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[November 09, 2012]
SERVICESOURCE INTERNATIONAL, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K for the year ended December 31, 2011.
This Quarterly Report on Form 10-Q contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements include, but are not limited to, statements related to changes in market conditions that impact our ability to generate service revenue on our customers' behalf; errors in estimates as to the service revenue we can generate for our customers; risks associated with material defects or errors in our software or the effect of data security breaches; our ability to adapt our solution to changes in the market or new competition; our ability to improve our customers' renewal rates, margins and profitability; our ability to increase our revenue and contribution margin over time from new and existing customers, including as a result of sales of our next-generation technology platform, Renew OnDemand, on a stand-alone subscription basis; our ability to effectively sell and/or implement Renew OnDemand; the potential effect of mergers and acquisitions on our customer base; business strategies and new sales initiatives; technology development; protection of our intellectual property; investment and financing plans; liquidity; competitive position; the effects of competition; industry environment; and potential growth opportunities.
Forward-looking statements are also often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "seek," "should," "target," "will," "would," and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section of this Quarterly Report on Form 10-Q titled "Risk Factors." Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
OVERVIEW We manage the service contract renewals process for renewals of maintenance, support and subscription agreements on behalf of our customers. Our integrated solution consists of a suite of cloud applications, dedicated service sales teams working under our customers' brands and our proprietary Renew OnDemand platform and applications. By integrating software, managed services and data, we address the critical steps of the renewals process including data management, quoting, selling and service revenue business intelligence. Our business is built on our pay-for-performance model, whereby our revenues are based on the service renewals customers achieve with our solution.
We are currently in the midst of a significant investment cycle in which we have taken steps designed to drive our future growth and profitability. We plan to further build out our infrastructure, develop our technology and release and support Renew OnDemand, our next-generation technology platform, offer additional cloud-based applications, including on a stand-alone, subscription basis, and hire additional sales, service sales and other personnel. These steps impacted our expenses in recent periods as well as our spending for capital expenditures, and are expected to continue to impact our profitability and cash flows in future periods. We have devoted significant resources to developing Renew OnDemand, our software application suite which was recently introduced, and we expect our investment in Renew OnDemand to continue. In addition, we plan to devote significant resources to expand our sales organization, build out the related partner ecosystem, and further develop our service organization to support the platform. The capital expenditures and expenses related to Renew OnDemand are in addition to the expenses of operating our existing technology platform. While these expenses will be incurred and recognized in the near-term, we expect to generate revenues from subscriptions to Renew OnDemand commencing in 2013.
Factors Affecting our Performance Sales Cycle. We sell our integrated solution through our sales organization. At the beginning of the sales process, our quota-carrying sales representatives contact prospective customers and educate them about our offerings. Educating prospective customers about the benefits of our solution can take time, as many of these prospects have not historically relied upon integrated solutions like ours for service revenue management, nor have they typically put out a formal request for proposal or otherwise made a decision to focus on this area. As part of the education process, we utilize our solutions design 16-------------------------------------------------------------------------------- Table of Contents team to perform a Service Performance Analysis ("SPA") of our prospect's service revenue. The SPA includes an analysis of best practices and benchmarks the prospect's service revenue against industry peers. Through the SPA process, which typically takes several weeks, we are able to assess the characteristics and size of the prospect's service revenue, identify potential areas of performance improvement, and formulate our proposal for managing the prospect's service revenue. The length of our sales cycle for a new customer, inclusive of the SPA process and measured from our first formal discussion with the customer until execution of a new customer contract, is typically longer than six months.
We generally contract with new customers to manage a specified portion of their service revenue opportunity, such as the opportunity associated with a particular product line or technology, contract type or geography. We negotiate the customized terms of our customer contracts, including commission rates, based on the output of the SPA, including the areas identified for improvement.
Once we demonstrate success to a customer with respect to the opportunity under contract, we seek to expand the scope of our engagement to include other opportunities with the customer. For some customers, we manage all or substantially all of their service contract renewals.
Implementation Cycle. After entering into an engagement with a new customer, and to a lesser extent after adding an engagement with an existing customer, we incur sales and marketing expenses related to the commissions owed to our sales personnel. The commissions are based on the estimated total contract value, a material portion of which is expensed upfront and the remaining portion of which is expensed over a period of eight to fourteen months, including commissions paid on multi-year contracts. We also make upfront investments in technology and personnel to support the engagement. These expenses are typically incurred one to three months before we begin generating sales and recognizing revenue.
Accordingly, in a given quarter, an increase in new customers, and, to a lesser extent, an increase in engagements with existing customers, or a significant increase in the contract value associated with such new customers and engagements, will negatively impact our gross margin and operating margins until we begin to achieve anticipated sales levels associated with the new engagements.
Although we expect new customer engagements to contribute to our operating profitability over time, in the initial periods of a customer relationship, the near term impact on our profitability can be negatively impacted by slower-than anticipated growth in revenues for these engagements as well as the impact of the upfront costs we incur, the lower initial level of associated service sales team productivity and lack of mature data and technology integration with the customer. As a result, an increase in the mix of new customers as a percentage of total customers may initially have a negative impact on our operating results. Similarly, a decline in the ratio of new customers to total customers may positively impact our operating results.
Contract Terms. Substantially all of our revenue comes from our pay-for-performance model. Under our pay-for-performance model, we earn commissions based on the value of service contracts we sell on behalf of our customers. In some cases, we earn additional performance-based commissions for exceeding pre-determined service renewal targets.
Since 2009, our new customer contracts have typically had a term of approximately 36 months, although we sometimes have contract terms of up to 60 months. Our contracts generally require our customers to deliver a minimum value of qualifying service revenue contracts for us to renew on their behalf during a specified period. To the extent that our customers do not meet their minimum contractual commitments over a specified period, they may be subject to fees for the shortfall. Our customer contracts are cancelable on relatively short notice, subject in most cases to the payment of an early termination fee by the customer. The amount of this fee is based on the length of the remaining term and value of the contract.
We invoice our customers on a monthly basis based on commissions we earn during the prior month, and with respect to performance-based commissions, on a quarterly basis based on our overall performance during the prior quarter.
Amounts invoiced to our customers are recognized as revenue in the period in which our services are performed or, in the case of performance commissions, when the performance condition is determinable. Because the invoicing for our services generally coincides with or immediately follows the sale of service contracts on behalf of our customers, we do not generate or report a significant deferred revenue balance. However, the combination of minimum contractual commitments, combined with our success in generating improved renewal rates for our customers, and our customers' historical renewal rates, provides us with revenue visibility. In addition, the performance improvement potential identified by our SPA process provides us with revenue visibility for new customers.
M&A Activity. Our customers, particularly those in the technology sector, participate in an active environment for mergers and acquisitions. Large technology companies have maintained active acquisition programs to increase the breadth and depth of their product and service offerings and small and mid-sized companies have combined to better compete with large technology companies. A number of our customers have merged, purchased other companies or been acquired by other companies. We expect merger and acquisition activity to continue to occur in the future.
17 -------------------------------------------------------------------------------- Table of Contents The impact of these transactions on our business can vary. Acquisitions of other companies by our customers can provide us with the opportunity to pursue additional business to the extent the acquired company is not already one of our customers. Similarly, when a customer is acquired, we may be able to use our relationship with the acquired company to build a relationship with the acquirer. In some cases we have been able to maintain our relationship with an acquired customer even where the acquiring company handles its other service contract renewals through internal resources. In other cases, however, acquirers have elected to terminate or not renew our contract with the acquired company.
For example, Oracle terminated our contracts with Sun Microsystems effective as of September 30, 2010 and had previously terminated our contract with another customer, BEA Systems, in April 2008.
Economic Conditions and Seasonality. An improving economic outlook generally has a positive, but mixed, impact on our business. As with most businesses, improved economic conditions can lead to increased end customer demand and sales. In particular, within the technology sector, we believe that the recent economic downturn led many companies to cut their expenses by choosing to let their existing maintenance, support and subscription agreements lapse. An improving economy may have the converse effect.
However, an improving economy may also cause companies to purchase new hardware, software and other technology products, which we generally do not sell on behalf of our customers, instead of purchasing maintenance, support and subscription services for existing products. To the extent this occurs, it would have a negative impact on our opportunities in the near term that would partially offset the benefits of an improving economy.
We believe the current uncertainty in the economy, combined with shifting market forces toward subscription-based models, is impacting a number of our customers and prospective customers, particularly in the traditional enterprise software and hardware segments. These forces have placed pressure on end customer demand for their renewal contracts and also have led to some slower decision making in general. This economic and industry environment has adversely affected the conversion rates for end customers and contracts. To the extent these conditions continue they will impact our future revenues.
We have added new customers in the fourth quarter of 2011 and during the first nine months of 2012 and have not yet fully ramped-up some of these customers. As a result, our revenues have not reflected, and are not expected in the fourth quarter of 2012 to reflect, the full potential contribution from these customers. In addition to the uncertainty in the macroeconomic environment, we experience a seasonal variance in our revenue typically for the third quarter of the year as a result of lower or flat renewal volume corresponding to the timing of our customers' product sales. The impact of this seasonal fluctuation can be amplified if the economy as a whole is experiencing disruption or uncertainty, leading to deferral of some renewal decisions.
Adoption of "Software-as-a-Service" Solutions. Within the software industry, there is a growing trend toward providing software to customers using a software-as-a-service model. Under this model, software-as-a-service companies provide access to software applications to customers on a remote basis, and provide their customers with a subscription to use the software, rather than licensing software to their customers. Software-as-a-service companies face a distinct set of challenges with respect to customer renewals, given the potentially lower switching costs for customers utilizing their solutions, and are more reliant on renewals for their long-term revenues than traditional software companies. Given the strategic importance of renewals to their model, software-as-a-service companies may be less inclined than traditional software companies to rely on third-party solutions such as ours to manage the sale of renewals of subscription contracts. We have tailored our solution to address the needs of software-as-a-service companies in this area and expect to continue to develop and enhance our solution as this market grows, especially with our Renew OnDemand application suite.
Basis of Presentation Net Revenue Substantially all of our net revenue is attributable to commissions we earn from the sale of renewals of maintenance, support and subscription agreements on behalf of our customers. We generally invoice our customers for our services in arrears on a monthly basis for sales commissions, and on a quarterly basis for certain performance sales commissions; accordingly, we typically have no deferred revenue related to these services. We do not set the price, terms or scope of services in the service contracts with end customers and do not have any obligations related to the underlying service contracts between our customers and their end customers.
We also earn revenue from the sale of subscriptions to our cloud based applications. To date, subscription revenue has been insignificant. However, we expect to generate revenues from subscriptions to Renew OnDemand commencing in 2013. Subscription fees are accounted for separately from commissions and they are billed on either a monthly or quarterly basis in advance and revenue is recognized ratably over the related subscription term.
18-------------------------------------------------------------------------------- Table of Contents We have generated a significant portion of our revenue from a limited number of customers. Our top ten customers accounted for 49% and 47% of our net revenue for the three months ended September 30, 2012 and 2011, respectively, and 48% and 48% for the nine months ended September 30, 2012 and 2011, respectively. Our business is geographically diversified. During the third quarter of 2012, 64 % of our net revenue was earned in North America and Latin America ("NALA"), 24% in Europe, Middle East and Africa ("EMEA") and 12% in Asia Pacific-Japan ("APJ"). Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from our sales centers in that geography. Predominantly all of the service contracts sold and managed by our sales centers relate to end customers located in the same geography.
Cost of Revenue and Gross Profit Our cost of revenue expenses include compensation, technology costs, including those related to the delivery of our cloud-based solutions, and allocated overhead costs. Compensation includes salary, bonus, benefits and stock-based compensation for our dedicated service sales teams. Our allocated overhead includes costs for facilities, information technology and depreciation, including amortization of internal-use software associated with our service revenue technology platform and cloud applications. Allocated costs for facilities consist of rent, maintenance and compensation of personnel in our facilities departments. Our allocated costs for information technology include costs associated with a third-party data center where we maintain our data servers, compensation of our information technology personnel and the cost of support and maintenance contracts associated with computer hardware and software. Our overhead costs are allocated to all departments based on headcount. To the extent our customer base or opportunity under management expands, we may need to hire additional service sales personnel and invest in infrastructure to support such growth. We currently expect that our cost of revenue will fluctuate significantly and may increase on an absolute basis and as a percentage of revenue in the near term, including for the reasons discussed above under "-Factors Affecting Our Performance-Implementation Cycle" and as a result of our near term plans to run dual technology platforms for several quarters as we commence the launch of Renew OnDemand while maintaining our existing technology platform.
Operating Expenses Sales and Marketing. Sales and marketing expenses are the largest component of our operating expenses and consist primarily of compensation and sales commissions for our sales and marketing staff, allocated expenses and marketing programs and events. We sell our solutions through our global sales organization, which is organized across three geographic regions: NALA, EMEA and APJ. Our commission plans provide that payment of commissions to our sales representatives is contingent on their continued employment, and we recognize expense over a period that is generally between twelve and fourteen months following the execution of the applicable contract. We currently expect sales and marketing expense to increase on an absolute basis and as a percentage of revenue in the near term based on commissions earned on customer contracts entered into in prior periods, as well as continued investments in sales and marketing personnel and programs as we expand our business domestically and internationally and pursue new sales initiatives.
Research and Development. Research and development expenses consist primarily of compensation, allocated costs and the cost of third-party service providers. We focus our research and development efforts on developing new products, including Renew OnDemand, our next-generation technology platform, and adding new features to our existing technology platform. In addition, we capitalize certain expenditures related to the development and enhancement of internal-use software related to our technology platform. We expect research and development spending, and the related expenses and capitalized costs, to increase on an absolute basis as a percentage of revenue in the near term as we continue to invest in our next-generation technology platform and cloud applications.
General and Administrative. General and administrative expenses consist primarily of compensation for our executive, human resources, finance and legal functions, and related expenses for professional fees for accounting, tax and legal services, as well as allocated expenses. We expect that our general and administrative expenses will increase on an absolute basis and as a percentage of revenue in the near term as our operations continue to expand.
Other Income (Expense) Other income (expense) consists primarily of interest expense associated with borrowings under our credit facility and foreign exchange transaction gains and losses and interest income.
Income Tax (Benefit) Provision We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary 19 -------------------------------------------------------------------------------- Table of Contents differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries' assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.
Results of Operations The table below sets forth our consolidated results of operations for the periods presented. The period-to-period comparison of financial results presented below is not necessarily indicative of financial results to be achieved in future periods.
Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 (in thousands) Net revenue $ 59,090 $ 50,088 $ 176,358 $ 144,722 Cost of revenue 34,544 28,034 101,002 82,399 Gross profit 24,546 22,054 75,356 62,323 Operating expenses: Sales and marketing 13,512 12,144 41,158 34,664 Research and development 4,416 3,547 13,295 9,650 General and administrative 10,000 8,969 30,639 24,692 Total operating expenses 27,928 24,660 85,092 69,006 Loss from operations (3,382 ) (2,606 ) (9,736 ) (6,683 ) Other income (expense), net 120 282 (304 ) (1,011 ) Loss before income taxes (3,262 ) (2,324 ) (10.040 ) (7,694 ) Income tax (benefit) provision 322 501 31,589 (21,152 ) Net Income (loss) $ (3,584 ) $ (2,825 ) $ (41,629 ) $ 13,458 Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 (in thousands) Includes stock-based compensation of: Cost of revenue $ 763 $ 470 $ 2,050 $ 1,286 Sales and marketing 2,180 1,111 5,836 2,981 Research and development 562 327 1,455 864 General and administrative 2,148 1,060 5,919 2,973 Total stock-based compensation $ 5,653 $ 2,968 $ 15,260 $ 8,104 20 -------------------------------------------------------------------------------- Table of Contents The following table sets forth our operating results as a percentage of net revenue: Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 (as % of net revenue) Net revenue 100 % 100 % 100 % 100 % Cost of revenue 58 % 56 % 57 % 57 % Gross profit 42 % 44 % 43 % 43 % Operating expenses Sales and marketing 23 % 24 % 23 % 24 % Research and development 7 % 7 % 8 % 7 % General and administrative 17 % 18 % 17 % 17 % Total operating expenses 47 % 49 % 48 % 48 % Loss from operations (5 )% (5 )% (5 )% (5 )% Three months ended September 30, 2012 and September 30, 2011 Net Revenue Three Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Net revenue by geography: NALA $ 37,647 64 % $ 31,952 64 % $ 5,695 18 % EMEA 14,159 24 % 12,365 25 % 1,794 15 % APJ 7,284 12 % 5,771 11 % 1,513 26 % Total net revenue $ 59,090 100 % $ 50,088 100 % $ 9,002 18 % Net revenue increased $9.0 million, or 18%, for the third quarter of 2012, compared to the third quarter of 2011. Our revenue performance was driven by a combination of growth in opportunity from new and existing customers, as well as strong performance across all of our service sales centers around the world in closing service revenue renewals. The increase in the number of customer engagements resulted from expansions of customer engagements with our existing customers due to the success of our solution with the customers as well as new customer acquisitions due to our investments in our sales organization primarily in NALA and APJ. The increase in net revenue reflects revenue growth in all geographies, particularly NALA and APJ, due to an increase in the number and value of service contracts sold on behalf of our customers and the ramp of new engagements entered into in 2011.
Cost of Revenue and Gross Profit Three Months Ended September 30, % 2012 2011 Change Change (in thousands) Cost of revenue $ 34,544 $ 28,034 $ 6,510 23 % Includes stock-based compensation of: 763 470 293 Gross profit 24,546 22,054 2,492 11 % Gross profit percentage 42 % 44 % (2 )% The 23% increase in our cost of revenue in the third quarter of 2012 reflected an increase in the number of service sales personnel, primarily in NALA and APJ as we pursue new sales initiatives resulting in a $4.6 million increase in compensation and a $1.6 million increase in allocated costs for facilities, including incremental facility costs related to an expansion of an existing facility, and greater allocations for information technology and depreciation.
Gross profit in the third quarter of 2012 21-------------------------------------------------------------------------------- Table of Contents was also adversely impacted by the slower ramp of some of our new engagements and due to staffing and technology costs associated with the deployment of our cloud applications. For the next several quarters, we expect that our spending will reflect increased spending to support our legacy service revenue intelligence platform in addition to our recently-announced Renew OnDemand application suite.
Operating Expenses Three Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Operating expenses: Sales and marketing $ 13,512 23 % $ 12,144 24 % $ 1,368 11 % Research and development 4,416 7 % 3,547 7 % 869 24 % General and administrative 10,000 17 % 8,969 18 % 1,031 11 % Total operating expenses $ 27,928 47 % $ 24,660 49 % $ 3,268 13 % Includes stock-based compensation of: Sales and marketing $ 2,180 $ 1,111 $ 1,069 Research and development 562 327 235 General and administrative 2,148 1,060 1,088 Total $ 4,890 $ 2,498 $ 2,392 Sales and marketing expenses The 11% increase in sales and marketing expenses in the third quarter of 2012 reflected an increase in the number of sales and marketing personnel, primarily in NALA and EMEA, resulting in a $1.8 million increase in compensation. The increase in headcount reflected our investment in sales and marketing resources aimed at expanding our customer base.
Research and development expenses The increase in research and development expense in the third quarter of 2012 reflected a $1.0 million increase in outside consulting services related to contract research and development services primarily in NALA. The increase was partially offset by capitalization of $1.5 million of labor and third party costs for development of internal-use software in the third quarter of 2012 as compared to $1.8 million capitalized costs in the third quarter of 2011. The increase in our spending on research in development reflects our continued investment in the development of our Renew OnDemand suite of applications designed to enable greater operational efficiencies and enhanced functionality for our customers.
General and administrative expenses The 11% increase in general and administrative expense in the third quarter of 2012 as compared to the second quarter of 2011 reflected a $1.1 million increase in compensation due to an increase in headcount in general and administrative primarily in NALA and APJ to support our expansion efforts.
Other Income, Net Three Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Other income, net $ 120 0 % $ 282 (1 )% $ (162 ) (57 )% The decrease in other income in the third quarter of 2012 primarily resulted from a loss on foreign exchange transactions due in part to a decrease in the value of the U.S. dollar relative to international currencies, most notably the Euro.
22 -------------------------------------------------------------------------------- Table of Contents Income Tax Provision Three Months Ended September 30, % 2012 2011 Change Change (in thousands) Income tax provision $ 322 $ 501 $ (179 ) (36 )% The computation of the effective tax rate does not include US losses, nor does it include losses incurred by our Singapore subsidiary, which are offset by a full valuation allowance. In the current quarter, we recorded a tax provision of $0.3 million, primarily reflecting expected cash taxes in jurisdictions where we have profitable operations.
Nine months ended September 30, 2012 and September 30, 2011 Net Revenue Nine Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Net revenue by geography: NALA $ 110,720 63 % $ 88,383 61 % $ 22,337 25 % EMEA 45,425 26 % 41,612 29 % 3,813 9 % APJ 20,213 11 % 14,727 10 % 5,486 37 % Total net revenue $ 176,358 100 % $ 144,722 100 % $ 31,636 22 % Net revenue increased $31.6 million, or 22%, in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011. Our revenue performance was driven by a combination of growth in opportunity from new and existing customers, as well as strong performance across all of our service sales centers around the world in closing service revenue renewals. The increase in number of customer engagements resulted from expansion of customer engagements with our existing customers due to the success of our solution with these customers as well as new customer acquisitions due to our investments in our sales organization primarily in NALA and APJ. The increase in net revenue reflects revenue growth in all geographies, particularly NALA and APJ, due to an increase in the number and value of service contracts sold on behalf of our customers and the ramp of new engagements entered into in 2011.
Cost of Revenue and Gross Profit Nine Months Ended September 30, % 2012 2011 Change Change (in thousands) Cost of revenue $ 101,002 $ 82,399 $ 18,603 23 % Includes stock-based compensation of: 2,050 1,286 764 Gross profit 75,356 62,323 13,033 21 % Gross profit percentage 43 % 43 % 0 % The 23% increase in our cost of revenue in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, reflected an increase in the number of service sales personnel, primarily in NALA and APJ, as we pursue new sales initiatives resulting in a $12.4 million increase in compensation and a $4.0 million increase in allocated costs for facilities, including incremental facility costs related to expansion of facilities in NALA and APJ, and greater allocations for information technology and depreciation.
For the next several quarters, we expect that our spending will reflect increased amounts to support our legacy service revenue intelligence platform in addition to our recently-announced Renew OnDemand application suite as well as increased spending on deployments of our cloud applications.
23-------------------------------------------------------------------------------- Table of Contents Operating Expenses Nine Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Operating expenses: Sales and marketing $ 41,158 23 % $ 34,664 24 % $ 6,494 19 % Research and development 13,295 8 % 9,650 7 % 3,645 38 % General and administrative 30,639 17 % 24,692 17 % 5,947 24 % Total operating expenses $ 85,092 48 % $ 69,006 48 % $ 16,086 23 % Includes stock-based compensation of: Sales and marketing $ 5,836 $ 2,981 $ 2,855 Research and development 1,455 864 591 General and administrative 5,919 2,973 2,946 Total $ 13,210 $ 6,818 $ 6,392 Sales and marketing expenses The 19% increase in sales and marketing expenses in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, reflected higher stock-based compensation and an increase in the number of sales and marketing personnel, primarily in NALA and EMEA resulting in a $3.4 million increase in compensation. The increase also resulted from a 2.0 million increase in marketing expenses as a result of additional investments in brand development to heighten awareness and maximize the strength of our brand and an increase in allocations for facilities and IT of $0.8 million.
Research and development expenses The increase in research and development expense in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, reflected an increase in the number of research and development personnel primarily in NALA, resulting in a $1.1 million increase in compensation, a $2.1million increase in outside consulting services related to contract research and development services and a $0.4 million increase in allocated costs. The increase was partially offset by capitalization of $5.8 million of labor and third party costs for development of internal-use software in the nine months ended September 30, 2012 compared to $3.5 million capitalized costs in the nine months ended September 30, 2011. The increase in our spending on research and development reflects our continued investment in the development of Renew OnDemand and additional cloud based applications designed to enable greater operational efficiencies and enhanced functionality for our customers.
General and administrative expenses The 24% increase in general and administrative expense in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011 reflected a $6.9 million increase in compensation due to an increase in headcount in the general and administrative functions primarily in NALA to support our global expansion, partially offset by a $0.9 million decrease in professional fees primarily related to expenses incurred in connection with our initial public offering in the first quarter of 2011.
Other Expense, Net Nine Months Ended September 30, 2012 2011 % of % of % Amount Net Revenue Amount Net Revenue Change Change (in thousands) Other expense, net $ 304 0 % $ 1,011 1 % $ (707 ) (70 )% The decrease in other expense in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, resulted from a $0.3 million decrease in interest expense and the write-off of costs associated with the borrowing due to the repayment of outstanding balances on our term loan and borrowings under our revolving credit facility in March 2011. Also contributing to the decrease was a $0.2 million increase in interest income in the nine months ended September 30, 2012 from our short-term investments.
24-------------------------------------------------------------------------------- Table of Contents Income Tax (Benefit) Provision Nine Months Ended September 30, % 2012 2011 Change Change (in thousands) Income tax (benefit) provision $ 31,589 $ (21,152 ) $ 52,741 * * not meaningful During the second quarter of 2012, a valuation allowance against our U.S.
deferred tax assets was recorded in the amount of $31.8 million. Accordingly, the computation of the effective tax rate does not include US losses, nor does it include losses incurred by our Singapore subsidiary, which are offset by a full valuation allowance. Current year-to-date tax expense also reflect the reversal of prior quarter deferred tax benefits, plus tax expense in jurisdictions we have tax profitable operations.
Liquidity and Capital Resources At September 30, 2012, we had cash and cash equivalents of $110.3 million, which primarily consisted of money market mutual funds held by well-capitalized financial institutions. During the quarter, we liquidated our short-term investment portfolio which consisted primarily of tax-exempt municipal bonds as well as commercial paper, with the proceeds reinvested in a money market fund with a well-capitalized domestic financial institution. The liquidation of these securities was primarily driven by the fact that we have operating losses in the U.S. and are unable to benefit from tax-exempt municipal securities which represented approximately 60 percent of our short-term investments. We anticipate re-investing a portion of its excess cash reserves with domestic fund managers during the fourth quarter of 2012.
Our quarterly cash from operations can vary significantly from period-to-period due to a number of factors including: the timing of our revenues and related customer billings; payment practices by our clients; the timing of our various operating expenses and our repayment terms with suppliers; and, the timing of payments to employees for our variable compensation arrangements.
Our primary operating cash requirements include the payment of compensation and related costs, working capital requirements related to accounts receivable, accounts payable and prepaid expenses, as well as costs for our facilities and information technology infrastructure. Historically, we have financed our operations principally from cash provided by our operating activities and to a lesser extent from borrowings under various credit facilities. We believe our existing cash and cash equivalents and short-term investments and our currently available credit facility will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months.
Credit Facility On June 29, 2012, we terminated a revolving credit facility scheduled to expire in February 2013. The credit facility provided for a $20.0 million line of credit. At the time of termination, no borrowings and a letter of credit in the face amount of $850,000 were outstanding under the credit facility.
On July 5, 2012, we entered into a new three-year credit agreement (the "Credit Agreement"). The Credit Agreement provides for a secured revolving line of credit in the amount of $25.0 million on and before July 5, 2013 and $30.0 million thereafter, in each case with a $2.0 million letter of credit sublimit.
The line of credit is scheduled to terminate on July 5, 2015 (the "Maturity Date"). Proceeds available under the Credit Agreement may be used for working capital and other general corporate purposes. We have the option to prepay the loans under the Credit Agreement in whole or in part at any time without premium or penalty. We also have the option to terminate the commitments under the Credit Agreement in whole at any time, and may reduce the commitments by up to $10.0 million between July 1, 2013 and June 30, 2014.
Amounts outstanding on the facility at September 30, 212 consisted of a letter of credit of $850,000 as required under an operating lease agreement for office space. The loans bear interest, at our option, at a base rate determined in accordance with the Credit Agreement, minus 0.50%, or at a LIBOR rate plus 2.00%. Principal, together with all accrued and unpaid interest, is due and payable on the Maturity Date. We are also obligated to pay a quarterly commitment fee, payable in arrears, based on the available commitments at a rate of 0.45%. At September 30, 2012, the interest rate for borrowings under the facility was 2.2%.
25 -------------------------------------------------------------------------------- Table of Contents The Credit Agreement contains customary affirmative and negative covenants, as well as financial covenants. Affirmative covenants include, among others, delivery of financial statements, compliance certificates and notices of specified events, maintenance of properties and insurance, preservation of existence, and compliance with applicable laws and regulations. Negative covenants include, among others, limitations on the ability of us and our subsidiaries to grant liens, incur indebtedness, engage in mergers, consolidations and sales of assets and engage in affiliate transactions. The Credit Agreement requires us to maintain a maximum leverage ratio and a minimum liquidity amount, each as defined in the Credit Agreement.
The Credit Agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and change in control of the Company, subject to grace periods in certain instances. Upon an event of default, the lender may declare the outstanding obligations of the Company under the Credit Agreement to be immediately due and payable and exercise other rights and remedies provided for under the Credit Agreement.
Our obligations under the Credit Agreement are guaranteed by our subsidiary, ServiceSource Delaware, Inc., and are secured by substantially all of our assets and our subsidiary's assets.
Summary Cash Flows The following table sets forth a summary of our cash flows for the periods indicated (in thousands): Nine Months Ended September 30, 2012 2011 Net cash provided by (used in) operating activities $ 9,154 $ (14,385 ) Net cash provided by (used in) investing activities 25,316 (54,677 ) Net cash provided by financing activities 10,311 104,738 Net increase in cash and cash equivalents, net of impact of foreign exchange changes on cash $ 44,294 $ 35,641 Operating Activities Net cash provided by operating activities was $9.1 million during the nine months ended September 30, 2012. Our net loss during the period was $41.6 million, which was impacted by a valuation allowance of $33.1 million for a substantial portion of our deferred tax assets and adjusted by non-cash charges of $7.1 million for depreciation and amortization and $15.3 million for stock-based compensation. Cash provided for operations resulted from changes in our working capital, including a $5.1 million increase in other accrued liabilities. Uses of cash were related to a $4.2 million increase in accounts receivable, a $5.1 million decrease in accrued compensation and benefits largely due to bonuses that were accrued at December 30, 2011 and were paid out during the first quarter of 2012 and a $1.1 million decrease in accounts payable.
Net cash used in operating activities was $14.4 million during the nine months ended September 30, 2011. Our net income during the period was $13.5 million which reflected a one-time, non-cash tax benefit of $21.4 million as a result of recognition of deferred tax assets resulting from our election to be subject to taxation as a corporation. The net income was adjusted by non-cash charges of $7.1 million for depreciation and amortization and $8.1 million for stock-based compensation. Cash used for operations during the nine months ended September 30, 2011 principally resulted from $18.1 million in payments to Oracle/Sun Microsystems and the related settlement of accrued payables owed to Oracle/Sun Microsystems and amounts owed to us by Oracle/Sun Microsystems.
Additional sources of cash resulted from changes in our working capital, including a $6.4 million decrease in accounts receivable a $3.4 million increase in accrued compensation and benefits, and a $0.8 million increase in other accrued liabilities. Uses of cash were related to a $2.2 million increase in prepaid expenses and other assets.
Investing Activities During the nine months ended September 30, 2012 cash provided by investing activities was principally from the sales of short-term investments, net of purchases and maturities, of $42.4 million. Use of cash was related to purchases of property and equipment of $17.0 million, including costs capitalized for development of internal-use software. The $54.7 million of cash used by investing activities during the nine months ending September 30, 2011 related to the purchase of available-for-sale short-term investments of $45.9 million and to a lesser extent for purchase of property and equipment, of $8.8 million, including costs capitalized for development of internal-use software.
26-------------------------------------------------------------------------------- Table of Contents Financing Activities Cash provided by financing activities was $10.3 million during the nine months ended September 30, 2012 and principally resulted from proceeds of $10.3 million from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan.
During the nine months ended September 30, 2011, cash provided by financing activities was $104.7 million and comprised primarily of proceeds from our initial public offering, net of issuance costs, of $87.7 million, and proceeds of $22.2 million from the exercise of stock options to purchase our common stock, partially offset by $15.7 million in net payments to payoff our term loan and payment of capital lease obligations.
Off-Balance Sheet Arrangements We do not have any relationships with other entities or financial partnerships, such as entities often referred to as structured finance or special-purpose entities, which have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commitments Our principal commitments consist of obligations under operating leases for office space and computer equipment. At September 30, 2012, the future minimum payments under these commitments were as follows (in thousands): Less than 1 More than 5 Total year 1-3 years 3-5 years years Obligations under capital leases $ 1,440 $ 733 $ 456 $ 153 $ 98 Operating lease obligations 41,786 8,308 16,388 7,384 9,706 $ 43,226 $ 9,041 $ 16,844 $ 7,537 $ 9,804 The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding, which specify significant terms including payment terms, related services and the approximate timing of the transaction. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.
Critical Accounting Policies and Estimates Management has determined that our most critical accounting policies are those related to revenue recognition, stock-based compensation, capitalized internal-use software and income taxes. We continue to monitor our accounting policies to ensure proper application of current rules and regulations. There have been no material changes in our critical accounting policies and estimates during the three and nine months ended September 30, 2012 as compared to the critical accounting policies and estimates disclosed in "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates of our Annual Report on Form 10-K for the year ended December 31, 2011 as filed with the Securities and Exchange Commission on March 6, 2012.
Recent Accounting Pronouncements The information contained in Note 1 to our condensed consolidated financial statements in Item 1 under the heading, "Recently Adopted Accounting Pronouncements," is incorporated by reference into this Item 2.
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