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ENERNOC 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 together with our "Selected Financial Data" and consolidated financial statements and accompanying notes thereto included elsewhere in this Annual Report on Form 10-K. In addition to the historical information, the discussion contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those expressed or implied by the forward-looking statements due to applications of our critical accounting policies and factors including, but not limited to, those set forth under the caption "Risk Factors" in Item 1A of Part I of this Annual Report on Form 10-K. Overview We are a leading provider of energy management applications, services and products for the smart grid, which include comprehensive demand response, data-driven energy efficiency and energy price and risk management applications, services and products. Our energy management applications, services and products enable cost effective energy management strategies for our C&I, electric power grid operator and utility customers by reducing real-time demand for electricity, increasing energy efficiency and improving energy supply transparency. We believe that we are the world's leading provider of demand response applications and services. Demand response is an alternative to traditional power generation and transmission infrastructure projects that enables electric power grid operators and utilities to reduce the likelihood of service disruptions, such as brownouts and blackouts, during periods of peak electricity demand, and otherwise manage the electric power grid during short-term imbalances of supply and demand or during periods when energy prices are high. We build on our position as a leading demand response services provider by using our NOC and energy management application platform to deliver a portfolio of additional energy management applications, services and products to new and existing C&I, electric power grid operator and utility customers. These additional energy management applications, services and products include our EfficiencySMART and SupplySMART applications and services, and certain wireless energy management products. EfficiencySMART is our data-driven energy efficiency suite that includes energy efficiency planning, audits, assessments, commissioning and retro-commissioning authority services, and a cloud-based energy analytics application used for managing energy across a C&I customer's portfolio of sites. The cloud-based energy analytics application also includes the ability to integrate with a C&I customer's existing energy management system, provide utility bill management and tools for measurement, tracking, analysis, reporting and management of greenhouse gas emissions. SupplySMART is our energy price and risk management application that provides our C&I customers located in restructured or deregulated markets throughout the United States with the ability to more effectively manage the energy supplier selection process, including energy supply product procurement and implementation, budget forecasting, and utility bill management. Our wireless energy management products are designed to ensure that our C&I customers can connect their equipment remotely and access meter data securely, and include both cellular modems and an agricultural specific wireless technology solution acquired as part of our acquisition of M2M in January 2011. Since inception, our business has grown substantially. We began by providing demand response services in one state in 2003 and have expanded to providing our portfolio of energy management applications, services and products in several regions throughout the United States, as well as internationally in Australia, Canada, New Zealand and the United Kingdom. 38-------------------------------------------------------------------------------- Table of Contents Revenues and Expense Components Revenues We derive recurring revenues from the sale of our energy management applications, services and products. We do not recognize any revenues until persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and we deem collection to be reasonably assured. Our revenues from our demand response services primarily consist of capacity and energy payments, including ancillary services payments, and revenues derived from the effective management of our portfolio of demand response capacity, including our participation in capacity auctions and bilateral contracts. We derive revenues from demand response capacity that we make available in open market programs and pursuant to contracts that we enter into with electric power grid operators and utilities. In certain markets, we enter into contracts with electric power grid operators and utilities, generally ranging from three to ten years in duration, to deploy our demand response services. We refer to these contracts as utility contracts. Where we operate in open market programs, our revenues from demand response capacity payments may vary month-to-month based upon our enrolled capacity and the market payment rate. Where we have a utility contract, we receive periodic capacity payments, which may vary monthly or seasonally, based upon enrolled capacity and predetermined payment rates. Under both open market programs and utility contracts, we receive capacity payments regardless of whether we are called upon to reduce demand for electricity from the electric power grid; and we recognize revenue over the applicable delivery period, even when payments are made over a different period. We generally demonstrate our capacity either through a demand response event or a measurement and verification test. This demonstrated capacity is typically used to calculate the continuing periodic capacity payments to be made to us until the next demand response event or measurement and verification test establishes a new demonstrated capacity amount. In most cases, we also receive an additional payment for the amount of energy usage that we actually curtail from the grid during a demand response event. We refer to this as an energy payment. As program rules may differ for each open market program in which we participate and for each utility contract, we assess whether or not we have met the specific service requirements under the program rules and recognize or defer revenues as necessary. We recognize demand response capacity revenues when we have provided verification to the electric power grid operator or utility of our ability to deliver the committed capacity under the open market program or utility contract. Committed capacity is verified through the results of an actual demand response event or a measurement and verification test. Once the capacity amount has been verified, the revenues are recognized and future revenues become fixed or determinable and are recognized monthly over the performance period until the next demand response event or measurement and verification test. In subsequent demand response events or measurement and verification tests, if our verified capacity is below the previously verified amount, the electric power grid operator or utility customer will reduce future payments based on the adjusted verified capacity amounts. Under certain utility contracts and open market program participation rules, our performance and related fees are measured and determined over a period of time. If we can reliably estimate our performance for the applicable performance period, we will reserve the entire amount of estimated penalties that will be incurred, if any, as a result of estimated underperformance prior to the commencement of revenue recognition. If we are unable to reliably estimate the performance and any related penalties, we defer the recognition of revenues until the fee is fixed or determinable. Any changes to our original estimates of net revenues are recognized as a change in accounting estimate in the earliest reporting period that such a change is determined. As of December 31, 2012, we had over 8,600 MW in our demand response network, meaning that we had entered into definitive contracts with our C&I customers representing over 8,600 MW of demand response capacity. In determining our MW in the seasonal demand response programs in which we participate, we typically count the maximum determinable amount of curtailable load for a C&I customer site over a trailing twelve-month period as the MW for that C&I customer site. However, the trailing period could be longer in certain programs under which significant rule changes have occurred or under which we do not have enough obligation to enroll all of our MW in a given program period, but have enough obligation in a future program 39-------------------------------------------------------------------------------- Table of Contents period to enroll those MW. We generally begin earning revenues from our MW within approximately one to three months from the date on which we enable the MW, or the date on which we can reduce the MW from the electric power grid if called upon to do so. The most significant exception is the PJM forward capacity market, which is a market from which we derive a substantial portion of our revenues. Because PJM operates on a June to May program-year basis, the revenues associated with a MW that we enable after June of each year will typically not be recognized until September of the following year. Certain other markets in which we currently participate, such as the Western Australia market and ISO-NE market, or may choose to participate in the future, operate or may operate in a manner that could create a delay in recognizing revenue from the MW that we enable in those markets. In the PJM open market program in which we participate, the program year operates on a June to May basis and performance is measured based on the aggregate performance during the months of June through September. As a result, fees received for the month of June could potentially be subject to adjustment or refund based on performance during the months of July through September. Based on changes to certain PJM program rules during the year ended December 31, 2012, or fiscal 2012, we concluded that we no longer had the ability to reliably estimate the amount of fees potentially subject to adjustment or refund until the performance period ends on September 30th of each year. Therefore, commencing in fiscal 2012, all demand response capacity revenues related to our participation in the PJM open market program are being recognized at the end of the performance period, or during the three months ended September 30th of each year. As a result of the fact that the period during which we are required to perform (June through September) is shorter than the period over which we receive payments under the program (June through May), a portion of the revenues that have been earned will be recorded and accrued as unbilled revenue. Our revenues have historically been higher in the second and third quarters of our fiscal year due to seasonality related to the demand response market. We expect, based on the fact that we recognize demand response capacity revenue related to our participation in the PJM open market program during the three months ended September 30th of each year, that our revenues will typically be higher in the third quarter as compared to any other quarter in our fiscal year. Revenues generated from open market sales to PJM accounted for 40%, 53% and 60% respectively, of our total revenues for the years ended December 31, 2012, 2011 and 2010. Under certain utility contracts and open market programs, such as PJM's Emergency Load Response Program, the period during which we are required to perform may be shorter than the period over which we receive payments under that contract or program. In these cases, we record revenue, net of reserves for estimated penalties related to potential delivered capacity shortfalls, over the mandatory performance obligation period, and a portion of the revenues that have been earned is recorded and accrued as unbilled revenue. Our unbilled revenue of $44.9 million from PJM as of December 31, 2012 will be billed and collected through June 2013. Our unbilled revenue of $64.1 million as of December 31, 2011 was collected through June 2012. Revenues generated from open market sales to ISO-NE accounted for 8%, 13% and 18%, respectively, of our total revenues for the years ended December 31, 2012, 2011 and 2010. Other than PJM and ISO-NE, no individual electric power grid operator or utility customers accounted for more than 10% of our total revenues for the years ended December 31, 2012, 2011 and 2010. If we choose to participate in additional or different markets in the future, the contribution of our current electric power grid operator and utility customers to total revenues will change. With respect to our EfficiencySMART and SupplySMART applications and services, these applications and services generally represent ongoing service arrangements where the revenues are recognized ratably over the service period commencing upon delivery of the contracted service to the customer. Under certain of our arrangements, in particular certain EfficiencySMART arrangements with our utility customers, a portion of the fees received may be subject to adjustment or refund based on the validation of the energy savings delivered after the implementation is complete. As a result, we defer the portion of the fees that are subject to adjustment or refund until such time as the right of adjustment or refund lapses, which is generally upon completion and validation of the implementation. In addition, under certain of our other arrangements, in particular those arrangements entered into by our wholly-owned subsidiary, M2M, we sell proprietary equipment to C&I 40-------------------------------------------------------------------------------- Table of Contents customers that is utilized to provide the ongoing services that we deliver. Currently, this equipment has been determined to not have stand-alone value. As a result, we defer the fees associated with the equipment and begin recognizing those fees ratably over the expected C&I customer relationship period, which is generally 3 years, once the C&I customer is receiving the ongoing services from us. In addition, we capitalize the associated direct and incremental costs, which primarily represent the equipment and third-party installation costs, and recognize such costs over the expected C&I customer relationship period. Revenues derived from EfficiencySMART and SupplySMART applications and services, and certain other wireless energy management products were $33.1 million, $27.5 million and $15.5 million, respectively, for the years ended December 31, 2012, 2011 and 2010. Cost of Revenues Cost of revenues for our demand response services primarily consists of amounts owed to our C&I customers for their participation in our demand response network and are generally recognized over the same performance period as the corresponding revenue. We enter into contracts with our C&I customers under which we deliver recurring cash payments to them for the capacity they commit to make available on demand. We also generally make an energy payment when a C&I customer reduces consumption of energy from the electric power grid during a demand response event. The equipment and installation costs for our devices located at our C&I customer sites, which monitor energy usage, communicate with C&I customer sites and, in certain instances, remotely control energy usage to achieve committed capacity are capitalized and depreciated over the lesser of the remaining estimated customer relationship period or the estimated useful life of the equipment, and this depreciation is reflected in cost of revenues. We also include in cost of revenues our amortization of acquired developed technology, amortization of capitalized internal-use software costs related to our DemandSMART application, the monthly telecommunications and data costs we incur as a result of being connected to C&I customer sites, and our internal payroll and related costs allocated to a C&I customer site. Certain costs, such as equipment depreciation and telecommunications and data costs, are fixed and do not vary based on revenues recognized. These fixed costs could impact our gross margin trends described elsewhere in this Annual Report on Form 10-K during interim periods. Cost of revenues for our EfficiencySMART and SupplySMART applications and services, and certain other wireless energy management products includes our amortization of capitalized internal-use software costs related to those applications, services and products, third-party services, equipment costs, equipment depreciation, and the wages and associated benefits that we pay to our project managers for the performance of their services. We defer incremental direct costs incurred related to the acquisition or origination of a utility contract or open market program in a transaction that results in the deferral or delay of revenue recognition. As of December 31, 2012 and 2011, we had no incremental direct costs deferred related to the acquisition or origination of a utility contract or open market program and during the years ended December 31, 2012, 2011 and 2010, no contract origination costs were deferred. During the year ended December 31, 2011, as a result of the termination of a certain contract, $0.9 million of previously deferred incremental direct costs were expensed. In addition, we defer incremental direct costs incurred related to customer contracts where the associated revenues have been deferred as long as the deferred incremental direct costs are deemed realizable. During the years ended December 31, 2012, 2011 and 2010, we deferred $17.7 million, $8.1 million and $3.9 million, respectively, of incremental direct costs associated with customer contracts. These deferred expenses would not have been incurred without our participation in a certain open market program and will be expensed in proportion to the related revenue being recognized. During the years ended December 31, 2012, 2011 and 2010, we expensed $10.8 million, $1.0 million and $4.9 million, respectively, of deferred incremental direct costs to cost of revenues. As of December 31, 2012, there had been no material realizability issues related to deferred incremental direct costs. We also capitalize the costs of our production and generation equipment utilized in the delivery of our demand response services and expense this equipment over the lesser of its estimated useful life or the term of the contractual arrangement. During the years ended December 31, 2012, 2011 and 2010, we capitalized $7.0 million, $9.5 million and $8.9 million, respectively, of production and generation equipment costs. We believe that the above accounting treatments appropriately match expenses with the associated revenue. 41 -------------------------------------------------------------------------------- Table of Contents Gross Profit and Gross Margin Gross profit consists of our total revenues less our cost of revenues. Our gross profit has been, and will be, affected by many factors, including (a) the demand for our energy management applications, services and products, (b) the selling price of our energy management applications, services and products, (c) our cost of revenues, (d) the way in which we manage, or are permitted to manage by the relevant electric power grid operator or utility, our portfolio of demand response capacity, (e) the introduction of new energy management applications, services and products, (f) our demand response event performance and (g) our ability to open and enter new markets and regions and expand deeper into markets we already serve. The effective management of our portfolio of demand response capacity, including our outcomes in negotiating favorable contracts with our customers and our participation in capacity auctions and bilateral contracts, and our demand response event performance, are the primary determinants of our gross profit and gross margin. Operating Expenses Operating expenses consist of selling and marketing, general and administrative, and research and development expenses. Personnel-related costs are the most significant component of each of these expense categories. We grew from 599 full-time employees at December 31, 2011 to 685 full-time employees at December 31, 2012 primarily as a result of our overall growth and expansion into new markets during this period. We expect to continue to hire employees to support our growth for the foreseeable future. In addition, we incur significant up-front costs associated with the expansion of the number of MW under our management, which we expect to continue for the foreseeable future. We expect our overall operating expenses to increase in absolute dollar terms for the foreseeable future as we continue to enable new C&I customer sites, further increase our headcount and expand the development of our energy management applications, services and products. In addition, amortization expense from intangible assets acquired in possible future acquisitions could potentially increase our operating expenses in future periods. Although we expect an increase in operating expenses in absolute dollar terms for the foreseeable future, we expect that operating expenses as a percentage of revenues will decrease as we continue to realize improvements in our operating leverage and overall cost management. Selling and Marketing Selling and marketing expenses consist primarily of (a) salaries and related personnel costs, including costs associated with share-based payment awards, related to our sales and marketing organization, (b) commissions, (c) travel, lodging and other out-of-pocket expenses, (d) marketing programs such as trade shows and (e) other related overhead. Commissions are recorded as an expense when earned by the employee. We expect an increase in selling and marketing expenses in absolute dollar terms for the foreseeable future as we further increase the number of sales professionals and, to a lesser extent, increase our marketing activities; however, we expect that selling and marketing expenses as a percentage of revenues will decrease for the foreseeable future. General and Administrative General and administrative expenses consist primarily of (a) salaries and related personnel costs, including costs associated with share-based payment awards and bonuses, related to our executive, finance, human resource, information technology and operations organizations, (b) facilities expenses, (c) accounting and legal professional fees, (d) depreciation and amortization and (e) other related overhead. We expect general and administrative expenses to continue to increase in absolute dollar terms for the foreseeable future as we invest in infrastructure to support our continued growth; however, we expect that general and administrative expenses as a percentage of revenues will decrease for the foreseeable future. Research and Development Research and development expenses consist primarily of (a) salaries and related personnel costs, including costs associated with share-based payment awards, related to our research and development organization, (b) payments to suppliers for design and consulting services, (c) costs relating to the design and development of 42 -------------------------------------------------------------------------------- Table of Contents new energy management applications, services and products and enhancement of existing energy management applications, services and products, (d) quality assurance and testing and (e) other related overhead. During the years ended December 31, 2012, 2011 and 2010, we capitalized software development costs of $4.7 million, $3.2 million and $6.8 million, respectively, which are included as software in property and equipment at December 31, 2012. We expect research and development expenses to increase in absolute dollar terms for the foreseeable future as we develop new technologies and enhance our existing technologies; however, we expect that research and development expenses as a percentage of revenues will decrease for the foreseeable future. Stock-Based Compensation We account for stock-based compensation in accordance with Accounting Standards Codification, or ASC 718, Stock Compensation. As such, all share-based payments to employees, including grants of stock options, restricted stock and restricted stock units, are recognized in the statement of operations based on their fair values as of the date of grant. During the year ended December 31, 2012, in lieu of a portion of cash bonuses related to our 2012 and 2013 bonus plans, we granted 1,023,010 shares of non-vested restricted stock to certain executives and non-executive employees that contain performance-based vesting conditions. These awards will vest in equal installments in 2013 and 2014 if the performance conditions are achieved. If the employee who received the restricted stock leaves the company for any reason prior to the vesting date, the shares of restricted stock will be forfeited and returned to us. In addition, in December 2011, we granted 283,334 shares of non-vested restricted stock to certain non-executive employees that contained performance-based vesting conditions in lieu of a portion of cash bonuses related to our 2012 and 2013 bonus plan. The performance conditions associated with the December 2011 grants were modified during the three months ended March 31, 2012. As a result of these grants of non-vested restricted stock, we anticipate that, on a per employee basis, stock-based compensation expense will increase for the foreseeable future with a corresponding decrease in cash compensation expense. For the years ended December 31, 2012, 2011 and 2010, we recorded expenses of approximately $13.6 million, $13.5 million and $15.7 million, respectively, in connection with share-based payment awards to employees and non-employees. With respect to option grants through December 31, 2012, a future expense of non-vested options of approximately $1.7 million is expected to be recognized over a weighted average period of 1.3 years. For non-vested restricted stock awards and restricted stock units subject to service-based vesting conditions outstanding as of December 31, 2012, we had $8.4 million of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average period of 2.5 years. For non-vested restricted stock awards subject to performance-based vesting conditions outstanding, and that were probable of vesting as of December 31, 2012, we had $3.9 million of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average period of 1.3 years. For non-vested restricted stock awards subject to outstanding performance-based vesting conditions that were not probable of vesting as of December 31, 2012, we had $0.7 million of unrecognized stock-based compensation expense. If and when any additional portion of our outstanding equity awards is deemed probable to vest or awards that are deemed probable to vest become not probable, we will reflect the effect of the change in estimate in the period of change by recording a cumulative catch-up adjustment to retroactively apply the new estimate. Although the number of share-based awards has increased significantly during the year ended December 31, 2012 as compared to the same period in 2011 due to stock-based compensation being issued in lieu of certain cash compensation, the overall amount of our stock-based compensation expense has decreased as a result of the lower fair value of these awards compared to awards granted in prior periods due to our lower stock price compared to the same period in 2011. Accordingly, the weighted average grant date fair value of share-based payments issued during the year ended December 31, 2012 was $8.05 per share as compared to $14.12 per share for the same period in 2011. Interest and Other (Expense) Income, Net Interest expense primarily consists of fees associated with the 2012 credit facility. Interest expense also consists of fees associated with issuing letters of credit and other financial assurances. Other income and expense consist primarily of gains or losses on transactions denominated in currencies other than our or our subsidiaries' functional currency, interest income earned on cash balances, and other non-operating income and expense. We historically have invested our cash in money market funds, treasury funds, commercial paper, and municipal bonds. 43 -------------------------------------------------------------------------------- Table of Contents Consolidated Results of Operations Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Revenues The following table summarizes our revenues for the years ended December 31, 2012 and 2011 (in thousands): December 31, Dollar Percentage 2012 2011 Change Change Revenues: DemandSMART $ 244,852 $ 259,150 $ (14,298 ) (5.5 )%EfficiencySMART, SupplySMART and Other 33,132 27,458 5,674 20.7 % Total revenues $ 277,984 $ 286,608 $ (8,624 ) (3.0 )% The overall decrease in our DemandSMART revenues was primarily attributable to changes in the following existing operating areas (dollars in thousands): Revenue (Decrease) Increase: December 31, 2011 to December 31, 2012 PJM $ (42,092 ) New England (14,347 ) OPA (4,396 ) Australia 17,962 Act129 13,513 Texas 5,996 California 3,873 Alberta 2,680 Other (1) 2,513 Total decreased DemandSMART revenues $ (14,298 ) (1) The amounts included in this category relate to net increases in various demand response programs, none of which are individually material. The decrease in our DemandSMART revenues for the year ended December 31, 2012, as compared to 2011, was primarily attributable to less favorable pricing and a decrease in our MW delivery obligations in the PJM and ISO-NE programs, in addition to decreased energy revenues as a result of fewer demand response events that yielded energy payments and a change in the mix of energy rates. In addition, the discontinuance of PJM's ILR program in June 2012 reduced our flexibility to manage our portfolio of demand response capacity in the PJM market and negatively impacted our revenues for the year ended December 31, 2012. The decrease in DemandSMART revenues was also attributable to the termination of an ISO-NE program during the three months ended June 30, 2012, from which we derived revenues throughout 2011 compared to only six months during the year ended December 31, 2012. In addition, DemandSMART revenues declined due to the recognition of $5.3 million of previously deferred revenues during the year ended December 31, 2011 as a result of an amendment to our utility contract with OPA, or the OPA contract. There was no similar recognition of deferred revenues under the OPA contract during the year ended December 31, 2012. The decrease in DemandSMART revenues was partially offset by an increase in enrolled MW and pricing in our Western Australia program and certain of our Texas programs, including ERCOT, Centerpoint and ONCOR and an increase in enrolled MW and improved performance in our California programs. The decrease in DemandSMART revenues was also partially offset by revenue we earned from the Pennsylvania Act 129, or Act 129, programs and a demand response program in Alberta, Canada for which no revenues were recognized in 2011. 44-------------------------------------------------------------------------------- Table of Contents For the year ended December 31, 2012, our EfficiencySMART, SupplySMART and other revenues increased, as compared to 2011, due to continued growth in customers and contracts, the commencement of revenue recognition in 2012 that resulted from the completion of the installation phase of a $10 million EfficiencySMART data-driven energy management application for the Massachusetts Department of Energy Resources, and enhanced customer relationships that resulted from our acquisitions of Global Energy and M2M in 2011. In addition, the increase in our EfficiencySMART, SupplySMART and other revenues for the year ended December 31, 2012 was attributable to the recognition of a full year of revenues during fiscal 2012 from our acquisitions of Global Energy and M2M, both of which occurred in early 2011. We currently expect our total DemandSMART revenues to increase during the year ending December 31, 2013, or fiscal 2013, as compared to fiscal 2012 primarily due to an increase in pricing and enrolled MW in our Western Australia demand response program, as well as an increase in PJM revenues as PJM prices return to more historical levels. Gross Profit and Gross Margin The following table summarizes our gross profit and gross margin percentages for our energy management applications, services and products for the years ended December 31, 2012 and 2011 (dollars in thousands): Year Ended December 31, 2012 2011 Gross Profit Gross Margin Gross Profit Gross Margin $ 123,444 44.4% $123,397 43.1% Despite a decline in revenue, the slight increase in gross profit for the year ended December 31, 2012, as compared to 2011, was primarily due to the gross profit generated from the increase in our enrolled MW and pricing in Western Australia and the gross profit generated from our new DemandSMART arrangements in fiscal 2012 when no revenues were recognized in 2011, including our Act 129 programs and our program in Alberta, Canada. The increase in gross profit was also attributable to improved management of our portfolio of demand response capacity and an overall reduction in the percentage of revenues paid to our C&I customers. This increase in gross profit was partially offset by less favorable pricing and a decrease in enrolled MW in our PJM and ISO-NE programs, as well as the termination of an ISO-NE program during the three months ended June 30, 2012 from which we derived revenues throughout 2011. In addition, the increase in gross profit was also partially offset by the recognition of $5.3 million of revenues during the year ended December 31, 2011 related to our OPA contract for which we had recognized the associated cost of such revenues prior to 2011. There were no similar transactions during the year ended December 31, 2012. Our gross margin during the year ended December 31, 2012 increased in comparison to 2011 due to improved management of our portfolio of demand response capacity, including the adjustment of our zonal capacity obligations through our participation in PJM incremental auctions and lower costs associated with our C&I contracts. These increases were offset by a decrease in gross margin under our OPA contract due to the recognition of revenues during the year ended December 31, 2011 in connection with the amendment to the OPA contract, for which we recognized the cost of such revenues in previous periods. The increase in our gross margin during the year ended December 31, 2012 compared to 2011 was also offset by the decrease in gross margin that resulted from the recognition of revenues during the year ended December 31, 2011 in connection with our participation in a California demand response program for which we recognized the cost of such revenues in previous periods. We currently expect that our gross margin for the year ending December 31, 2013 will be slightly higher than our gross margin for the year ended December 31, 2012 due to the continuing improvement in the management of our portfolio of demand response capacity, as well as lower costs associated with our C&I contracts. We also expect that our gross margin for the three months ending September 30, 2013 will be the highest gross margin among our four quarterly reporting periods in fiscal 2013 due to the seasonality of the demand response industry, which is consistent with our gross margin pattern in fiscal 2012 and prior years. 45 -------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table summarizes our operating expenses for the years ended December 31, 2012 and 2011 (dollars in thousands): Year Ended December 31, Percentage 2012 2011 Change Operating Expenses: Selling and marketing $ 55,963 $ 51,907 7.8 % General and administrative 71,643 66,773 7.3 % Research and development 16,226 14,254 13.8 % Total $ 143,832 $ 132,934 8.2 % In certain forward capacity markets in which we participate, such as PJM, we may enable our C&I customers, meaning we may install our equipment at a C&I customer site to allow for the curtailment of MW from the electric power grid, up to twelve months in advance of enrolling the C&I customer in a particular program. As a result, there has been a trend of incurring operating expenses at the time of enablement, including salaries and related personnel costs, associated with enabling certain of our C&I customers, in advance of recognizing the corresponding revenues. Selling and Marketing Expense The following table summarizes our selling and marketing expenses for the years ended December 31, 2012 and 2011 (dollars in thousands): Year Ended December 31, Percentage 2012 2011 Change Payroll and related costs $ 35,374 $ 34,143 3.6 % Stock-based compensation 4,641 4,203 10.4 % Other 15,948 13,561 17.6 % Total $ 55,963 $ 51,907 7.8 % The increase in payroll and related costs for the year ended December 31, 2012 compared to 2011 was primarily due to an increase in the number of selling and marketing full-time employees from 204 at December 31, 2011 to 212 at December 31, 2012. This increase was partially offset by lower commissions and a decrease in cash bonuses for fiscal 2012 as a portion of those bonuses will be settled in shares of our common stock and therefore is recorded in stock-based compensation expense. In addition, we incurred higher travel related costs of $0.5 million primarily as a result of our continued international expansion. The increase in stock-based compensation for the year ended December 31, 2012 compared to 2011 was primarily due to a portion of the bonuses for fiscal 2012 that will be settled in shares of our common stock rather than cash and is, therefore, recorded as a component of stock-based compensation expense. This increase was offset by a lower grant date fair value of stock-based awards granted during the year ended December 31, 2012, which was lower than the grant date fair value of stock-based awards that became fully vested during the year ended December 31, 2011, as well as a reversal of stock-based compensation expense that resulted from forfeitures of a greater number of stock-based awards during the year ended December 31, 2012. The increase in other selling and marketing expenses for the year ended December 31, 2012 compared to 2011 was due to a $1.3 million increase in amortization expense related to acquired intangible assets that resulted from our acquisition of Energy Response in July 2011, a $1.3 million increase in the allocation to selling and marketing of company-wide overhead costs, which are allocated based upon headcount, due to higher facilities 46-------------------------------------------------------------------------------- Table of Contents and IT costs, and an increase in professional services fees of $0.7 million. This increase was partially offset by the recording in 2011 of approximately $0.5 million of impairment charges associated with the discontinued use of the trade name intangible assets acquired in connection with our acquisition of Energy Response and another immaterial acquisition that we completed in 2011, in addition to the discontinuation of certain customer relationships related to our acquisition of eQ. We did not incur any such charges in 2012. We also incurred lower marketing costs of $0.3 million in 2012 compared to 2011. General and Administrative Expenses The following table summarizes our general and administrative expenses for the years ended December 31, 2012 and 2011 (dollars in thousands): Year Ended December 31, Percentage 2012 2011 Change Payroll and related costs $ 37,538 $ 34,057 10.2 % Stock-based compensation 7,755 8,255 (6.1 )% Other 26,350 24,461 7.7 % Total $ 71,643 $ 66,773 7.3 % The increase in payroll and related costs for the year ended December 31, 2012 compared to 2011 was primarily attributable to an increase in the number of general and administrative full-time employees from 322 at December 31, 2011 to 383 at December 31, 2012. This increase was partially offset by a portion of the bonuses for fiscal 2012 that will be settled in shares of our common stock rather than cash and is, therefore, recorded as a component of stock-based compensation expense. The decrease in stock-based compensation for the year ended December 31, 2012 compared to 2011 was primarily due to the reversal of stock-based compensation expense related to the forfeiture of stock-based awards that were granted to our former chief financial officer, as well as fully-vested stock awards that were granted to our board of directors at a lower grant-date fair value in the year ended December 31, 2012 than the fair value of stock-based awards granted to them during 2011. These decreases were offset by an increase in stock-based compensation related to a portion of the bonuses for fiscal 2012 that will be settled in shares of our common stock rather than cash, which is recorded as a component of stock-based compensation expense. The increase in other general and administrative expenses for the year ended December 31, 2012 compared to 2011 was attributable to an increase of $3.2 million in facilities expenses due to higher rent and insurance costs in addition to higher depreciation expense that resulted from a change in useful life of the leasehold improvements under our current lease, an increase of $2.5 million in higher fees mainly associated with regulatory compliance, and an increase of $0.8 million in information technology and communication costs in support of our business. The increase in other general and administrative expenses for the year ended December 31, 2012 compared to 2011 was also attributable to a lease termination charge of $1.1 million resulting from our election to terminate the operating lease for our current corporate headquarters effective June 30, 2013. These increases in other general and administrative expenses for the year ended December 31, 2012 were offset by a decrease of $3.8 million in finance charges, most of which were attributable to charges that we recorded during the year ended December 31, 2011 in connection with a certain contract that we terminated during 2011. The increase in other general and administrative expenses for the year ended December 31, 2012 was also offset by an increase of $2.1 million in the allocation to selling and marketing, and research and development of company-wide overhead costs. 47-------------------------------------------------------------------------------- Table of Contents Research and Development Expenses The following table summarizes our research and development expenses for the years ended December 31, 2012 and 2011 (dollars in thousands): Year Ended December 31, Percentage 2012 2011 Change Payroll and related costs $ 9,172 $ 7,682 19.4 % Stock-based compensation 1,220 1,006 21.3 % Other 5,834 5,566 4.8 % Total $ 16,226 $ 14,254 13.8 % The increase in payroll and related costs for the year ended December 31, 2012 compared to 2011 was primarily driven by an increase in the number of research and development full-time employees from 73 at December 31, 2011 to 90 at December 31, 2012, as well as an increase in salary rates per full-time employee. This increase was partially offset by an increase in capitalized application development costs primarily related to our DemandSMART application, as well as a portion of the bonuses for fiscal 2012 that will be settled in shares of our common stock rather than cash and is, therefore, recorded as a component of stock-based compensation expense. The increase in stock-based compensation for the year ended December 31, 2012 compared to 2011 was related to a portion of the bonuses for fiscal 2012 that will be settled in shares of our common stock rather than cash and is, therefore, recorded as a component of stock-based compensation expense. The increase in other research and development expenses for the year ended December 31, 2012 compared to 2011 was due to an increase of $0.8 million in the allocation to research and development of company-wide overhead costs which are allocated based upon headcount. The increase in other research and development expenses was also due to an increase of $0.5 million in software licensing fees. This increase was partially offset by an impairment charge of $0.5 million related to an indefinite-lived in-process research and development intangible asset and an impairment charge related to a definite-lived patent intangible asset of less than $0.1 million that were recorded in 2011 as a result of a review and realignment of our development efforts. In addition, we incurred lower professional services fees during the year ended December 31, 2012 of $0.4 million compared to 2011 and lower miscellaneous equipment expenses of $0.1 million. Interest and Other (Expense) Income, Net The increase in interest expense of $0.5 million for the year ended December 31, 2012 compared to 2011 was mainly attributable to the costs associated with the renegotiation of our 2012 credit facility, higher average outstanding letter of credit balances in addition to higher partner bank fees. Other income (expense), net for the year ended December 31, 2012 was primarily comprised of foreign currency gains (losses) and a nominal amount of interest income. We had approximately $21.2 million at December 31, 2012 exchange rates ($20.4 million Australian) in intercompany receivables denominated in Australian dollars that arose from the acquisition of Energy Response in July 2011. Substantially all of the foreign currency gains (losses) represent unrealized gains (losses) and, therefore, are non-cash in nature. We currently do not hedge any of our foreign currency transactions. 48 -------------------------------------------------------------------------------- Table of Contents Income Taxes We recorded a provision for income taxes of $1.8 million and $1.8 million for the years ended December 31, 2012 and 2011, respectively. Although our federal and state net operating loss carryforwards exceeded our taxable income for the years ended December 31, 2012 and 2011, our annual effective tax rate was greater than zero due to the following: • estimated foreign taxes resulting from guaranteed profit allocable to our foreign subsidiaries, which have been determined to be limited-risk service providers acting on behalf of the U.S. parent for tax purposes, for which there are no tax net operating loss carryforwards; • certain state taxes for jurisdictions where the states currently limit or disallow the utilization of net operating loss carryforwards; and • amortization of tax deductible goodwill, which generates a deferred tax liability that cannot be offset by net operating losses or other deferred tax assets since its reversal is considered indefinite in nature.Our effective tax rate for the year ended December 31, 2012 was 8.6% compared to an effective tax rate of 15.6% for the year ended December 31, 2011. We review all available evidence to evaluate the recovery of our deferred tax assets, including the recent history of accumulated losses in all tax jurisdictions over the last three years, as well as our ability to generate income in future periods. As of December 31, 2012 and December 31, 2011, due to the uncertainty related to the ultimate use of our deferred income tax assets, we have provided a full valuation allowance against our U.S., Australian and New Zealand deferred tax assets. Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Revenues The following table summarizes our revenues for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, Dollar Percentage 2011 2010 Change Change Revenues: DemandSMART $ 259,150 $ 264,608 $ (5,458 ) (2.1 )%EfficiencySMART, SupplySMART and Other 27,458 15,549 11,909 76.6 % Total revenues $ 286,608 $ 280,157 $ 6,451 2.3 % 49 -------------------------------------------------------------------------------- Table of Contents For the year ended December 31, 2011, our demand response revenues decreased by $5.5 million, or 2%, as compared to the year ended December 31, 2010. The decrease in our DemandSMART revenues was primarily attributable to changes in the following existing operating areas (dollars in thousands): Revenue Increase (Decrease): December 31, 2010 to December 31, 2011 PJM $ (14,431 ) New England (14,123 ) New York (2,601 ) Public Service Company of New Mexico, or PNM (560 ) OPA 12,204 California 5,090 Australia 3,725 ERCOT 1,793 XCEL Energy 959 Salt River Project, or SRP 880 UK National Grid 798 Tucson Electric Power, or TEP 646 Other(1) 162 Total decreased demand response revenues $ (5,458 ) The decrease in our DemandSMART revenues during the year ended December 31, 2011 compared to 2010 was primarily attributable to less favorable pricing in the PJM and New York markets, as well as a decrease in MW enrolled in our ISO-NE program and less favorable pricing compared to 2010 due to the commencement of a new ISO-NE program in June 2010. The decrease in DemandSMART revenues was also partially attributable to fewer demand response events being called by PJM during the year ended December 31, 2011, which resulted in decreased energy payments, as compared to 2010. The decrease in DemandSMART revenues was also partially attributable to a decrease in MW enrolled in our PNM program during the year ended December 31, 2011 as compared to 2010. The decrease in DemandSMART revenues was partially offset by an increase in revenues recognized as a result of amendments to the OPA contract during the year ended December 31, 2011 that resulted in the recognition of $5.3 million of revenues during the year that had been previously deferred. The decrease in DemandSMART revenues was also partially offset by stronger demand response event performance in our California demand response programs, our ability to recognize revenues based on the finalization of performance in a certain California demand response program, and an increase in our enrolled MW in the XCEL Energy, SRP, UK National Grid, and certain other demand response programs in which we participate. The decrease in DemandSMART revenues was also partially offset by our participation in demand response programs in Australia and the TEP demand response program. We did not receive any revenues related to the Australia or TEP programs during the year ended December 31, 2010. For the year ended December 31, 2011, our EfficiencySMART, SupplySMART and other revenues increased by $11.9 million compared to 2010 primarily due to our acquisitions of Global Energy and M2M, both of which occurred in January 2011. In addition, we completed a certain EfficiencySMART project during 2011, which resulted in the recognition of $0.6 million of revenues that had been previously deferred. 50 -------------------------------------------------------------------------------- Table of Contents Gross Profit and Gross Margin The following table summarizes our gross profit and gross margin percentages for our energy management applications, services and products for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, 2011 2010 Gross Profit Gross Margin Gross Profit Gross Margin $ 123,397 43.1% $120,325 42.9% The increase in gross profit during the year ended December 31, 2011 compared to 2010 was primarily due to our ability to recognize revenues that had previously been deferred in connection with the OPA contract, pursuant to which we recognized the cost of such revenues in prior periods due to the uncertainty of the realizability of these costs. The increase in gross profit was also partially attributable to stronger demand response event performance in certain of the demand response programs in which we participate, including ISO-NE, which in some cases resulted in increased energy payments for the year ended December 31, 2011 compared to 2010, as well as our ability to recognize revenues based on the finalization of performance in a certain California demand response program for which the corresponding cost of revenues were recorded during the year ended December 31, 2010. The acquisitions that we completed in 2011 also contributed to the increase in gross profit for the year ended December 31, 2011. The increase in gross profit was partially offset by less favorable pricing in PJM and ISO-NE, as well as fewer demand response events being called by PJM during the year ended December 31, 2011, which resulted in decreased energy payments from PJM compared to 2010. The slight increase in gross margin during the year ended December 31, 2011, compared to 2010 was primarily due to the recognition of revenues in connection with the OPA contract, pursuant to which we recognized the cost of revenues in prior periods due to the uncertainty of the realizability of these costs. The increase was partially offset by less favorable pricing in PJM and ISO-NE, which was not entirely offset by lower payments to our C&I customers. Operating Expenses The following table summarizes our operating expenses for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, Percentage 2011 2010 Change Operating Expenses: Selling and marketing $ 51,907 $ 44,029 17.9 % General and administrative 66,773 54,983 21.4 % Research and development 14,254 10,097 41.2 % Total $ 132,934 $ 109,109 21.8 % In certain forward capacity markets in which we participate, such as PJM, we may enable our C&I customers, meaning we may install our equipment at a C&I customer site to allow for the curtailment of MW from the electric power grid, up to twelve months in advance of enrolling the C&I customer in a particular demand response program. As a result, there has been a trend of increasing operating expenses at the time of enablement, including salaries and related personnel costs associated with enabling certain of our C&I customers, in advance of recognizing the corresponding revenues. The increase in payroll and related costs within our operating expenses for the year ended December 31, 2011 compared to 2010 was primarily driven by an increase in headcount from 484 full time employees at December 31, 2010 to 599 full time employees at December 31, 2011, which was substantially due to the acquisitions that we completed in 2011. 51 -------------------------------------------------------------------------------- Table of Contents Selling and Marketing Expense The following table summarizes our selling and marketing expenses for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, Percentage 2011 2010 Change Payroll and related costs $ 34,143 $ 29,765 14.7 % Stock-based compensation 4,203 4,583 (8.3 )% Other 13,561 9,681 40.1 % Total $ 51,907 $ 44,029 17.9 % The increase in payroll and related costs for the year ended December 31, 2011 compared to 2010 was primarily due to an increase in the number of selling and marketing full-time employees from 176 at December 31, 2010 to 204 at December 31, 2011 which was partially offset by a decrease of $0.6 million in sales commissions payable to employees in our sales organization for the year ended December 31, 2011. The decrease in stock-based compensation for the year ended December 31, 2011 compared to 2010 was primarily due to significant stock-based awards granted in 2007 that became fully vested prior to June 30, 2011. The decrease was also partially attributable to the reversal of stock-based compensation expense that resulted from forfeitures of a greater number of stock-based awards in connection with an increase in our attrition rate. These decreases were offset by a full year of stock-based compensation expense related to awards granted during the year ended December 31, 2010 and by stock-based compensation expense related to awards granted during the year ended December 31, 2011. The increase in other selling and marketing expenses for the year ended December 31, 2011 compared to 2010 was primarily attributable to an increase in amortization expense of $3.5 million due to the customer relationship and trade name intangible assets acquired in connection with the acquisitions we completed in 2011. During the year ended December 31, 2011, we recorded an impairment charge of $0.2 million related to the discontinued use of the trade name intangible assets acquired in connection with our acquisition of Energy Response and another immaterial acquisition that we completed in 2011, contributing to the increase in selling and marketing expenses for the year ended December 31, 2011 compared to 2010. In addition, during the year ended December 31, 2011, as a result of the discontinuation of certain customer relationships related to our acquisition of eQ, we recorded an impairment charge of $0.3 million during the three month period ended December 31, 2011. The increase in other selling and marketing expenses for the year ended December 31, 2011 compared to 2010 was also partially attributable to an increase in professional services fees of $0.2 million. The increase in other selling and marketing expenses for the year ended December 31, 2011 was offset by a decrease in marketing costs of $0.5 million due to our rebranding efforts that took place in 2010. General and Administrative Expenses The following table summarizes our general and administrative expenses for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, Percentage 2011 2010 Change Payroll and related costs $ 34,057 $ 28,709 18.6 % Stock-based compensation 8,255 10,252 (19.5 )% Other 24,461 16,022 52.7 % Total $ 66,773 $ 54,983 21.4 % 52 -------------------------------------------------------------------------------- Table of Contents The increase in general and administrative expenses for the year ended December 31, 2011 compared to 2010 was partially due to an increase in the number of general and administrative full-time employees from 250 at December 31, 2010 to 322 at December 31, 2011. The increase in headcount was partly offset by the timing of the hiring of those new full-time employees during 2011. The decrease in stock-based compensation for the year ended December 31, 2011 compared to 2010 was primarily due to prior period stock-based awards that became fully vested in the first half of 2011 and the reversal of stock-based compensation expense that resulted from forfeitures of a greater number of stock-based awards in connection with an increase in our attrition rate. The decrease in stock-based compensation expense from 2010 was also partially attributable to fully-vested stock awards granted to our board of directors during the year ended December 31, 2011 with a lower grant-date fair value than the same amount of fully-vested stock awards granted during 2010. The increase in other general and administrative expenses for the year ended December 31, 2011 compared to 2010 was primarily attributable to a $4.3 million increase in finance costs due to charges that we recorded in connection with a certain contract that we terminated during the year ended December 31, 2011. As a result of this termination, we recorded charges of $4.1 million during the year ended December 31, 2011, which represented the $3.2 million paid upon the termination and $0.9 million that had been previously capitalized. In addition, the increase in other general and administrative expenses for the year ended December 31, 2011 compared to 2010 was also due to an increase in professional services fees of $1.5 million incurred in connection with the integration of the acquisitions that we completed in 2011, technology and communication costs of $1.3 million due to increased software licensing fees and computer supplies, and an increase in facility costs of $1.3 million due to the expansion of our office space as a result of our recent acquisitions. Research and Development Expenses The following table summarizes our research and development expenses for the years ended December 31, 2011 and 2010 (dollars in thousands): Year Ended December 31, Percentage 2011 2010 Change Payroll and related costs $ 7,682 $ 5,517 39.2 % Stock-based compensation 1,006 907 10.9 % Other 5,566 3,673 51.5 % Total $ 14,254 $ 10,097 41.2 % The increase in research and development expenses for the year ended December 31, 2011 compared to 2010 was primarily driven by the costs associated with an increase in the number of research and development full-time employees from 58 at December 31, 2010 to 73 at December 31, 2011 and the timing associated with our hiring of new full-time employees during 2011 compared to 2010, as well as an increase in salary rates per full-time employee. The increase was offset by an increase in capitalized internal payroll and related costs of $0.3 million for the year ended December 31, 2011. The increase in stock-based compensation for the year ended December 31, 2011 compared to 2010 was primarily due to costs related to equity awards granted to new employees during 2011, including a senior level employee. The increase in other research and development expenses for the year ended December 31, 2011 compared to 2010 was attributable to a $0.6 million increase in technology and communications expenses related to software licensing fees and a $0.5 million impairment charge. This increase was also attributable to an increase in the allocation of facility costs of $0.2 million due to the expansion of our office space as a result of recent acquisitions, an increase of $0.4 million in professional services fees related to our intellectual property and an increase of $0.2 million in miscellaneous equipment expenses as a result of the expansion of our hardware product offerings. 53-------------------------------------------------------------------------------- Table of Contents During the three months ended December 31, 2011, as a result of our review and realignment of our development efforts, we abandoned our efforts to complete the development of a certain in-process research and development indefinite-lived intangible asset related to our acquisition of Zox. As a result, we recorded an impairment charge related to this indefinite-lived in-process research and development intangible asset of $0.5 million and an impairment charge related to the associated definite-lived patent intangible asset of less than $0.1 million. Interest and Other (Expense) Income, Net Interest expense for the year ended December 31, 2011 includes amortization of capitalized debt issuance costs, interest on our outstanding capital leases and letters of credit origination fees. The increase in interest expense for the year ended December 31, 2011 compared to 2010 was due to the amortization of capitalized debt issuance costs associated with our previously outstanding $75.0 million senior secured revolving credit facility, as amended, that we and one of our subsidiaries entered into with SVB and a certain other financial institution in April 2011, which we refer to as the 2011 credit facility, which were significantly higher than the amortization of debt issuance costs associated with our previously outstanding $35.0 million secured revolving credit and term loan facility that we and one of our subsidiaries entered into with SVB in August 2008. Other expense, net for the year ended December 31, 2011 was primarily comprised of foreign currency losses related to certain intercompany receivables denominated in foreign currencies. Other expense, net for the year ended December 31, 2010 was primarily comprised of a nominal amount of foreign currency losses related to certain intercompany receivables denominated in foreign currencies offset by a nominal amount of interest income. The significant increase in losses arising from transactions denominated in foreign currencies for the year ended December 31, 2011 compared to 2010 was due to the significant increase in foreign denominated intercompany receivables held by us from one of our Australian subsidiaries, primarily as a result of the funding provided to complete the acquisition of Energy Response, and the strengthening of the United States dollar as compared to the Australian dollar during the year ended December 31, 2011. As of December 31, 2011, we had an intercompany receivable from our Australian subsidiary that is denominated in Australian dollars and not deemed to be of a "long-term investment" nature totaling $33.7 million at December 31, 2011 exchange rates ($33.1 million Australian). The significant increase in losses arising from transactions denominated in foreign currencies was primarily unrealized losses and therefore a non-cash expense. We did not engage in any currency hedging transactions during the year ended December 31, 2011. Income Taxes We recorded a provision for income taxes of $1.8 million and $0.8 million for the years ended December 31, 2011 and 2010, respectively. Although our federal and state net operating loss carryforwards exceeded our taxable income for the years ended December 31, 2011 and 2010, our annual effective tax rate was greater than zero due to the following: • estimated foreign taxes resulting from guaranteed profit allocable to our foreign subsidiaries, which have been determined to be limited-risk service providers acting on behalf of the U.S. parent for tax purposes, for which there are no tax net operating loss carryforwards; • certain state taxes for jurisdictions where the states currently limit or disallow the utilization of net operating loss carryforwards; and • amortization of tax deductible goodwill, which generates a deferred tax liability that cannot be offset by net operating losses or other deferred tax assets since its reversal is considered indefinite in nature.Our effective tax rate for the year ended December 31, 2011 was 15.6% compared to an effective tax rate of 8.0% for the year ended December 31, 2010. We review all available evidence to evaluate the recovery of our deferred tax assets, including the recent history of accumulated losses in all tax jurisdictions over the last three years, as well as our ability to generate income in future periods. As of December 31, 2011 and December 31, 2010, due to the uncertainty related to the ultimate use of our deferred income tax assets, we have provided a full valuation allowance against these U.S. deferred tax assets. 54 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Overview We have generated significant cumulative losses since inception. As of December 31, 2012, we had an accumulated deficit of $103.4 million. As of December 31, 2012, our principal sources of liquidity were cash and cash equivalents totaling $115.0 million, an increase of $27.7 million from the December 31, 2011 balance of $87.3 million. At December 31, 2012 and December 31, 2011, the majority of our excess cash was invested in money market funds. We believe our existing cash and cash equivalents at December 31, 2012 and our anticipated net cash flows from operating activities will be sufficient to meet our anticipated cash needs, including investing activities, for at least the next 12 months. Our future working capital requirements will depend on many factors, including, without limitation, the rate at which we sell our energy management applications, services and products to customers and the increasing rate at which letters of credit or security deposits are required by electric power grid operators and utilities, the introduction and market acceptance of new energy management applications, services and products, the expansion of our sales and marketing and research and development activities, and the geographic expansion of our business operations. To the extent that our cash and cash equivalents and our anticipated cash flows from operating activities are insufficient to fund our future activities or planned future acquisitions, we may be required to raise additional funds through bank credit arrangements, including the potential expansion, renewal or replacement of the 2012 credit facility, or public or private equity or debt financings. We also may raise additional funds in the event we determine in the future to effect one or more acquisitions of businesses, technologies or products. In addition, we may elect to raise additional funds even before we need them if the conditions for raising capital are favorable. Any equity or equity-linked financing could be dilutive to existing stockholders. In the event we require additional cash resources we may not be able to obtain bank credit arrangements or complete any equity or debt financing on terms acceptable to us or at all. If we fail to extend, renew or replace the 2012 credit facility and we still have letters of credit issued and outstanding under the 2012 credit facility when it matures on April 15, 2013, we will be required to post up to 105% of the value of the letters of credit in cash with SVB to collateralize those letters of credit. Cash Flows The following table summarizes our cash flows for the years ended December 31, 2012, 2011 and 2010 (dollars in thousands): Year Ended December 31, 2012 2011 2010 Cash flows provided by operating activities $ 31,011 $ 27,637 $ 45,148 Cash flows used in investing activities (3,585 ) (95,516 ) (15,424 ) Cash flows provided by financing activities 356 1,997 3,974 Effects of exchange rate changes on cash (38 ) (237 ) (21 ) Net change in cash and cash equivalents $ 27,744 $ (66,119 ) $ 33,677 Cash Flows Provided by Operating Activities Cash provided by operating activities primarily consists of net (loss) income adjusted for certain non-cash items including depreciation and amortization, stock-based compensation expense, and the effect of changes in working capital and other activities. Cash provided by operating activities for the year ended December 31, 2012 was approximately $31.0 million and consisted of a net loss of $22.3 million, offset by $42.3 million of non-cash items and $11.0 million of net cash provided by working capital and other activities. The non-cash items primarily consisted of depreciation and amortization, stock-based compensation expense, impairment charges, unrealized foreign 55 -------------------------------------------------------------------------------- Table of Contents exchange transaction gains, deferred taxes and non-cash interest expense. Cash provided by working capital and other activities consisted of a decrease of $19.2 million in unbilled revenues relating to the PJM demand response market, a decrease in prepaid expenses and other assets of $2.9 million, an increase of $22.5 million in deferred revenue, an increase of $1.4 million in accrued payroll and related expenses and an increase of $1.6 million in other noncurrent liabilities. These amounts were offset by cash used in working capital and other activities consisting of an increase in accounts receivable of $19.5 million due to the timing of cash receipts under the demand response programs in which we participate, an increase in capitalized incremental direct customer contract costs of $5.7 million, a decrease in accrued capacity payments of $9.2 million, the majority of which was related to the PJM demand response market and a decrease of $2.4 million in accounts payable, accrued performance adjustments and accrued expenses primarily due to the repayment of certain accrued performance adjustments. Cash provided by operating activities for the year ended December 31, 2011 was approximately $27.6 million and consisted of a net loss of $13.4 million and $0.5 million of net cash used in working capital and other activities offset by $41.5 million of non-cash items, primarily consisting of depreciation and amortization, deferred taxes, stock-based compensation expense, property and equipment and intangible assets impairment charges, and unrealized foreign exchange losses. Cash used in working capital and other operating activities consisted of a decrease in accrued capacity payments of $7.4 million relating primarily to the decrease in PJM revenues and therefore the associated decrease in capacity payments to C&I customers from 2010 to 2011, a decrease of $2.1 million in accounts payable and accrued expenses and other current liabilities due to the timing of payments, an increase in other assets of $3.8 million, an increase in prepaid expenses and other current assets of $5.0 million, and a decrease in other noncurrent liabilities of $0.2 million. These amounts were offset by cash provided by working capital and other operating activities consisting of a decrease of $7.0 million in unbilled revenues relating to the PJM demand response market, a decrease of $2.7 million in accounts receivable due to the timing of cash receipts under the demand response programs in which we participate, an increase of $7.0 million in deferred revenue, and an increase of $1.3 million in accrued payroll and related expenses. Cash provided by operating activities for the year ended December 31, 2010 was $45.1 million and consisted of net income of $9.6 million, $33.9 million of non-cash items, primarily depreciation and amortization, deferred taxes, stock-based compensation expense and impairment of property and equipment, and $1.6 million of net cash used in working capital and other activities. Cash used in working capital and other operating activities consisted of an increase of $32.8 million in unbilled revenues relating to the PJM demand response market, an increase of $4.9 million in accounts receivable due to the timing of cash receipts under the programs in which we participate and an increase in prepaid expenses and other assets of $0.7 million. These amounts were offset by cash provided by working capital and other activities which reflected an increase of $2.2 million in accrued payroll and related expenses, an increase of $5.8 million in accounts payable and accrued expenses due to the timing of payments, an increase in accrued capacity payments of $25.2 million, the majority of which was related to the PJM demand response market, and an increase of $6.8 million in deferred revenue. Cash Flows Used in Investing Activities Cash used in investing activities was $3.6 million for the year ended December 31, 2012. During the year ended December 31, 2012, we incurred $15.9 million in capital expenditures primarily related to the purchase of office and IT equipment, capitalized internal use software costs, demand response equipment and other miscellaneous capital expenditures. In addition our restricted cash and deposits decreased by $12.4 million due to a decline in deposits principally related to the financial assurances required for the demand response programs in which we participated, as these deposits were replaced with letters of credit. Cash used in investing activities was $95.5 million for the year ended December 31, 2011. During the year ended December 31, 2011, we acquired Global Energy for a purchase price of $26.7 million, of which we paid $19.9 million in cash, M2M for a purchase price of $28.6 million, of which we paid $17.5 million in cash, and Energy Response for a purchase price of $30.1 million, of which we paid $27.3 million in cash, and we completed another immaterial acquisition for a purchase price of $5.2 million, of which we paid $3.9 million in cash. The net cash acquired from these acquisitions was $1.1 million. Additionally, our cash investments 56 -------------------------------------------------------------------------------- Table of Contents included the cash portion of the acquisition contingent consideration for Cogent of $1.5 million. Our other principal cash investments during the year ended December 31, 2011 related to capitalized internal use software costs used to build out and expand our energy management applications, services and products and purchases of property and equipment. We incurred $17.6 million in capital expenditures primarily related to the purchase of office equipment, demand response equipment and other miscellaneous expenditures. In addition, during the year ended December 31, 2011, our deposits increased by $8.4 million primarily due to financial assurance requirements related to our demand response programs in Australia and our long-term assets increased by $0.5 million due to financing costs in connection with the 2011 credit facility. Cash used in investing activities was $15.4 million for the year ended December 31, 2010. Our principal cash investments during the year ended December 31, 2010, which totaled $19.4 million, related to capitalizing internal use software costs used to build out and expand our energy management applications and services, and purchases of property and equipment. During the year ended December 31, 2010, we acquired SmallFoot and Zox for a purchase price of $1.4 million, of which $1.1 million was paid in cash. Additionally, our cash investments included the cash portion of the earn-out payment due in connection with our acquisition of SRC of $0.9 million. We had a decrease in restricted cash and deposits of $6.0 million primarily as a result of demand response event performance in July 2010 under a certain open market program in which we participated, resulting in our restricted cash becoming unrestricted in July 2010. Cash Flows Provided by Financing Activities Cash provided by financing activities was $0.4 million, $2.0 million and $4.0 million for the years ended December 31, 2012, 2011 and 2010, respectively, and consisted primarily of proceeds that we received from exercises of options to purchase shares of our common stock. Credit Facility Borrowings Subject to continued compliance with the covenants contained in our 2012 credit facility, the full amount of the 2012 credit facility may be available for issuances of letters of credit and up to $5.0 million of the 2012 credit facility may be available for swing line loans. We are charged letter of credit fees in connection with the issuance or renewal of letters of credit equal to 2% of each letter of credit. The interest on revolving loans under the 2012 credit facility will accrue, at our election, at either (i) the Eurodollar Rate with respect to the relevant interest period plus 2.00% or (ii) the ABR (defined as the highest of (x) the "prime rate" as quoted in the Wall Street Journal, (y) the Federal Funds Effective Rate plus 0.50% and (z) the Eurodollar Rate for a one-month interest period plus 1.00%) plus 1.00%. We expense the interest and letter of credit fees under the 2012 credit facility, as applicable, in the period incurred. The obligations under the 2012 credit facility are secured by all of our domestic assets and the assets of several of our subsidiaries, excluding our foreign subsidiaries. The 2012 credit facility terminates and all amounts outstanding thereunder are due and payable in full on April 15, 2013. We incurred total financing costs of $0.5 million in connection with the 2012 credit facility, which were deferred and are being amortized to interest expense over the term of the 2012 credit facility, or through April 15, 2013. The 2012 credit facility contains customary terms and conditions for credit facilities of this type, including, among other things, restrictions on our ability to incur additional indebtedness, create liens, enter into transactions with affiliates, transfer assets, make certain acquisitions, pay dividends or make distributions on, or repurchase, our common stock, consolidate or merge with other entities, or undergo a change in control. In addition, we are required to meet certain monthly and quarterly financial covenants customary with this type of credit facility. The 2012 credit facility contains customary events of default, including for payment defaults, breaches of representations, breaches of affirmative or negative covenants, cross defaults to other material indebtedness, bankruptcy and failure to discharge certain judgments. If a default occurs and is not cured within any applicable cure period or is not waived, SVB may accelerate our obligations under the 2012 credit facility. If we are determined to be in default then any amounts outstanding under the 2012 credit facility would become immediately due and payable and we would be required to collateralize with cash any outstanding letters of credit up to 105% of the amounts outstanding. 57-------------------------------------------------------------------------------- Table of Contents As of December 31, 2012, we were in compliance with all of our covenants under the 2012 credit facility. We believe that it is reasonably assured that we will comply with the financial covenants under the 2012 credit facility for the foreseeable future. The 2012 credit facility will expire in April 2013. If we are unable to renew the 2012 credit facility under favorable terms or enter into a new credit facility, we may be required to collateralize with cash any outstanding letters of credit. As of December 31, 2012, we had no borrowings but had outstanding letters of credit totaling $42.6 million under the 2012 credit facility. The increase of $11.0 million from the amount of outstanding letters of credit at December 31, 2011, which totaled $31.6 million, is due to additional financial assurance requirements resulting from new customer arrangements and increases in delivery obligations under certain open market bidding programs. As of December 31, 2012, we had $7.4 million available under the 2012 credit facility for future borrowings or issuances of additional letters of credit. Contingent Earn-Out Payments As discussed in Note 2 of our consolidated financial statements contained herein, in connection with our acquisition of Energy Response, we may be obligated to pay additional contingent purchase price consideration related to an earn-out payment of $10.4 million based on December 31, 2012 exchange rates ($10.0 million Australian). The earn-out payment, if any, will be based on the development of a demand response reserve capacity market in the National Electric Market in Australia by December 31, 2013 that meets certain market size and price per megawatt conditions. This milestone needs to be achieved in order for the earn-out payment to occur, and there will be no partial payment if the milestone is not fully achieved. We determined that the initial fair value of the earn-out payment as of the acquisition date was $0.3 million. As of December 31, 2012, the liability associated with the earn-out payment was recorded at $0.4 million after adjusting for changes in exchange rates. Capital Spending We have made capital expenditures primarily for general corporate purposes to support our growth and for equipment installations related to our business. Our capital expenditures totalled $15.9 million, $17.6 million and $19.4 million during the years ended December 31, 2012, 2011 and 2010, respectively. Furthermore, we expect our capital expenditures for fiscal 2013 to increase partially due to the capital expenditures related to the lease for our new corporate headquarters. Contractual Obligations In June 2012, we exercised the termination option under our current lease and provided notice of our election to terminate our current lease for our corporate headquarters. The termination will be effective as of June 30, 2013. As a result of our election to terminate our current lease, we are required to make a lease termination payment of $1.1 million, of which $0.6 million was paid upon exercise of the election to terminate and the remaining $0.5 million is due and payable on or before July 1, 2013. Information regarding our significant contractual obligations of the types described below is set forth in the following table and includes the new lease for our corporate headquarters and the change in the expected payments under our current lease. Payments due by period have been presented based on payments due subsequent to December 31, 2012 (in thousands): Payments Due By Period Less than 1 - 3 3 - 5 More than Contractual Obligations Total 1 Year Years Years 5 Years Operating lease obligations $ 32,399 $ 5,379 $ 8,939 $ 7,703 $ 10,378 Total $ 32,399 $ 5,379 $ 8,939 $ 7,703 $ 10,378 58 -------------------------------------------------------------------------------- Table of Contents Our operating lease obligations relate primarily to the leases of our corporate headquarters in Boston, Massachusetts and our offices in Walnut Creek, San Francisco, Irvine and Concord, California; Baltimore, Maryland; Boise, Idaho; Dallas, Texas; Melbourne, Australia; and London, United Kingdom as well as certain property and equipment. In connection with the acquisition of Energy Response, in addition to the amounts paid at closing, we may be obligated to pay additional contingent purchase price consideration related to an earn-out payment equal to $10.4 million based on December 31, 2012 exchange rates ($10.0 million Australian). The earn-out payment, if any, will be based on the development of a demand response reserve capacity market in the National Electricity Market in Australia by December 31, 2013 that meets certain market size and price per megawatt conditions. This milestone needs to be achieved in order for the earn-out payment to occur and there will be no partial payment if the milestone is not fully achieved. We determined that the initial fair value of the earn-out payment as of the acquisition date was $0.3 million. This fair value was included as a component of the purchase price resulting in an aggregate purchase price of $30.1 million. At December 31, 2012, the liability was recorded at $0.4 million after adjusting for changes in exchange rates. In connection with our acquisition of M2M, we are required to pay additional consideration that was deferred at the date of the acquisition. This deferred purchase price consideration of $7.0 million will be paid upon the earlier of the satisfaction of certain conditions contained in the definitive agreement or seven years after the acquisition date of January 25, 2011. The deferred purchase price consideration is not subject to adjustment or forfeiture. We recorded our estimate of the fair value of the deferred purchase price consideration based on the evaluation of the likelihood of the achievement of the contractual conditions that would result in the payment of the deferred purchase price consideration prior to seven years from the acquisition date and weighted probability assumptions of these outcomes. The cash portion of the deferred purchase price consideration of less than $0.5 million is recorded as a liability, discounted to reflect the time value of money. As the milestone payment date approaches, the fair value of this liability will increase. The fair value of the deferred purchase price consideration of $3.4 million, related to the 254,654 shares of common stock to be issued upon the milestone payment date has been classified as additional paid-in capital within stockholders' equity. With respect to the cash portion of the deferred purchase price consideration, the increase in fair value is recorded as an expense in our accompanying consolidated statements of operations. During each of the years ended December 31, 2012 and 2011, we recorded a charge of less than $0.1 million related to the accretion for the time value of money discount. At December 31, 2012, the liability was recorded at $0.5 million. The deferred purchase price consideration to be paid in shares meets the requirements of an equity instrument and, accordingly, will not be remeasured at fair value each reporting period. This acquisition had no contingent consideration or earn-out payments. As of December 31, 2012, we had no borrowings, but had outstanding letters of credit totaling $42.6 million under the 2012 credit facility. As of December 31, 2012, we had $7.4 million available under the 2012 credit facility for future borrowings or issuances of additional letters of credit. If we are unable to renew the 2012 credit facility under favorable terms or enter into a new credit facility, we may be required to collateralize with cash any outstanding letters of credit. We typically grant certain customers a limited warranty that guarantees that our hardware products will substantially conform to current specifications for one year from the delivery date. Based on our operating history, the liability associated with product warranties has been determined to be nominal. We also indemnify our customers from third-party claims relating to the intended use of our products. Pursuant to these clauses, we indemnify and agree to pay any judgment or settlement relating to a claim. We guarantee the electrical capacity we have committed to deliver pursuant to certain utility contracts. Such guarantees may be secured by cash or letters of credit. Performance guarantees as of December 31, 2012 and 2011 were $44.5 million and $34.2 million, respectively. These performance guarantees include deposits held by certain customers of $1.9 million and $14.3 million, respectively, at December 31, 2012 and December 31, 2011. 59 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements As of December 31, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. We have issued letters of credit in the ordinary course of our business in order to participate in certain demand response programs. As of December 31, 2012, we had outstanding letters of credit totaling $42.6 million. For information on these commitments and contingent obligations, see "Liquidity and Capital Resources - Credit Facility Borrowings" above and Note 12 to our consolidated financial statements contained herein. Additional Information Non-GAAP Financial Measures To supplement our consolidated financial statements presented on a GAAP basis, we disclose certain non-GAAP measures that exclude certain amounts, including non-GAAP net (loss) income, non-GAAP net (loss) income per share, adjusted EBITDA and free cash flow. These non-GAAP measures are not in accordance with, or an alternative for, generally accepted accounting principles in the United States. The GAAP measure most comparable to non-GAAP net (loss) income is GAAP net (loss) income; the GAAP measure most comparable to non-GAAP net (loss) income per share is GAAP net (loss) income per share; the GAAP measure most comparable to adjusted EBITDA is GAAP net (loss) income; and the GAAP measure most comparable to free cash flow is net cash provided by (used in) operating activities. Reconciliations of each of these non-GAAP financial measures to the corresponding GAAP measure are included below. Use and Economic Substance of Non-GAAP Financial Measures Management uses these non-GAAP measures when evaluating our operating performance and for internal planning and forecasting purposes. Management believes that such measures help indicate underlying trends in our business, are important in comparing current results with prior period results, and are useful to investors and financial analysts in assessing our operating performance. For example, management considers non-GAAP net (loss) income to be an important indicator of the overall performance because it eliminates the effects of events that are either not part of our core operations or are non-cash compensation expenses. In addition, management considers adjusted EBITDA to be an important indicator of our operational strength and performance of our business and a good measure of our historical operating trend. Moreover, management considers free cash flow to be an indicator of our operating trend and performance of our business. The following is an explanation of the non-GAAP measures that we utilize, including the adjustments that management excluded as part of the non-GAAP measures for the years ended December 31, 2012, 2011 and 2010, respectively, as well as reasons for excluding these individual items: • Management defines non-GAAP net (loss) income as net income (loss) before expenses related to stock-based compensation and amortization expenses related to acquisition-related intangible assets, net of related tax effects. • Management defines adjusted EBITDA as net (loss) income, excluding depreciation, amortization, stock-based compensation, interest, income taxes and other income (expense). Adjusted EBITDA eliminates items that are either not part of our core operations or do not require a cash outlay, such as stock-based compensation. Adjusted EBITDA also excludes depreciation and amortization expense, which is based on our estimate of the useful life of tangible and intangible assets. These estimates could vary from actual performance of the asset, are based on historic cost incurred to build out our deployed network and may not be indicative of current or future capital expenditures. • Management defines free cash flow as net cash provided by (used in) operating activities less capital expenditures. Management defines capital expenditures as purchases of property and equipment, which includes capitalization of internal-use software development costs. 60 -------------------------------------------------------------------------------- Table of Contents Material Limitations Associated with the Use of Non-GAAP Financial Measures Non-GAAP net (loss) income, non-GAAP net (loss) income per share, adjusted EBITDA and free cash flow may have limitations as analytical tools. The non-GAAP financial information presented here should be considered in conjunction with, and not as a substitute for or superior to the financial information presented in accordance with GAAP and should not be considered measures of our liquidity. There are significant limitations associated with the use of non-GAAP financial measures. Further, these measures may differ from the non-GAAP information, even where similarly titled, used by other companies and therefore should not be used to compare our performance to that of other companies. 61-------------------------------------------------------------------------------- Table of Contents Non-GAAP Net (Loss) Income and Non-GAAP Net (Loss) Income per Share Net loss for the year ended December 31, 2012 was $22.3 million, or $0.84 per basic and diluted share, compared to a net loss of $13.4 million, or $0.52 per basic and diluted share for the year ended December 31, 2011, and net income of $9.6 million, or $0.39 per basic share and $0.37 per diluted share, for the year ended December 31, 2010. Excluding stock-based compensation charges and amortization of expenses related to acquisition-related assets, net of tax effects, non-GAAP net loss for the year ended December 31, 2012 was $1.4 million, or $0.05 per basic and diluted share, compared to a non-GAAP net income of $5.9 million, or $0.23 per basic share and $0.22 per diluted share, for the year ended December 31, 2011, and a non-GAAP net income of $25.4 million, or $1.03 per basic share and $0.97 per diluted share, for the year ended December 31, 2010. The reconciliation of GAAP net (loss) income to non-GAAP net (loss) income is set forth below: Year Ended December 31, 2012 2011 2010 (In thousands, except share and per share data) GAAP net (loss) income $ (22,293 ) $ (13,383 ) $ 9,577 ADD: Stock-based compensation 13,616 13,464 15,742 ADD: Amortization expense of acquired intangible assets 7,241 5,856 1,452 LESS: Income tax effect on Non-GAAP adjustments (1) - - (1,380 ) Non-GAAP net (loss) income $ (1,436 ) $ 5,937 $ 25,391 GAAP net (loss) income per basic share $ (0.84 ) $ (0.52 ) $ 0.39 ADD: Stock-based compensation 0.52 0.52 0.64 ADD: Amortization expense of acquired intangible assets 0.27 0.23 0.06 LESS: Income tax effect on Non-GAAP adjustments (1) - - (0.06 ) Non-GAAP net (loss) income per basic share $ (0.05 ) $ 0.23 $ 1.03 GAAP net (loss) income per diluted share $ (0.84 ) $ (0.52 ) $ 0.37 ADD: Stock-based compensation 0.52 0.52 0.60 ADD: Amortization expense of acquired intangible assets 0.27 0.23 0.05 LESS: Income tax effect on Non-GAAP adjustments (1) - - (0.05 ) LESS: Dilutive impact on weighted average common stock equivalents - (0.01 ) - Non-GAAP net (loss) income per diluted share $ (0.05 ) $ 0.22 $ 0.97 Weighted average number of common shares outstanding Basic 26,551,234 25,799,494 24,611,729 Diluted 26,551,234 26,766,359 26,054,162 (1) Represents the increase in the income tax provision recorded for the year ended December 31, 2010 based on our effective tax rate for the year ended December 31, 2010. The non-GAAP adjustments would have no impact on the provision for income taxes recorded for the years ended December 31, 2012 and 2011. 62 -------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA Adjusted EBITDA was $ 18.4 million, $ 26.0 million, and $42.8 million for the years ended December 31, 2012, 2011 and 2010, respectively. The reconciliation of adjusted EBITDA to net (loss) income is set forth below: Year Ended December 31, 2012 2011 2010 Net (loss) income $ (22,293 ) $ (13,383 ) $ 9,577 Add back: Depreciation and amortization 25,218 22,043 15,866 Stock-based compensation expense 13,616 13,464 15,742 Other (income) expense (1,457 ) 987 85 Interest expense 1,591 1,053 718 Provision for income tax 1,771 1,806 836 Adjusted EBITDA $ 18,446 $ 25,970 $ 42,824 Free Cash Flow Net cash provided by operating activities was $31.0 million, $27.6 million and $45.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. We generated $15.2 million, $10.0 million and $25.8 million of free cash flow for the years ended December 31, 2012, 2011 and 2010, respectively. The reconciliation of free cash flow to net cash provided by operating activities is set forth below: Year Ended December 31, 2012 2011 2010 Net cash provided by operating activities $ 31,011 $ 27,637 $ 45,148 Subtract: Purchases of property and equipment (15,854 ) (17,613 ) (19,394 ) Free cash flow $ 15,157 $ 10,024 $ 25,754 Critical Accounting Policies and Use of Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition for multiple element arrangements, allowance for doubtful accounts, valuations and purchase price allocations related to business combinations, expected future cash flows including growth rates, discount rates, terminal values and other assumptions and estimates used to evaluate the recoverability of long-lived assets and goodwill, estimated fair values of intangible assets and goodwill, amortization methods and periods, certain accrued expenses and other related charges, stock-based compensation, contingent liabilities, tax reserves and recoverability of our deferred tax assets and related valuation allowance. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates if past experience or other assumptions do not turn out to be substantially accurate. Any differences could have a material impact on our financial condition and results of operations. We believe that of our significant accounting policies, which are described in Note 1 to our consolidated financial statements beginning on page F-1 of Appendix A to this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. 63-------------------------------------------------------------------------------- Table of Contents Revenue Recognition We recognize revenues in accordance with ASC 605, Revenue Recognition, or ASC 605. In all of our arrangements, we do not recognize any revenues until persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and we deem collection to be reasonably assured. In making these judgments, we evaluate these criteria as follows: • Evidence of an arrangement. We consider a definitive agreement signed by the customer and us or an arrangement enforceable under the rules of an open market bidding program to be representative of persuasive evidence of an arrangement. • Delivery has occurred. We consider delivery to have occurred when service has been delivered to the customer and no post-delivery obligations exist. In instances where customer acceptance is required, delivery is deemed to have occurred when customer acceptance has been achieved. • Fees are fixed or determinable. We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within normal payment terms. If the fee is subject to refund or adjustment and we cannot reliably estimate this amount, we recognize revenues when the right to a refund or adjustment lapses. If offered payment terms significantly exceed our normal terms, we recognize revenues as the amounts become due and payable or upon the receipt of cash. • Collection is reasonably assured. We conduct a credit review at the inception of an arrangement to determine the creditworthiness of the customer. Collection is reasonably assured if, based upon our evaluation, we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not reasonably assured, revenues are deferred and recognized upon the receipt of cash. We enter into contracts and open market bidding programs with utilities and electric power grid operators to provide demand response applications and services. Demand response revenues consist of two elements: revenue earned based on our ability to deliver committed capacity to our electric power grid operator and utility customers, which we refer to as capacity revenue; and revenue earned based on additional payments made to us for the amount of energy usage actually curtailed from the grid during a demand response event, which we refer to as energy event revenue. We recognize demand response revenue when we have provided verification to the electric power grid operator or utility of our ability to deliver the committed capacity which entitles us to payments under the utility contract or open market program. Committed capacity is generally verified through the results of an actual demand response event or a measurement and verification test. Once the capacity amount has been verified, the revenue is recognized and future revenue becomes fixed or determinable and is recognized monthly until the next demand response event or test. In subsequent verification events, if our verified capacity is below the previously verified amount, the electric power grid operator or utility customer will reduce future payments based on the adjusted verified capacity amounts. Ongoing demand response revenue recognized between demand response events or tests that are not subject to penalty or customer refund are recognized in revenue. If the revenue is subject to refund and the amount of refund cannot be reliably estimated, the revenue is deferred until the right of refund lapses. We have evaluated the factors within ASC 605 regarding gross versus net revenue reporting for our demand response revenues and payments to C&I customers. Based on the evaluation of the factors within ASC 605, we determined that all of the applicable indicators of gross revenue reporting were met. These applicable indicators of gross revenue reporting included, but were not limited to, the following: • We are the primary obligor in our arrangements with electric power grid operators and utility customers because we provide demand response services directly to electric power grid operators and utilities under long-term contracts or pursuant to open market programs and contract separately with C&I customers to deliver such services. We manage all interactions with the electric power grid operators and utilities, while C&I customers do not interact with the electric power grid operators and utilities. In addition, we assume the entire performance risk under arrangements with electric power grid operators and utility customers, 64 -------------------------------------------------------------------------------- Table of Contents including the posting of financial assurance to assure timely delivery of committed capacity with no corresponding financial assurance received from C&I customers. In the event of a shortfall in delivered committed capacity, we are responsible for all penalties assessed by the electric power grid operators and utilities without regard for any recourse we may have with our C&I customers. • We have latitude in establishing pricing, as the pricing under our arrangements with electric power grid operators and utilities is negotiated through a contract proposal and contracting process or determined through a capacity auction. We then separately negotiate payment to C&I customers and have complete discretion in the contracting process with the C&I customer. • We have complete discretion in determining the supplier (C&I customer) to provide the demand response services, provided that the C&I customer is located in the same region as the applicable electric power grid operator or utility. • We are involved in both the determination of service specifications and performing part of the services, including the installation of metering and other equipment for the monitoring, data gathering and measurement of performance, as well as, in certain circumstances, the remote control of C&I customer loads. As a result, we determined that we earn revenue (as a principal) from the delivery of demand response services to electric power grid operators and utility customers and we record the amounts billed to the electric power grid operators and utility customers as gross demand response revenues and the amounts paid to C&I customers as cost of revenues. In the PJM open market program in which we participate, the program year operates on a June to May basis and performance is measured based on the aggregate performance during the months of June through September. As a result, fees received for the month of June could potentially be subject to adjustment or refund based on performance during the months of July through September. Based on recent changes to certain PJM program rules, we have concluded that we no longer have the ability to reliably estimate the amount of fees potentially subject to adjustment or refund until the performance period ends on September 30th of each year. Therefore, commencing in fiscal 2012, all demand response capacity revenues related to our participation in the PJM open market program are being recognized at the end of the performance period, or September 30th of each year. Because the period during which we are required to perform (June through September) is shorter than the period over which we receive payments under the program (June through May), a portion of the revenues that have been earned are recorded and accrued as unbilled revenue. As a result of the billing period not coinciding with the revenue recognition period, we had $44.9 million in unbilled revenues from PJM at December 31, 2012. Certain of the forward capacity programs in which we participate may be deemed derivative contracts under ASC 815, Derivatives and Hedging, or ASC 815. In such situations, we believe we meet the scope exception under ASC 815 as a normal purchase, normal sale as that term is defined in ASC 815 and, accordingly, the arrangement is not treated as a derivative contract. Energy event revenues are recognized when earned. Energy event revenue is deemed to be substantive and represents the culmination of a separate earnings process and is recognized when the energy event is initiated by the electric power grid operator or utility customer and we have responded under the terms of the contract or open market program. With respect to our non-demand response revenues, which represent our EfficiencySMART, SupplySMART and other revenues, these generally represent ongoing service arrangements where the revenues are recognized ratably over the service period commencing upon delivery of the contracted service with the customer. Under certain of our arrangements, in particular certain EfficiencySMART arrangements with utilities, a portion of the fees received may be subject to adjustment or refund based on the validation of the energy savings delivered after the implementation is complete. As a result, we defer the portion of the fees that are subject to adjustment or refund until such time as the right of adjustment or refund lapses, which is generally upon completion and validation of the implementation. In addition, under certain of our other arrangements, we sell proprietary equipment to C&I customers that is utilized to provide the ongoing services that the we deliver. 65-------------------------------------------------------------------------------- Table of Contents Currently, this equipment has been determined to not have stand-alone value. As a result, we defer revenues associated with the equipment and we begin recognizing such revenue ratably over the expected C&I customer relationship period (generally 3 years), once the C&I customer is receiving the ongoing services from us. In addition, we capitalize the associated direct and incremental costs, which primarily represent the equipment and third-party installation costs, and recognizes such costs over the expected C&I customer relationship period. We adopted ASC Update No. 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, at the beginning of its first quarter of the fiscal year ended December 31, 2011, fiscal 2011, on a prospective basis for transactions originating or materially modified on or after January 1, 2011. The impact of adopting ASU 2009-13 was not material to our financial statements for fiscal 2011, and if it was applied in the same manner to the fiscal year ended December 31, 2010, or fiscal 2010, would not have had a material impact to revenue for fiscal 2010. The adoption of ASU 2009-13 has not had and is not expected to have a significant impact on the timing and pattern of revenue recognition due to our limited number of multiple element arrangements. We typically determine the selling price of our services based on vendor specific objective evidence, or VSOE. Consistent with its methodology under previous accounting guidance, we determine VSOE based on its normal pricing and discounting practices for the specific service when sold on a stand-alone basis. In determining VSOE, our policy is to require a substantial majority of selling prices for a product or service to be within a reasonably narrow range. We also consider the class of customer, method of distribution, and the geographies into which its products and services are sold when determining VSOE. We typically have had VSOE for its products and services. In certain circumstances, we are not able to establish VSOE for all deliverables in a multiple element arrangement. This may be due to the infrequent occurrence of stand-alone sales for an element, a limited sales history for new services or pricing within a broader range than permissible by our policy to establish VSOE. In those circumstances, we proceed to the alternative levels in the hierarchy of determining selling price. Third Party Evidence, or TPE, of selling price is established by evaluating largely similar and interchangeable competitor products or services in stand-alone sales to similarly situated customers. We are typically not able to determine TPE and has not used this measure since we have been unable to reliably verify standalone prices of competitive solutions. Management's best estimate of selling price, or ESP, is established in those instances where neither VSOE nor TPE are available, considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing information gathered from experience in customer negotiations, market research and information, recent technological trends, competitive landscape and geographies. Use of ESP is limited to a very small portion of our services, principally certain EfficiencySMART services. We maintain a reserve for customer adjustments and allowances as a reduction in revenues. In determining our revenue reserve estimate, and in accordance with internal policy, we rely on historical data and known performance adjustments. These factors, and unanticipated changes in the economic and industry environment, could cause our reserve estimates to differ from actual results. We record a provision for estimated customer adjustments and allowances in the same period as the related revenues are recorded. These estimates are based on the specific facts and circumstances of a particular program, analysis of credit memoranda data, historical customer adjustments, and other known factors. If the data we use to calculate these estimates does not properly reflect reserve requirements, then a change in the allowances would be made in the period in which such a determination is made and revenues in that period could be affected. During the year ended December 31, 2012, we recorded a revenue reserve of $0.5 million based on our analysis. Reserve requirements in 2011 and 2010 were not material. Business Combinations We record tangible and intangible assets acquired and liabilities assumed in business combinations under the purchase method of accounting. Amounts paid for each acquisition are allocated to the assets acquired and liabilities assumed based on their fair values at the dates of acquisition. The fair value of identifiable intangible assets is based on detailed valuations that use information and assumptions provided by management. We estimate the fair value of contingent consideration at the time of the acquisition using all pertinent information 66 -------------------------------------------------------------------------------- Table of Contents known to us at the time to assess the probability of payment of contingent amounts. We allocate any excess purchase price over the fair value of the net tangible and intangible assets acquired and liabilities assumed to goodwill. We use the income approach to determine the estimated fair value of identifiable intangible assets, including customer contracts, customer relationships, non-compete agreements and trade names. This approach determines fair value by estimating the after-tax cash flows attributable to an in-process project over its useful life and then discounting these after-tax cash flows back to a present value. We base our revenue assumptions on estimates of relevant market sizes, expected market growth rates and expected trends, including introductions by competitors of new services and products. We base the discount rate used to arrive at a present value as of the date of acquisition on the time value of money and market participant investment risk factors. The use of different assumptions could materially impact the purchase price allocation and our financial condition and results of operations. Customer relationships represent established relationships with customers, which provide a ready channel for the sale of additional energy management applications, services and products. Non-compete agreements represent arrangements with certain employees that limit or prevent their ability to take employment at a competitor for a fixed period of time. Trade names represent acquired product names that we intend to continue to utilize. We have also utilized the cost approach to determine the estimated fair value of acquired indefinite-lived intangible assets related to acquired in-process research and development given the stage of development as of the acquisition date and the lack of sufficient information regarding future expected cash flows. The cost approach calculates fair value by calculating the reproduction cost of an exact replica of the subject intangible asset. We calculate the replacement cost based on actual development costs incurred through the date of acquisition. In determining the appropriate valuation methodology, we consider, among other factors: the in-process projects' stage of completion; the complexity of the work completed as of the acquisition date; the costs already incurred; the projected costs to complete; the expected introduction date; and the estimated useful life of the technology. We believe that the estimated in-process research and development amounts so determined represent the fair value at the date of acquisition and do not exceed the amount a third party would pay for the projects. Impairment of Intangible Assets and Goodwill Intangible Assets We amortize our intangible assets that have finite lives using either the straight-line method or, if reliably determinable, based on the pattern in which the economic benefit of the asset is expected to be consumed utilizing expected undiscounted future cash flows. Amortization is recorded over the estimated useful lives ranging from one to ten years. We review our intangible assets subject to amortization to determine if any adverse conditions exist or a change in circumstances has occurred that would indicate impairment or a change in the remaining useful life. If the carrying value of an asset exceeds its undiscounted cash flows, we will write-down the carrying value of the intangible asset to its fair value in the period identified. In assessing recoverability, we must make assumptions regarding estimated future cash flows and discount rates. If these estimates or related assumptions change in the future, we may be required to record impairment charges. We generally calculate fair value as the present value of estimated future cash flows to be generated by the asset using a risk-adjusted discount rate. If the estimate of an intangible asset's remaining useful life is changed, we will amortize the remaining carrying value of the intangible asset prospectively over the revised remaining useful life. During the year ended December 31, 2012, we did not identify any adverse conditions or change in expected cash flows or useful lives of our definite-lived intangible assets that could indicate the existence of a potential impairment. During the year ended December 31, 2011, as a result of a discontinuation of certain trade names acquired in connection with the acquisition of Energy Response in July 2011 and another immaterial acquisition that 67-------------------------------------------------------------------------------- Table of Contents occurred in January 2011, we determined that these definite-lived intangible assets were impaired and recorded an impairment charge of $0.2 million to reduce the carrying value of these assets to zero, which was included in selling and marketing expense in the accompanying consolidated statements of operations. In addition, during the year ended December 31, 2011, as a result of the discontinuation of certain customer relationships related to a 2009 acquisition, we recorded an impairment charge of $0.3 million which was included in selling and marketing expense in the accompanying consolidated statements of operations. During the year ended December 31, 2011, as a result of our review and realignment of our development efforts, we discontinued our efforts to complete the development of a certain in-process research and development indefinite-lived intangible asset related to our March 2010 acquisition of Zox. As a result, we recorded an impairment charge related to this indefinite-lived in-process research and development intangible asset of $0.5 million and an impairment charge related to the associated definite-lived patent intangible asset of less than $0.1 million, both of which are included in research and development expenses in the accompanying consolidated statements of operations for the year ended December 31, 2011. We had no indefinite-lived intangible assets as of December 31, 2012 or 2011, respectively. Goodwill In accordance with ASC 350, Intangibles-Goodwill and Other, or ASC 350, we test goodwill at the reporting unit level for impairment on an annual basis and between annual tests if events and circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying value. We have determined that we currently have two reporting units: (1) our consolidated Australian operations and (2) all other operations. Although our chief operating decision maker, which is our chief executive officer and certain members of our executive management team, collectively, make business decisions based on the evaluation of financial information at the entity level, certain discrete financial information is available related to our consolidated Australian operations with such discrete financial information utilized by the business unit manager to manage the consolidated Australian operations and make decisions for those operations. The consolidated Australian operations are comprised of the operations acquired in the acquisitions of Energy Response and another immaterial acquisition, as well as the operations of our subsidiary, EnerNOC Australia Pty Ltd. Events that would indicate impairment and trigger an interim impairment assessment include, but are not limited to, current economic and market conditions, including a decline in market capitalization, a significant adverse change in legal factors, business climate or operational performance of the business, and an adverse action or assessment by a regulator. Our annual impairment test date is November 30, which we refer to as the impairment date. In performing the test, we utilize the two-step approach prescribed under ASC 350. The first step requires a comparison of the carrying value of the reporting units to the fair value of these units. We consider a number of factors to determine the fair value of a reporting unit, including an independent valuation to conduct this test. The valuation is based upon expected future discounted operating cash flows of the reporting unit as well as analysis of recent sales or offerings of similar companies. We base the discount rate used to arrive at a present value as of the date of the impairment test on our weighted average cost of capital, or WACC. If the carrying value of the reporting unit exceeds its fair value, we will perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of a reporting unit's goodwill to its carrying value. In order to determine the fair value of our reporting units, we utilize both a market approach based on the quoted market price of our common stock and the number of shares outstanding and a discounted cash flow, or DCF, under the income approach. The key assumptions that drive the fair value in the DCF model are the discount rates (i.e. WACC), terminal values, growth rates, and the amount and timing of expected future cash flows. If the current worldwide financial markets and economic environment were to deteriorate, this would likely result in a higher WACC because market participants would require a higher rate of return. In the DCF, as the WACC increases, the fair value decreases. The other significant factor in the DCF is its projected financial information (i.e., amount and timing of expected future cash flows and growth rates) and if its assumptions were to be adversely impacted, this could result in a reduction of the fair value of the entity. As a result of completing the first step on the impairment date, the fair value exceeded the carrying value, and as such the second step of 68-------------------------------------------------------------------------------- Table of Contents the impairment test was not required. To date, we have not been required to perform the second step of the impairment test. As of the impairment date and as of December 31, 2012, our market capitalization exceeded the fair value of our consolidated net assets by more than 30%. In addition, as of the impairment date, the fair value of both our consolidated Australian reporting unit and our all other operations reporting unit exceeded each of their respective carrying values by more than 50%. The estimate of fair value requires significant judgment. Any loss resulting from an impairment test would be reflected in operating loss in our consolidated statements of operations. The annual impairment testing process is subjective and requires judgment at many points throughout the analysis. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded. Impairment of Long-Lived Assets We review long-lived assets, including property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable over their remaining estimated useful lives. If these assets are considered to be impaired the long-lived assets are measured for impairment at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets or liabilities. Impairment is recognized in earnings and equals the amount by which the carrying value of the assets exceeds their fair market value determined by either a quoted market price, if any, or a value determined by utilizing a DCF technique. If these assets are not impaired, but their useful lives have decreased, the remaining net book value is amortized over the revised useful life. During the years ended December 31, 2012, 2011 and 2010, we identified impairment indicators related to certain demand response equipment as a result of the removal of such equipment from service during each of these respective years. As a result of these impairment indicators, we performed impairment tests during the years ended December 31, 2012, 2011 and 2010, and recognized impairment charges of $1.1 million, $0.6 million and $0.6 million, respectively, representing the difference between the carrying value and fair market value of the demand response equipment, which is included in cost of revenues in the accompanying consolidated statements of operations. The fair market value was determined utilizing Level 3 inputs, as defined by ASC 820, Fair Value Measurements and Disclosures, or ASC 820, based on the projected future cash flows discounted using the estimated market participant rate of return for this type of asset. In connection with the decision that we made in the fourth quarter of 2012 to net settle a portion of our future contractual delivery obligations in a certain open market bidding program, we concluded that it was more likely than not that certain of our production and generation equipment utilized in connection with this demand response arrangement would be disposed or abandoned, significantly before the end of its previously estimated useful life, and that this represented a potential indicator of impairment. Accordingly, we performed an impairment test during the year ended December 31, 2012. The applicable long-lived assets are measured for impairment at the lowest level at which identifiable cash flows are largely independent of the cash flows of other assets or liabilities. We determined that the undiscounted cash flows to be generated by the asset group over its remaining estimated useful life would not be sufficient to recover the carrying value of the asset group. We then determined the fair value of the asset group using a discounted cash flow technique based on Level 3 inputs, as defined by ASC 820, and a discount rate of 11%, which we determined represents a market rate of return for the assets being evaluated for impairment. Our estimate of the fair value of the asset group was $0.4 million compared to the carrying value of the asset group of $1.5 million. As a result, we recorded an impairment charge of $1.1 million during the year ended December 31, 2012, which is reflected in cost of revenues in the accompanying consolidated statements of operations. The impairment charge was allocated to the individual assets within the asset group on a pro-rata basis using the relative carrying amounts of those assets. 69-------------------------------------------------------------------------------- Table of Contents We also re-evaluated the estimated useful life of this production and generation equipment and concluded that a change in the estimated useful life was required. As a result, in December 2012, we revised the estimated useful life of the remaining net book value of the production and generation equipment totaling $0.4 million to fully depreciate these assets over the shorter of their estimated remaining useful life or the date on which our delivery obligations under this demand response arrangement are expected to cease. During the years ended December 31, 2011 and 2010, we identified potential indicators of impairment related to certain demand response and back-up generator equipment as a result of lower than estimated demand response event performance by these assets. As a result of the potential indicators of impairment, we performed impairment tests. The applicable long-lived assets are measured for impairment at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets or liabilities. We determined that the undiscounted cash flows to be generated by the asset group over its remaining estimated useful life would not be sufficient to recover the carrying value of the asset group. We determined the fair value of the asset group using a discounted cash flow technique based on Level 3 inputs, as defined by ASC 820, and a discount rate of 11%, which we determined represents a market rate of return for the assets being evaluated for impairment. We recorded impairment charges of $0.1 million and $1.1 million during the years ended December 31, 2011 and 2010, respectively, which is reflected in cost of revenues in the accompanying consolidated statements of operations. The impairment charges were allocated to the individual assets within the asset group on a pro-rata basis using the relative carrying amounts of those assets. Software Development Costs We capitalize eligible costs associated with software developed or obtained for internal use. We capitalize the payroll and payroll-related costs of employees who devote time to the development of internal-use computer software in addition to applicable third-party costs. We amortize these costs on a straight-line basis over the estimated useful life of the software, which is generally two to three years. Our judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value and impairment of the capitalized costs, and in determining the estimated useful lives over which the costs are amortized. Internal use software development costs of $4.7 million, $3.2 million and $6.8 million for the years ended December 31, 2012, 2011 and 2010, respectively, have been capitalized. Included in the capitalized software development costs for the year ended December 31, 2012 is $0.7 million of software development costs related to the implementation of a company-wide human resource system which was put into production in June 2012 and is being amortized over a three-year useful life. During the year ended December 31, 2010, we capitalized $1.3 million of software development costs related to a company-wide enterprise resource planning system implementation project which was put into production in June 2011 and is being amortized over a five-year useful life. The costs for the development of new software and substantial enhancements to existing software that is intended to be sold or marketed, or external use software, are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized. We determine that technological feasibility of external use software is established at the time a working model of software is completed. Because we believe our current process for developing external use software will be essentially completed concurrently with the establishment of technological feasibility, no costs have been capitalized to date. Stock-Based Compensation We recognize stock-based compensation expense associated with the fair value of stock options, restricted stock and restricted stock units issued to our employees. Determining the amount of stock-based compensation to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. We use a lattice model to determine the fair value of our stock options. We consider a number of factors to determine the fair value of stock options. The model requires us to make estimates of the following assumptions: Expected volatility-We are responsible for estimating volatility and have considered a number of factors, including third-party estimates, when estimating volatility. We currently use a combination of historical and implied volatility, which is weighted based on a number of factors. 70-------------------------------------------------------------------------------- Table of Contents Exit rate post-vesting-We use historical option forfeiture and expiration data to estimate the post vesting exit-rate. We believe that this historical data is currently the best estimate of the expected future post-vesting forfeiture rate. Risk-free interest rate-The yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected term assumption is used as the risk-free interest rate. The fair value of stock awards where vesting is solely based on service vesting conditions is expensed ratably over the vesting period. With respect to certain awards of restricted stock where vesting contains certain performance-based vesting conditions, the fair value is expensed based on the accelerated attribution method as prescribed by ASC 718 over the vesting period. During the year ended December 31, 2012, we granted 1,023,010 shares of non-vested restricted stock to certain executives and non-executive employees that contain performance-based vesting conditions and these awards will vest in equal installments in 2013 and 2014 if the performance conditions are achieved. If the employee who received the restricted stock leaves our employment prior to the vesting date for any reason, the shares of restricted stock will be forfeited and returned to us. In November 2011, our board of directors approved a plan to include performance-based stock awards as part of the annual non-executive bonus plan. In December 2011, 283,334 shares were issued under our Amended and Restated 2007 Employee, Director and Consultant Stock Plan with a fair value of $2.7 million and these awards will vest in equal installments in 2013 and 2014 if the performance conditions are achieved. Through December 31, 2011, we determined that no awards were probable of vesting and as a result, no stock-based compensation expense related to these awards was recorded through December 31, 2011. In March 2012, the performance conditions were modified and we determined that the modified performance conditions were probable of being achieved. As the performance-based stock awards were improbable of vesting prior to the modification of the performance conditions, the original grant date fair value is no longer used to measure compensation cost for the awards. The fair value of these awards was re-measured as of the modification date resulting in a new grant date fair value of $2.1 million after accounting for cancelled grants due to employee terminations. As these awards were probable of vesting as of March 31, 2012 and a portion of the service period had lapsed, we recorded a cumulative catch-up adjustment of stock-based compensation expense during 2012 as required by ASC 718. During the year ended December 31, 2012, there were no other changes to probabilities of existing performance-based stock awards which had a material impact on stock-based compensation expense or amounts expected to be recognized. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Based on an analysis of historical forfeitures, we have determined a specific forfeiture rate for certain employee groups and have applied forfeiture rates ranging from 0% to 8.1% as of December 31, 2012 depending on the specific employee group. This analysis is re-evaluated periodically and the forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those awards that vest. We recognized $13.6 million, $13.5 million and $15.7 million of stock-based compensation expense for employee equity awards during the years ended December 31, 2012, 2011 and 2010, respectively. Of the stock options outstanding at December 31, 2012, 1,265,418 options were held by our employees and directors and 9,893 options were held by non-employees. For outstanding unvested stock options related to employees as of December 31, 2012, we had $1.7 million of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average period of 1.3 years. There were no material unvested non-employee stock options as of December 31, 2012. For non-vested restricted stock and restricted stock units subject to service-based vesting conditions outstanding as of December 31, 2012, we had $8.5 million of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average 2.5 years. For non-vested restricted stock subject to performance-based vesting conditions outstanding and that were probable of vesting as of December 31, 2012, we had $3.9 million of unrecognized stock-based compensation expense, which is expected to be recognized over 71-------------------------------------------------------------------------------- Table of Contents a weighted average period of 1.3 years. For non-vested restricted stock subject to performance-based vesting conditions outstanding that were not probable of vesting as of December 31, 2012, we had $0.7 million of unrecognized stock-based compensation expense. If and when any additional portion of these equity awards are deemed probable to vest or awards that are deemed probable to vest become not probable, we will reflect the effect of the change in estimate in the period of change by recording a cumulative catch-up adjustment to retroactively apply the new estimate. Accounting for Income Taxes We use the asset and liability method for accounting for income taxes. Under this method, we determine deferred tax assets and liabilities based on the difference between financial reporting and taxes bases of our assets and liabilities. We measure deferred tax assets and liabilities using enacted tax rates and laws that will be in effect when we expect the differences to reverse. We have incurred consolidated net losses since our inception and as a result, we had not recognized net United States deferred taxes as of December 31, 2012 or December 31, 2011. Our deferred tax liabilities primarily relate to deferred taxes associated with our acquisitions and property and equipment. Our deferred tax assets relate primarily to net operating loss carryforwards, accruals and reserves, deferred revenue and stock-based compensation. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. In accordance with ASC 740, Income Taxes, or ASC 740, we are required to evaluate uncertainty in income taxes recognized in our financial statements. ASC 740 prescribes a recognition threshold and measurement criteria for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition and defines the criteria that must be met for the benefits of a tax position to be recognized. We had $0.4 million and $0 unrecognized tax benefits as of December 31, 2012 and 2011, respectively. In the ordinary course of global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Judgment is required in determining our worldwide income tax provision. In our opinion, it is not required that we have a provision for income taxes for any years subject to audit. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of matters will not be different than that which is reflected in our historical income tax provisions and accruals. In the event our assumptions are incorrect, the differences could have a material impact on our income tax provision and operating results in the period in which such determination is made. Recent Accounting Pronouncements Presentation of Comprehensive Income In June 2011, the Financial Accounting Standards Board, or FASB, issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, or ASU 2011-05, which requires an entity to present total comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 does not change any of the components of comprehensive income, but it eliminates the option to present the components of other comprehensive income as part of the statement of stockholders equity. ASU 2011-05 was effective in the first quarter of 2012 and should be applied retrospectively. As such, we adopted ASU 2011-05 in 2012 and have provided a separate statement of comprehensive income (loss) in our consolidated financial statements. 72-------------------------------------------------------------------------------- Table of Contents In December 2011, the FASB issued ASU 2011-12, deferring certain provisions of ASU 2011-05. One of the provisions of ASU 2011-05 required entities to present reclassification adjustments out of accumulated other comprehensive income (loss) by component in both the statement in which net income is presented and the statement in which other comprehensive income (loss) is presented (for both interim and annual financial statements). This requirement is indefinitely deferred by ASU 2011-12 and will be further deliberated by the FASB at a future date. The effective date of ASU 2011-12 is the same as that for the unaffected provisions of ASU 2011-05. Disclosures about Offsetting Assets and Liabilities In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, or ASU 2011-11. ASU 2011-11 requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. An entity is required to apply ASU 2011-11 for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by ASU 2011-11 retrospectively for all comparative periods presented. We do not expect that the adoption of ASU 2011-11 will have a significant, if any, impact on our consolidated financial statements. Selected Quarterly Financial Data The table below sets forth selected unaudited quarterly financial information. The information is derived from our unaudited consolidated financial statements and includes, in the opinion of management, all normal and recurring adjustments that management considers necessary for a fair statement of results for such periods. The operating results for any quarter are not necessarily indicative of results for any future period. Year Ended December 31, 2012 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr (In thousands, except per share data) Revenues $ 24,450 $ 33,273 $ 177,947 $ 42,314 Gross profit 5,888 8,345 95,000 14,211 Operating expenses 33,958 36,111 35,689 38,074 (Loss) income from operations (28,070 ) (27,766 ) 59,311 (23,863 ) Net (loss) income (27,713 ) (29,136 ) 60,348 (25,792 ) Basic net (loss) income per share: $ (1.06 ) $ (1.10 ) $ 2.26 $ (0.96 ) Diluted net (loss) income per share: $ (1.06 ) $ (1.10 ) $ 2.21 $ (0.96 ) Year Ended December 31, 2011 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr (In thousands, except per share data) Revenues $ 31,762 $ 58,904 $ 169,183 $ 26,759 Gross profit 12,561 20,377 84,832 5,627 Operating expenses 31,132 32,869 33,861 35,072 (Loss) Income from operations (18,571 ) (12,492 ) 50,971 (29,445 ) Net (loss) income (19,272 ) (12,973 ) 46,878 (28,016 ) Basic net (loss) income per share: $ (0.76 ) $ (0.51 ) $ 1.83 $ (1.08 ) Diluted net (loss) income per share: $ (0.76 ) $ (0.51 ) $ 1.77 $ (1.08 ) |