News Column

SPS COMMERCE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 31, 2014

Overview

We are a leading provider of cloud-based supply chain management solutions, providing prewired, proven integrations and comprehensive retail performance analytics to thousands of customers worldwide. We provide our solutions through the SPS Commerce platform, a cloud-based software suite that improves the way suppliers, retailers, distributors and other customers manage and fulfill orders. We derive the majority of our revenues from thousands of monthly recurring subscriptions from businesses that utilize our solutions. We plan to continue to grow our business by further penetrating the supply chain management market, increasing revenues from our customers as their businesses grow, expanding our distribution channels, expanding our international presence and, from time to time, developing new solutions and applications. We also intend to selectively pursue acquisitions that will add customers, allow us to expand into new regions or allow us to offer new functionalities. For the three months ended June 30, 2014, our revenues were $31.1 million, an increase of 21% from the comparable period in 2013, and represented our 54th consecutive quarter of increased revenues. Total operating expenses increased 19% and net income increased 122% for the same period in 2014 from 2013. Similar results were experienced for the six months ended June 30, 2014 with increased revenues of 22%, increased operating expenses of 17% and increased net income of 108% compared to the same period in 2013.



Key Financial Terms and Metrics

We have several key financial terms and metrics, including annualized average recurring revenues per recurring revenue customer, which we also refer to as wallet share. During the six months ended June 30, 2014, there were no changes in the definitions of our key financial terms and metrics, which are discussed in more detail under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the year ended December 31, 2013 as filed with the Securities and Exchange Commission on February 20, 2014. To supplement our financial statements, we also provide investors with Adjusted EBITDA and non-GAAP income per share, both of which are non-GAAP financial measures. We believe that these non-GAAP measures provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Our management uses these non-GAAP measures to compare the company's performance to prior periods for trend analyses and planning purposes. Adjusted EBITDA is also used for purposes of determining executive and senior management incentive compensation. These measures are also presented to our board of directors. These non-GAAP measures should not be considered a substitute for, or superior to, financial measures calculated in accordance with generally accepted accounting principles in the United States of America ("GAAP"). These non-GAAP financial measures exclude significant expenses and income that are required by GAAP to be recorded in our financial statements and are subject to inherent limitations. Investors should review the reconciliations of non-GAAP financial measures to the comparable GAAP financial measures that are included in this "Management's Discussion and Analysis of Financial Condition and Results of Operations." 11



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Critical Accounting Policies and Estimates

This discussion of our financial condition and results of operations is based upon our condensed consolidated financial statements, which are prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates of the carrying value of certain assets and liabilities on historical experience and on various other assumptions that we believe to be reasonable. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments for uncertain matters that could have a material effect on our financial condition and results of operations. Accordingly, we believe that our policies for revenue recognition, the allowance for doubtful accounts, income taxes and stock-based compensation are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. During the six months ended June 30, 2014, there were no changes in our significant accounting policies or estimates. See Note A to our consolidated financial statements included in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission on February 20, 2014, for additional information regarding our accounting policies. 12



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Results of Operations

The following table presents our results of operations for the periods indicated (dollars in thousands): Three Months Ended June 30, 2014 2013 Change % of revenue % of revenue $ % Revenues $ 31,100 100.0 % $ 25,658 100.0 % $ 5,442 21.2 % Cost of revenues 9,627 31.0 7,943 31.0 1,684 21.2 Gross profit 21,473 69.0 17,715 69.0 3,758 21.2 Operating expenses Sales and marketing 11,570 37.2 9,647 37.6 1,923 19.9 Research and development 3,365 10.8 2,657 10.4 708 26.6 General and administrative 4,842 15.6 4,211 16.4 631 15.0 Amortization of intangible assets 682 2.2 717 2.8 (35 ) (4.9 ) Total operating expenses 20,459 65.8 17,232 67.2 3,227 18.7 Income from operations 1,014 3.3 483 1.9 531 109.9 Other income (expense) Interest income 50 0.2 22 0.1 28 127.3 Other income (expense), net 35 0.1 (48 ) (0.2 ) 83 * Total other income (expense), net 85 0.3 (26 ) (0.1 ) 111 * Income before income taxes 1,099 3.5 457 1.8 642 140.5 Income tax expense (460 ) (1.5 ) (169 ) (0.7 ) 291 172.2 Net income $ 639 2.1 $ 288 1.1 351 121.9 Six Months Ended June 30, 2014 2013 Change % of revenue % of revenue $ % Revenues $ 60,039 100.0 % $ 49,410 100.0 % $ 10,629 21.5 % Cost of revenues 18,882 31.4 15,009 30.4 3,873 25.8 Gross profit 41,157 68.6 34,401 69.6 6,756 19.6 Operating expenses Sales and marketing 22,454 37.4 18,872 38.2 3,582 19.0 Research and development 6,339 10.6 5,160 10.4 1,179 22.8 General and administrative 9,353 15.6 8,258 16.7 1,095 13.3 Amortization of intangible assets 1,399 2.3 1,434 2.9 (35 ) (2.4 ) Total operating expenses 39,545 65.9 33,724 68.3 5,821 17.3 Income from operations 1,612 2.7 677 1.4 935 138.1 Other income (expense) Interest income 99 0.2 45 0.1 54 120.0 Other expense (21 ) - (132 ) (0.3 ) 111 (84.1 ) Total other income (expense), net 78 0.1 (87 ) (0.2 ) 165 * Income before income taxes 1,690 2.8 590 1.2 1,100 186.4 Income tax expense (678 ) (1.1 ) (103 ) (0.2 ) 575 558.3 Net income $ 1,012 1.7 $ 487 1.0 525 107.8



Due to rounding, totals may not equal the sum of the line items in the table above.

* Percentage is not meaningful.

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Three and Six Months Ended June 30, 2014 compared to Three and Six Months Ended June 30, 2013

Revenues. Revenues for the three months ended June 30, 2014 increased $5.4 million, or 21%, to $31.1 million from $25.7 million for the same period in 2013. Revenues for the six months ended June 30, 2014 increased $10.6 million, or 22%, to $60.0 million from $49.4 million for the same period in 2013.



The increase in revenues for both the three and six month periods resulted from two primary factors: the increase in recurring revenue customers and the increase in annualized average recurring revenues per recurring revenue customer, which we also refer to as wallet share.

The number of recurring revenue customers increased 10% to 20,745 at June 30, 2014 from 18,871 at June 30, 2013. Annualized average recurring revenues per recurring revenue customer, or wallet share, increased 12% to $5,467 for the three months ended June 30, 2014 from $4,869 for the same period in 2013. This increase in wallet share was primarily attributable to increased fees resulting from increased usage of our solutions by our recurring revenue customers and growth in larger customers. Recurring revenues from recurring revenue customers accounted for 90% of our total revenues for each of the three and six months ended June 30, 2014, compared to 88% and 89%, respectively, for the same periods in 2013. We anticipate that the number of recurring revenue customers and wallet share will continue to increase as we increase the number of solutions we offer and increase the penetration of those solutions across our customer base. Cost of Revenues. Cost of revenues for the three months ended June 30, 2014 increased $1.7 million, or 21%, to $9.6 million from $7.9 million for the same period in 2013. Cost of revenues for the six months ended June 30, 2014 increased $3.9 million, or 26%, to $18.9 million from $15.0 million for the same period in 2013. The increase in cost of revenues for the three and six month periods in 2014 was primarily due to increased headcount in 2014 which resulted in higher personnel costs. Also contributing to the increase for both periods were increased expenses for software subscriptions in 2014 as compared to 2013. As a percentage of revenues, cost of revenues was 31% for each of the three months ended June 30, 2014 and 2013, compared to 31% and 30%, respectively, for the same periods in 2013. Going forward, we anticipate that cost of revenues will increase in absolute dollars as we continue to expand our business. Sales and Marketing Expenses. Sales and marketing expenses for the three months ended June 30, 2014 increased $1.9 million, or 20%, to $11.6 million from $9.6 million for the same period in 2013. Sales and marketing expenses for the six months ended June 30, 2014 increased $3.6 million, or 19%, to $22.5 million from $18.9 million for the same period in 2013. The increase in sales and marketing expenses for the three and six month periods in 2014 was primarily due to increased headcount in 2014, which resulted in higher personnel costs, as well as increased commissions earned by sales personnel from new business. We also had increased promotional, occupancy, depreciation and stock-based compensation expenses in 2014 as compared to 2013. As a percentage of revenues, sales and marketing expenses were 37% for each of the three and six months ended June 30, 2014 compared to 38% for each of the comparable periods in 2013. As we expand our business, we will continue to add resources to our sales and marketing efforts over time, and we expect that these expenses will continue to increase in absolute dollars. Research and Development Expenses. Research and development expenses for the three months ended June 30, 2014 increased $708,000, or 27%, to $3.4 million from $2.7 million for the same period in 2013. Research and development expenses for the six months ended June 30, 2014 increased $1.2 million, or 23%, to $6.3 million from $5.2 million for the same period in 2013. The increased research and development expenses for the three and six month periods in 2014 were primarily due to increased headcount in 2014, which resulted in higher personnel costs. We also had increased expenses for depreciation in 2014 as compared to 2013. As a percentage of revenues, research and development expenses were 11% for each of the three and six months ended June 30, 2014, compared to 10% for each of the same periods in 2013. As we enhance and expand our solutions and applications, we expect that research and development expenses will continue to increase in absolute dollars. 14



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General and Administrative Expenses. General and administrative expenses for the three months ended June 30, 2014 increased $631,000, or 15%, to $4.8 million from $4.2 million for the same period in 2013. General and administrative expenses for the six months ended June 30, 2014 increased $1.1 million, or 13%, to $9.4 million from $8.3 million for the same period in 2013. The increase in general and administrative expenses for the three and six month periods in 2014 was primarily due to increased stock-based compensation, legal costs and maintenance expenses for computer software and hardware in 2014 as compared to 2013. As a percentage of revenues, general and administrative expenses were 16% for each of the three months ended June 30, 2014 and 2013, compared to 16% and 17%, respectively, for the same periods in 2013. Going forward, we expect that general and administrative expenses will continue to increase in absolute dollars as we expand our business. Income Tax Expense. We recorded income tax expense of $460,000 and $678,000 for the three and six months ended June 30, 2014. We recorded income tax expense of $169,000 and $103,000 for the three and six months ended June 30, 2013. Our provisions for income taxes included current foreign and state income tax expense, as well as deferred tax expense. We expect that our annual effective income tax rate will be approximately 40%. The increase in income tax expense for the three and six months ended June 30, 2014, compared to the same periods in 2013, was primarily due to the increase in pretax book income in 2014. In addition, there was a discrete tax benefit of $117,000 in 2013 for the retroactive benefit of the 2012 federal R&D credit. The American Taxpayer Relief Act of 2012 was enacted on January 2, 2013 and extended the federal R&D credit from January 1, 2012 through December 31, 2013. Adjusted EBITDA. Adjusted EBITDA, which is a non-GAAP measure of financial performance, consists of net income plus depreciation and amortization, interest expense, interest income, income tax expense, non-cash, stock-based compensation expense and other adjustments as necessary for a fair presentation. For second quarter 2014, other adjustments included the impact of a use tax refund related to items previously expensed. The following table provides a reconciliation of net income to Adjusted EBITDA (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net income $ 639$ 288$ 1,012$ 487 Depreciation and amortization of property and equipment 1,519 1,182 2,823 2,353 Amortization of intangible assets 682 717 1,399 1,434 Interest income (50 ) (22 ) (99 ) (45 ) Income tax expense 460 169 678 103 Other (69 ) - (69 ) - EBITDA 3,181 2,334 5,744 4,332 Stock-based compensation expense 1,359 1,111 2,698 2,035 Adjusted EBITDA $ 4,540$ 3,445$ 8,442$ 6,367 15



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Non-GAAP Income Per Share. Non-GAAP income per share, which is also a non-GAAP measure of financial performance, consists of net income plus non-cash, stock-based compensation expense and amortization expense related to intangible assets divided by the weighted average number of shares of common stock outstanding during each period. The following table provides a reconciliation of net income to non-GAAP income per share (in thousands, except per share amounts): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net income $ 639$ 288$ 1,012$ 487 Stock-based compensation expense 1,359 1,111 2,698 2,035 Amortization of intangible assets 682 717 1,399 1,434 Non-GAAP income $ 2,680$ 2,116$ 5,109$ 3,956 Shares used to compute non-GAAP income per share Basic 16,210 15,076 16,183 14,983 Diluted 16,768 15,785 16,799 15,677 Non-GAAP income per share Basic $ 0.17$ 0.14$ 0.32$ 0.26 Diluted $ 0.16$ 0.13$ 0.30$ 0.25



Liquidity and Capital Resources

At June 30, 2014, our principal sources of liquidity were cash and cash equivalents of $136.5 million and accounts receivable, net of allowance for doubtful accounts, of $13.3 million. Our working capital at June 30, 2014 was $145.5 million compared to $137.2 million at December 31, 2013. The increase in working capital from December 31, 2013 to June 30, 2014 resulted from the following:



$5.2 million increase in cash and cash equivalents, due primarily to the

$6.9 million of cash provided by operations and the $1.6 million of cash

received from the exercise of stock options and proceeds from our employee

stock purchase plan, reduced by the $3.4 million of cash used for capital

expenditures;



$1.7 million increase in net accounts receivable, as new accounts exceeded

collections of outstanding balances for the six months ended June 30, 2014;



$1.4 million increase in deferred costs, current, for expenses related to

increased implementation resources and commission payments for new business; $496,000 increase in prepaid expenses and other current assets due primarily to prepaid service contracts;



$1.2 million increase in accounts payable, primarily due to timing of

payments;



$342,000 decrease in accrued compensation and benefits, due primarily to

payroll timing;



$996,000 decrease in accrued expenses and other current liabilities due

primarily to payments completed under a software licensing agreement; and

$577,000 increase in deferred revenue, current, due to new business for

the six months ended June 30, 2014. 16



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Net Cash Flows from Operating Activities

Net cash provided by operating activities was $6.9 million for the six months ended June 30, 2014 compared to $8.6 million for the same period in 2013. The increase in net income, the changes in non-cash expenses, including increased depreciation and stock-based compensation, and the changes in our working capital accounts, including those discussed above, resulted in the overall decrease in net cash provided by operations.



Net Cash Flows from Investing Activities

Net cash used in investing activities was $3.4 million and $1.7 million for the six months ended June 30, 2014 and 2013, respectively, all for capital expenditures. Our capital expenditures are for supporting our business growth and existing customer base, as well as for our internal use such as equipment for our employees.



Net Cash Flows from Financing Activities

Net cash provided by financing activities was $1.7 million and $2.2 million for the six months ended June 30, 2014 and 2013, respectively, all related to the exercise of stock options and our employee stock purchase plan.



Credit Facility

We have a revolving credit agreement with JPMorgan Chase Bank, N.A. that will mature on September 30, 2016. The revolving credit agreement provides for a $20 million revolving credit facility that we may draw upon from time to time, subject to certain terms and conditions. There were no borrowings outstanding at June 30, 2014 and we were in compliance with all covenants under the revolving credit agreement as of that date.



Adequacy of Capital Resources

Our future capital requirements may vary significantly from those now planned and will depend on many factors, including the costs to develop and implement new solutions and applications, the sales and marketing resources needed to further penetrate our market and gain acceptance of new solutions and applications we develop, the expansion of our operations in the United States and internationally, the response of competitors to our solutions and applications and our use of capital for acquisitions, if any. Historically, we have experienced increases in our expenditures consistent with the growth in our operations and personnel, and we anticipate that our expenditures will continue to increase as we grow our business. We believe our cash and cash equivalents and our cash flows from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months. Inflation and changing prices did not have a material effect on our business during the six months ended June 30, 2014. We do not expect that inflation or changing prices will materially affect our business in the foreseeable future.



Our results of operations and cash flows are not materially affected by fluctuations in foreign currency exchange rates.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.

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