quarter of 2003.  Interest in 2003 primarily related to the PubliGroupe debt that was settled in the second quarter of 2003.  Interest expense in both periods was offset by interest income from cash in overnight deposits and money market accounts.

 

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CHANGE IN FAIR VALUE OF WARRANT LIABILITY. Each quarter the liability related to warrants outstanding from our preferred stock and subordinated convertible debenture offerings will be adjusted to fair value.  The $0.9 million gain is due to a decrease in the fair value of the warrants outstanding which reduced the corresponding liability.  The decrease in the fair value is primarily due to a lower stock price at the end of the first quarter compared to when the warrants were issued.

 

OTHER INCOME, NET. The $0.2 million in 2004 primarily relates to amounts recovered from a former subsidiary that was shut down.

 

PROVISION FOR INCOME TAXES. The provision for income taxes recorded for the three month period ended March 31, 2004 of $0.1 million consist primarily of income taxes on earnings of our foreign subsidiaries.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Operating Activities

 

Since our inception we have financed our operations through equity financings and long-term debt.  We used approximately $1.4 million and $2.6 million of cash in operating activities during the first quarter of 2004 and 2003, respectively, generally as a result of our net operating losses, adjusted for certain non-cash items included in our operating results as well as changes in various components of working capital.

 

Investing and Financing Activities

 

Net cash used by investing activities was approximately $1.9 million and $0.5 million during the first quarter of 2004 and 2003, respectively.  Investing activities during the first quarter of 2004 related $1.6 million to the acquisition of RMK and $0.3 million to capital expenditures for general operational purposes.  During 2003, we paid $0.2 million as part of the acquisition of certain assets of Insight First, Inc. and as an investment in iPromotions, Inc. and $0.3 million for capital expenditures, including capitalized software.

 

Financing activities provided $34.4 million and $30,000 in the three months ended March 31, 2004 and 2003, respectively.  Financing activities in 2004 primarily related to proceeds from our secondary offering of common stock and the exercise of stock options.  Financing activities in 2003 primarily related to the exercise of stock options.

 

Certain Contingencies and Capital Requirements

 

The $15.0 million principal amount of our subordinated convertible debentures is due September 2006.  Semi-annual interest payments at 2% began in January 2004.  Both the principal and interest may be paid in common stock.

 

Pursuant to our agreement with Lycos, Inc. there is $3.4 million related to the transition payment due  in equal installments at each quarter end in 2004 and specified minimum annual payments.  For 2004, the minimal annual payment is $10.0 million and is payable $2.5 million 45 days after each quarter end.

 

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The operating lease agreements relate to our offices throughout the United States and internationally with original lease periods expiring between 2004 and 2008.

 

The Company has various employment agreements with employees, the majority of which are for one year with an automatic renewal.  The potential obligation under these contracts is approximately $4.1 million for 2004 including salary and performance based target bonuses.  These contracts call for severance payments in the event of involuntary termination which generally range in amount from three months to one year’s salary.  All non-U.S. employees have employment contracts as required by local law.  The majority of these contracts allow for resignation or termination by either party at any time, according to the notice period provisions contained in the employment contracts, or according to the minimum notice period as mandated by local law.  The contracts or, if no expressed provision is included in the contract, local law also require severance for involuntary terminations ranging from one to six months.  As of March 31, 2004, there were approximately 63 employees in Europe whose annualized base salaries are approximately $4.7 million.

 

As of March 31, 2004, we had approximately $1.0 million remaining of cash outlay obligations relating to restructuring and exit costs consisting of severance and rent.  We expect to pay approximately $0.3 in the remainder of 2004, $0.2 million in each year from 2005 to 2007 and $0.1 million in 2008.

 

Our capital requirements depend on numerous factors, including market demand of our services, the capital required to support and maintain our technology, and the resources we devote to marketing and selling our services.  We may sell additional equity or debt securities that would result in further dilution to our stockholders.  Stockholders many experience extreme dilution due to both our common stock price and the significant amount of financing we may raise.  These securities may have rights senior to those holders of our common stock.  Any indebtedness could contain covenants, which restrict our operations.  Our subordinated convertible debentures limit our ability to incur additional debt.

 

We believe that our existing cash and cash equivalents and cash flow from operating activities will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

We did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet financial arrangements or other contractually narrow or limited purposes at March 31, 2004. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

 

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CRITICAL ACCOUNTING POLICIES

 

We continue to invest resources to the process of comprehensively documenting and analyzing our system of internal controls. We have identified areas of our internal controls requiring improvement, and we are in the process of designing enhanced processes and controls to address any issues identified through this review. Areas for improvement include streamlining our domestic and international billing processes, further limiting internal access to certain data systems and continuing to improve coordination across business functions. Although we believe that our efforts have strengthened our internal controls, we are continuing to work to improve our internal controls, including in the areas of access and security. Accordingly, we plan to continue to invest the resources necessary to ensure the effectiveness of our internal controls and procedures, including in the areas of access and security.

 

General

 

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America.  As such, we are required to make certain estimates, judgments and assumptions that management believes are reasonable based upon the information available.  These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.

 

The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating the reported consolidated financial results include the following:

 

Revenue Recognition

 

Integrated Media Solutions

 

24/7 Web Alliance revenues are generated by delivering advertising impressions for a fixed fee to third-party Web sites. 24/7 Search revenues are derived from driving valid visitors to a client’s Web site. E-mail related revenues are derived from delivering advertisements to e-mail lists for advertisers and Web sites. Our agreements are primarily short-term and we recognize revenues as services are delivered provided that no significant obligations of ours remain outstanding and collection of the resulting receivable is probable.

 

We are obligated to make payments to third-party Web sites, search engine distribution partners and e-mail lists which have contracted with us to be part of our Network, in the period the advertising impressions, valid visitors or e-mails are delivered.  Such expenses are classified as cost of revenue in accompanying consolidated statements of operations.

 

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