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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 June 30, 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

 

24/7 Real Media, Inc.

(Exact name of registrant as specified in its charter)

 

DELAWARE

 

13-3995672

(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)

 

(IRS EMPLOYER
IDENTIFICATION NO.)

 

 

 

1250 BROADWAY, NEW YORK, NY

 

10001

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

 

(ZIP CODE)

 

(212) 231-7100

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

 

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 ý NO o

 

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 August 5, 2004

Common Stock, par value $.01 per share

 

34,175,937 Shares

 

 



 

24/7 Real Media, Inc.

June 30, 2004

FORM 10-Q

INDEX

 

Part I. Financial Information

 

Item 1. Consolidated Financial Statements

 

Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003

 

Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003 (unaudited)

 

Consolidated Statements of Cash Flows for the six months ended June 30, 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.

 

2



 

PART I. FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

24/7 REAL MEDIA, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 

 

June 30,
2004

 

December 31,
2003

 

 

 

(unaudited)

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

52,511

 

$

21,645

 

Marketable securities

 

2,896

 

 

Accounts receivable, less allowances of $1,146 and $971,  respectively

 

19,888

 

11,603

 

Prepaid expenses and other current assets

 

1,824

 

1,669

 

 

 

 

 

 

 

Total current assets

 

77,119

 

34,917

 

 

 

 

 

 

 

Property and equipment, net

 

2,907

 

2,862

 

Goodwill

 

14,530

 

2,621

 

Intangible assets, net

 

5,960

 

3,352

 

Other assets

 

6,602

 

2,428

 

 

 

 

 

 

 

Total assets

 

$

107,118

 

$

46,180

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

11,015

 

$

6,266

 

Accrued liabilities

 

12,775

 

10,086

 

Deferred revenue

 

2,837

 

2,544

 

 

 

 

 

 

 

Total current liabilities

 

26,627

 

18,896

 

 

 

 

 

 

 

Subordinated convertible debentures, 2%, due 2006

 

13,625

 

13,320

 

Warrant liability

 

747

 

3,595

 

Other long-term liabilities

 

312

 

332

 

 

 

 

 

 

 

Total liabilities

 

41,311

 

36,143

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock; $.01 par value; 10,000,000 shares authorized,  689,351 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;  34,161,742 and 23,367,421 shares issued and outstanding, respectively

 

342

 

234

 

Additional paid-in capital

 

1,160,815

 

1,106,984

 

Deferred stock compensation

 

(107

)

(257

)

Accumulated other comprehensive income

 

788

 

305

 

Accumulated deficit

 

(1,096,038

)

(1,097,237

)

Total stockholders’ equity

 

65,807

 

10,037

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

107,118

 

$

46,180

 

 

See accompanying notes to unaudited interim consolidated financial statements.

 

3



 

24/7 REAL MEDIA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, expect share and per share data)

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

(unaudited)

 

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Integrated media solutions

 

$

14,891

 

$

8,362

 

$

27,930

 

$

16,705

 

Technology solutions

 

4,706

 

3,788

 

9,048

 

7,269

 

Total revenues

 

19,597

 

12,150

 

36,978

 

23,974

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

Integrated media solutions

 

10,487

 

5,084

 

19,928

 

10,594

 

Technology solutions (exclusive of $0, $10, $0 and $10, respectively, reported below as stock-based compensation)

 

879

 

1,062

 

1,701

 

2,227

 

Total cost of revenues

 

11,366

 

6,146

 

21,629

 

12,821

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

8,231

 

6,004

 

15,349

 

11,153

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing (exclusive of $186, $33, $210 and $41, respectively, reported below as stock-based compensation)

 

3,893

 

3,227

 

7,209

 

6,371

 

General and administrative (exclusive of $92, $67, $263 and $105, respectively, reported below as stock-based compensation)

 

3,019

 

2,776

 

6,001

 

5,698

 

Product development (exclusive of $20, $36, $24 and $38, respectively, reported below as stock-based compensation)

 

1,095

 

755

 

2,146

 

1,342

 

Amortization of intangible assets and deferred financing costs

 

1,414

 

661

 

2,202

 

1,308

 

Stock-based compensation

 

298

 

146

 

497

 

194

 

Restructuring costs

 

501

 

 

501

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

10,220

 

7,565

 

18,556

 

14,913

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(1,989

)

(1,561

)

(3,207

)

(3,760

)

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

(96

)

(56

)

(278

)

(147

)

Change in fair value of warrant liability

 

881

 

 

1,809

 

 

Gain on legal settlement

 

2,896

 

 

2,896

 

 

Other income (expense), net

 

(69

)

(834

)

111

 

(834

)

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

1,623

 

(2,451

)

1,331

 

(4,741

)

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

32

 

33

 

132

 

40

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

1,591

 

(2,484

)

1,199

 

(4,781

)

 

 

 

 

 

 

 

 

 

 

Dividends on preferred stock

 

(104

)

(158

)

(222

)

(287

)

Preferred stock conversion discount

 

 

(1,780

)

 

(1,780

)

Net income (loss) attributable to common stockholders

 

$

1,487

 

$

(4,422

)

$

977

 

$

(6,848

)

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share attributable to common stockholders

 

$

0.04

 

$

(0.31

)

$

0.03

 

$

(0.50

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in basic net income (loss) per share

 

34,054,489

 

14,475,512

 

29,836,259

 

13,689,656

 

 

 

 

 

 

 

 

 

 

 

Diluted net income (loss) per share attributable to common stockholders

 

$

0.04

 

$

(0.31

)

$

0.03

 

$

(0.50

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in diluted net income (loss) per share

 

43,886,508

 

14,475,512

 

39,845,899

 

13,689,656

 

 

See accompanying notes to unaudited interim consolidated financial statements.

 

4



 

24/7 REAL MEDIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

 

 

Six months ended June 30,

 

 

 

2004

 

2003

 

 

 

(unaudited)

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

1,199

 

$

(4,781

)

Adjustments to reconcile net income (loss) to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

945

 

1,238

 

Provision for doubtful accounts and sales reserves

 

349

 

293

 

Amortization of intangible assets and deferred financing costs

 

2,202

 

1,308

 

Amortization of warrants

 

306

 

 

Non-cash compensation

 

497

 

194

 

Accrued interest on notes payable

 

149

 

166

 

Non-cash gain from legal settlement

 

(2,896

)

 

Change in fair value of warrant liability

 

(1,809

)

 

Changes in operating assets and liabilities, net of effects of acquisitions and dispositions:

 

 

 

 

 

Accounts receivable

 

(3,563

)

(1,933

)

Prepaid assets and other current assets

 

(126

)

642

 

Other assets

 

(4,433

)

43

 

Accounts payable and accrued liabilities

 

2,131

 

(1,405

)

Deferred revenue

 

282

 

671

 

 

 

 

 

 

 

Net cash used in operating activities

 

(4,767

)

(3,564

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Cash paid for acquisitions, net

 

(1,958

)

(150

)

Capital expenditures, including capitalized software

 

(819

)

(506

)

Cash paid for investment

 

 

(50

)

 

 

 

 

 

 

Net cash used in investing activities

 

(2,777

)

(706

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock, net

 

37,364

 

 

Proceeds from exercise of stock options and conversion of warrants

 

587

 

486

 

Payment of capital lease obligations

 

(24

)

(24

)

Proceeds from issuance of preferred stock, net

 

 

6,792

 

Retirement of debt

 

 

(1,500

)

 

 

 

 

 

 

Net cash provided by financing activities

 

37,927

 

5,754

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

30,383

 

1,484

 

Effect of foreign currency on cash

 

483

 

(38

)

Cash and cash equivalents at beginning of year

 

21,645

 

7,674

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

52,511

 

$

9,120

 

 

See accompanying notes to unaudited interim consolidated financial statements.

 

5



 

(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.

 

6



 

(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 and Marketable Securities
 

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.

 

Marketable securities consist of corporate equity securities.  The Company has classified its marketable securities as available-for-sale.  Accordingly, these investments are carried at fair value, with unrealized gains and losses, net of related taxes, as a separate component of stockholders’ equity.  The Company recognizes gains and losses when these securities are sold.  The Company has not recognized any gains or losses from the sale of its marketable securities.

 

(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 and six month periods ended June 30, 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

 

7



 

potential credits issued to customers.  The amount of the reserve is determined based on historical credits issued.

 

(f)  Unbilled Receivables
 

At June 30, 2004 and December 31, 2003, accounts receivable included approximately $3.5 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.

 

(g)  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 and six month periods ended June 30, 2004 was $0.1 million and $0.2 million, respectively, and accumulated amortization as of June 30, 2004 was $0.3 million.

 

(h)  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, in the period the advertising impressions, valid visitors or e-mails are delivered. Such expenses are classified as cost of revenues in the accompanying consolidated statements of operations.

 

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

 

8



 

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 or collected in advance of services being completed are deferred until the conclusion of the period of the service for which the advance billing or collection relates.  Deferred revenues are included on the consolidated balance sheets 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.

 

(i)  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 a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded on 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 June 30, 2004 by $1.8 million on the consolidated balance sheet and recorded a change in fair value of warrant liability on the consolidated statement of operations.

 

In June 2004, the Company amended the registration rights agreement related to the subordinated convertible debentures.  The amendment provided that the Company is no longer obligated to pay any filing or maintenance penalties pursuant to the registration rights agreement with respect to the warrants issued to the holders of the debentures.  Accordingly, the Company reclassified the warrant liability related to the debentures to additional paid in capital.

 

9



 

(j)  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 income (loss) would have been adjusted to the pro forma amounts indicated below:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

(in thousands, except per share amounts)

 

Net income (loss) attributable to common stockholders:

 

 

 

 

 

 

 

 

 

As reported

 

$

1,487

 

$

(4,422

)

$

977

 

$

(6,848

)

Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax effect

 

1,400

 

1,204

 

3,168

 

3,414

 

Pro forma

 

$

87

 

$

(5,626

)

$

(2,191

)

$

(10,262

)

Basic net income (loss) attributable to common stockholders per share:

 

 

 

 

 

 

 

 

 

As reported

 

$

0.04

 

$

(0.31

)

$

0.03

 

$

(0.50

)

Pro forma

 

0.00

 

(0.39

)

(0.07

)

(0.75

)

Diluted net income (loss) attributable to common stockholders per share:

 

 

 

 

 

 

 

 

 

As reported

 

$

0.04

 

$

(0.31

)

$

0.03

 

$

(0.50

)

Pro forma

 

0.01

 

(0.39

)

(0.05

)

(0.75

)

 

The per share weighted-average fair value of stock options granted for the three and six month periods ended June 30, 2004 was $5.77 and $4.83, respectively, and was $0.50 and $0.80 for the three and six month period ended June 30, 2003, respectively, on the date of grant using the Black-Scholes method with the following weighted-average assumptions:

 

10



 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Expected dividend yield

 

0

%

0

%

0

%

0

%

Risk-free interest rate

 

2.59

%

1.13

%

2.30

%

1.42

%

Expected life (in years)

 

3.0

 

1.5

 

2.6

 

2.4

 

Volatility

 

136

%

94

%

132

%

132

%

 

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

 

(k)  Preferred Stock
 

 

 

 

 

 

 

 

 

Shares Ouststanding at

 

Series

 

Shares
Authorized

 

Price Per
Share

 

Conversion
Rate

 

June 30,
2004

 

December 31,
2003

 

A

 

800,000

 

$

10.00

 

$

1.02675

 

611,351

 

750,000

 

C

 

718,250

 

10.00

 

1.20790

 

78,000

 

78,250

 

 

 

 

 

 

 

 

 

689,351

 

828,250

 

 

During the six month period ended June 30, 2004, 138,649 shares of Series A and 250 shares of Series C Preferred Stock were converted into 1,350,364 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 June 30, 2004, there are approximately $0.7 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.

 

(l)  Comprehensive Income (Loss)
 

Total comprehensive income (loss) for the six month periods ended June 30, 2004 and 2003 was $1.7 million and $(4.8) million, respectively.  Comprehensive income (loss) resulted from net income (losses) of $1.2 million and $(4.8) million, and in 2004 foreign currency translation adjustment of $0.5 million.

 

11



 

(m) Basic and Diluted Net Income (Loss) Per Share

 

Net income (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 income (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.  Potential common shares consist of incremental common shares issuable upon the exercise of stock options and warrants (using the treasury stock method), the conversion of subordinated convertible debentures and preferred stock (using the if-converted method) and the vesting of restricted stock.

 

The computation of diluted net income (loss) per share for the three month period ended June 30, 2004 excludes outstanding options of approximately 2.2 million to purchase shares of common stock and the effects of 0.5 million shares issuable upon the exercise or conversion of common stock warrants, since their inclusion would have an antidilutive effect.  Similarly, for the six month period ended June 30, 2004, the computation excludes outstanding options of approximately 0.3 million to purchase shares of common stock and the effects of 0.5 million shares issuable upon the exercise or conversion of common stock warrants.

 

The computation of net income (loss) per share for the three and six month period ended June 30, 2003 excludes outstanding options of 3.5 million to purchase shares of common stock and the effects of 1.9 million shares issuable upon the exercise or conversion of common stock warrants and 13.7 million shares issuable upon the conversion of preferred stock, since their inclusion would have an antidilutive effect.

 

(n)  Reclassifications

 

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

 

(o)  Recent Accounting Pronouncements

 

In April 2004, the EITF issued EITF Issue No. 03-06 (“EITF 03-06”), Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share, which addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock.  The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security.  EITF 03-06 is effective for fiscal periods beginning after March 31, 2004.  The Company is currently evaluating the effect of adopting EITF 03-06 on its financial statements.

 

(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

 

12



 

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 as follows: $11.9 million to goodwill; $2.3 million to agency relationships; $0.7 million to trade name; $0.5 million to acquired technology; and $0.7 million to other intangible assets.  The purchase price allocation is subject to revision pending final 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:

 

Asset/ Liability

 

Amount

 

 

 

 

 

Cash and cash equivalents

 

$

3,469

 

Other current assets

 

5,151

 

Fixed assets

 

170

 

Non-current assets

 

385

 

Accrued liabilities

 

(5,119

)

 

 

$

4,056

 

 

(b)  Acquisition of Insight First, Inc.

 

On January 21, 2003, the Company acquired certain assets of Insight First, Inc., including specific contracts, intangible assets, and employee relationships, related to the 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.

 

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:

 

13



 

Asset/ Liability

 

Amount

 

 

 

 

 

Fixed assets

 

$

44

 

Accrued liabilities

 

(41

)

 

 

$

3

 

 

(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 and six month periods ended June 30, 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
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

$

19,597

 

$

15,089

 

$

36,978

 

$

29,874

 

Net income (loss) attributable to common stockholders

 

1,487

 

(4,509

)

977

 

(7,065

)

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) attributable to common stockholders per share

 

$

0.04

 

$

(0.27

)

$

0.03

 

$

(0.44

)

Weighted average shares used in basic per share calculation (1)

 

34,054,489

 

16,601,933

 

29,906,361

 

15,897,898

 

 

 

 

 

 

 

 

 

 

 

Diluted net income (loss) atrributable to common stockholders per share

 

$

0.04

 

$

(0.27

)

$

0.03

 

$

(0.44

)

Weighted average shares used in diluted per share calculation (1)

 

43,886,508

 

16,601,933

 

39,916,001

 

15,897,898

 

 


(1) The weighted average shares used to compute pro forma basic and diluted net income (loss) per share for the three and six month periods ended June 30, 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.

 

(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, intangible assets, and employee relationships related to the Company’s 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

 

14



 

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.  The Company wrote-off the investment in the second quarter of 2004.

 

(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 six month period ended June 30, 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 and six month periods ended June 30, 2004.

 

(a)  Goodwill

 

The $14.5 million in goodwill at June 30, 2004 relates $11.9 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 $6.0 million in intangible assets, net at June 30, 2004 relates $3.7 million to RMK, $1.4 million to Real Media, $0.8 million to Insight First and $0.1 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.

 

15



 

 

 

June 30,
2004

 

December 31,
2003

 

Estimated
Useful Lives

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Goodwill (1)

 

$

14,530

 

$

2,621

 

 

 

 

 

 

 

 

 

 

 

Technology (2)

 

$

7,813

 

$

7,263

 

4

 

Less accumulated amortization

 

(5,237

)

(4,142

)

 

 

Net Technology

 

2,576

 

3,121

 

 

 

 

 

 

 

 

 

 

 

Other Intangible assets (3)

 

4,160

 

500

 

4 - 5

 

Less accumulated amortization

 

(776

)

(269

)

 

 

Net Other intangible assets

 

3,384

 

231

 

 

 

 

 

 

 

 

 

 

 

Gross Intangible assets

 

11,973

 

7,763

 

 

 

Less accumulated amortization

 

(6,013

)

(4,411

)

 

 

Net Intangible assets

 

$

5,960

 

$

3,352

 

 

 

 


(1) Goodwill increased $11.9 million due to the acquisition of RMK.

(2) Acquired technology increased $0.5 million due to the acquisition of RMK.

(3) Other intangible assets include trade names, agency relationships and non-compete agreements and increased $3.7 million due to the acquisition of RMK.

 

(5)  RESTRUCTURING

 

Restructuring-related liabilities include estimates for, among other things, involuntary terminations of employees and disposition of lease obligations.  Key variables in determining such estimates include timing of sublease rentals, estimates of sublease rental payment amounts and tenant improvement costs, and estimates for brokerage and other related costs.  The Company periodically evaluates and, if necessary, adjusts the estimates based on currently-available information.

 

The following sets forth the activities in the Company’s restructuring reserve for the six month period ended June 30, 2004, which is included in accrued liabilities in the consolidated balance sheet (in thousands):

 

 

 

Beginning
Balance

 

Current year
provision

 

Current Year
Utilization

 

Ending Balance

 

Employee termination benefits

 

$

470

 

$

335

 

$

(513

)

$

292

 

Office closing costs

 

1,165

 

166

 

(453

)

878

 

Other exit costs

 

28

 

 

(28

)

 

 

 

$

1,663

 

$

501

 

$

(994

)

$

1,170

 

 

16



 

(6)  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 these Debentures.  The redemption right constitutes an embedded derivative.  The value of the embedded derivative at June 30, 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.  For the three and six month periods ended June 30, 2004, approximately $0.1

 

17



 

million and $0.3 million of the deferred costs are included in amortization expense and at June 30, 2004, the unamortized portion of the debt issuance costs is $1.2 million.

 

(7)  EQUITY INSTRUMENTS

 

PREFERRED STOCK

 

During the six month period ended June 30, 2004, 138,649 shares of Series A and 250 shares of Series C Preferred Stock were converted into 1,350,364 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.  In connection with the offering, the Company and selling stockholders granted to the underwriters an option to purchase up to an additional 1.2 million 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. The underwriters exercised the over-allotment option in April 2004.  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.  The Company estimates $1.0 million of other offering expenses of which approximately $0.7 million has been paid as of June 30, 2004.

 

(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.

 

(d)  Additional Paid-in Capital

 

During the six month period ended June 30, 2004, the Company’s additional paid-in capital increased by $53.8 million primarily due to $37.0 million in connection with the Company’s secondary offering of common stock, $14.6 million in connection with the acquisition of RMK, $1.0 million in connection with the amendment of the registration rights agreement related to the

 

18



 

debentures, $0.6 million in other stock-based compensation issued to employees and $0.6 million from exercise of stock options and warrants.

 

(8)  STOCK INCENTIVE PLANS

 

For the six month period ended June 30, 2004, the Company granted 1.9 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.

 

(9)  SUPPLEMENTAL CASH FLOW INFORMATION

 

Cash Paid for Interest

 

For the six months ended June 30, 2004 and 2003, the amount of cash paid for interest was $82,000 and $5,000, respectively.

 

(10)  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 and six month periods ended June 30, 2004 and 2003, is as follows:

 

19



 

 

 

Three months ended June 30, 2004

 

Six months ended June 30, 2004

 

 

 

Integrated
Media
Solutions

 

Technology
Solutions

 

Corporate

 

Total

 

Integrated
Media
Solutions

 

Technology
Solutions

 

Corporate

 

Total

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

14,891

 

$

4,706

 

$

 

$

19,597

 

$

27,930

 

$

9,048

 

$

 

$

36,978

 

Depreciation

 

191

 

255

 

11

 

457

 

439

 

478

 

28

 

945

 

Amortization of intangible assets and deferred financing costs

 

953

 

329

 

132

 

1,414

 

1,280

 

658

 

264

 

2,202

 

Stock-based compensation

 

131

 

20

 

147

 

298

 

159

 

20

 

318

 

497

 

Segment income (loss) from operations

 

(728

)

840

 

(2,101

)

(1,989

)

(893

)

1,579

 

(3,893

)

(3,207

)

Interest income (expense), net

 

27

 

 

(123

)

(96

)

50

 

 

(328

)

(278

)

Change in fair value of warrant liability

 

 

 

881

 

881

 

 

 

1,809

 

1,809

 

Gain on legal settlement

 

 

 

2,896

 

2,896

 

 

 

2,896

 

2,896

 

Other income (expense), net

 

47

 

 

(116

)

(69

)

38

 

 

73

 

111

 

Income tax expense

 

(32

)

 

 

(32

)

(132

)

 

 

(132

)

Segment income (loss)

 

(686

)

840

 

1,437

 

1,591

 

(937

)

1,579

 

557

 

1,199

 

 

 

 

Three months ended June 30, 2003

 

Six months ended June 30, 2003

 

 

 

Integrated
Media
Solutions

 

Technology
Solutions

 

Corporate

 

Total

 

Integrated
Media
Solutions

 

Technology
Solutions

 

Corporate

 

Total

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

8,362

 

$

3,788

 

$

 

$

12,150

 

$

16,705

 

$

7,269

 

$

 

$

23,974

 

Depreciation

 

370

 

187

 

24

 

581

 

804

 

380

 

54

 

1,238

 

Amortization of intangible assets and

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

deferred financing costs

 

333

 

328

 

 

661

 

666

 

642

 

 

1,308

 

Stock-based compensation

 

75

 

15

 

56

 

146

 

95

 

15

 

84

 

194

 

Segment income (loss) from operations

 

106

 

21

 

(1,688

)

(1,561

)

(386

)

(21

)

(3,353

)

(3,760

)

Interest income (expense), net

 

8

 

 

(64

)

(56

)

10

 

 

(157

)

(147

)

Other income (expense)

 

4

 

 

(838

)

(834

)

4

 

 

(838

)

(834

)

Income tax expense

 

(33

)

 

 

(33

)

(40

)

 

 

(40

)

Segment income (loss)

 

85

 

21

 

(2,590

)

(2,484

)

(412

)

(21

)

(4,348

)

(4,781

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2004

 

36,885

 

10,853

 

59,380

 

107,118

 

 

 

 

 

 

 

 

 

December 31, 2003

 

10,381

 

11,173

 

24,626

 

46,180

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

United
Kingdom

 

South Korea

 

Other -
International

 

Total

 

 

 

(in thousands)

 

Period ended June 30, 2004

 

 

 

 

 

 

 

 

 

 

 

Revenues for the three months ended

 

$

9,947

 

$

2,912

 

$

3,365

 

$

3,373

 

$

19,597

 

Revenues for the six months ended

 

18,370

 

6,192

 

6,517

 

5,899

 

36,978

 

Long-lived assets

 

11,964

 

309

 

16,213

 

1,513

 

29,999

 

 

 

 

 

 

 

 

 

 

 

 

 

Period ended June 30, 2003

 

 

 

 

 

 

 

 

 

 

 

Revenues for the three months ended

 

$

7,203

 

$

2,181

 

$

 

$

2,766

 

$

12,150

 

Revenues for the six months ended

 

14,644

 

4,301

 

 

5,029

 

23,974

 

Long-lived assets at December 31, 2003

 

9,549

 

146

 

 

1,568

 

11,263

 

 

(11)  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,

 

20



 

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 of 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

 

In March 2004, the Federal Circuit Court of Appeals has affirmed, without opinion, a July 2003 decision of the U.S. Federal Court for the Western District of Washington that granted summary judgment to aQuantive, Inc. in a lawsuit that alleged that aQuantive infringed the Company’s U.S. patent number 6,026,368.  The lower court’s ruling held that aQuantive’s Atlas DMT advertisement serving system does not infringe the ‘368 patent.  The Company filed a request for rehearing before the Federal Circuit Court of Appeals that was denied.

 

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, 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 June 1, 2004, the Company and David J. Moore, its Chief Executive Officer, reached a settlement with chinadotcom Corporation (“chinadotcom”) involving the release of all claims and the termination of all litigation matters involving the two companies and their affiliates.  As part of the settlement, chinadotcom agreed to issue to 24/7 Real Media 400,000 Class A common shares of chinadotcom.  The shares, valued at $2.9 million based on market price on the date of settlement, is included on the consolidated statement of operations as a gain on legal settlement.

 

21



 

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.

 

22



 

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. Through 24/7 Search, we connect advertisers with consumers who use search engines to find information about products and services.  Our Open AdSystem technology helps Web publishers and advertisers target, convert and retain online customers and maintain audience relationships.

 

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

 

Integrated Media Solutions

 

24/7 Web Alliance

 

We generate revenue through the 24/7 Web Alliance primarily from fees paid by client advertisers for advertising impressions.  We typically count an advertising impression each time a request is made to our servers to display an advertiser’s advertisement to an end user.  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.

 

23



 

We share advertising revenue generated through the 24/7 Web Alliance with Web publishers included in the 24/7 Web Alliance.  Our 24/7 Web Alliance consists of our 24/7 Network, a network of hundreds of Web sites offering a variety of content primarily in the U.S., and the 24/7 Portfolio, a select global portfolio of brand name Web sites.  We generally retain between 40% and 50% of advertising revenues generated from 24/7 Network Web sites and between 20% and 40% of advertising revenue generated from 24/7 Portfolio Web sites.  Our revenue share may vary depending on, among other things, audience size, the number of unique visitors, impressions and page views; geography and the prominence of the Web publisher’s brand name.

 

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.

 

 

 

Number of Paid
Impressions (in
billions)

 

Average CPM

 

Q2 2004

 

14.3

 

 

0.86

 

 

Q1 2004

 

9.6

 

 

1.03

 

 

Q4 2003

 

6.6

 

 

0.90

 

 

Q3 2003

 

5.9

 

 

0.95

 

 

Q2 2003

 

6.2

 

 

0.88

 

 

Q1 2003

 

6.1

 

 

0.79

 

 

Q4 2002

 

4.8

 

 

0.99

 

 

Q3 2002

 

3.0

 

 

1.23

 

 

Q2 2002

 

3.3

 

 

1.19

 

 

Q1 2002

 

4.2

 

 

1.01

 

 

 

24/7 Search

 

24/7 Search provides services 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 engine distribution partners, we submit advertiser Web site content via automated data feeds.  Our services only provide that our client advertisers’ Web site content will be included in the database of our search engine distribution partners.  We do not guarantee our client advertisers any particular ranking within search results listings displayed by our search engine distribution partners to users.

 

We generate revenue through 24/7 Search primarily from performance-based fees paid by our client advertisers for valid visitor traffic to their Web sites.  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 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

 

24



 

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.  We also provide search agency services to client advertisers that involves placing and managing CPC keyword bids for them with our distribution partners.  For this service, we charge our client advertiser the amount of the CPC bid plus a fixed commission for each valid visitor delivered and only recognize the fixed commission as revenue.

 

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.

 

 

 

Number of Valid
Visitors (in
millions)

 

Average CPC

 

Q2 2004

 

11.7

 

 

0.20

 

Q1 2004

 

13.2

 

 

0.23

 

Q4 2003

 

12.6

 

 

0.21

 

Q3 2003

 

9.0

 

 

0.24

 

Q2 2003

 

11.0

 

 

0.21

 

Q1 2003

 

16.5

 

 

0.19

 

Q4 2002

 

12.5

 

 

0.18

 

Q3 2002

 

9.6

 

 

0.21

 

Q2 2002

 

10.7

 

 

0.22

 

Q1 2002

 

8.4

 

 

0.20

 

 

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. We provide these solutions to our customers from software hosted on our servers or from software hosted on a customer’s server that is administrated by us.  Our technology Solutions 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;

 

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

 

      Insight XE, which offers Web publishers active campaign reporting and marketing intelligence and help advertisers measure, analyze and manage online audiences;

 

      Insight ACT, which, in combination with Insight XE and Open AdStream, enables Web publishers to identify and target segments of their audiences based on user activity; and

 

25



 

      Insight SE, which we designed 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 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.

 

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. 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 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 and OAD

 

Insight XE

 

 

 

 

 

Number of
Active Client
Contracts (1)

 

Number of
Active Client
Contracts (1)

 

Number of Paid
Impressions
(in billions)

 

Number of
Active Client
Contracts (1)

 

Number of Paid
Pageviews
(in billions)

 

Annual
Revenue per
Contract

 

Q2 2004

 

210

 

161

 

19.5

 

 

42

 

3.4

 

45,579

 

Q1 2004

 

201

 

138

 

18.6

 

 

32

 

1.1

 

46,814

 

Q4 2003

 

199

 

133

 

11.9

 

 

17

 

3.0

 

45,009

 

Q3 2003

 

219

 

146

 

10.6

 

 

16

 

2.7

 

42,845

 

Q2 2003

 

221

 

142

 

9.6

 

 

14

 

2.3

 

40,191

 

Q1 2003

 

235

 

151

 

8.8

 

 

13

 

1.8

 

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.

 

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.

 

26



 

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, South Korea.  Revenue contributed by RMK for the three and six month periods ended June 30, 2004 was approximately $3.3 million and $6.5 million, respectively.

 

The following table compares the results of operations for the three and six month periods ended June 30, 2004 to the results of operations for the three and six month periods ended June 30, 2003 (in thousands):

 

 

 

Three months ended June 30,

 

Dollar
Variance

 

Six months ended June 30,

 

Dollar
Variance

 

2004

 

2003

2004

 

2003

 

 

(in thousands)

 

(in thousands)

 

 

 

(unaudited)

 

 

 

(unaudited)

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Integrated media solutions

 

$

14,891

 

$

8,362

 

$

6,529

 

$

27,930

 

$

16,705

 

$

11,225

 

Technology solutions

 

4,706

 

3,788

 

918

 

9,048

 

7,269

 

1,779

 

Total revenues

 

19,597

 

12,150

 

7,447

 

36,978

 

23,974

 

13,004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Integrated media solutions

 

10,487

 

5,084

 

5,403

 

19,928

 

10,594

 

9,334

 

Technology solutions

 

879

 

1,062

 

(183

)

1,701

 

2,227

 

(526

)

Total cost of revenues

 

11,366

 

6,146

 

5,220

 

21,629

 

12,821

 

8,808

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

8,231

 

6,004

 

2,227

 

15,349

 

11,153

 

4,196

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

3,893

 

3,227

 

666

 

7,209

 

6,371

 

838

 

General and administrative

 

3,019

 

2,776

 

243

 

6,001

 

5,698

 

303

 

Product development

 

1,095

 

755

 

340

 

2,146

 

1,342

 

804

 

Amortization of intangible assets and deferred financing costs

 

1,414

 

661

 

753

 

2,202

 

1,308

 

894

 

Stock-based compensation

 

298

 

146

 

152

 

497

 

194

 

303

 

Restructuring costs

 

501

 

 

501

 

501

 

 

501

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

10,220

 

7,565

 

2,655

 

18,556

 

14,913

 

3,643

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(1,989

)

(1,561

)

(428

)

(3,207

)

(3,760

)

553

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

(96

)

(56

)

(40

)

(278

)

(147

)

(131

)

Change in fair value of warrant liability

 

881

 

 

881

 

1,809

 

 

1,809

 

Gain on legal settlement

 

2,896

 

 

2,896

 

2,896

 

 

2,896

 

Other income (expense), net

 

(69

)

(834

)

765

 

111

 

(834

)

945

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

1,623

 

(2,451

)

4,074

 

1,331

 

(4,741

)

6,072

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

32

 

33

 

(1

)

132

 

40

 

92

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

1,591

 

$

(2,484

)

$

4,075

 

$

1,199

 

$

(4,781

)

$

5,980

 

 

27



 

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 $12.1 million and $21.8 million for the three and six month periods ended June 30, 2004, respectively, as compared to $5.5 million and $10.2 million for the three and six month periods ended June 30, 2003, respectively, an increase of 120.2% and 114.3%, respectively.  The increase is primarily related to revenue contributed by RMK and sales of additional advertising inventory provided by Lycos, Inc. Web sites, which increased the number of paid impressions delivered through our 24/7 Network from 6.2 billion in 2003 to 14.3 billion in 2004.  RMK contributed revenue of $3.1 million and $6.1 million for the three and six month periods ended June 30, 2004, respectively.

 

24/7 Search revenue was $2.5 million and $5.5 million for the three and six month periods ended June 30, 2004, respectively, as compared to $2.3 million and $5.4 million for the three and six month periods ended June 30, 2003, respectively, an increase of 8.3% and 2.3%, respectively.  During the first six months of 2003, we generated a significant portion of our 24/7 Search revenue from Inktomi, which accounted for approximately 15.8% and 38.9% of our 24/7 Search revenue for the three and six month periods ended June 30, 2003, respectively.  Our contract with Inktomi expired in May 2003.  The loss of revenue related to Inktomi was partially offset by revenue from increased traffic generated through expanded relationships with our other distribution partners and new search relationships.

 

Other Media Services revenue in 2004 is generated from e-mail and revenue in 2003 was generated from e-mail and iPromotions, which was sold in January 2003.  iPromotions revenue was $0.1 million and $0.2 million for the three and six month periods ended June 30, 2003, respectively.  E-mail revenue decreased $0.2 million or 41.3% from $0.5 million to $0.3 million for the three month periods ended June 30, 2003 and 2004, respectively, and decreased $0.4 million or 36.2% from $1.0 million to $0.6 million for the six month periods ended June 30, 2003 and 2004, 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 $4.7 million and $9.0 million for the three and six month periods ended June 30, 2004, respectively, as compared to $3.8 million and $7.3 million for the three and six month periods ended June 30, 2003, respectively, representing an increase of 24.2% and 24.5%, respectively.  The increase reflects increased usage by customers of our Open AdStream Central and our Insight XE services, new customer wins globally, and, to a lesser extent, revenue contributed by RMK.  In particular, the Company’s hosted solutions delivered 22.9 billion paid impressions and page views in the period, up from 11.9 billion in the second quarter of 2003.  RMK contributed revenue of $0.3 million and $0.4 million for the three and six month period ended June 30, 2004, respectively.

 

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 search engine distribution partner (for 24/7 Search) or a list provider (for e-mail), 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.

 

28



 

Gross profit margins were 29.6% and 28.7% for the three and six month periods ended June 30, 2004, respectively, and 39.2% and 36.6% for the three and six month period ended June 30, 2003, respectively.  This decrease reflects the addition of RMK, which has a lower gross profit margin than our other business units, and increased upward pressure on the cost of traffic, particularly CPC bid prices, for 24/7 Search.  In addition, 24/7 Search generated a greater portion of its revenue from bid-for-placement which generally has 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 for our 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 profit margins were 81.3% and 81.2% for the three and six month periods ended June 30, 2004, respectively, and 72.0% and 69.4% for the three and six month period ended June 30, 2003, respectively.  The increase in gross profit 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 $3.9 million and $7.2 million for the three and six month periods ended June 30, 2004, respectively, $3.2 million and $6.4 million for the three and six month periods ended June 30, 2003, respectively.  Sales and marketing expenses decreased as a percentage of revenue from 26.6% to 19.9% for the three month periods ended June 30, 2003 and 2004, respectively, and from 26.6% to 19.5% for the six month periods ended June 30, 2003 and 2004, respectively, as we were able to gain operating leverage off the existing cost structure.  The number of employees included in sales and marketing increased from 122 at June 30, 2003 to 141 at June 30, 2004, primarily due to the addition of 32 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 $6.0 million for the three and six month periods ended June 30, 2004, respectively, and $2.8 million and $5.7 million for the three and six months ended June 30, 2003, respectively.  As a percentage of revenue, the expenses decreased from 22.8% to 15.4% for the three month periods ended June 30, 2003 and 2004, respectively, and from 23.8% to 16.2% for the six month periods ended June 30, 2003 and 2004, respectively.  General and administrative costs increased slightly to support the growth of the business; however it decreased as a percentage of revenue.  The number of general and administrative employees at June 30, 2004 and 2003 was 47 and 44, 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 $2.2 million for the three and six month periods ended June 30, 2004, respectively, as compared to $0.8 million and $1.3 million for the three and six month periods ended June 30, 2003, respectively.  We capitalized approximately $0.4 million of Open Advertiser development costs for the six month period ended June 30, 2003.  The Company ceased capitalization of the costs when 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 32 at June 30, 2003 to 40 at June 30, 2004.

 

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AMORTIZATION OF INTANGIBLE ASSETS AND DEFERRED FINANCING COSTS. Amortization expense relates to intangible assets acquired with 24/7 Search in August 2000, Real Media in October 2001, Now Marketing in September 2002, Insight First in January 2003, and RMK in January 2004; deferred financing costs associated with the subordinated convertible debenture offering in September 2003; and the transition payment to Lycos in February 2004.  Amortization expense was $1.4 million and $2.2 million for the three and six month periods ended June 30, 2004, respectively, and $0.7 million and $1.3 million for the three and six month periods ended June 30, 2003, respectively.  For the six month period ended June 30, 2004, amortization expense related $1.1 million to acquired technology, $0.5 million to other intangible assets, $0.3 million to deferred financing costs and $0.3 million to the transition payment to Lycos.  Amortization expense for the six month period ended June 30, 2003 related to acquired technology.  In the fourth quarter of 2003, the Company made the strategic decision to no longer support the 24/7 Messenger product that was acquired with Now Marketing.  The related acquired technology was amortized until December 31, 2003 and the remaining balance of $1.3 million was considered impaired.

 

STOCK-BASED COMPENSATION. Stock-based compensation was $0.3 million and $0.5 million for the three and six month periods ended June 30, 2004, respectively, and $0.1 million and $0.2 million for the three and six month periods ended June 30, 2003, respectively.  The expense for the six month period ended June 30, 2004 consists of $0.3 million accrued for potential performance incentives and $0.2 million in amortization of deferred compensation for restricted shares issued to certain employees.  The expense for the six month period ended June 30, 2003 consists of $0.1 million in amortization of deferred compensation for restricted shares issued to certain employees and $0.1 million in other compensation given to employees.

 

RESTRUCTURING COSTS.  During the second quarter of 2004, the Company took additional steps to align its sales, development and administrative organization and reduce corporate overhead to position itself for profitable growth in the future growth consistent with the Company’s long-term goals.  This involved the involuntary termination of approximately seven employees, as well as charges for excess real estate space, primarily at our German office.  The Company recorded a restructuring charge of approximately $0.5 million.

 

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 $0.1 million and $0.3 million for the three and six month periods ended June 30, 2004, respectively, and $0.1 million and $0.2 million for the three and six month periods ended June 30, 2003, respectively.  Interest expense in 2004 primarily relates to subordinated convertible debentures issued in the third quarter of 2003 of which a portion is cash and amortization of warrants issued with the debentures.  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.

 

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 and $1.8 million gain for the three and six month periods ended June 30, 2004, respectively, 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 second quarter compared to when the warrants were issued.

 

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GAIN ON LEGAL SETTEMENT.  The $2.9 million for the six month period ended June 30, 2004 related to our legal settlement with chinadotcom Corporation (“chinadotcom”) received in the form of 0.4 million shares of chinadotcom common stock, valued at the market price on the date of settlement.

 

OTHER INCOME (EXPENSE), NET. Other income of $0.1 million for the six month period ended June 30, 2004 consists of $0.2 million in amounts recovered from a former subsidiary offset by $0.1 million of legal fees and other expenses related to previous patent litigation.  Other expense of $0.8 million for the six month period ended June 30, 2003 consists of $1.2 million in legal fees and other expenses related to patent litigation offset by $0.4 million in income related to the settlement of liabilities of disposed businesses on favorable terms.

 

PROVISION FOR INCOME TAXES. The provision for income taxes recorded for the three and six month periods ended June 30, 2004 consist primarily of income taxes on earnings of our foreign subsidiaries.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash flows for the six month periods ended June 30, 2004 and 2003 were as follows (in thousands):

 

 

 

Six month period ended

 

 

 

 

 

June 30,
2004

 

June 30,
2003

 

Year-over-Year
Change

 

 

 

 

 

 

 

($)

 

 

 

 

 

 

 

 

 

Net cash used in operating activities

 

$

(4,767

)

$

(3,564

)

$

1,203

 

Net cash used in investing activities

 

$

(2,777

)

$

(706

)

$

2,071

 

Net cash provided by financing activities

 

$

37,927

 

$

5,754

 

$

32,173

 

 

Operating Activities

 

Since our inception we have financed our operations through equity financings and long-term debt.  We used approximately $4.8 million and $3.6 million of cash in operating activities during the six month periods ended June 30, 2004 and 2003, respectively, generally as a result of our net operating income (loss), adjusted for certain non-cash items included in our operating results as well as changes in various components of working capital.

 

Investing Activities

 

Net cash used in investing activities was approximately $2.8 million and $0.7 million during the six month periods ended June 30, 2004 and 2003, respectively.  Investing activities during the six month period of 2004 relate $2.0 million to the acquisition of RMK and $0.8 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 $0.5 million for capital expenditures, including capitalized software.

 

Financing Activities

 

Financing activities provided $37.9 million and $5.8 million for the six month periods ended June 30, 2004 and 2003, respectively.  Financing activities in 2004 related $37.4 million to net

 

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proceeds from our secondary offering of common stock and $0.6 million to the exercise of stock options.  Financing activities in 2003 related $6.8 million to net proceeds from the issuance of our preferred stock and $0.5 million to the exercise of stock options offset by $1.5 million from the retirement of the PubliGroupe promissory notes.

 

CERTAIN COMMITMENTS AND CONTRACTUAL OBLIGATIONS

 

Subordinated Convertible Debentures.  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.

 

Services Agreement with Lycos, Inc.  Pursuant to our agreement with Lycos, Inc., we have a remaining liability of $2.3 million related to the transition payment due in equal installments at each quarter end in 2004 and specified minimum annual payments due 45 days after each quarter end.  For 2004, the minimal annual payment is $10.0 million and is payable $2.5 million 45 days after each quarter end.

 

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

 

Other Commitments and Contingencies

 

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.  The Company pays bonuses to executive employees based on the achievement of revenue goals and other financial measures including earnings before interest, taxes, amortization and stock-based compensation. These contracts also require 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 June 30, 2004, there were approximately 66 employees in Europe whose annualized base salaries are approximately $4.9 million.

 

We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors, and officers and former directors, officers and employees of acquired companies, in certain circumstances.  The indemnification provided by us to our officers and directors does not have a stipulated maximum, therefore we are not able to develop a reasonable estimate of the maximum liabilities.  To date, we have not incurred material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements.

 

In connection with our commercial agreements, we provide indemnifications of varying scope and terms to customers, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such agreements and out of intellectual property infringement claims made by third parties.

 

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As of June 30, 2004, we had approximately $1.2 million remaining of cash outlay obligations relating to restructuring and exit costs consisting of severance and rent.  We expect to pay approximately $0.5 in the remainder of 2004, $0.2 million in each year from 2005 to 2007 and $0.1 million in 2008.

 

We continue to increase capital expenditures and operating lease commitments, which is consistent with our increased staffing and operational expansion, and we anticipate that this will continue in the future as business conditions merit.  Additionally, we will continue to evaluate possible acquisitions of, or investments in businesses, products, and technologies that are complementary to our business, which may require the use of cash. Management believes existing cash and investments will be sufficient to meet operating requirements for at least the next twelve months; however, we may sell additional equity or debt securities or obtain credit facilities to further enhance our liquidity position beyond June 30, 2005. The sale of additional securities could result in further dilution to our stockholders.

 

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 June 30, 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.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

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:

 

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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 revenues in the accompanying consolidated statements of operations.

 

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 do not exceed one year.

 

Expenses from the Company’s licensing, maintenance and technical support 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 or collected in advance of services being completed are deferred until the conclusion of the period of the service for which the advance billing or collection relates.  Deferred revenues are included on the consolidated balance sheets 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.

 

Accounts Receivable

 

We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s current credit worthiness, as determined by a review of their current credit information. We regularly monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. While such credit losses have

 

34



 

historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that have been experienced in the past.

 

Valuation of goodwill and intangible assets

 

Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS 142 eliminates the amortization of goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with finite lives and addresses impairment testing and recognition for goodwill and intangible assets. SFAS No. 144 establishes a single model for the impairment of long-lived assets.

 

We assess goodwill for impairment annually unless events occur that require more frequent reviews. Long-lived assets, including amortizable intangibles, are tested for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Discounted cash flow analyses are used to assess nonamortizable intangible impairment while undiscounted cash flow analyses are used to assess long-lived asset impairment. If an assessment indicates impairment, the impaired asset is written down to its fair market value based on the best information available. Estimated fair market value is generally measured with discounted estimated future cash flows. Considerable management judgment is necessary to estimate undiscounted and discounted future cash flows. Assumptions used for these cash flows are consistent with internal forecasts.

 

On an on-going basis, management reviews the value and period of amortization or depreciation of long-lived assets, including goodwill and other intangible assets. During this review, we re-evaluate the significant assumptions used in determining the original cost of long-lived assets. Although the assumptions may vary from transaction to transaction, they generally include revenue growth, operating results, cash flows and other indicators of value. Management then determines whether there has been an impairment of the value of long-lived assets based upon events or circumstances that have occurred since acquisition. The impairment policy is consistently applied in evaluating impairment for each of our wholly owned subsidiaries and investments.

 

Contingencies and Litigation

 

We evaluate contingent liabilities including threatened or pending litigation in accordance with SFAS No. 5, Accounting for Contingencies, and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based on the facts and circumstances and in some instances based in part on the advice of outside legal counsel.

 

MARKET FOR COMPANY’S COMMON EQUITY

 

We have not declared or paid any dividends on our capital stock since our inception and do not anticipate paying dividends in the foreseeable future. Our current policy is to retain earnings, if any, to finance the expansion of our business. In addition, our subordinated convertible debentures restrict our ability to pay cash dividends on our capital stock. The future payment of dividends will depend on the results of operations, financial condition, capital expenditure plans and other factors that we deem relevant and will be at the sole discretion of our Board of Directors.

 

35



 

Since our initial public offering on August 13, 1998 until June 2002, our common stock traded on the Nasdaq National Market under the symbol “TFSM.”  In June 2002, we transferred our common stock to the Nasdaq SmallCap Market, where it currently trades under that same symbol.

 

RISK FACTORS

 

RISKS RELATED TO 24/7 REAL MEDIA, INC.

 

WE MAY NOT BE ABLE TO SUSTAIN OUR PROFITABILITY.

 

We achieved profitability in accordance with generally accepted accounting principles, or GAAP, for the three and six month periods ended June 30, 2004 but we may not be able to sustain profitability in the future. We incurred net losses of $2.5 million and $4.8 million for the three and six month periods ended June 30, 2003, respectively.  Each of our predecessors had net losses in every year of their operation.  We may incur operating losses in the current period and for the foreseeable future. Even if we do maintain GAAP profitability, we may not be able to sustain or increase our current level of profitability on a quarterly or annual basis in the future.

 

WE HAVE A LIMITED OPERATING HISTORY ON WHICH AN INVESTOR CAN EVALUATE OUR BUSINESS.

 

We have a limited operating history. You must consider the risks, expenses and difficulties typically encountered by companies with limited operating histories, particularly companies in new and rapidly expanding markets such as Internet advertising. These risks include our ability to:

 

      develop new relationships and maintain existing relationships with our Web sites, advertisers, search engine providers and other third parties;

 

      continue to develop and upgrade our technology;

 

      respond to competitive developments;

 

      implement and improve operational, financial and management information systems;

 

      adapt to industry consolidation; and

 

      attract, retain and motivate qualified employees.

 

Our limited operating history makes it difficult to predict future revenues and operating expenses.

 

OUR BUSINESS MAY SUFFER IF WE ARE UNABLE TO SUCCESSFULLY IMPLEMENT OUR BUSINESS MODEL.

 

A significant part of our business model is to generate revenue by providing interactive marketing solutions to advertisers, advertising agencies and Web publishers. The profit potential for this business model is unproven. To be successful, both Internet advertising and our solutions will need to achieve broad market acceptance by advertisers, advertising agencies and Web

 

36



 

publishers. Our ability to generate significant revenue from advertisers will depend, in part, on our ability to contract with Web publishers that have Web sites with adequate available advertisement space inventory. Further, these Web sites must generate sufficient user traffic with demographic characteristics attractive to our advertisers. The intense competition among Internet advertising sellers has led to the creation of a number of pricing alternatives for Internet advertising. These alternatives make it difficult for us to project future levels of advertising revenue and applicable gross margin that can be sustained by us or the Internet advertising industry in general.

 

Intensive marketing and sales efforts may be necessary to educate prospective advertisers regarding the uses and benefits of, and to generate demand for, our products and services, including our newer products and services such as 24/7 Search, Open Advertiser and Insight. Enterprises may be reluctant or slow to adopt a new approach that may replace, limit or compete with their existing direct marketing systems. In addition, since online direct marketing is emerging as a new and distinct business apart from online advertising, potential adopters of online direct marketing services will increasingly demand functionality tailored to their specific requirements. We may be unable to meet the demands of these clients. Acceptance of our new solutions will depend on the continued emergence of Internet commerce, communication and advertising. Demand for our new solutions may not emerge or become sustainable.

 

OUR FUTURE REVENUES AND RESULTS OF OPERATIONS MAY BE DIFFICULT TO FORECAST AND RESULTS IN PRIOR PERIODS MAY NOT BE INDICATIVE OF FUTURE RESULTS.

 

At times in the past and in certain segments, our revenues have grown significantly and also have decreased during certain periods and in certain segments. Accurate predictions of future revenues are difficult because of the rapid changes in our markets and our possible need to sell assets to fund operations. We have also acquired or disposed of various subsidiaries and product lines over the last several years. Accordingly, investors should not rely on past revenue growth rates as an indicator of future revenue growth.

 

Our results of operations have fluctuated and may continue to fluctuate significantly in the future as a result of a variety of factors, many of which are beyond our control. These factors include:

 

      the addition of new or loss of existing clients;

 

      changes in fees paid by advertisers or other clients;

 

      changes in service fees payable by us to owners of Web sites, or advertisement serving fees payable by us to third parties;

 

      the demand by advertisers and Web publishers for our advertising solutions;

 

      the introduction of new Internet marketing services by us or our competitors;

 

      variations in the levels of capital or operating expenditures and other costs relating to the maintenance or expansion of our operations, including personnel costs;

 

      changes in governmental regulation of the Internet; and

 

37



 

      general economic conditions.

 

Our future revenues and results of operations may be difficult to forecast due to the above factors. In addition, our expense levels are based in large part on our investment plans and estimates of future revenues. Any increased expenses may precede or may not be followed by increased revenues, as we may be unable to, or may elect not to, adjust spending in a timely manner to compensate for any unexpected revenue shortfall. As a result, we believe that period-to-period comparisons of our results of operations may not be meaningful.

 

You should not rely on past periods as indicators of future performance. In future periods, our results of operations may fall below the expectations of securities analysts and investors, which could adversely affect the trading price of our common stock.

 

OUR REVENUES ARE SUBJECT TO FLUCTUATIONS BY SEASON AND DUE TO GENERAL ECONOMIC CONDITIONS.

 

We believe that our revenues are subject to seasonal fluctuations because advertisers generally place fewer advertisements during the first and third calendar quarters of each year. Furthermore, Internet user traffic typically drops during the summer months, which reduces the number of advertisements to sell and deliver. Expenditures by advertisers tend to vary in cycles that reflect overall economic conditions as well as budgeting and buying patterns. Our revenue could be materially reduced by a decline in the economic prospects of advertisers or the economy in general, which could alter current or prospective advertisers’ spending priorities or budget cycles or extend our sales cycle. Due to such risks, you should not rely on quarter-to-quarter comparisons of our results of operations as an indicator of our future results.

 

OUR REVENUE COULD DECLINE IF WE FAIL TO EFFECTIVELY MANAGE OUR EXISTING ADVERTISING INVENTORY AND OUR GROWTH COULD BE IMPEDED IF WE FAIL TO ACQUIRE ACCESS TO NEW ADVERTISING INVENTORY.

 

Our success depends in part on our ability to effectively manage our existing advertising inventory. The Web publishers that list their unsold advertising inventory with us are not bound by long-term contracts. In addition, Web publishers can change the amount of inventory they make available to us at any time. If a Web publisher decides not to make advertising space from its Web sites available to us, we may not be able to replace this advertising space with advertising space from other Web sites that have comparable traffic patterns and user demographics quickly enough to fulfill our advertisers’ requests. This would result in lost revenue. We expect that our customers’ requirements will become more sophisticated as the Web matures as an advertising medium. If we fail to manage our existing advertising space effectively to meet our customers’ changing requirements, our revenue could decline. Our growth also depends on our ability to expand our advertising inventory. To attract new advertisers, we must maintain a consistent supply of attractive advertising space. We intend to expand our advertising inventory by selectively adding to our network new Web publishers that offer attractive demographics, innovative and quality content and large audiences. Our ability to attract new Web publishers to our network and to retain Web publishers currently in our network will depend on various factors, some of which are beyond our control. These factors include our ability to introduce new and innovative product lines and services, our ability to efficiently manage our existing advertising inventory, our pricing policies and the cost-efficiency to Web publishers of outsourcing all or part of their advertising sales. In addition, the number of competing intermediaries that purchase advertising inventory from Web publishers continues to increase. The size of our inventory may not increase or even remain constant in the future.

 

38



 

OUR TECHNOLOGY SOLUTIONS MAY NOT BE SUCCESSFUL AND MAY CAUSE BUSINESS DISRUPTION.

 

Open AdSystem is our proprietary advertisement serving technology that is intended to serve as our sole advertisement serving solution. We have developed a variety of products to work on or with this platform. Some of these products, such as our Open Advertiser, Insight ACT and Insight SE products, are not yet available or are only available in beta version to some or all of our customers. We must, among other things, ensure that the technology will function efficiently at high volumes, interact properly with our database, offer the functionality demanded by our customers and assimilate our sales and reporting functions. We must further complete development of our beta products. This development effort could fail technologically or could take more time than expected. Customers may become dissatisfied by any system failure that interrupts our ability to provide our services to them, including failures affecting our ability to deliver advertisements without significant delay to the viewer. Sustained or repeated system failures would reduce the attractiveness of our solutions to advertisers, advertising agencies and Web publishers and result in contract terminations, fee rebates and make-goods, thereby reducing our revenue. Slower response time or system failures may also result from straining the capacity of our deployed software or hardware due to an increase in the volume of advertising delivered through our servers. To the extent that we do not effectively address any capacity constraints or system failures, our business, results of operations and financial condition could be materially and adversely affected.

 

WE HAVE SUBSTANTIAL DEBT, AND WE MAY NOT GENERATE SUFFICIENT CASH FLOW TO MEET OUR DEBT SERVICE OBLIGATIONS.

 

In September 2003, we issued to a single holder a 2% subordinated convertible debenture in the principal amount of $15.0 million that matures in September 2006. The amount of our debt could have important consequences, including:

 

      impairing our ability to obtain additional financing for working capital, capital expenditures, acquisitions or general corporate purposes;

 

      requiring us to dedicate a substantial portion of any operating cash flow that we generate to paying principal and interest on indebtedness, thereby reducing the funds available for operations;

 

      limiting our ability to grow and make capital expenditures due to the covenants contained in our debt arrangements;

 

      impairing our ability to adjust rapidly to changing market conditions, invest in new or developing technologies, or take advantage of significant business opportunities that may arise;

 

      placing us at a competitive disadvantage compared to our competitors that have less debt; and

 

      making us more vulnerable if there is an economic downturn or if our business experiences difficulties.

 

39



 

If we cannot generate sufficient additional cash flow, we may not be able to meet our debt service obligations, repay our debt when due, or comply with other covenants in the subordinated convertible debentures. If we breach the debentures, the investor could require repayment of all amounts owed, and we may not have sufficient cash reserves to repay such amounts.

 

WE MAY BE UNABLE TO RAISE THE FUNDS NECESSARY TO REPAY OR REFINANCE OUR INDEBTEDNESS. THE ISSUANCE OF STOCK UPON REDEMPTION OF OUR SUBORDINATED CONVERTIBLE DEBENTURES MAY SUBSTANTIALLY DILUTE THE INTERESTS OF OTHER SECURITY HOLDERS.

 

Stockholders could experience substantial dilution resulting from our election to pay the semi-annual accrued interest due in common stock or repay the principal amount in common stock. We are obligated to make semi-annual interest payments on January 1 and July 1 of each year and the entire principal face amount of the debentures is due and payable on September 26, 2006. We may elect to pay interest in cash, in shares of our common stock or in additional debentures. In addition, if, after September 26, 2005, the price of our common stock does not exceed the conversion price of the debentures for a period of five consecutive trading days we may be required to repurchase $7.5 million in principal amount of the debentures on September 26, 2005. We may elect to repay the principal amount of the debentures in cash or in shares of our common stock. If we so elect, payment in shares shall be based upon ninety percent of the average of the volume weighted average price of our common stock on the principal market as reported by Bloomberg Financial L.P. during the five trading days immediately prior to the interest payment date, in the case of an interest payment, or during the 15 trading days immediately prior to the maturity date, in the case of the repayment of the principal amount of the debentures.

 

If we decide to repay the principal in cash we will need additional capital to fund this obligation. Our ability to arrange financing and the cost of this financing will depend upon many factors, including: general economic and capital market conditions generally, and in particular the non-investment grade debt market; credit availability from banks or other lenders; investor confidence in our industry generally and our company specifically; and provisions of tax and securities law that are conducive to raising capital.

 

If we need additional funds and are unable to raise them, our inability to raise them will have an adverse effect on our operations. If we decide to raise additional funds by incurring debt, we may become subject to additional or more restrictive financial covenants and ratios. If we fail to make the mandatory redemptions in cash and if our stock price significantly declines, we could potentially be obligated to issue a larger number of shares of our common stock in redemption of the debentures.

 

WE MAY NEED TO RAISE ADDITIONAL FUNDS TO CONTINUE OPERATIONS.

 

A significant acquisition, an unforeseen reduction in our revenues, an impairment of our receivables, or an increase in expenses or capital expenditures may require us to raise additional funds to continue operations. To the extent we encounter additional opportunities to raise cash, we may sell additional equity or debt securities, which would result in further dilution of our stockholders. Stockholders may experience extreme dilution due to our current stock price and the amount of financing we may need to raise and these securities may have rights senior to those of holders of our common stock. Our subordinated convertible debentures limit our ability to incur additional debt, and any future indebtedness that we may incur could contain covenants that restrict our operating flexibility.

 

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We have limited access to the capital markets to raise capital. The capital markets have been unpredictable in the past, especially for unprofitable companies such as ours. In addition, it is difficult to raise capital in the current market conditions. The amount of capital that a company such as ours is able to raise often depends on variables that are beyond our control, such as the share price of our stock and its trading volume. As a result, efforts to secure financing on terms attractive to us may not be successful, and we may not be able to secure additional financing on any terms.

 

Due to our operating losses, it may be difficult to obtain debt financing. If we are able to consummate a financing arrangement, the amount raised may not be sufficient to meet our future needs. If adequate funds are not available on acceptable terms, or at all, our business, results of operation, financial condition and continued viability will be materially and adversely affected.

 

WE DISCLOSE PRO FORMA INFORMATION, WHICH MAY EXCLUDE ITEMS THAT ARE IMPORTANT TO AN INVESTOR’S UNDERSTANDING OF OUR RESULTS OF OPERATIONS.

 

We prepare and release quarterly unaudited financial statements prepared in accordance with GAAP. We also disclose and discuss certain pro forma and other non-GAAP information in the related earnings release and investor conference call. This pro forma financial information excludes or may exclude certain special charges and other costs. We believe the disclosure of the pro forma financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases, and to compare the GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls.

 

OUR ACQUISITIONS MAY NOT BE SUCCESSFUL.

 

We were formed in February 1998 to consolidate three Internet advertising companies and have since acquired other companies. We may continue pursuing selective acquisitions of businesses, technologies and product lines as a key component of our growth strategy. If we acquire additional companies, we will continue to face risks of integrating and improving our financial and management controls, advertisement serving technology, reporting systems and procedures, and expanding, training and managing our work force. This process of integration may take a significant period of time and will require the dedication of management and other resources, which may distract management’s attention from our other operations. Any future acquisition or investment may result in the use of significant amounts of cash, potentially dilutive issuances of equity securities, incurrence of debt and amortization expenses related to intangible assets. In addition, acquisitions involve numerous risks, including:

 

      the difficulties in the integration and assimilation of the operations, technologies, products and personnel of an acquired business;

 

      the diversion of management’s attention from other business concerns;

 

      the availability of favorable acquisition financing for future acquisitions; and

 

      the potential loss of key employees of any acquired business.

 

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Our inability to successfully integrate any acquired company, or failure to achieve any expected synergies, could adversely affect our business.

 

WE MAY NOT BE ABLE TO SUCCESSFULLY INTEGRATE REAL MEDIA KOREA CO., LTD. INTO OUR COMPANY.

 

In January 2004, we completed our acquisition of Real Media Korea Co., Ltd. We may not realize the anticipated financial and strategic goals of this acquisition, and this acquisition may not be successful. The success of this acquisition will depend in part on our ability to expand the business of Real Media Korea into new geographical markets in the region. We may have difficulty integrating the business and operations of Real Media Korea or retaining their key personnel as well as implementing and maintaining standards, controls, procedures and policies that are consistent with ours. Additionally, our ongoing business and management’s attention may be disrupted or diverted by transition or integration issues and the complexity of managing geographically and culturally diverse locations. These factors could have a material adverse effect on our business, results of operations and financial condition or cash flows.

 

OUR NET OPERATING LOSS CARRYFORWARDS MAY BE LIMITED.

 

Due to the “change in ownership” provisions of the Internal Revenue Code, the availability of our net operating loss and credit carryforwards may be subject to an annual limitation against taxable income in future periods, which could substantially limit the eventual utilization of these carryforwards.

 

WE COULD BE ADVERSELY AFFECTED BY AN IMPAIRMENT OF A SIGNIFICANT AMOUNT OF GOODWILL AND/OR INTANGIBLE ASSETS ON OUR BALANCE SHEET.

 

In the course of our operating history, we have acquired and disposed of numerous assets and businesses. Some of our acquisitions have resulted in the recording of a significant amount of goodwill and/or intangible assets on our financial statements. The goodwill and/or intangible assets were recorded because the fair value of the net assets acquired was less than the purchase price. We may not realize the full value of the goodwill and/or intangible assets. As such, we evaluate on at least an annual basis whether events and circumstances indicate that all or some of the carrying value of goodwill and/or intangible assets are no longer recoverable, in which case we would write off the unrecoverable portion as a charge to our earnings.

 

To improve our operating performance, we may determine to acquire other assets or businesses complementary to our business and, as a result, we may record additional goodwill and/or intangible assets in the future. The possible write-off of the goodwill and/or intangible assets could negatively impact our future earnings. We will also be required to allocate a portion of the purchase price of any acquisition to the value of any intangible assets that meet the criteria specified in the Statement of Financial Accounting Standards No. 141, “Business Combinations,” such as marketing, customer or contract-based intangibles. The amount allocated to these intangible assets could be amortized over a fairly short period. As a result, our earnings and the market price of our common stock could be negatively affected.

 

THE SUCCESS OF OUR 24/7 SEARCH OPERATIONS DEPENDS ON A SMALL NUMBER OF SEARCH ENGINE CLIENTS, AND THE LOSS OF A SINGLE SEARCH ENGINE CLIENT COULD RESULT IN A SUBSTANTIAL DECREASE IN OUR 24/7 SEARCH REVENUE.

 

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We have generated a significant portion of our 24/7 Search revenue from relationships with a small number of search engines, including Alta Vista, Ask Jeeves, Google, MyGeek and Overture. We expect that a small number of search engine distribution partners will continue to generate a majority or more of our 24/7 Search revenue for the foreseeable future. The interruption or loss of any of our primary search engine relationships could cause a significant decrease in 24/7 Search revenue. As a result of consolidation among search engines, and other search marketing companies, we could lose one of more of our distribution partners or face increased competition from search engines (including our current search engine distribution partners) that internally develop or acquire capabilities similar to our service. In addition, as the operations and strategies of our search engine distribution partners continue to evolve, we may be required to adjust our business strategy to maintain relationships with our clients, which could have a material adverse effect on our 24/7 Search revenue.

 

OUR CUSTOMERS AND PARTNERS MAY EXPERIENCE ADVERSE BUSINESS CONDITIONS THAT COULD ADVERSELY AFFECT OUR BUSINESS.

 

As a result of unfavorable conditions in the capital markets, some of our customers may have difficulty raising sufficient capital to support their long-term operations. As a result, these customers have reduced their spending on Internet advertising, which has materially and adversely affected our business, financial condition and results of operations. In addition, we have entered into a strategic business relationship with Lycos, and may enter into similar relationships with other companies. These companies may experience similar adverse business conditions that may render them unable to meet our expectations for the strategic business relationship or to fulfill their contractual obligations to us. Such an event could have a material adverse impact on our business, financial condition and results of operations.

 

WE HAVE SIGNIFICANT OBLIGATIONS UNDER OUR AGREEMENT WITH LYCOS AND WE EXPECT LYCOS TO REPRESENT A SIGNIFICANT PORTION OF OUR REVENUES.

 

We recently entered into an agreement with Lycos, Inc. to provide media sales, advertisement serving and analytics technology services to Lycos’ U.S. Web properties.  We expect that Lycos will generate a significant portion of our revenues.  As part of our agreement with Lycos, we must hire additional personnel and implement additional controls and procedures to provide advertising sales, billing and other important services related to the Lycos Web properties.  To the extent that we cannot hire additional personnel or adequately implement additional controls and procedures, our relationship with Lycos may suffer and our obligations under this agreement may materially and adversely affect our business, results of operations and financial condition.

 

Our agreement with Lycos requires us to make a minimum annual payment of $10 million in 2004, along with an initial payment of $4.5 million to be paid to Lycos over the course of 2004. We are also required to make minimum annual payments in each subsequent year during the term of the agreement. Our minimum annual payments under this agreement could increase during the term of the agreement. To the extent that we fail to sell adequate advertising space on Lycos’ Web properties, or if prices for advertising space fall below our expectations, our obligations under this agreement may materially and adversely affect our business, results of operations and financial condition.

 

Lycos may have the right to terminate our agreement if Lycos or we are acquired.  Terra Lycos, the parent company of Lycos, recently engaged an investment banker to consider and advise on a

 

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possible sale of the Lycos property.  If our agreement with Lycos is terminated, although we would not have to make minimum annual payments, we would lose a significant portion of our revenues which could materially and adversely affect our business, results of operations and financial condition.

 

IF WE LOSE OUR CEO OR OTHER SENIOR MANAGERS, OUR BUSINESS WILL BE ADVERSELY AFFECTED.

 

Our success depends, to a significant extent, upon our senior management and key sales and technical personnel, particularly David J. Moore, our Chief Executive Officer, Jonathan K. Hsu, our Chief Financial Officer, Christopher J. Wagner, our Chief Executive Officer - Europe, Jae Woo Chung, our Chief Executive Officer - Korea, David Hills, our President, Media Solutions, and Tony Schmitz, our Chief Technology Officer and President, Technology Solutions. The loss of the services of one or more of these persons could materially and adversely affect our ability to develop our business. Our success also depends on our ability to attract and retain qualified technical, sales and marketing, customer support, financial and accounting, and managerial personnel. We may be unable to retain our key personnel or attract, integrate or retain other highly qualified personnel in the future. We have experienced in the past, and may continue to experience in the future, difficulty in hiring and retaining candidates with appropriate qualifications, especially in sales and marketing positions.

 

WE MIGHT EXPERIENCE SIGNIFICANT DEFECTS IN OUR PRODUCTS.

 

Software products frequently contain errors or failures, especially when first introduced or when new versions are released. We might experience significant errors or failures in our products, or they might not work with other hardware or software as expected, which could delay the enhancement of our products, or which could adversely affect market acceptance of our products. Any significant product errors or design flaws would slow the adoption of our products and cause damage to our reputation, which would seriously harm our business. If customers were dissatisfied with product functionality or performance, we could lose revenue or be subject to liability for service or warranty costs and claims, and our business, operating results and financial condition could be adversely affected.

 

SOME OF OUR SOFTWARE IS LICENSED FROM THIRD PARTIES.

 

Some of our products, including one or more modules for our Open AdSystem platform, contain software licensed from third parties. Some of these licenses may not be available to us in the future or on terms that are acceptable or allow our products to remain competitive. Our inability to use any of this third party software could result in shipment delays, delays in the development of future products or enhancements of existing products, or other disruptions in our business, which could materially and adversely affect our business, financial condition and operating results.

 

OUR OPERATIONS ARE VULNERABLE TO NATURAL DISASTERS AND OTHER EVENTS, INCLUDING TERRORIST ATTACKS, BECAUSE WE HAVE LIMITED BACKUP SYSTEMS.

 

We have limited backup systems and have experienced system failures and electrical outages from time to time in the past, which have disrupted our operations. We have a limited disaster recovery plan in the event of damage from fire, floods, typhoons, earthquakes, power loss, telecommunications failures, break-ins and similar events. Our operations are dependent on our ability to protect our computer systems against these unexpected adverse events.

 

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If any of the foregoing occurs, we may experience a complete system shutdown. Any business interruption insurance that we carry is unlikely to be sufficient to compensate us for loss of business in the event of a significant catastrophe.

 

In addition, interruptions in our services could result from the failure of our telecommunications providers to provide the necessary data communications capacity in the time frame we require. Our Open AdSystem technology resides on computer systems located in our data centers housed by Cable & Wireless in the United States and Level3 Communications in Europe. These systems’ continuing and uninterrupted performance is critical to our success. Despite precautions that we have taken, unanticipated problems affecting our systems have from time to time in the past caused, and in the future could cause, interruptions in the delivery of our solutions. Our business, results of operations and financial condition could be materially and adversely affected by any damage or failure that interrupts or delays our operations. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers or one or more copies of our Web sites to mirror our online resources. Although we believe we carry property insurance with adequate coverage limits, our coverage may not be adequate to compensate us for all losses, particularly with respect to loss of business and reputation, that may occur.

 

In addition, terrorist acts or acts of war may cause damage to our employees, facilities, clients, our clients’ customers and vendors, which could significantly impact our revenues, costs and expenses and financial position. The potential for future terrorist attacks, the national and international responses to terrorist attacks or perceived threats to national security, and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways that cannot be presently predicted. We are predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war.

 

OUR INTERNATIONAL OPERATIONS FACE LEGAL AND CULTURAL CHALLENGES.

 

We have operations in a number of international markets, including Asia, Canada and Europe. To date, we have limited experience in marketing, selling and distributing our solutions internationally. International operations are subject to other risks, including:

 

      changes in regulatory requirements;

 

      reduced protection for intellectual property rights in some countries;

 

      potentially adverse tax consequences;

 

      general import/export restrictions relating to encryption technology and/or privacy;

 

      difficulties and costs of staffing and managing foreign operations;

 

      political and economic instability;

 

      fluctuations in currency exchange rates; and

 

      seasonal reductions in business activity during the summer months in Europe and certain other parts of the world.

 

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WE MAY BE UNABLE TO PROMOTE AND MAINTAIN OUR BRANDS.

 

We believe that establishing and maintaining the brand identities of our products and services is a critical aspect of attracting and expanding a large client base. Promotion and enhancement of our brands will depend largely on our success in continuing to provide high quality service. If businesses do not perceive our existing services to be of high quality, or if we introduce new services or enter into new business ventures that are not favorably received by businesses, we will risk diluting our brand identities and decreasing their attractiveness to existing and potential customers.

 

In order to attract and retain customers and to promote and maintain brands in response to competitive pressures, we may also have to increase substantially our financial commitment to creating and maintaining a distinct brand loyalty among our customers. If we incur significant expenses in an attempt to improve our services or to promote and maintain our brands, our business, prospects, financial condition and results of operations could be materially adversely affected. Moreover, any brand identities we establish may be diluted as a result of any inability to protect our trademarks and service marks or domain names, which could have a material adverse effect on our business, prospects, financial condition and results of operations.

 

RISKS RELATED TO THE MARKET FOR OUR COMMON STOCK.

 

WE HAVE A VERY SUBSTANTIAL OVERHANG OF COMMON STOCK AND FUTURE SALES OF OUR COMMON STOCK WILL CAUSE SUBSTANTIAL DILUTION AND MAY NEGATIVELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK.

 

As of June 30, 2004, there were approximately 34.2 million shares of our common stock outstanding. As of that date, we also had an aggregate of approximately 13.8 million shares of common stock that may be sold into the market in the future, including approximately 4.9 million shares of our common stock issuable upon exercise of options, 6.7 million shares of our common stock issuable upon conversion of our outstanding preferred stock and exercise of the related warrants and 2.2 million shares of our common stock issuable upon conversion of the debentures and exercise of the related warrants. In addition, if we undertake an additional financing involving securities convertible into shares of our common stock, the aggregate number of shares into which those securities are convertible will further increase our overhang.

 

We cannot predict the effect, if any, that future sales of shares of our common stock into the market, or the availability of shares of common stock for future sale, will have on the market price of our common stock. Sales of substantial amounts of common stock (including shares issued upon the exercise of stock options or conversion of shares of preferred stock), or the perception that such sales could occur, may materially and adversely affect prevailing market prices for our common stock.

 

OUR SHARE PRICE MAY BE VOLATILE AND COULD DECLINE SUBSTANTIALLY.

 

The market price of our common stock has fluctuated in the past and may continue to be volatile. In addition, the stock market has experienced extreme price and volume fluctuations. The market prices of the securities of Internet-related companies have been especially volatile. Investors may be unable to resell their shares of our common stock at or above the purchase price. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. Many companies in our industry have been subject to this type of litigation in the past. We may also become involved in

 

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this type of litigation. Litigation is often expensive and diverts management’s attention and resources, which could materially and adversely affect our business, financial condition and results of operations.

 

THE POWER OF OUR BOARD OF DIRECTORS TO DESIGNATE AND ISSUE SHARES OF STOCK COULD HAVE AN ADVERSE EFFECT ON HOLDERS OF OUR COMMON STOCK.

 

We are authorized to issue up to 350,000,000 shares of common stock, which may be issued by our board of directors for such consideration as they may consider sufficient without seeking stockholder approval. The issuance of additional shares of common stock in the future will reduce the proportionate ownership and voting power of current stockholders. Our Certificate of Incorporation also authorizes us to issue up to 10,000,000 shares of preferred stock, the rights and preferences of which may be designated by our board of directors. These designations may be made without stockholder approval. The designation and issuance of preferred stock in the future could create additional securities that would have dividend and liquidation preferences prior in right to the outstanding shares of common stock. These provisions could also impede a change in control.

 

SUNRA CAPITAL HOLDINGS, LTD. AND PUBLIGROUPE USA HOLDING, INC. COLLECTIVELY CONTROL A SUBSTANTIAL PORTION OF OUR TOTAL OUTSTANDING VOTING POWER AND WILL LIKELY BE ABLE TO INFLUENCE CERTAIN APPROVAL MATTERS.

 

Sunra Capital Holdings Ltd. and affiliated parties are currently the beneficial owners of a significant percentage of our common stock, including shares of our Series A Preferred Stock which benefit from protective provisions regarding specific corporate matters.  PubliGroupe USA Holdings also owns a significant percentage of our common stock, and has agreed to vote on all corporate matters in accordance with the recommendations of our Board of Directors.

 

Based on their voting power, Sunra and PubliGroupe may be able to influence the outcome of matters requiring stockholder approval, including the election of directors, amendment of our charter and approval of significant corporate transactions.  Sunra and PubliGroupe also could deter a change in control of 24/7 Real Media, despite the approval of other stockholders, if, for example, a third party required their consent as a condition to closing a transaction with us.

 

OUR PREFERRED STOCK HAS LIQUIDATION PREFERENCE AND PARTICIPATION RIGHTS THAT COULD REDUCE OR ELIMINATE ANY PROCEEDS AVAILABLE TO OUR COMMON STOCKHOLDERS UPON A SALE OF OUR COMPANY.

 

Under certain circumstances, upon our sale, liquidation or dissolution, our Series A and Series C preferred stockholders may be entitled to receive an aggregate liquidation preference of $6.9 million plus accrued dividends, before our common stockholders receive any payment. After receipt of this payment, the preferred stockholders may also have the right to participate in receiving proceeds payable to the common stockholders on an as-converted basis. As a result, in the event of our sale, liquidation or dissolution, including one in which the total proceeds represent a premium to the then prevailing price per share of our common stock, our common stockholders may experience substantial dilution in the amount payable to them, and if total proceeds are less than or equal to the liquidation preference, then our common stockholders will not receive any proceeds.

 

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EFFECTS OF ANTI-TAKEOVER PROVISIONS COULD INHIBIT THE ACQUISITION OF OUR COMPANY.

 

Some of the provisions of our Certificate of Incorporation, our Bylaws and Delaware law could, together or separately:

 

      discourage potential acquisition proposals;

 

      delay or prevent a change in control;

 

      impede the ability of our stockholders to change the composition of our board of directors in any one year; and

 

      limit the price that investors might be willing to pay in the future for shares of our common stock.

 

WE DO NOT INTEND TO PAY FUTURE CASH DIVIDENDS.

 

We currently do not anticipate paying cash dividends on our common stock at any time in the near future. We may never pay cash dividends or distributions on our common stock. In addition, our subordinated convertible debentures restrict our ability to pay cash dividends on our common stock. Whether we pay cash dividends in the future will be at the discretion of our Board of Directors and will be dependent upon our financial condition, results of operations, capital requirements, contractual restrictions and any other factors that the Board of Directors decides is relevant.

 

RISKS RELATED TO OUR INDUSTRY.

 

OUR BUSINESS MAY NOT GROW IF THE INTERNET ADVERTISING MARKET DOES NOT CONTINUE TO DEVELOP.

 

The Internet as a marketing medium has not been in existence for a sufficient period of time to demonstrate its effectiveness. Our business would be adversely affected if the Internet advertising market fails to develop in the near future. There are currently no widely accepted standards to measure the effectiveness of Internet advertising other than clickthrough rates, which generally have been declining. Such standards may not develop to sufficiently support the Internet as a significant advertising medium. Actual or perceived ineffectiveness of online advertising in general, or inaccurate measurements or database information in particular, could limit the long-term growth of online advertising and cause our revenue levels to decline.

 

OUR FAILURE TO COMPETE SUCCESSFULLY MAY HINDER OUR GROWTH.

 

The markets for Internet advertising and related products and services are intensely competitive and such competition is expected to increase. Our failure to compete successfully may hinder our growth. We believe that our ability to compete depends upon many factors both within and beyond our control, including:

 

      the timing and market acceptance of new products and enhancements of existing services developed by us and our competitors;

 

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      changing demands regarding customer service and support;

 

      shifts in sales and marketing efforts by us and our competitors; and

 

      the ease of use, performance, price and reliability of our services and products.

 

Some of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical and marketing resources than ours. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products or services to address the needs of our prospective clients. We may be unable to compete successfully against current or future competitors. In addition, the Internet must compete for a share of advertisers’ total budgets with traditional advertising media, such as television, radio, cable and print, as well as content aggregation companies and other companies that facilitate Internet advertising. To the extent that the Internet is perceived to be a limited or ineffective advertising medium, advertisers may be reluctant to devote a significant portion of their advertising budgets to Internet advertising, which could limit the growth of Internet advertising.

 

CHANGES IN GOVERNMENT REGULATION COULD DECREASE OUR REVENUES AND INCREASE OUR COSTS.

 

Laws and regulations directly applicable to Internet communications, commerce and advertising are becoming more prevalent, and new laws and regulations are under consideration by the United States Congress and state legislatures. Any legislation enacted or restrictions arising from current or future government investigations or policy could dampen the growth in use of the Internet generally and decrease the acceptance of the Internet as a communications, commercial and advertising medium. State governments or governments of foreign countries might attempt to regulate our transmissions or levy sales or other taxes relating to our activities. The laws governing the Internet, however, remain largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet and Internet advertising. In addition, the growth and development of Internet commerce may prompt calls for more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on companies conducting business over the Internet. Our business, results of operations and financial condition could be materially and adversely affected by the adoption or modification of laws or regulations relating to the Internet.

 

CHANGES IN LAWS AND STANDARDS RELATING TO DATA COLLECTION AND USE PRACTICES AND THE PRIVACY OF INTERNET USERS AND OTHER INDIVIDUALS COULD HARM OUR BUSINESS.

 

The U.S. federal and various state governments have recently proposed limitations on the collection and use of information regarding Internet users. In October 1998, the European Union adopted a directive that may limit our collection and use of information regarding Internet users in Europe. The effectiveness of our Open AdSystem technology could be limited by any regulation limiting the collection or use of information regarding Internet users. Since many of the proposed laws or regulations are just being developed, we cannot yet determine the impact these regulations may have on its business. In addition, growing public concern about privacy and the collection, distribution and use of personal information has led to self-regulation of these practices by the Internet advertising and direct marketing industry and to increased federal and state regulation. The Network Advertising Initiative, or NAI, of which we are an associate

 

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member along with other Internet advertising companies, has developed self-regulatory principles for online preference marketing. We are also subject to various federal and state regulations concerning the collection, distribution and use of personal information. These laws include the Children’s Online Privacy Protection Act, and state laws that limit or preclude the use of voter registration and drivers license information, as well as other laws that govern the collection and use of consumer credit information. While we monitor legislative initiatives, in the event that more onerous federal or state laws or regulations are enacted or applied to us or our clients, our business, financial condition and results of operations could be materially and adversely affected.

 

PRIVACY CONCERNS MAY PREVENT US FROM COLLECTING USER DATA.

 

Growing concerns about the use of cookies and data collection may limit our ability to develop user profiles, offer our behavioral targeting and otherwise provide Internet advertisement services and technology. Web sites typically place small files of information, commonly known as “cookies”, on a user’s hard drive, generally without the user’s knowledge or consent. Cookie information is passed to the Web site through the Internet user’s browser software. Our Open AdSystem technology targets advertising to users through the use of cookies and other non-personally-identifying information. Open AdSystem enables the use of cookies to deliver targeted advertising and to limit the frequency with which an advertisement is shown to a user. Most currently available Internet browsers allow users to modify their browser settings to prevent cookies from being stored on their hard drive, and a small minority of users are currently choosing to do so. Users can also delete cookies from their hard drive or modify them at any time. Some Internet commentators and privacy advocates have suggested limiting or eliminating the use of cookies. Any reduction or limitation in the use of cookies could limit the effectiveness of our sales and marketing efforts and impair our targeting capabilities. Microsoft Corporation has changed the design and instrumentation of its Web browser in such a way as to give users the option to accept or reject third party cookies. Giving users the option to decline such cookies could result in a reduction of the number of Internet users that we can profile anonymously. Such changes also could adversely affect our ability to determine the reach of advertising campaigns sold and delivered by us and the frequency with which users of sites in the 24/7 Network see the same advertisement.

 

If the use or effectiveness of cookies is limited, we would likely have to switch to other technology that would allow us to gather demographic and behavioral information. While such technology currently exists, it is substantially less effective than cookies. Replacement of cookies could require significant engineering time and resources, might not be completed in time to avoid negative consequences to our business, financial condition or results of operations, and might not be commercially feasible.

 

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WE DEPEND ON PROPRIETARY RIGHTS, AND WE FACE THE RISK OF INFRINGEMENT.

 

Our success and ability to compete are substantially dependent on our internally developed technologies and trademarks, which we protect through a combination of patent, copyright, trade secret and trademark law. We have received two patents in the United States, and have filed and intend to file additional patent applications in the United States. In addition, we apply to register our trademarks in the United States and internationally. Our patent applications or trademark applications may not be approved. Even if they are approved, such patents or trademarks may be successfully challenged by others or invalidated. If our trademark registrations are not approved because third parties own such trademarks, our use of such trademarks will be restricted unless we enter into arrangements with such third parties that may be unavailable on commercially reasonable terms.

 

We generally enter into confidentiality or license agreements with our employees, consultants and corporate partners, and generally control access to and distribution of our technologies, documentation and other proprietary information. Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, parties may attempt to disclose, obtain or use our solutions or technologies. The steps we have taken may not prevent misappropriation of our solutions or technologies, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States.

 

We have licensed, and we may license in the future, elements of our trademarks, trade dress and similar proprietary rights to third parties. While we attempt to ensure that the quality of our brand is maintained by these business partners, such partners may take actions that could materially and adversely affect the value of our proprietary rights or our reputation. The value of our proprietary rights could decline in the future since the validity, enforceability and scope of protection of certain proprietary rights in Internet-related industries is uncertain and still evolving.

 

We may be subject to claims of alleged infringement of the trademarks and other intellectual property rights of third parties by us or the Web publishers with Web sites in the 24/7 Network. Such claims and any resultant litigation could subject us to significant liability for damages and could result in the invalidation of our proprietary rights. In addition, even if we prevail, such litigation could be time-consuming and expensive to defend, and could result in the diversion of our time and attention, any of which could materially and adversely affect our business, results of operations and financial condition. Any claims or litigation from third parties may also result in limitations on our ability to use the trademarks and other intellectual property subject to such claims or litigation unless we enter into arrangements with the third parties responsible for such claims or litigation, which may be unavailable on commercially reasonable terms.

 

From time to time, we may selectively pursue claims of infringement of our patents and other intellectual property rights by third parties. Such claims and any resultant litigation, such as our ongoing litigation with aQuantive, Inc., present the risk that a court could determine, either preliminarily or finally, that some of our patents or other intellectual property rights are not valid, which may make it difficult to sell our technology solutions and may lead to a loss of and an inability to generate licensing revenue from our patents. In addition, even if we prevail, such litigation could be time-consuming and expensive to pursue, and could result in the diversion of our time and attention, any of which could materially and adversely affect our business, results of operations and financial condition.

 

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WE MAY BE SUBJECT TO INTELLECTUAL PROPERTY LIABILITY.

 

We may be liable for content available or posted on the Web sites of our publishers. We may be liable to third parties for content in the advertising we serve if the music, artwork, text or other content involved violates the copyright, trademark or other intellectual property rights of such third parties or if the content is defamatory. Any claims or counterclaims could be time consuming, result in costly litigation or divert management’s attention.

 

WE FACE RISKS ASSOCIATED WITH TECHNOLOGICAL CHANGE.

 

The Internet and Internet advertising markets are characterized by rapidly changing technologies, evolving industry standards, frequent new product and service introductions and changing customer demands. Our future success will depend on our ability to adapt to rapidly changing technologies and to enhance existing solutions and develop and introduce a variety of new solutions to address our customers’ changing demands. We may experience difficulties that could delay or prevent the successful design, development, introduction or marketing of our solutions. In addition, our new solutions or enhancements must meet the requirements of our current and prospective customers and must achieve significant market acceptance. Material delays in introducing new solutions and enhancements may cause customers to forego purchases of our solutions and purchase those of our competitors.

 

In addition, the development of commercial software and technology that blocks, eliminates or otherwise screens out Internet advertising may reduce the value of advertising inventory on our 24/7 Web Alliance and the benefits of our technology solutions to our customers.  We cannot guarantee that a new commercial software or technology, for end-users or enterprises, will not be capable of eliminating a portion or all of the advertisement formats, including banners, pop-ups, pop-unders and other formats, that we utilize through our 24/7 Web Alliance or that we currently deliver through our technology solutions.  To the extent that our customers refuse to pay for advertisements that are blocked, or if the use of blocking software exceeds our expectations, our business, results of operations and financial condition may be materially and adversely affected.

 

OUR NETWORK OPERATIONS MAY BE VULNERABLE TO HACKING, VIRUSES AND OTHER DISRUPTIONS, WHICH MAY MAKE OUR PRODUCTS AND SERVICES LESS ATTRACTIVE AND RELIABLE.

 

Internet usage could decline if any well-publicized compromise of security occurs. “Hacking” involves efforts to gain unauthorized access to information or systems or to cause intentional malfunctions or loss or corruption of data, software, hardware or other computer equipment. Hackers, if successful, could misappropriate proprietary information or cause disruptions in our service. We may be required to expend capital and other resources to protect our Web site against hackers. Any measures we may take may not be effective. In addition, the inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability, as well as materially damage our reputation and decrease our user traffic.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

INTEREST RATE RISK

 

The primary objective of our investment activities is to preserve capital.  Cash and cash equivalents are investments with original maturities of three months or less.  Therefore, changes in the market’s interest rates do not affect the value of the investments as recorded by 24/7 Real

 

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Media.  The following table presents the amounts of our financial instruments that are subject to interest rate risk by expected maturity and average interest rates as of June 30, 2004 (in thousands):

 

 

 

2004

 

2005

 

2006

 

Thereafter

 

TOTAL

 

Cash and cash equivalents

 

$

52,511

 

$

 

$

 

$

 

$

52,511

 

Average interest rate

 

0.90

%

 

 

 

 

 

 

0.90

%

Marketable securities

 

$

2,896

 

 

 

 

 

 

 

$

2,896

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan payable

 

$

 

$

 

$

15,000

 

$

 

$

15,000

 

Loan payable

 

 

 

 

 

2.00

%

 

 

2.00

%

 

The 2% subordinated convertible debentures due 2006 contain a provision that gives the holder the ability to call a portion of the note upon the satisfaction of a trading price condition. This condition constitutes an embedded derivative. The value of this embedded derivative at June 30, 2004 is immaterial to our financial position. We will review the value of the derivative on a quarterly basis in the future, in accordance with SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.  As of June 30, 2004, we did not hold any other derivative financial instruments.

 

FOREIGN CURRENCY RISK

 

We transact business in a variety of foreign countries and are thus subject to exposure from adverse movements in foreign currency exchange rates.  This exposure is primarily related to revenue and operating expenses denominated in European and Korean currencies.  The effect of foreign exchange rate fluctuations for the three and six month periods ended June 30, 2004 and 2003 were not material.  We do not use derivative financial instruments to limit our foreign currency risk exposure.  As of June 30, 2004, we had $5.8 million in cash and cash equivalents denominated in foreign currencies.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of Controls and Procedures

 

As of the end of the period covered by this Form 10-Q, an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures was carried out by us under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer.  Based on that conclusion, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures have been designed and are being operated in a manner that provides reasonable assurance that the information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management

 

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necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

In 2003, as a complement to our existing overall program of internal control, we initiated a company-wide review of our internal control over financial reporting as part of the process of preparing for compliance with Section 404 of the Sarbanes-Oxley Act of 2002. As a result of the review, we have made numerous improvements to the design and effectiveness of our internal control through the six month period ended June 30, 2004.  We anticipate that improvements will continue to be made.

 

Changes in Internal Control

 

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

 

On January 12, 2004, our former Chief Financial Officer, Norman Blashka, left the Company to pursue other interests.  Jonathan K. Hsu was promoted to the role of Chief Financial Officer on January 12, 2004.

 

In addition, during the first quarter of 2004, we acquired Real Media Korea Co., Ltd.  As part of our ongoing integration activities, we are continuing to incorporate our controls and procedures into RMK.

 

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PART II.  OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

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

 

In March 2004, the Federal Circuit Court of Appeals has affirmed, without opinion, a July 2003 decision of the U.S. Federal Court for the Western District of Washington that granted summary judgment to aQuantive, Inc. in a lawsuit that alleged that aQuantive infringed on our U.S. patent number 6,026,368.  The lower court’s ruling held that aQuantive’s Atlas DMT advertisement serving system does not infringe the ‘368 patent.  We filed a request for rehearing before the Federal Circuit Court of Appeals that was denied.

 

Brian Anderson

 

On July 5, 2001, Brian Anderson, former Chief Executive of our AwardTrack, Inc. subsidiary, served us 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, intentional infliction of emotional distress and breach of fiduciary duty, in connection with the acquisition of AwardTrack and subsequent events. We removed the lawsuit to federal court in California and moved to dismiss the complaint in its entirety. This motion was granted in part, with leave to amend, and denied in part. The plaintiff has subsequently refiled the complaint and we have filed a counterclaim. Discovery is concluded, and we have moved for summary judgment to dismiss the complaint in its entirety.

 

chinadotcom Corporation

 

On June 1, 2004, we and David J. Moore, our Chief Exective Officer, reached a settlement with chinadotcom involving the release of all claims and the termination of all litigation matters involving the two companies and their affiliates. As part of the settlement, chinadotcom agreed to issue to us 400,000 Class A common shares of chinadotcom.  The shares, valued at $2.9 million based on market price on the date of settlement, is included on the consolidated statement of operations as a gain on legal settlement.

 

General

 

We are 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 our financial position, results of operation or liquidity.

 

Item 2.  Changes in Securities and Use of Proceeds

 

Registered Secondary Stock Offering - Exercise of Over-Allotment Option

 

In connection with the registered secondary stock offering by the Company in March 2004, the Company and selling stockholders granted to the underwriters an option to purchase up to an additional 1.2 million 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

 

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selling stockholders, respectively. The underwriters exercised the over-allotment option in April 2004.

 

Senior Subordinated Debentures - Amendment to Registration Rights Agreement

 

In June 2004, the Company amended the registration rights agreement related the subordinated convertible debentures.  The amendment provided that the Company is no longer obligated to pay any filing or maintenance penalties pursuant to the registration rights agreement with respect to the warrants issued to the holders of the debentures.

 

Item 3.  Defaults Upon Senior Securities

 

None.

 

Item 4.  Submission of Matters to a Vote of Securities Holders

 

None.

 

Item 5.  Other Information

 

None.

 

Item 6.  Exhibits and Reports on Form 8-K

 

(a)           Exhibits.

 

Exhibit 31.1

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

Exhibit 31.2

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

Exhibit 32.1

 

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003.*

 

 

 

Exhibit 32.2

 

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003.*

 


(*)           This certification accompanies this Quarterly Report on Form 10-Q, is not deemed filed with the SEC and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of this Quarterly Report on Form 10-Q), irrespective of any general incorporation language contained in such filing.

 

(b)           Reports on Form 8-K.

 

None.

 

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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of New York, State of New York on August 9, 2004.

 

 

24/7 REAL MEDIA, INC.

 

 

 

 

 

By:

  /s/ DAVID J. MOORE

 

 

 

David J. Moore

 

 

Chairman and Chief Executive Officer

 

 

(Principal Executive Officer)

 

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