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DEALERTRACK TECHNOLOGIES, INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and related notes thereto. In addition, you should read the sections entitled "Cautionary Statements Relating to Forward-Looking Statements" and "Risk Factors" in Part 1, Item 1 and Item 1A, respectively, in this AnnualReport onForm 10-K. Overview Dealertrack's web-based software solutions and services enhance efficiency and profitability for all major segments of the automotive retail industry, including dealers, lenders, OEMs, third-party retailers, agents and aftermarket providers. Dealertrack operates the largest online credit application networks in the United States and Canada. We believe Dealertrack delivers the industry's most comprehensive solution set for automotive retailers, including: · Dealer Management solutions, which provide independent and franchised dealers with a powerful dealer management system (DMS) featuring easy-to-use tools and real-time data access to enhance their efficiency; · Sales and F&I solutions, which allow dealers to streamline the in-store and online sales processes as they structure deals from a single integrated platform; 26 · Inventory solutions, which deliver vehicle inventory management and transportation offerings to help dealers accelerate used-vehicle turn rates and assisting with the facilitation of vehicle delivery; · Processing solutions, which include online motor vehicle registration, lien and titling applications and services, and collateral management services; · Digital Retailing solutions, which integrate advanced vehicle search, pricing and payment tools directly into a retailer's website; and · Interactive solutions, which deliver digital marketing and website offerings to assist dealers in achieving higher lead conversion rates by helping optimize the maximum amount of shoppers to their websites. We are a Delaware corporation formed in August 2001. We are organized as a holding company and conduct a substantial amount of our business through our subsidiaries, including Dealertrack AAX, Inc., Dealertrack Aftermarket Services, Inc., Dealertrack Canada, Inc., Dealertrack Digital Services, Inc., Dealertrack, Inc., Dealertrack Processing Solutions, Inc., FDI Computer Consulting, Inc., General Systems Solutions, Inc., and Dealertrack Systems, Inc. We monitor our business performance using a number of measures that are not found in our consolidated financial statements. These measures include the number of active dealers and lenders, active lender to dealership relationships in the Dealertrack network, the number of transactions processed, average transaction price, transaction revenue per car sold, the number of subscribing dealers in the Dealertrack network, and the average monthly subscription revenue per subscribing dealership. We believe that improvements in these metrics will result in improvements in our financial performance over time. We also view the acquisition and successful integration of acquired companies as important milestones in the growth of our business as these acquired companies bring new products to our customers and expand our technological capabilities. We believe that successful acquisitions will also lead to improvements in our financial performance over time. In the near term, however, the purchase accounting treatment of acquisitions can have a negative impact on our consolidated statement of operations, as the depreciation and amortization expenses associated with acquired assets can be substantial for several years following each acquisition. As a result, we monitor our non-GAAP financial measures and other business statistics as a measure of operating performance in addition to net income (loss) and the other measures included in our consolidated financial statements. The following table consists of our non-GAAP financial measures and certain other business statistics that management continually monitors (amounts in thousands are GAAP net income (loss), adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), adjusted net income, capital expenditure data and transactions processed): Year Ended December 31, 2012 2011 2010 GAAP net income (loss) $ 20,454 $ 65,135 $ (27,833 ) Non-GAAP Financial Measures and Other Business Statistics: Adjusted EBITDA - previous presentation (non-GAAP) (1) $ 83,681 $ 74,409 $ 42,070 Adjusted EBITDA (non-GAAP) (1) $ 97,273 $ 85,904 $ 53,303 Adjusted net income (non-GAAP) (1) $ 49,068 $ 43,443 $ 21,943 Capital expenditures, software and website development costs $ 40,803 $ 32,236 $ 30,938 Active dealers in our U.S. network as of end of the year (2) 19,067 17,543 16,829 Active lenders in our U.S. network as of end of the year (3) 1,261 1,120 970 Active lender to dealer relationships as of end of the year (4) 174,628 164,776 140,359 Transactions processed (5) 87,833 74,450 49,373 Average transaction price (6) $ 2.61 $ 2.53 $ 2.10Transaction revenue per car sold (7) $ 6.95 $ 6.39 $ 3.74 Subscribing dealers in U.S. and Canada as of end of the year (8) 17,619 16,003 13,996 Average monthly subscription revenue per subscribing dealership (9) $ 708 $ 813 $ 749 (1) Adjusted EBITDA is a non-GAAP financial measure that represents GAAP net income (loss) excluding interest, taxes, depreciation and amortization expenses, stock-based compensation, contra-revenue and certain items, as applicable, such as: impairment charges, restructuring charges, impact of acquisition-related activity (including contingent consideration changes, compensation expense, basis difference amortization, and professional service fees), realized gains on sales of previously impaired securities, gains or losses on sales or disposals of subsidiaries and other assets, rebranding expense and certain other non-recurring items. In response to requests, and in consideration of comparable peer companies, stock-based compensation expense is now excluded from the calculation of the Adjusted EBITDA non-GAAP measure. This reduces the comparability with prior periods. This non-cash expense was included in presentations prior to the fourth quarter of 2011 and is captioned above as "Adjusted EBITDA - previous presentation (non-GAAP)." 27 Adjusted net income is a non-GAAP financial measure that represents GAAP net income (loss) excluding stock-based compensation expense, the amortization of acquired identifiable intangibles, contra-revenue, and certain items, as applicable, such as: impairment charges, restructuring charges, impact of acquisition-related activity (including contingent consideration changes, compensation expense, basis difference amortization, and professional service fees), realized gains on sales of previously impaired securities, gains or losses on sales or disposals of subsidiaries and other assets, adjustments to deferred tax asset valuation allowances, non-cash interest expense, rebranding expense and certain other non-recurring items. These adjustments to net income (loss), which are shown before taxes, are adjusted for their tax impact at their applicable statutory rates. Adjusted EBITDA and adjusted net income are presented because management believes that they provide additional information with respect to the performance of our fundamental business activities and are also frequently used by securities analysts, investors and other interested parties in the evaluation of comparable companies. We rely on adjusted EBITDA and adjusted net income as primary measures to review and assess the operating performance of our company and management team in connection with our executive compensation plan incentive payments. Adjusted EBITDA and adjusted net income have limitations as analytical tools and you should not consider them in isolation from, or as a substitute for, analysis of our results as reported under GAAP. Some of these limitations are: • Adjusted EBITDA and adjusted net income do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; • Adjusted EBITDA and adjusted net income do not reflect changes in, or cash requirements for, our working capital needs; • Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and adjusted EBITDA and adjusted net income do not reflect any cash requirements for such replacements; • Non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it from adjusted net income and adjusted EBITDA when evaluating our ongoing performance for a particular period; • Adjusted EBITDA and adjusted net income do not reflect the impact of certain charges or gains resulting from matters we consider not to be indicative of our ongoing operations; and • Other companies may calculate adjusted EBITDA and adjusted net income differently than we do, limiting its usefulness as a comparative measure. Because of these limitations, adjusted EBITDA and adjusted net income should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using adjusted EBITDA and adjusted net income only as supplements to our GAAP results. Adjusted EBITDA and adjusted net income are measures of our performance that are not required by, or presented in accordance with, GAAP. Adjusted EBITDA and adjusted net income are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income (loss), operating income or any other performance measures derived in accordance with GAAP or as alternatives to cash flow from operating activities as a measure of our liquidity. The following table sets forth the reconciliation of adjusted EBITDA, a non-GAAP financial measure, from net income (loss), our most directly comparable financial measure, in accordance with GAAP (in thousands): Year Ended December 31, 2012 2011 2010 GAAP net income (loss) $ 20,454 $ 65,135 $ (27,833 ) Interest income (745 ) (331 ) (525 ) Interest expense - cash 3,357 927 175Interest expense - non-cash (10) 7,444 - - Provision for (benefit from) income taxes, net 12,249 (2,403 ) 30,597 Depreciation of property and equipment and amortization of capitalized software and website costs 23,345 20,961 17,329 Amortization of acquired identifiable intangibles 28,333 29,727 19,424 EBITDA (non-GAAP) 94,437 114,016 39,167 Adjustments: Gain on disposal of subsidiaries and sale of other assets (33,193 ) (47,321 ) - Acquisition-related and other professional fees 2,711 4,721 1,905 Contra-revenue (11) 4,215 4,248 1,580 Integration and other related costs (including amounts related to stock-based compensation) 1,530 1,223 - Change in fair value of warrant 6,310 (1,000 ) - Rebranding expense 1,909 - - Acquisition-related contingent consideration changes and compensation expense, net (12) 1,777 (1,069 ) - Amortization of equity method investment basis difference (13) 3,985 - - Realized gain on sale of previously impaired securities - (409) (582 ) Adjusted EBITDA - previous presentation (non-GAAP) 83,681 74,409 42,070 Stock-based compensation (excluding amounts included in integration and other related costs) 13,592 11,495 11,233 Adjusted EBITDA (non-GAAP) $ 97,273 $ 85,904 $ 53,303 28 The following table sets forth the reconciliation of adjusted net income, a non-GAAP financial measure, from net income (loss), our most directly comparable financial measure in accordance with GAAP (in thousands): Year Ended December 31, 2012 2011 2010 GAAP net income (loss) $ 20,454 $ 65,135 $ (27,833 ) Adjustments: Deferred tax asset valuation allowance (non-taxable) (14) - (21,912 ) 28,406 Amortization of acquired identifiable intangibles 28,333 29,727 19,424 Stock-based compensation (excluding integration and other related costs) 13,592 11,495 11,233 Gain on disposal of subsidiaries and sale of other assets (33,193 ) (47,321 ) - Interest expense - non-cash (not tax-impacted) (10) 7,444 - - Acquisition-related and other professional fees 2,711 4,721 1,905 Contra-revenue (11) 4,215 4,248 1,580 Integration and other related costs (including amounts related to stock-based compensation) 1,583 1,223 - Change in fair value of warrant 6,310 (1,000 ) - Amortization of equity method investment basis difference (13) 3,985 - - Rebranding expense 1,909 - - Acquisition-related contingent consideration changes and compensation expense, net (12) 1,777 (1,069 ) - Accelerated depreciation of certain technology assets (15) 1,004 - - Disposed deferred tax liabilities (non-taxable) - (3,221 ) - Amended state tax returns impact (non-taxable) - (239 ) 101 Realized gain on sale of previously impaired securities (non-taxable) - (409 ) (582 ) Tax impact of adjustments (16) (11,056 ) 2,065 (12,291 ) Adjusted net income (non-GAAP) $ 49,068 $ 43,443 $ 21,943 (2) We consider a dealer to be active in our U.S. network as of a date if the dealer completed at least one revenue-generating credit application processing transaction using the U.S. Dealertrack network during the most recently ended calendar month. The number of active U.S. dealers is based on the number of dealer accounts as communicated by lenders on the U.S. Dealertrack network. (3) We consider a lender to be active in our U.S. network as of a date if it is accepting credit application data electronically from U.S. dealers in the U.S. Dealertrack network. (4) Each lender to dealer relationship represents a pair between an active U.S. lender and an active U.S. dealer at the end of a given period. (5) Represents revenue-generating transactions processed in the U.S. Dealertrack, Dealertrack Aftermarket Services, Dealertrack Processing Solutions and Dealertrack Canada networks at the end of a given period. (6) Represents the average revenue earned per transaction processed in the U.S. Dealertrack, Dealertrack Aftermarket Services, Dealertrack Processing Solutions and Dealertrack Canada networks during a given period. Revenue used in the calculation adds back (excludes) transaction related contra-revenue. (7) Represents transaction services revenue divided by our estimate of total new and used car sales for the period in the U.S. and Canada. Revenue used in this calculation adds back (excludes) transaction related contra-revenue. (8) Represents the number of dealerships in the U.S. and Canada with one or more active subscriptions at the end of a given period. Subscriptions to Dealertrack CentralDispatch have been excluded as their customers include brokers and carriers in addition to dealers. 29 (9) Represents subscription services revenue divided by average subscribing dealers for a given period in the U.S. and Canada. Revenue used in the calculation adds back (excludes) subscription related contra-revenue. In addition, subscribing dealers and subscription services revenue from Dealertrack CentralDispatch have been excluded from the calculation as a majority of these customers are not dealers. (10) Represents interest expense relating to the amortization of deferred financing costs and debt discount in connection with the senior convertible notes and revolving credit facility. (11) For further information, please refer to Note 15 and Note 17 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. (12) Represents the change in the acquisition-related contingent consideration from the eCarList and ClickMotive acquisitions and other additional acquisition-related compensation charges. (13) Represents amortization of the basis difference between the book basis of contributed Chrome assets and the fair value of the investment in Chrome Data Solutions. (14) At December 31, 2010, we determined that the ultimate realization of deferred tax assets for U.S. federal and state income tax purposes was not considered more likely than not and recorded a full valuation allowance of $28.4 million against our net U.S. deferred tax assets. As a result of the acquisition of Dealertrack Processing Solutions in 2011, we evaluated the combined enterprises past and expected future results, including the impact of the future reversal of the acquired deferred tax liabilities, and determined that the future reversal of the acquired deferred tax liabilities would provide sufficient taxable income to support realization of certain of DealerTrack's deferred tax assets and thereby we reduced the valuation allowance by approximately $24.5 million. In addition, as a result of the sale of ALG in 2011, and the establishment of deferred tax liabilities on the transaction along with the expected future reversal of deferred tax liabilities, we evaluated the need for a full valuation allowance on our remaining net deferred tax assets and determined that the ultimate realization of deferred tax assets for U.S. federal and state income tax purposes was considered more likely than not and we reversed a portion of the remaining valuation allowance on our net U.S. deferred tax assets. For further information please refer to Note 13 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. (15) Represents the accelerated depreciation of certain technology assets due to the discontinuation of those projects. (16) The tax impact of adjustments for the year ended December 31, 2012, are based on a U.S. statutory tax rate of 38.2% applied to taxable adjustments other than amortization of acquired identifiable intangibles and stock-based compensation expense, which are based on a blended tax rate of 38.1% and 37.7%, respectively. The tax impact of adjustments for the year ended December 31, 2011, are based on a U.S. statutory tax rate of 37.4% applied to taxable adjustments other than amortization of acquired identifiable intangibles and stock-based compensation expense, which are based on a blended tax rate of 37.2% and 37.0%, respectively. The tax impact of adjustments for the year ended December 31, 2010, are based on a U.S. effective tax rate of 36.9% applied to taxable adjustments other than amortization of acquired identifiable intangibles and stock-based compensation expense, which are based on a blended tax rate of 35.4% and 36.7%, respectively. Revenue Transaction Services Revenue. Transaction services revenue consists of revenue earned from our lender customers for each credit application or contract that dealers submit to them. In addition, we earn transaction services revenue from lender customers for each financing contract executed via our electronic contracting and digital contract processing solutions, as well as for any ALG portfolio residual value analyses performed prior to its disposal in 2011. In addition, we earn transaction service revenue from lender customers for collateral management transactions. We also earn transaction services revenue from dealers or other service and information providers, such as aftermarket providers, accessory providers and credit report providers, for each fee-bearing product accessed by dealers. This includes transaction services revenue for completion of on-line registrations with department of motor vehicles, completion of inventory appraisals, and accessing of credit reports. Subscription Services Revenue. Subscription services revenue consists of revenue earned from our dealers and other customers (typically on a monthly basis) for use of our subscription or license-based products and services. Our subscription services enable dealers and other customers to manage their dealership data and operations, compare various financing and leasing options and programs, sell insurance and other aftermarket products, analyze, merchandise, and transport inventory and execute financing contracts electronically. Other Revenue. Other revenue consists of revenue primarily earned through forms programming, data conversion, hardware and equipment sales from our Dealer Management solution, shipping fees and commissions earned from our digital contract business, and consulting and analytical revenue earned from ALG in periods prior to its disposal in 2011. Training fees are also included in other revenue. See "Critical Accounting Policies and Estimates" for further discussion of revenue recognition. 30 Operating Expenses Cost of Revenue. Cost of revenue primarily consists of expenses related to running our network infrastructure (including Internet connectivity, hosting expenses, and data storage), amortization expense on acquired intangible assets, capitalized software and website development costs, compensation and related benefits for network and technology development personnel, amounts paid to third parties pursuant to contracts under which (i) a portion of certain revenue is owed to those third parties (revenue share) or, (ii) fees are due on the number of transactions processed and direct costs for data licenses. Cost of revenue also includes hardware costs associated with our DMS product offering, and compensation, related benefits and travel expenses associated with DMS installation personnel, compensation and related benefits associated with strategic inventory consulting personnel, compensation and related benefits, and temporary labor associated with personnel who process transactions for our digital contract, collateral management, and registration and titling solutions, and advertising expenses associated with certain of our search and media product offerings. For those periods prior to the disposal of ALG, cost of revenue also included direct costs (printing, binding and delivery) associated with residual value guides. Product Development Expenses. Product development expenses consist primarily of compensation and related benefits, consulting fees and other operating expenses associated with our product development departments. The product development departments perform research and development, in addition to enhancing and maintaining existing products. Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of compensation and related benefits, facility costs, professional services fees for our sales, marketing, customer service and administrative functions, and public company costs. We allocate overhead such as occupancy and telecommunications charges, and depreciation expense based on headcount, as we believe this to be the most accurate measure. As a result, a portion of general overhead expenses are reflected in each operating expense category. Acquisitions We have grown our business since inception through a combination of organic growth and acquisitions. The operating results of each business acquired have been included in our consolidated financial statements from the respective dates of acquisition. Our acquisitions have been recorded under the acquisition method of accounting, pursuant to which the total purchase price is allocated to the net assets acquired based upon estimates of the fair value of those net assets. Any excess purchase price is allocated to goodwill. Amortization expense relating to definite-lived intangible assets is recorded as a cost of revenue. On August 1, 2012, Dealertrack, Inc. purchased all of the issued and outstanding shares of capital stock of 1st Auto Transport Directory, Inc., now known as Dealertrack CentralDispatch, for a cash purchase price of $73.8 million, reflective of final working capital adjustments. Dealertrack CentralDispatch delivers a comprehensive suite of vehicle transportation related solutions for auto dealers, brokers, shippers, and carriers within the U.S. and Canadian automotive retail markets. Dealertrack CentralDispatch's offerings include CentralDispatch.com, a leading business-to-business, subscription-based network for facilitating vehicle transportation, with more than 13,000 network subscribers; jTracker.com, a CRM and lead management tool for automotive transportation brokers; and MoveCars.com, one of the premier online advertising directories for the vehicle transportation industry. On October 1, 2012, Dealertrack, Inc. purchased all of the equity interests of ClickMotive, LLC, a leading provider of interactive marketing solutions for the automotive retailing industry. The total consideration, which consisted of $48.7 million, net of acquired cash, and $0.3 million in contingent consideration, is reflective of final working capital adjustments. ClickMotive provides SaaS solutions exclusively to the automotive industry by offering a leading comprehensive digital marketing platform that combines the power of the web, mobile, social, search and video into one online marketing platform. Currently, more than 3,000 U.S. automotive dealerships leverage ClickMotive's platform. On November 1, 2012, Dealertrack Canada, Inc. acquired the assets of Ford Motor Company of Canada, Limited's iCONNECT Direct DMS business for CAD $6.9 million (USD $6.9 million) in cash. For further information regarding these acquisitions, please refer to Note 8 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of our operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (GAAP). The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the amounts reported for assets, liabilities, revenue, expenses and the disclosure of contingent liabilities. Our critical accounting policies are those that we believe are both important to the portrayal of our financial condition and results of operations and that involve difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The estimates are based on historical experience and on various assumptions about the ultimate outcome of future events. Our actual results may differ from these estimates if unforeseen events occur or should the assumptions used in the estimation process differ from actual results. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: 31 Revenue Recognition We recognize revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or the services have been rendered, (iii) the fee is fixed or determinable, and (iv) collection of the resulting receivable is reasonably assured. Our revenue is presented net of a provision for sales credits, which is estimated based on historical results, and established in the period in which services are provided. Transaction Services Revenue Lender Transaction Services Revenue Lender transaction services revenue consists of transaction revenue earned from our lender customers for (1) each electronic receipt of credit application or contract data that dealers submit to them through the Dealertrack credit application network; (2) for each financing contract executed via our electronic contracting and digital contract processing solution; (3) for collateral management transactions; and (4) for any data services performed. Credit Application Transaction Revenue Our web-based credit application network facilitates the online credit application process by enabling dealers to transmit a consumer's credit application information to one or more lenders. Credit application revenue consists of revenue earned on a per transaction basis and set-up fees charged to lenders for establishing connections. Transaction revenue is earned upon the electronic receipt of the credit application data and set-up fees are recognized ratably over the expected customer relationship period of four years. Electronic and Digital Contracting Transaction Revenue Our eContracting product allows dealers to obtain electronic signatures and provide contracts electronically to lender customers that participate in the solution. Our digital contract processing service receives paper-based contracts from dealers, digitizes the contract and submits them in electronic format to the respective lenders. Electronic and digital contracting revenue is recognized on a per transaction basis after services have been rendered. Collateral Management Services Transaction Revenue Our collateral management solution provides vehicle title and administration services for our customers, which are comprised mainly of lenders. The solution facilitates communication between our customers and the state department of motor vehicles by providing a solution for our customers to monitor title perfection and expedite the processing of liens with the state department of motor vehicles. We offer both paper-based and electronic-based title services depending on state requirements. Customer contracts for title services are principally comprised of two elements: (1) title perfection confirmation and (2) title administration. For paper-based titles, title perfection confirmation occurs upon the receipt of title and lien documentation supporting title perfection from the department of motor vehicles. For electronic-based titles, title perfection confirmation is achieved upon electronic acknowledgement that department of motor vehicles' records reflect the customer as the lien holder. For paper-based titles, title administration services require us to physically hold, store and manually release the title. For electronic-based titles, title administration services require data storage. The release of the electronic title can be accomplished by the lien holder and does not require manual action by us. Deliverables for paper and electronic title management arrangements are separated into more than one unit of accounting when (i) the delivered element(s) have value to the customer on a stand-alone basis, (ii) delivery of the undelivered element(s) is probable and substantially in our control, and (iii) relative selling price is determined. Based on the above criteria, paper and electronic-based collateral management service revenue are separated into two units of accounting. We recognize a portion of the paper-based transaction fee upon receipt of title and lien documentation supporting title perfection from the department of motor vehicles. For electronic-based titles, we recognize a portion of the fee upon electronic acknowledgement that the department of motor vehicles' records reflect the customer as the lien holder. For paper-based title services, amounts allocated to each unit of accounting are based upon vendor-specific objective evidence. For electronic-based title services, amounts allocated to each unit of accounting are based upon estimated selling price, which is based upon an adjustment to the selling price of our individual paper-based title services, when sold separately. The adjustment to the selling price is due to the lower selling price of electronic-based services compared to paper-based services. For customers in which we bill the entire transaction fee in advance, the title administration portion of the fee for both paper and electronic-based titles is deferred and recognized over the title administration period, which is estimated at approximately three years. This estimate is based upon a historical analysis of the average time period between the date of financing and the date of pay-off. Collateral management services revenue also includes revenue earned from converting a new customer's title portfolio to our collateral management solution, which may include other ancillary services. Amounts earned from converting a new customer's portfolio are recognized over the customer's estimated portfolio loan life which varies depending on the customer. Amounts earned from other ancillary services are recognized on a per transaction basis after services have been rendered. 32 Data Services Transaction Revenue Data service solutions are designed to help lenders analyze investment risk through detailed study of return rates and historic market trends. Whether a lender portfolio consists of leases, loans, or both, our data service products will analyze lenders automotive investments for maximum return. Data services revenue is recognized on a per record basis after services have been rendered. Dealer and Other Service Provider Transaction Services Revenue Registration Transaction Revenue Our registration and titling services solution provides various web-based and service-bureau based automotive vehicle registration services to customers. Registration and titling services revenue is recognized on a per transaction basis after services have been rendered. Aftermarket Transaction Revenue The Dealertrack Aftermarket Network streamlines and integrates the entire aftermarket sales and submission process. Aftermarket solution providers connected to the Dealertrack Aftermarket Network enable their dealers to have free access to real-time information needed to make aftermarket sales decisions. Aftermarket services revenue is recognized on a per transaction basis after services have been rendered. Credit Bureau Transaction Revenue Our credit bureau service provides our dealer customers the ability to access credit reports from several reporting agencies or resellers online. We offer these credit reports on both a reseller and agency basis. We recognize credit bureau revenue on a per transaction basis after services have been rendered. Credit bureau revenue is recognized from all but one credit bureau provider on a net basis due to the fact that we are not considered the primary obligor, and recognized on a gross basis from one provider as we have risk of loss and are considered the primary obligor in the transaction. Other Transaction Revenue Other transaction revenue includes revenue from appraisal solutions that provide dealers the ability to complete real-time vehicle appraisals as well as revenue from compliance solutions. This transaction revenue is recognized on a per transaction basis after services have been rendered. Subscription Services Revenue Subscription services revenue consists of revenue earned from primarily our dealers and other customers (typically on a monthly basis) for use of our subscription or licensed-based products and services. Our subscription services enable dealer customers to manage their dealership data and operations, compare various financing and leasing options and programs, sell insurance and other aftermarket products, manage, merchandise, and advertise their inventory and execute financing contracts electronically. Revenue is recognized from such contracts ratably over the contract period. Set-up fees, if applicable, are recognized ratably over the expected dealer customer relationship period, which is generally 36 to 60 months. For contracts that contain two or more subscription products and services, we recognize revenue in accordance with the above policy using relative selling price when the delivered products have stand-alone value. Search Engine Optimization and Marketing We record revenue for search engine optimization (SEO) and search engine marketing (SEM) based on the assessment of multiple factors, including whether we are the primary obligor to the arrangement and whether we maintain latitude in establishing price. In instances in which we are the primary obligor or establish price, we record the total amounts received from customers within subscription services revenue, and online search provider payments as cost of revenue. In instances in which we are paid by customers to recommend allocation of their budgeted spend, we record subscription services revenue for the net amounts paid to us by our customers. In the latter instance, our customers budgeted spend and amounts paid to the online search providers do not impact our consolidated results of operations. Other Revenue Other revenue consists of revenue primarily earned through forms programming, data conversion, hardware and equipment sales from our Dealer Management solution, shipping commissions earned from our digital contract business, and consulting and analytical revenue earned from ALG in periods prior to its disposal in 2011. Training fees are also included in other revenue. Other revenue is recognized when the service is rendered. Customer Funds Under contractual arrangements, our registration and titling services solution collects funds from our customers and remits such amounts to the various state departments of motor vehicle registries (registries). Customer funds receivable primarily represents transactions processed by our customers for which we have not collected our fees or the fees payable to the various registries. In addition, payments made to the various registries in advance of receipt from the customer, are recorded as customer funds receivable. Customer funds payable primarily includes transactions processed by our customers for which we have not remitted the fees to the various registries. Customer funds are maintained in separate bank accounts and are segregated from our operating cash. 33 Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The amount of the allowance account is based on historical experience and our analysis of the accounts receivable balances outstanding. While credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, additional allowances may be required which would result in an additional expense in the period that this determination was made. Software and Website Development Costs and Amortization We capitalize costs of materials, consultants, payroll and payroll-related costs incurred by employees involved in developing internal use computer software. Costs incurred during the preliminary project and post-implementation stages are charged to expense. Software and website development costs are amortized on a straight-line basis over estimated useful lives. Capitalized costs are generally amortized over two years while our platform updates are amortized over five years and costs related to our ERP implementation are amortized over seven years. We perform periodic reviews to ensure that unamortized software and website costs remain recoverable from future revenue. Capitalized software and website development costs, net, were $46.2 million and $37.3 million as of December 31, 2012 and 2011, respectively. Amortization expense totaled $13.9 million, $12.3 million and $9.7 million for the years ended December 31, 2012, 2011 and 2010, respectively. Amortization expense for the year ended December 31, 2012 included $1.0 million of accelerated depreciation of certain technology assets due to the discontinuation of those projects. Goodwill We record as goodwill the excess of purchase price over the fair value of the tangible and identifiable intangible assets acquired. Goodwill is tested annually for impairment as well as whenever events or circumstances change that would make it more likely than not that an impairment may have occurred. Goodwill is tested for impairment using a two-step approach. The first step tests for potential goodwill impairment by comparing the fair value of our one reporting unit to its carrying value. If the fair value of the reporting unit is less than its carrying value, the second step is to calculate and record an impairment loss to the extent that the implied fair value of the goodwill of the reporting unit is less than the carrying value of goodwill. Goodwill is required to be assessed at the operating segment or lower level. We determined that the components of our one operating segment have similar economic characteristics, nature of products, distribution, shared resources and type of customer such that the components should be aggregated into a single reporting unit for purposes of performing the impairment test for goodwill. We perform our annual impairment analysis as of the first day of the fourth quarter. The evaluation of impairment involves comparing the current estimated fair value of our reporting unit to the carrying value, including goodwill. We estimate the fair value of our reporting unit by primarily using a market capitalization approach, and also looking at the outlook for the business. The results of our most recent annual assessments performed on October 1, 2012 and 2011 did not indicate any impairment of our goodwill. In each year, the fair value of our reporting unit was significantly in excess of the carrying value, which includes goodwill. As of October 1, 2012, our market capitalization was approximately $1.2 billion compared to our book value, including goodwill,of approximately $565 million. Intangibles and Long-lived Assets We evaluate our long-lived assets, including property and equipment and finite-lived intangible assets for potential impairment on an individual asset basis or at the lowest level asset grouping for which cash flows can be separately identified. Intangible asset impairments are assessed whenever changes in circumstances could indicate that the carrying amounts of those productive assets exceed their projected undiscounted cash flows. When it is determined that impairment exists, the related asset group is written down to its estimated fair value. The determination of future cash flows and the estimated fair value of long-lived assets involve significant estimates on the part of management. In order to estimate the fair value of a long-lived asset, we may engage a third party to assist with the valuation. Our process for assessing potential triggering events may include, but is not limited to, analysis of the following: · any sustained decline in our stock price below book value; · results of our goodwill impairment test; · sales and operating trends affecting products and groupings; · the impact on current and future operating results related to industry statistics including fluctuation of lending relationships between financing sources and automobile dealers, actual and projected annual vehicle sales, and the number of dealers within our network; · any losses of key acquired customer relationships; and · changes to or obsolescence of acquired technology, data, and trademarks. We also evaluate the remaining useful life of our long-lived assets on a periodic basis to determine whether events or circumstances warrant a revision to the remaining estimated amortization period. 34 Senior Convertible Notes In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 470-20, Debt with Conversion and Other Options, we separately account for the liability and equity components of our senior convertible notes. The estimated fair value of the liability component is computed based on an assessment of the fair value of a similar debt instrument that does not include a conversion feature. The equity component, which is recognized as a debt discount and recorded in additional paid-in capital, represents the difference between the gross proceeds from the issuance of the notes and the estimated fair value of the liability component at the date of issuance. The debt discount is amortized over the expected life of a similar liability without the equity component. The effective interest rate used to amortize the debt discount was based on our estimated non-convertible borrowing rate of a similar liability without an equity component as of the date thenotes were issued. Income Taxes We account for income taxes in accordance with the provisions of FASB ASC Topic 740, Accounting for Income Taxes, which requires deferred tax assets and liabilities to be recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be reversed. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. In 2010, we recorded valuation allowances relating to cumulative U.S. book losses, some of which were subsequently reversed as a result of acquisition and disposal activity. Uncertain tax positions are recorded in our consolidated balance sheet in accrued liabilities - other. Interest and penalties, if any, related to tax positions taken in our tax returns are recorded in interest expense and general and administrative expenses, respectively, in our consolidated statement of operations. On January 3, 2013, the President of the United States signed into law the American Taxpayer Relief Act of 2012 (the 2012 Act), which extends the U.S. research and development tax credit for tax years 2012 and 2013, as well as other provisions. Given the effective dates of the various provisions in the 2012 Act, the 2012 Act had no impact on our 2012 results and is expected to have an impact of approximately $0.5 million to $1.0 million of benefit in our 2013 tax provision related to the extension of the U.S. research and development tax credit for tax years 2012 and 2013. Stock-Based Compensation Expense and Assumptions Stock-Based Compensation Expense Stock-based compensation is measured at the grant date based on the fair value of the award, and recognized as an expense over the requisite service period, net of an estimated forfeiture rate. We currently have three types of stock-based compensation awards: stock options, restricted stock units and performance stock units. There are no longer any restricted common stock awards outstanding. The following summarizes stock-based compensation expense recognized for the three years ended December 31, 2012, 2011 and 2010 (in thousands): Year Ended December 31, 2012 2011 2010 Stock options $ 4,608 $ 4,941 $ 5,732 Restricted stock units 7,101 5,293 3,354 Performance stock units 1,883 1,057 477 Restricted common stock - 321 1,670 Total stock-based compensation expense $ 13,592 $ 11,612 $ 11,233 A summary of the unamortized stock-based compensation expense and associated weighted average remaining amortization periods for stock options, restricted stock units and performance stock units is presented below: Weighted Unamortized Average Stock-Based Remaining Compensation Amortization Expense Period (in thousands) (in years) Stock options $ 9,096 2.82 Restricted stock units $ 13,785 2.63 Performance stock units $ 2,237 1.08 Stock-Based Compensation Assumptions and Vesting Requirements Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require the input of highly subjective assumptions, including the expected life, expected stock price volatility, and the number of awards that will be forfeited prior to the completion of the vesting requirements. We use Black-Scholes-Merton and binomial lattice-based valuation pricing models to value our stock-based awards. Expected Life The expected life is determined based upon the experience of similar entities whose shares are publicly-traded. The expected life for stock-based awards granted prior to December 31, 2007 were determined based on the "simplified" method, due to our limited public company history, except for options granted under the Stock Option Exchange Program (SOEP) which were determined by means of Monte-Carlo simulations. 35 Expected Stock Price Volatility Beginning in 2012, we determine the expected volatility of any stock-based awards we issue based on our historical volatility. Previously, due to our limited public company history, the expected volatility for stock-based awards was determined using a time-weighted average of our historical volatility and the expected volatility of similar entities whose common shares are publicly-traded. Risk-Free Interest Rate and Dividend Yield The risk-free interest rates used for all stock-based awards granted were the actual U.S. Treasury zero-coupon rates for bonds matching our expected life of an option on the date of grant. The expected dividend yield is not applicable to our stock-based award grants as we have not paid any dividends on our common stock. We do not anticipate declaring or paying cash dividends on our common stock, and we are currently limited in doing so pursuant to our credit facility. Option Vesting Requirements Options granted generally vest over a period of four years (three years for directors) from the vesting commencement date, with the exception of options granted under the SOEP. Options granted generally expire seven years from the date of grant, except for stock options granted prior to July 11, 2007, which expire ten years from the date of grant. Options, to the extent unvested, expire on the date of termination of employment, and to the extent vested, generally expire at the end of the three-month period following termination of employment, except in the case of executive officers, who under certain conditions have a twelve-month period following termination of employment to exercise. Exchanged options granted under the SOEP vested 25% after six months from the new grant date, 25% after twelve months from the new grant date, and 1/48 each month thereafter. Restricted Stock Unit Vesting Requirements Restricted stock units granted are generally subject to an annual cliff vest over four years (one year for directors) from the vesting commencement date, with the exception of performance stock unit awards. Long Term Incentive Plan (LTIP) The LTIP awards were earned upon the achievement of EBITDA and market-based targets for fiscal years 2007, 2008 and 2009 and the grantee's continuous employment in active service until the final vest date, which was approximately three years from the grant date. Performance Stock Unit Vesting Requirements The performance stock unit awards are earned upon the achievement of adjusted net income and total shareholder return targets and the grantee's continuous employment in active service until the final vest date, which is approximately three years from the grant date. Fair Value Inputs The fair value of each share-based award grant has been estimated on the date of grant using the Black-Scholes-Merton Option Pricing Model with the following assumptions: December 31, 2012 2011 2010 Expected volatility 47.3 - 49.9% 49.5 % 50.3 % Expected dividend yield 0 % 0 % 0 % Expected life (in years) 4.18 4.10 4.18 Risk-free interest rate 0.50 - 0.62% 0.67 - 1.63% 0.94 - 1.91% Weighted-average fair value of stock options granted $ 10.79 $ 8.36 $ 6.32 Weighted-average fair value of restricted stock units granted $ 28.03 $ 20.30 $ 15.30 The fair value of ANI Performance Awards is estimated on the date of grant using a Black-Scholes-Merton valuation pricing model. The fair value of TSR Performance Awards is estimated on the date of grant using a binomial lattice-based valuation pricing model. The weighted-average assumptions were as follows: December 31, 2012 2011 2010 Expected dividend yield 0 % 0 % 0 % Risk-free interest rate 0.39 % 1.16 % 1.33 % Weighted-average fair value of ANI Performance Awards granted $ 27.99 $ 19.48 $ 16.91 Weighted-average fair value of TSR Performance Awards granted $ 28.98 $ 21.27 $ 17.62 Application of alternative assumptions could produce significantly different estimates of the fair value of stock-based compensation and consequently, the related amounts recognized in our consolidated statements of operations. 36 Fair Value Measurements We have segregated all financial assets and liabilities that are measured at fair value on a recurring basis into the most appropriate level within the fair value hierarchy based on the inputs used to determine fair value at the measurement date. A reconciliation of the beginning and ending balances of Level 3 investments as of December 31, 2011 and 2012 is as follows (in thousands): Balance as of December 31, 2010 $ 2,704 Sale of tax-advantaged preferred stock (1) (2,485 ) Realized gain on securities included in the consolidated statement of operations (1) 409 Reversal of unrealized gain on securities sold recorded in other comprehensive income (178 ) Redemption of auction rate security (2) (450 ) Acquisition of warrant (3) 5,500 Change in fair value of warrant (3) 1,000 Balance as of December 31, 2011 $ 6,500 Change in fair value of warrant (3) (6,310 ) Exercise of warrant (3) (190 ) Balance as of December 31, 2012 $ - A reconciliation of the beginning and ending balances of contingent consideration, a Level 3 liability, as of December 31, 2011 and 2012 is as follows (in thousands): Balance as of December 31, 2010 $ - Record contingent consideration at fair value - eCarList (4) (2,900 ) Change in fair value of contingent consideration - eCarList (4) 2,000 Balance as of December 31, 2011 $ (900 ) Change in fair value of contingent consideration - eCarList (4) 900 Record fair value of contingent consideration - ClickMotive (5) (250 ) Change in fair value of contingent consideration - ClickMotive (5) (750 ) Balance as of December 31, 2012 $ (1,000 ) (1) Level 3 long-term marketable securities as of December 31, 2010 included a tax-advantaged preferred stock of a financial institution with a fair value of $2.3 million. As of December 31, 2010, it was uncertain whether we would be able to liquidate these securities within the next twelve months; as such we classified them as long-term on our consolidated balance sheets. Due to the lack of observable market quotes we utilized valuation models that relied exclusively on Level 3 inputs including those that are based on expected cash flow streams, including assessments of counterparty credit quality, default risk underlying the security, discount rates and overall capital market liquidity. In June 2011, we sold this security for approximately $2.5 million and recorded a gain of approximately $0.4 million in our consolidated statement of operations. (2) Level 3 short-term marketable securities as of December 31, 2010 included an auction rate security invested in a tax-exempt state government obligation that was valued at par of $0.4 million. Our intent was not to hold the auction rate security invested in a tax-exempt state government obligation to maturity, but rather to use the interest reset feature to provide liquidity. In October 2010, $1.1 million of this security was redeemed by the issuer at par. Due to continued failures in the marketplace auctions, we held the remaining $0.4 million auction rate security until the maturity date in September 2011, when it was redeemed by the issuer at par. (3) In connection with our October 1, 2011 disposal of ALG, we acquired a warrant to purchase 6.3 million additional shares of TrueCar common stock and recorded the warrant as a long-term investment. As a result of a net settlement feature, the warrant was revalued each reporting period through its expiration date of October 1, 2012, with the change in fair value recorded in the consolidated statements of operations. Prior to its exercise, the fair value of the warrant was estimated using a Black-Scholes-Merton option pricing model. In September 2012, we exercised the warrant at a value of $0.2 million based on an independent valuation approved by the board of directors of TrueCar. During 2012, the value of the warrant decreased by $6.3 million as a result of a decrease in the remaining expected term and estimated share price. The value of the shares received upon net exercise is now part of our existing cost method investment in TrueCar. 37 (4) A portion of the purchase price of eCarList included contingent consideration that was payable in the first quarter of 2013 based upon the achievement of certain revenue targets in 2012. The fair value of the contingent consideration was determined based upon probability-weighted revenue forecasts for the underlying period. The contingent consideration was revalued each reporting period, until settled, with the resulting gains and losses recorded in the consolidated statements of operations. The revenue targets for 2012 were not met, and therefore no contingent consideration payments will be made. We recorded a fair value adjustment in the amount of $0.9 million of income for the year ended December 31, 2012 as a result of the decrease in the estimated settlement of the contingent consideration from the estimated amount as of December 31, 2011. (5) In connection with our October 1, 2012 acquisition of ClickMotive, a portion of the purchase price included contingent consideration that is payable in the first quarter of 2014 based upon the achievement of certain performance targets in 2013. The fair value of the contingent consideration is determined based upon probability-weighted revenue forecasts for the underlying period. The contingent consideration is revalued each reporting period, until settled, with the resulting gains and losses recorded in the consolidated statements of operations. The fair value of the contingent consideration as of the acquisition date was estimated at approximately $0.3 million. We estimated the fair value of the contingent consideration as of December 31, 2012 to be $1.0 million and recorded expense of approximately $0.8 million for the three months ended December 31, 2012 as a result of the increase in the contingent consideration liability. The increase in contingent consideration includes the impact of an adjustment to the performance targets made subsequent to the close of the acquisition. Results of Operations The following table sets forth the selected consolidated statements of operations for the periods indicated: Year Ended December 31, 2012 2011 2010 % of Net % of Net % of Net $ Amount Revenue $ Amount Revenue $ Amount Revenue (in thousands, except percentages) Consolidated Statements of Operations: Net revenue $ 388,872 100.0 % $ 353,294 100.0 % $ 243,826 100.0 % Operating expenses: (1) Cost of revenue 220,695 56.8 197,152 55.8 129,014 52.9 Product development 11,732 3.0 13,012 3.7 12,537 5.1 Selling, general and administrative 142,518 36.6 128,892 36.5 101,620 41.7 Total operating expenses 374,945 96.4 339,056 96.0 243,171 99.7 Income from operations 13,927 3.6 14,238 4.0 655 0.3 Interest income 745 0.2 331 0.1 525 0.2 Interest expense (10,801 ) (2.8 ) (927 ) (0.3 ) (175 ) (0.1 ) Other (expense) income, net (5,532 ) (1.4 ) 1,360 0.4 1,177 0.5 Gain on disposal of subsidiaries and sale of other assets 33,193 8.5 47,321 13.5 - - Earnings from equity method investment, net 1,167 0.3 - - - - Realized gain on securities 4 0.0 409 0.1 582 0.2 Income before (provision for) benefit from income taxes 32,703 8.4 62,732 17.8 2,764 1.1 (Provision for) benefit from income taxes, net (12,249 ) (3.1 ) 2,403 0.6 (30,597 ) (12.5 ) Net income (loss) $ 20,454 5.3 % $ 65,135 18.4 % $ (27,833 ) (11.4 )% (1) For the year ended December 31, 2011, we reclassified approximately $3.0 million of salary and benefit costs from cost of revenue and product development to selling, general and administrative due to cost center changes. For the year ended December 31, 2010, we reclassified approximately $0.8 million of salary and benefit costs from product development to selling, general and administrative and cost of revenue due to cost center changes. 38 Years Ended December 31, 2012 and 2011 Revenue Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages)Transaction services revenue $ 225,011 $ 184,892 $ 40,119 22 % Subscription services revenue 145,148 146,621 (1,473) (1 )% Other 18,713 21,781 (3,068 ) (14 )% Total net revenue $ 388,872 $ 353,294 $ 35,578 10 % Transaction Services Revenue. The increase in transaction services revenue was a result of an increase in automobile sales and improving credit availability, application and other financing-related activity. These and other industry trends had a positive impact on the following changes in our key transaction-related business metrics. Year Ended December 31, Variance 2012 2011 Amount Percent Average transaction price (1) $ 2.61 $ 2.53 $ 0.08 3 %Transaction revenue per car sold $ 6.95 $ 6.39 $ 0.56 9 % Active lenders in our U.S. network as of end of the year 1,261 1,120 141 13 % Active lender to dealer relationships as of end of the year 174,628 164,776 9,852 6 % Transactions processed (in thousands, except percentages) 87,833 74,450 13,383 18 % (1) - Revenue used in the calculation adds back (excludes) contra revenue. Our average transaction price and the total number of transactions processed increased 3% and 18%, respectively, which resulted in an increase in transaction services revenue of $6.2 million and $33.8 million, respectively. In addition, there was a decrease in contra-revenue of $0.1 million. Contributing factors to the increase in average transaction price and the total number of transactions processed included $15.4 million of additional revenue from Processing Solutions (whose transactions are generally at a higher average price than our other transactions); a 13% increase in lender customers active in our U.S. Dealertrack network (new lender customers are generally lower transaction volume customers with higher prices per transaction); and a 6% increase in our number of lender to dealer relationships. The increase in our number of lender to dealer relationships was attributable to more active dealers, more active lenders on our U.S. network, and an increase in the average number of lenders that dealers use. Subscription Services Revenue. The decrease in subscription services revenue is primarily a result of the sale of ALG and the contribution of the net assets of Chrome to the Chrome Data Solutions joint venture. The decrease was partially offset by additional subscription services revenue from the acquisitions of eCarList on July 1, 2011, Dealertrack CentralDispatch on August 1, 2012, and ClickMotive on October 1, 2012 and an increase in subscribing dealers. The net decrease in subscription services revenue was a result of the following changes in our key subscription-related business metrics. Year Ended December 31, Variance 2012 2011 Amount Percent Average monthly subscription revenue per subscribing dealership (1) (2) $ 708 $ 813 $ (105 ) (13 )% Subscribing dealers in U.S. and Canada as of end of the year (2) 17,619 16,003 1,616 10 % (1) - Revenue used in the calculation adds back (excludes) contra revenue. (2) - Subscribing dealers and subscription services revenue from Dealertrack CentralDispatch have been excluded from the calculation as a majority of these customers are not dealers. The elimination of ALG and Chrome revenue, which did not impact the subscribing dealers metric, contributed $26.5 million to the decrease in subscription services revenue. This decrease was offset by incremental revenue from entities acquired during 2012 of $8.9 million, as well as an increase in the average number of subscribing dealers in our network, including additional subscription services revenue of $9.8 million from eCarList, and the continued selling of our DMS, Inventory and Compliance solutions, including cross selling those solutions to existing customers. Other Revenue. The decrease in other revenue of $3.1 million was primarily due to the elimination of $2.4 million of other revenue from the ALG and Chrome businesses. Operating Expenses Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) Cost of revenue $ 220,695 $ 197,152 $ 23,543 12 % Product development 11,732 13,012 (1,280 ) (10 )%Selling, general and administrative 142,518 128,892 13,626 11 % Total operating expenses $ 374,945 $ 339,056 $ 35,889 11 % 39 For 2011, we reclassified approximately $3.0 million of salary and benefit costs from cost of revenue and product development to selling, general and administrative due to cost center changes. Cost of Revenue. The increase in cost of revenue was the result of a net increase of $6.3 million in compensation and related benefit costs, primarily due to an incremental six months of compensation and related benefit costs related to the acquisition of eCarList, one month related to the acquisition of Dealertrack Processing Solutions, five months related to the acquisition of Dealertrack CentralDispatch and three months related to the acquisition of ClickMotive. These were partially offset by the elimination of compensation and related benefit costs from the disposal of ALG and contribution of Chrome. There were additional increases in technology expenses of $10.0 million, which includes technology support and other consulting expenses, an increase in Processing solutions costs of $4.3 million relating to additional revenue, an increase in acquired intangible amortization expense of $2.5 million related to 2012 acquisitions and $1.9 million related to 2011 acquisitions, an increase in Inventory solution costs of $1.7 million relating to additional revenue, an increase in costs associated with our Canadian operations of $1.3 million as a result of expanding our product offerings in Canada, an increase in Interactive solution costs of $1.4 million including search optimization and marketing costs associated with our product offerings related to eCarList, and an increase in stock-based compensation of $0.6 million. These costs were partially offset by the elimination of $1.4 million of operating costs and $2.5 million of amortization expense from the disposal of ALG and contribution of Chrome and a $3.2 million decrease in amortization expense for fully amortized intangibles. Product Development Expenses. The decrease in product development expenses was primarily the result of an overall decrease in salary and related benefit costs from the elimination of former ALG and Chrome employees, offset by product development expenses related to acquired businesses. Selling, General and Administrative Expenses. The increase in selling, general and administrative expenses was the result of a net increase of $5.2 million in compensation and related benefit costs, primarily due to an additional six months of compensation and related benefit costs related to the acquisition of eCarList and the additional month of compensation and related benefit costs related to the acquisition of Dealertrack Processing Solutions. These were partially offset by the elimination of compensation and related costs from the disposal of ALG and contribution of Chrome. Additionally, there were increases of $1.0 million of expense related to accelerated depreciation for discontinued technology projects, $1.9 million of costs related to rebranding, $1.3 million in stock-based compensation, $0.9 million in travel and related costs, $0.8 million of expense recorded for an increase in ClickMotive contingent consideration, $0.7 million in temporary labor costs, and $0.4 million in bad debt expense. The impact of changes in eCarList contingent consideration was $0.9 million of income during 2012 and $2.0 million of income during 2011, contributing a $1.1 million net increase in expense during 2012. The increases to selling, general and administrative expenses were partially offset by a net decrease in professional services and deal related costs of $0.9 million. Interest Income Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) Interest income $ 745 $ 331 $ 414 125 % The increase is related to interest income recorded from our cash balances and investments in marketable securities from the cash proceeds received from the issuance of the senior convertible notes in March 2012. Interest Expense Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) Interest expense $ (10,801 ) $ (927 ) $ (9,874 ) 1,065 % The increase in interest expense is due to interest expense from the senior convertible notes issued in March 2012, including coupon interest of $2.5 million, amortization of debt discount of $6.2 million, and amortization of debt issuance costs of $0.8 million. Interest expense related to our revolving credit facility for 2012 consisted of commitment fees of $0.5 million and amortization of debt issuance costs of $0.5 million. Other (Expense) Income, Net Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) Other (expense) income, net $ (5,532 ) $ 1,360 $ (6,892 ) (507 )% The decrease in other (expense) income, net is primarily due to the $6.3 million decrease in the value of our warrant in TrueCar in 2012 prior to exercise. Offsetting a portion of this expense was $0.6 million of gain during 2012 relating to previously deferred revenue and costs which were recorded in conjunction with our acquisition of Ford of Canada's iCONNECT DMS. 40 Gain on Disposal of Subsidiaries and Sale of Other Assets Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) Gain on disposal of subsidiaries and sale of other assets $ 33,193 $ 47,321 $ (14,128 ) (30 )% During 2012, we recorded a gain on the contribution of the net assets of Chrome to the Chrome Data Solutions joint venture in the amount of $27.7 million and a gain of $5.5 million related to the sale of a Chrome-branded asset, which was not contributed to the joint venture. During 2011, we recorded a gain on the sale of ALG in the amount of $47.3 million. Earnings from Equity Method Investment, Net Year Ended December 31, Variance 2012 2011 $ Amount Percent (In thousands, except percentages) Earnings from equity method investment, net $ 1,167 $ - $ 1,167 100 % During 2012, we recorded net earnings from the Chrome joint venture of $1.2 million. This consisted of $5.2 million for our 50% share of the joint venture's net income, which was reduced by approximately $4.0 million of amortization relating to the basis difference between the book basis of the contributed assets and the fair value of the investment recorded. Realized Gain on Securities Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages)Realized gain on securities $ 4 $ 409 $ (405 ) (99 )% During 2011, we sold a portion of our investments in tax-advantaged preferred securities for approximately $2.5 million and recorded a gain of approximately $0.4 million. (Provision for) Benefit from Income Taxes, Net Year Ended December 31, Variance 2012 2011 $ Amount Percent (in thousands, except percentages) (Provision for) benefit from income taxes, net $ (12,249 ) $ 2,403 $ (14,652 ) (610 )% The net provision for income taxes for 2012 of $12.2 million primarily consisted of $8.0 million of federal income tax expense, $1.0 million of state income tax expense and $3.2 million of tax expense for our Canadian subsidiary. Included in our tax provision for 2012 was $1.5 million of income tax benefit in the U.S., $3.2 million of provision for Canadian subsidiaries and $10.5 million of income tax provision for discrete items. Provision for discrete items included $10.5 million on the gain recorded in conjunction with the contribution of the net assets of Chrome for the investment in Chrome Data Solutions, $1.3 million of provision from the elimination of the Chrome deferred tax assets and goodwill, income tax provision of $1.8 million on the gain recorded from the sale of a Chrome-branded asset net of a reduction in valuation allowance resulting from the asset sale, $2.4 million of benefit on the change in value of our warrant in TrueCar, $0.5 million of benefit from a change in state income tax rates and $0.2 million of benefit from tax return filings. The primary components of our $2.4 million tax benefit for 2011 consisted of $22.2 million of tax provision on our pre-tax results, offset by a favorable release of valuation allowance of $23.1 million, inclusive of state tax valuation allowance releases. Our provision on pre-tax results includes $19.4 million for federal, $0.9 million for state (net of federal benefit) and $1.9 million for Canada. The provision was also impacted by a benefit related to the completion of our 2010 U.S. tax return of $1.2 million, a net benefit on reversal of tax exposures and tax return filings of $0.2 million, and other items amounting to a $0.4 million aggregate benefit, including the reversal of contingent consideration. These additional benefits were offset by the deferred tax liability impact related to the ALG disposal of $0.3 million. For 2011, the permanent item relating to intangible amortization for our Canadian subsidiary did not have a significant impact on tax expense. Our effective tax rate for 2012 was a provision of 37.5% compared with a benefit of 3.8% for 2011. At December 31, 2010, we determined that the ultimate realization of deferred tax assets for U.S. federal and state income tax purposes was not considered more likely than not and recorded a full valuation allowance of $28.4 million against our net U.S. deferred tax assets. As a result of the acquisition of Dealertrack Processing Solutions in 2011, we evaluated the combined enterprises past and expected future results, including the impact of the future reversal of the acquired deferred tax liabilities, and determined that the future reversal of the acquired deferred tax liabilities would provide sufficient taxable income to support realization of certain of DealerTrack's deferred tax assets and thereby we reduced the valuation allowance by approximately $24.5 million. In addition, as a result of the sale of ALG in 2011, and the establishment of deferred tax liabilities on the transaction along with the expected future reversal of deferred tax liabilities, we evaluated the need for a full valuation allowance on our remaining net deferred tax assets and determined that the ultimate realization of deferred tax assets for U.S. federal and state income tax purposes was considered more likely than not and we reversed a portion of the remaining valuation allowance on our net U.S. deferred tax assets. 41 Years Ended December 31, 2011 and 2010 Revenue Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages)Transaction services revenue $ 184,892 $ 102,000 $ 82,892 81 % Subscription services revenue 146,621 123,547 23,074 19 % Other 21,781 18,279 3,502 19 % Total net revenue $ 353,294 $ 243,826 $ 109,468 45 % Transaction Services Revenue. The increase in transaction services revenue was primarily due to the acquisition of Dealertrack Processing Solutions on January 31, 2011, which contributed $56.8 million, or 69%, of the increase in transaction services revenue. In addition, improving credit availability through our U.S. credit application processing network, an increase in automobile sales and the addition of Ally to our U.S. network contributed to the increase in transaction services revenue. As seen in the table below, these and other industry trends had a positive impact on our key business metrics for 2011 as compared to the same period in 2010. Year Ended December 31, Variance 2011 2010 Amount PercentAverage transaction price (1) $ 2.53 $ 2.10 $ 0.43 21 % Transaction revenue per car sold $ 6.39 $ 3.74 $ 2.65 71 % Active lenders in our U.S. network as of end of the year 1,120 970 150 16 % Active lender to dealer relationships as of end of the year 164,776 140,359 24,417 17 % Transactions processed (in thousands, except percentages) 74,450 49,373 25,077 51 % (1) - Revenue used in the calculation adds back (excludes) contra revenue. The increase in the average transaction price and the total number of transactions processed resulted in increases in revenue of $32.2 million and $52.7 million, respectively. These increases were partially offset by an increase in contra-revenue of $2.1 million primarily related to transaction services revenue earned from our strategic relationship with Ally and through the use of service credits related to the AAX acquisition. Contributing factors to the increase in average transaction price and the total number of transactions processed were the acquisition of Dealertrack Processing Solutions (whose transactions are generally at a higher average price than our historical transactions) which added additional volume, a 16% increase in lender customers active in our U.S. Dealertrack network (new lender customers are generally lower transaction volume customers with a higher price per transaction compared to average transaction prices) and a 17% increase in our number of lender to dealer relationships. The increase in our number of lender to dealer relationships was attributable to more active dealers, more active lenders on our U.S. network, and an increase in the average number of lenders that dealers use, and was improved, in part, by our strategic relationship with Ally. Subscription Services Revenue. The increase in subscription services revenue was a result of continued success in selling our existing subscription solutions and the acquisition of eCarList on July 1, 2011, which contributed $6.5 million, or 28%, to the increase in subscription services revenue. The increase was offset by the sale of ALG on October 1, 2011. ALG subscription services revenue for the fourth quarter of 2010 amounted to $0.9 million. In addition, the increase in subscription services revenue was also due to the following improvements in our key business metrics for 2011, as compared to the same period in 2010. Year Ended December 31, Variance 2011 2010 Amount Percent Average monthly subscription revenue per subscribing dealership (1) $ 813 $ 749 $ 64 9 % Subscribing dealers in U.S. and Canada as of end of the year 16,003 13,996 2,007 14 % (1) - Revenue used in the calculation adds back (excludes) contra revenue. The increase in average monthly spend per subscribing dealer contributed $11.6 million to subscription services revenue and the increase in average number of subscribing dealers in our network contributed $12.0 million to subscription services revenue; these increases were partially offset by $0.5 million in contra-revenue resulting from the use of service credits associated with the AAX acquisition. The increase in average monthly spend per subscribing dealer was primarily due to the acquisition of eCarList on July 1, 2011 and to the continued success of selling DMS, inventory and compliance solutions, including our ability to cross sell those solutions to existing customers. For comparative purposes, the average monthly spend per subscribing dealer excluding historic ALG subscription services revenue would have been $797 and $730 for 2011 and 2010, respectively. Other Revenue. The increase in other revenue was primarily due to an increase in installation, training and hardware revenue from our DMS business. 42 Operating Expenses Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Cost of revenue $ 197,152 $ 129,014 $ 68,138 53 % Product development 13,012 12,537 475 4 %Selling, general and administrative 128,892 101,620 27,272 27 % Total operating expenses $ 339,056 $ 243,171 $ 95,885 39 % For 2011, we reclassified approximately $3.0 million of salary and benefit costs from cost of revenue and product development to selling, general and administrative due to cost center changes. For 2010, we reclassified approximately $0.8 million of salary and benefit costs from product development to selling, general and administrative and cost of revenue due to cost center changes. Cost of Revenue. The increase in cost of revenue was primarily the result of increases of $18.7 million in intangible amortization related to intangibles recorded from 2011 acquisition activity (primarily Dealertrack Processing Solutions and eCarList), $11.8 million in costs related to Dealertrack Processing Solutions, which primarily includes transaction fees that are paid to third parties and temporary labor associated with processing transactions, $5.6 million in technology expense, which includes hosting expenses, technology support and other consulting expenses, $4.0 million in software amortization and depreciation charges, $3.2 million primarily related to temporary labor as a result of the growing volume of eDocs transactions, $2.9 million in occupancy and telecommunications costs primarily due to the acquisition of Dealertrack Processing Solutions, $1.4 million in costs related to eCarList, which primarily includes advertising expenses associated with their product offerings, $1.3 million in increased maintenance and installation costs associated with our Dealer Management solution, and $1.0 million in increased costs associated with our Canadian operations as a result of expanding our product offerings in Canada. Additionally, there were increases of $22.2 million in salary compensation and $3.8 million in bonus compensation and related benefit costs primarily due to the acquisition of Dealertrack Processing Solutions, team member additions, and an increase in payroll and other taxes. These increases were partially offset by a decrease in intangible amortization expense of $7.8 million primarily due to intangible assets becoming fully amortized during 2011. Product Development Expenses. The increase in product development expenses was primarily the result of increased salary and related benefit costs primarily due to team member additions and increased bonus compensation, in addition to such costs resulting from the acquisition of Dealertrack Processing Solutions. Selling, General and Administrative Expenses. The increase in selling, general and administrative expenses was primarily the result of an increase of $10.1 million in salary compensation and related benefit costs, primarily due to the acquisition of Dealertrack Processing Solutions, and an increase of $5.3 million in bonus compensation. Additionally, there were increases of $2.8 million in deal related costs due to the acquisitions of Dealertrack Processing Solutions and eCarList, the sale of ALG in 2011, and the contribution of Chrome occurring on January 1, 2012, $1.2 million in bad debt expense, $1.2 million in recruiting and relocation costs, $0.9 million in training expenses, $0.9 million in office and computer related supplies and materials resulting from team member additions, $0.9 million in selling and travel expenses, and $0.5 million in occupancy and telecommunications costs. These increases were partially offset by the $2.0 million decrease in the eCarList contingent consideration liability and a decrease of $0.3 million in depreciation charges. Interest Income Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Interest income $ 331 $ 525 $ (194 ) (37 )% The decrease in interest income was primarily related to the use of cash for acquisitions (primarily Dealertrack Processing Solutions and eCarList) during 2011, which reduced our cash balances. Interest Expense Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Interest expense $ (927 ) $ (175 ) $ (752 ) 430 % The increase in interest expense was primarily due to the 0.4% commitment fee on the undrawn balance of the credit facility and amortization of deferred financing costs related to the credit facility, which were $0.7 million. In addition, there was $0.2 million of interest expense and debt discount amortization on the outstanding note payable related to eCarList. 43 Other Income, Net Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Other income, net $ 1,360 $ 1,177 $ 183 16 % During 2011, we recorded other income of $1.0 million relating to the increase in the fair value of our warrant in TrueCar and $0.4 million from non-recurring activities outside our ordinary operations. During 2010, we earned $0.8 million of income resulting from non-recurring activities outside our ordinary operations and a settlement of $0.4 million received during the first quarter of 2010 related to the cancellation of a services agreement for our eDocs business. Gain on Disposal of Subsidiaries and Sale of Other Assets Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Gain on disposal of subsidiaries and sale of other assets $ 47,321 $ - $ 47,321 100 % During 2011, we recorded a gain on the sale of ALG in the amount of $47.3 million. Realized Gain on Securities Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Realized gain on securities $ 409 $ 582 $ (173 ) (30 )% During 2011, we sold a portion of our investments in tax-advantaged preferred securities for approximately $2.5 million and recorded a gain of approximately $0.4 million. During 2010, we sold a portion of our investments in tax-advantaged preferred securities for approximately $1.4 million and recorded a gain of approximately $0.6 million. Benefit from (Provision for) Income Taxes, Net Year Ended December 31, Variance 2011 2010 $ Amount Percent (in thousands, except percentages) Benefit from (provision for) income taxes, net $ 2,403 $ (30,597 ) $ 33,000 108 % The primary components of our $2.4 million tax benefit for 2011 consisted of $22.2 million of tax provision on our pre-tax results, offset by a favorable release of valuation allowance of $23.1 million, inclusive of state tax valuation allowance releases. Our provision on pre-tax results includes $19.4 million for federal, $0.9 million for state (net of federal benefit) and $1.9 million for Canada. The provision was also impacted by a benefit related to the completion of our 2010 U.S. tax return of $1.2 million, a net benefit on reversal of tax exposures and tax return filings of $0.2 million, and other items amounting to a $0.4 million aggregate benefit, including the reversal of contingent consideration. These additional benefits were offset by the deferred tax liability impact related to the ALG disposal of $0.3 million. For 2011, the permanent item relating to intangible amortization for our Canadian subsidiary did not have a significant impact on tax expense. The net provision for income taxes for 2010 of $30.6 million consisted primarily of the recognition of a U.S. deferred tax valuation allowance of $28.4 million, $2.1 million of state income tax expense and $2.2 million of tax expense for our Canadian subsidiary, partially offset by $2.1 million of federal income tax benefit. The primary component of the federal income tax benefit of $2.1 million in 2010 is the result of tax loss carry backs. Included in tax expense for our Canadian subsidiary for 2010 was $0.7 million for a permanent item relating to intangible amortization. This amount had a 27.0% impact on the effective tax rate for 2010. Our effective tax rate for 2011 was a benefit of 3.8% compared with an expense of 1,107% for 2010. As of December 31, 2010, while we were forecasting sufficient U.S. book taxable income in future periods, we were in a three-year cumulative pretax book loss position in the United States. As a result of cumulative U.S. book losses incurred in recent years and uncertainty as to the extent and timing of profitability in future periods, we recorded, during the fourth quarter of 2010, a full valuation allowance of $28.4 million against our net U.S. deferred tax assets, excluding deferred tax liabilities related to indefinite-lived assets. As a result of establishing a full valuation allowance against our net U.S. deferred tax assets, we did not recognize any deferred tax benefits related to U.S. net losses incurred during 2010. 44 As a result of the acquisition of Dealertrack Processing Solutions on January 31, 2011, we evaluated the combined enterprises past and expected future results, including the impact of the future reversal of the acquired deferred tax liabilities, and determined that the future reversal of the acquired deferred tax liabilities would provide sufficient taxable income to support realization of certain of Dealertrack's deferred tax assets, and thereby we reduced the valuation allowance by approximately $24.5 million during the three months ended March 31, 2011. As a result of the sale of ALG on October 1, 2011, and the establishment of deferred tax liabilities on the transaction along with the expected future reversal of deferred tax liabilities, we evaluated the need for a full valuation allowance on our net deferred tax assets for the three months ended December 31, 2011. We determined that the ultimate realization of deferred tax assets for U.S. federal and state income tax purposes is considered more likely than not, primarily due to taxable income in the federal carry back period, anticipated sufficient taxable income and cumulative U.S. book income earned in recent years. During the three months ended December 31, 2011, we reversed a portion of the remaining valuation allowance on our net U.S. deferred tax assets that had been established during the three months ended December 31, 2010. Quarterly Results of Operations The following table presents our unaudited quarterly consolidated results of operations for each of the eight quarters in the period ended December 31, 2012. The unaudited quarterly consolidated information has been prepared substantially on the same basis as our audited consolidated financial statements. You should read the following tables presenting our quarterly consolidated results of operations in conjunction with our audited consolidated financial statements for our full years and the related notes. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for the fair statement of our consolidated financial position and operating results for the quarters presented. The operating results for any quarters are not necessarily indicative of the operating results for any future period. First Second Third Fourth Quarter (1) Quarter Quarter Quarter (Unaudited) (in thousands, except for per share data) 2012 Net revenue $ 91,617 $ 96,396 $ 99,084 $ 101,775 Gross profit (2) 38,467 42,684 43,609 43,417 Income from operations 1,345 5,673 5,428 1,481 Net income (loss) 16,961 5,925 (2,931 ) 499 Basic net income (loss) per share (3) $ 0.40 $ 0.14 $ (0.07 ) $ 0.01 Diluted net income (loss) per share (3) $ 0.39 $ 0.13 $ (0.07 ) $ 0.01 Weighted average common stock outstanding (basic) 42,091 42,470 42,661 42,765 Weighted average common stock outstanding (diluted) 43,720 43,957 42,661 44,221 First Second Third Fourth Quarter (4) Quarter Quarter Quarter (5) 2011 Net revenue $ 77,191 $ 89,051 $ 95,793 $ 91,259 Gross profit (2) 32,764 40,486 43,664 39,228(Loss) income from operations (1,074 ) 5,878 7,044 2,390 Net income 24,728 2,166 5,361 32,880 Basic net income per share (3) $ 0.61 $ 0.05 $ 0.13 $ 0.79 Diluted net income per share (3) $ 0.59 $ 0.05 $ 0.13 $ 0.76 Weighted average common stock outstanding (basic) 40,852 41,203 41,396 41,613 Weighted average common stock outstanding (diluted) 42,104 42,550 42,497 43,038 (1) Net income for the three months ended March 31, 2012 includes a gain of $27.7 million on the contribution of the net assets of Chrome to the Chrome Data Solutions joint venture. (2) Gross profit is calculated as net revenue less cost of revenue. For the three months ended March 31, 2011, we reclassified approximately $1.6 million of salary and benefit costs from product development and selling, general and administrative to cost of revenue due to cost center changes. Additionally, we reclassified approximately $0.9 million for the three months ended June 30, 2011, $1.1 million for the three months ended September 30, 2011 and $1.0 million for the three months ended December 31, 2011 of salary and benefit costs from product development and cost of revenue to selling, general and administrative due to cost center changes. 45 (3) The addition of earnings per share by quarter may not equal total earnings per share for the year, as a result of the weighted average shares outstanding calculation. (4) Net income for the three months ended March 31, 2011 includes a partial reversal of the valuation allowance on our U.S. deferred tax assets in the amount of $24.5 million as a result of the deferred tax liabilities from the acquisition of Dealertrack Processing Solutions on January 31, 2011. (5) Net income for the three months ended December 31, 2011 includes a gain of $47.3 million on the sale of ALG, which also resulted in the reversal of the remaining valuation allowance on our U.S. deferred tax assets. Liquidity and Capital Resources We expect that our liquidity requirements will continue to be for working capital, acquisitions, capital expenditures and general corporate purposes. Our capital expenditures, software and website development costs for the year ended December 31, 2012 were $40.8 million, of which $32.7 million was paid in cash. As of December 31, 2012, we had $143.8 million of cash and cash equivalents, $34.0 million in short-term marketable securities, $4.4 million in long-term marketable securities, and $172.1 million in working capital, as compared to $78.7 million of cash and cash equivalents, $46 thousand in short-term marketable securities, and $94.5 million in working capital as of December31, 2011. On February 27 and February 29, 2012, we entered into the first and second amendments, respectively, to our credit agreement. Under the amended credit agreement, the interest rate on the revolving credit facility is determined quarterly and is equal to LIBOR or Prime, as applicable, plus a margin of (a) between 150 basis points and 225 basis points in the case of Eurodollar/CDOR loans and (b) between 50 basis points and 125 basis points in the case of ABR loans. The rate, in each case, is based on a consolidated leverage ratio for us and our restricted subsidiaries (the ratio of consolidated total debt of us and our restricted subsidiaries to consolidated EBITDA of us and our restricted subsidiaries). Additionally, under the credit facility we are required to make quarterly commitment fee payments on any available unused revolving amounts at a rate between 25 basis points and 40 basis points based on our consolidated leverage ratio. For further information, please refer to Note 18 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. On March 5, 2012, we issued $200.0 million aggregate principal amount of 1.50% senior convertible notes in a private placement. The net proceeds from the offering were $193.0 million after deducting the initial purchaser's fees and offering expenses. The notes bear interest at a rate of 1.50% per year, payable semi-annually in cash on March 15 and September 15 of each year, beginning on September 15, 2012. In connection with the private offering of the notes, we entered into convertible note hedge transactions with the hedge counterparties for $43.9 million. We also entered into issuer warrant transactions with the hedge counterparties for aggregate proceeds to Dealertrack of approximately $29.7 million. The net cost of these call spread hedge transactions amounted to $14.2 million. We capitalized approximately $7.0 million of debt issuance costs associated with the notes, all of which has been paid. It is our intent to settle the par value of the notes in cash, and we expect to have the liquidity to do so. For further information, please refer to Note 19 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. On August 1, 2012, Dealertrack, Inc. purchased all of the issued and outstanding shares of capital stock of 1st Auto Transport Directory, Inc., now known as Dealertrack CentralDispatch, for a cash purchase price of $73.8 million in cash, reflective of final working capital adjustments. On October 1, 2012, Dealertrack, Inc. purchased all of the equity interests of ClickMotive, LLC, for total consideration $48.7 million, net of cash acquired, and $0.3 million in contingent consideration, reflective of final working capital adjustments. On November 1, 2012, Dealertrack Canada, Inc. acquired the assets of Ford Motor Company of Canada, Limited's iCONNECT Direct DMS business for CAD $6.9 million (USD $6.9 million) in cash. For further information regarding these acquisitions, please refer to Note 8 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. We expect to have sufficient liquidity to meet our short-term liquidity requirements (including capital expenditures and acquisitions) through working capital and net cash flows from operations, cash on hand, investments in marketable securities and our credit facility. The following table sets forth the cash flow components for the following periods (in thousands): Year Ended December 31, 2012 2011 2010Net cash provided by operating activities $ 70,723 $ 64,926 $ 19,148 Net cash used in investing activities (198,164 ) (186,168 ) (28,208 ) Net cash provided by financing activities 192,074 7,906 3,525 46 Operating Activities Years ended December 31, 2012 and 2011 The increase in net cash provided by operations of $5.8 million included an increase of $4.1 million in our deferred tax provision, an increase of $7.3 million from the change in the adjustments to the fair value of a warrant, an increase of $7.2 million of debt issuance costs and debt discount amortization from our senior convertible notes, and an increase of $14.1 million from the gains on disposal of subsidiaries and sale of other assets. Gains on disposal of subsidiaries and sale of other assets for 2012 included a $27.7 million gain from the contribution of the net assets of Chrome to the Chrome Data Solutions joint venture and a $5.5 million gain from the sale of a Chrome-branded asset as compared to 2011 which included a $47.3 million gain on the sale of ALG. In addition, there was a decrease of $44.7 million from the reduction in net income and an increase of $6.7 million in windfall tax benefits. The operating cash flow increase as a result of changes in operating assets and liabilities includes the following 2012 activity: increase of $5.1 million from cash distributions from equity method investments, increase of $5.0 million in net deferred financing costs relating to the senior convertible notes and the amended credit facility, and $5.0 million of non-recurring payments to customers. Years ended December 31, 2011 and 2010 The increase in net cash provided by operating activities of $45.8 million was primarily attributable to an increase in net income of $93.0 million and an increase in depreciation and amortization expense of $13.9 million. There was also a one-time $15.0 million payment to Ally during 2010. This increase was offset by a $32.5 million change in deferred taxes, primarily valuation allowance activity, and the $47.3 million gain on the sale of ALG. The acquisitions of Dealertrack Processing Solutions, Automotive Information Center and eCarList contributed approximately $19.2 million to the $13.9 million increase in depreciation and amortization. In addition, there was an increase of approximately $3.1 million due to asset purchases and capitalized software projects that began amortization in 2011. These increases were offset by a decrease of $7.8 million due to intangible assets becoming fully amortizedduring 2011. Investing Activities Years ended December 31, 2012 and 2011 The increase in net cash used in investing activities of $12.0 million is primarily due to a net increase of purchases in marketable securities of $42.3 million and an increase in capital expenditures, software and website development costs of $3.1 million, offset by a decrease of $22.1 million related to acquisitions. Increases in cash provided by investing activities during 2012 also include $5.5 million received from the sale of a Chrome-branded, while net cash used in investing activities in 2011 also includes a $7.5 million cash investment in TrueCar. The decrease in cash used for acquisitions relates to the $152.0 million for the acquisitions of Dealertrack Processing Solutions, Automotive Information Center and eCarList, net of acquired cash, in 2011, as compared to $129.9 million during 2012 for the acquisitions of Dealertrack CentralDispatch, ClickMotive and the Ford iCONNECT DMS business, net of acquired cash. The increase in capital expenditures reflects our continued investment in development of products, as well as our ERP system, while the increase in marketable securities reflects the investment of proceeds from our convertible debt offering. Years ended December 31, 2011 and 2010 The increase in net cash used in investing activities of $158.0 million is primarily the result of payments of $152.0 million during 2011 for acquisitions, net of acquired cash, compared to payments for intangible assets of $3.0 million during 2010. In addition, $7.5 million of the increase was a result of the cash investment in TrueCar and an increase of $1.9 million in capital expenditures, software and website development costs compared to 2010. Financing Activities Years ended December 31, 2012 and 2011 The increase in net cash provided by financing activities of $184.2 million is primarily due to the issuance of senior convertible notes in the amount of $200.0 million and an increase of $6.7 million in windfall tax benefits, offset by the net payment for a call spread overlay of $14.2 million related to the senior convertible notes, $5.8 million of additional debt issuance costs resulting from the senior convertible notes and the amended credit facility, and a $2.3 million decrease in proceeds from the exercise of employee stock options. Years ended December 31, 2011 and 2010 The increase in net cash provided by financing activities of $4.4 million was primarily due to the increase in proceeds received from stock option exercises of approximately $7.8 million, offset by a decrease in the stock-based compensation windfall tax benefit of $1.7 million and $1.9 million of debt issuance costs paid during 2011. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2012 (in thousands): Less Than After Total 1 Year 1-3 Years 4-5 Years 5 Years Senior convertible notes (1) $ 213,500 $ 3,000 $ 6,000 $ 204,500 $ - Operating lease obligations 38,997 7,716 11,604 9,374 10,303 Capital lease obligations 205 99 93 13 - Note payable (2) 11,439 11,439 - - - Continuing employment compensation (2) 2,874 2,594 280 - - Earn out contingent consideration (2) 1,000 - 1,000 - - Total contractual cash obligations $ 268,015 $ 24,848 $ 18,977 $ 213,887 $ 10,303 47 (1) Consists of $200.0 million aggregate principal amount of 1.50% convertible senior notes that mature on March 15, 2017, unless repurchased or converted prior to maturity. The amounts in the table assume the payment of interest on our senior convertible notes through their maturity date and the payment of the principal amount of the notes at their maturity date. Interest on the notes is payable semi-annually. The senior convertible notes will be convertible, subject to certain conditions, into cash, shares of our common stock, or a combination of cash and shares of common stock, at our option. It is our intent to settle the par value of the notes in cash, and we expect to have the liquidity todo so. (2) For further information please refer to Note 8, in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. Pursuant to employment or severance agreements with certain employees, we have a commitment to pay severance of approximately $6.2 million as of December 31, 2012, in the event of termination without cause, as defined in the agreements, as well as certain potential gross-up payments to the extent any such severance payment would constitute an excess parachute payment under the Internal Revenue Code. Additionally, in the event of termination without cause due to a change in control, we would also have a commitment to pay additional severance of $2.2 million as of December 31, 2012. The total liability for the uncertain tax positions as of December 31, 2012 and 2011, were $0.9 million and $0.8 million, respectively, which may be reduced by a federal tax benefit, if paid. As of both December 31, 2012 and 2011, we have accrued interest and penalties related to tax positions taken on our tax returns of approximately $0.1 million. We have a $200.0 million credit facility which is available subject to certain conditions. The credit facility matures on March 1, 2017. As of December 31, 2012, we had no amounts outstanding under this credit facility. For further information, please refer to Note 18 in the accompanying notes to the consolidated financial statements included in this Annual Report on Form 10-K. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. Effects of Inflation Our monetary assets, consisting primarily of cash and cash equivalents, marketable securities, receivables, long-term investments, and our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected significantly by inflation. We believe that replacement costs of equipment, furniture and leasehold improvements will not materially affect our operations. However, the rate of inflation affects our expenses, which may not be readily recoverable in the prices of products and services we offer. Recent Accounting Pronouncements In February 2013, the FASB issued Accounting Standards Update No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which requires that companies present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification. The guidance is effective for reporting periods beginning after December 15, 2012. We do not expect the adoption to have a material impact on our consolidated financial statements. In July 2012, the FASB issued amended guidance that simplifies how entities may test indefinite-lived intangible assets other than goodwill for impairment. After an assessment of certain qualitative factors, if it is determined to be more likely than not that an indefinite-lived asset is impaired, entities must perform the quantitative impairment test. Otherwise, the quantitative test is optional. The amended guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. We do not expect the adoption to have a material impact on our consolidated financial statements. |