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General
CNET, Inc. (the Company, which may be referred to as we, us or our) is a leading media company that provides consumers with authoritative information online and on television regarding computers, the Internet and digital technologies. We seek to use our editorial, technical, product database and programming expertise to engage consumers and attract advertisers. Based on the volume of traffic over our branded online network, we believe that we have an established leadership position in our market. We believe that our online network is the most frequently used source of technology information online, with an average of approximately 9.5 million pages viewed daily during the first quarter of 1999.
Results of Operations
Revenues
Total Revenues
Total revenues were $19.6 million and $9.8 million for the three months ended March 31, 1999 and 1998, respectively.
Internet Revenues
Total Internet revenues were $18.0 million and $8.0 million for the three months ended March 31, 1999 and 1998, respectively. Internet revenues consist primarily of revenues derived from the sale of advertisements on pages delivered to users of our Internet network. Advertising programs are generally delivered on either an "impression" based program or a "performance" based program. An impression based program earns revenues when an advertisement is delivered to a user of our Internet network. A performance based program earns revenues when a user of our Internet network responds to an advertisement by linking to an advertisers Internet network. Advertising rates vary depending upon whether a program is impression or performance based, where advertisements are placed and the amount and length of the advertiser's commitment. Advertising revenues are recognized in the period in which the advertisements are delivered. Our ability to sustain or increase revenues for Internet advertising will depend on numerous factors, which include, but are not limited to, our ability to increase our inventory of delivered Internet pages on which advertisements can be displayed and our ability to maintain or increase advertising rates. In the fourth quarter of 1998 CNET began generating revenue from lead- based compensation from its shopping services.
The increase in revenues for CNET Online of $9.9 million for the three month period ended March 31, 1999 compared to the same period in 1998 was attributable to increased pages delivered and increased advertisements sold on our network and an increase in our average revenue yield per page delivered. Average daily pages delivered on our network were approximately 9.5 million for the three months ended March 31, 1999 as compared to 6.3 million for the three months ended March 31, 1998, or an increase of 51%. The increased traffic from the three months ended March 31, 1998 to the three months ended March 31, 1999 was primarily related to an increase in the number of users of our network. In the fourth quarter of 1998, we began generating revenues from lead-based advertising on our shopping services. These lead-based programs, which were offered during the three months ended March 31, 1999, but were not offered during the same period in 1998, contributed to our increased average revenue yield per page.
In addition, Internet revenues included non-advertising revenues of $150,000 and $1.0 million for the three months ended March 31, 1999 and 1998, respectively. Non-advertising revenues include fees earned from Company sponsored trade shows, electronic commerce revenues, content licensing revenues, technology licensing and consulting.
A portion of our Internet revenues were derived from barter transactions whereby we delivered advertisements on our Internet channels in exchange for advertisements on the Internet sites of other companies. Barter transactions accounted for $1.2 million and $709,000 for the three months ended March 31, 1999 and 1998, respectively.
Television Revenues
Television revenues were $1.7 million and $1.8 million for the three months ended March 31, 1999 and 1998, respectively. Pursuant to our agreement with USA Networks, USA Networks licensed the right to carry the two hour programming block, Digital Domain, on its networks for a fee equal to the cost of production of those programs up to a maximum of $5.5 million from July 1, 1997 to June 30, 1998 and $5.9 million from July 1, 1998 to June 30, 1999. This agreement with USA Networks expires on June 30, 1999, but has been extended until September 30, 1999.
We also produce a television program, TV.com, which is exclusively distributed by Trans World International ("TWI"). Through February 28, 1998, TWI sold the advertisements on TV.com and these revenues were used to offset the costs of distribution and production of the program. Beginning March 1, 1998, we assumed responsibility for the sale of advertisements on TV.com and began paying a distribution fee to TWI. The decrease in revenues related to our television operations was primarily related to decreased revenues for TV.com.
Television operations accounted for 8% and 18% of total revenues and Internet operations accounted for 92% and 82% of total revenues for the three months ended March 31, 1999 and 1998, respectively. We expect to experience fluctuations in television and Internet revenues in the future that may be dependent on many factors, including demand for the Company's Internet sites and television programming and our ability to develop, market and introduce new and enhanced Internet content and television programming.
Cost of Revenues
Total Cost of Revenues
Total cost of revenues were $8.4 million and $7.0 million for the three months ended March 31, 1999 and 1998, respectively. Cost of revenues includes costs associated with the production and delivery of television programming and the production of our Internet channels. The principal elements of cost of revenues for our television operations have been the production costs of our television programs, which primarily consist of payroll and related expenses for the editorial and production staff and costs for facilities and equipment. The principal elements of cost of revenues for our Internet operations have been payroll and related expenses for the editorial, production and technology staff, as well as costs for facilities and equipment.
Cost of Internet Revenues
Cost of Internet revenues were $6.8 million and $5.3 million for the three months ended March 31, 1999 and 1998, respectively, representing 38% and 65% of the related revenues, respectively. The increase of $1.5 million for the three months ended March 31, 1999 as compared to the same period in 1998 was primarily attributable to increases in personnel and personnel related costs. In addition, costs of approximately $400,000 were recognized in the three months ended March 31, 1999 related to the acquisition of Shopper.com, which was acquired in May 1998 and the acquisitions of NetVentures, AuctionGate, Winfiles and KillerApp which were all acquired during the three months ended March 31, 1999.
Cost of Television Revenues
Cost of television revenues were $1.6 million and $1.7 million for the three months ended March 31, 1999 and 1998, repsectively, representing approximately 97% and 100% of the related revenues, respectively.
Sales and Marketing
Sales and marketing expenses consist primarily of payroll and related expenses, consulting fees and advertising expenses. Sales and marketing expenses were $4.9 million and $2.5 million for the three months ended March 31, 1999 and 1998, respectively, representing 25% of total revenues for each of the periods. Sales and marketing expenses increased $2.4 million for the three months ended March 31, 1999 compared to the same period in 1998. This increase was related to increased personnel in sales and sales support roles and their related expenses of approximately $1.0 million and an increase in marketing expenses of $1.4 million. The increase in marketing expenses was primarily related to increased expenses for advertising of $1.1 million, which included an increase in barter transactions of $245,000. We regularly evaluate our marketing efforts and may determine to significantly increase our marketing expenditures in the future.
Development
Development expenses include expenses for the development and production of new Internet channels and for the research and development of new or improved technologies to enhance the features and functionality of our Internet network, including payroll and related expenses for editorial, production and technology staff, as well as costs for facilities and equipment. Costs associated with the development of a new Internet channel are no longer recognized as development expenses when the new channel begins generating revenue.
Development expenses were $1.5 million and $777,000 for the three months ended March 31, 1999 and 1998, respectively, representing 8% for each of the periods. The increase in development expenses of approximately $731,000 for the three months ended March 31, 1999 as compared to the same period in 1998 was primarily attributable to increased personnel costs related to the enhancement of the functionality of our Internet network.
General and Administrative
General and administrative expenses consist of payroll and related expenses for executive, finance and administrative personnel, professional fees and other general corporate expenses. General and administrative expenses were $1.5 million and $1.6 million for the three months ended March 31, 1999 and 1998, respectively, representing 8% and 17% of total revenues, respectively.
Goodwill Amortization
We acquired Winfiles on February 26, 1999 for a total purchase price of $11.5 million. The acquisition was a purchase of assets and approximately $11.0 million of the purchase price was attributable to goodwill. We are amortizing the goodwill related to the purchase of Winfiles over three years.
Other Income (Expense)
Total other income (expense) was $20.1 million and $(3.5) million for the three months ended March 31, 1999 and 1998, respectively. Other income (expense) consists of equity losses, gain on the sale of equity investments, interest income and interest expense. Equity losses included our interest in SNAP! LLC ("snap.com") Pursuant to an agreement in June 1998 with NBC Multimedia, snap. was formed as a limited liability company, of which NBC Multimedia and us share control. We have recorded snap.com's financial results using the equity method of accounting effective January 1, 1998.
We had no equity losses for the three months ended March 31, 1999, and equity losses were $3.7 million for the three months ended March 31, 1998. All of the equity losses in 1998 were related to snap.com.
Gains on the sale of equity investments were $19.9 million for the three months ended March 31, 1999 and we had no gains on the sale of equity investments for the three months ended March 31, 1998. The gains on sale of equity investments in the first quarter of 1999 relates to the merger agreement between beyond.com and BuyDirect.com, which resulted in our owning approximately 755,000 shares of beyond.com due to our ownership interest in BuyDirect. We recorded a non-cash gain related to shares we received on the date of the merger. Our investment in beyond.com is classified as marketable securities on our balance sheet and fluctuations in the value of this investment will be recorded as unrecognized gain (loss) on investments in the comprehensive income section of our balance sheet in future quarters until we realize a gain or loss on actual sales of the securities.
Income (Loss)
We recorded net income of $23.0 million or $0.61 per diluted share for the three months ended March 31, 1999 compared to net losses of $5.7 million or $0.19 per share for the comparable period in 1998. Net income increased $28.7 million for the three months ended March 31, 1999 as compared to the similar period in 1998. This change was attributable to an increase in total revenues of $9.8 million and increases to cost of revenues and operating expenses of $4.8 million, resulting in an increase to operating profit of $5.1 million. Other income and expense increased $23.6 million due to the gains on sales of investments recognized in 1999 and the reduction of equity losses that were incurred in 1998. The increases in operating income combined with the increase in other income resulted in an increase in net income of $28.7 million.
Liquidity and Capital Resources
As of March 31, 1999, we had cash and cash equivalents of $208.2 million. Cash used in operating activities of $2.7 million for the three months ended March 31, 1999 was primarily due to an increase in other current assets and other assets of $12.9 million which was due primarily to an increase in a note receivable, an increase in accrued liabilities of $3.0 million, increases in prepaid expenses and a non-cash gain on investments of $19.9 million. These increases were partially offset by net income of $23.0 million and depreciation and amortization and the amortization of program costs of $3.8 million. Net cash used in operating activities of $4.9 million in for the three months ended March 31, 1998 was primarily attributable to net losses in such periods. Net cash used in investing activities of $10.9 million for the three months ended March 31, 1999 was primarily related to acquisitions and to purchases of equipment and programming assets. Net cash used in investing activities of $2.6 million for the three months ended March 31, 1998 was primarily attributable to purchases of equipment and programming assets. Cash flows provided by financing activities of $170.2 million for the three months ended March 31, 1999 consisted primarily of the issuance of convertible debt and the issuance of common stock through the exercise of stock options. Cash flows provided by financing activities for the three months ended March 31, 1998 consisted primarily of proceeds from the issuance of common stock through the exercise of stock options. We believe that existing funds will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.
As of March 31, 1999 we had obligations outstanding under notes payable and under certain capital leases and under our convertible debt obligation of $180.2 million. Such obligations were incurred to finance equipment purchases, acquire Winfiles.com and to obtain proceeds for general corporate purposes, which may include potentially significant increases in marketing expenditures and working capital.
Seasonality and Cyclicality
We believe that advertising sales in traditional media, such as television, are generally lower in the first and third calendar quarters of each year than in the respective preceding quarters and that advertising expenditures fluctuate significantly with economic cycles. Depending on the extent to which the Internet is accepted as an advertising medium, seasonality and cyclicality in the level of advertising expenditures generally could become more pronounced for Internet advertising. Advertising expenditures account for substantially all of our revenues, and seasonality and cyclicality in advertising expenditures generally, or with respect to Internet-based advertising specifically, could therefore have a material adverse effect on our business, financial condition or operating results. We may also experience seasonality in connection with our shopping services, which may reflect seasonal trends in the retail industry. The level of consumer retail spending generally decreases in the first and third calendar quarters.
Year 2000 Compliance
We are aware of the issues associated with the programming code and embedded technology in existing systems as the year 2000 approaches. The "year 2000 issue" arises from the potential for computers to fail or operate incorrectly because their programs incorrectly interpret the two digit date fields "00" as 1900 or some other year, rather than the year 2000. The year 2000 issue creates risk for us from unforeseen problems in our computer systems and from third parties, including our customers, vendors and manufacturers. Failures of our and/or third parties' computer systems could result in an interruption in, or a failure of, our normal business activities or operations. Such failures could materially and adversely affect our business prospects, financial condition and operating results.
To mitigate this risk, we have established a formal year 2000 program to oversee and coordinate the assessment, remediation, testing and reporting activities related to this issue. We ares currently in the assessment phase of our year 2000 program. As part of this assessment, we will review the following systems to determine if they are year 2000 compliant:
* our application systems (financial systems, various custom-
developed business applications)
* technology infrastructure (networks, servers, desktop
equipment)
* facilities (security systems, fire alarm systems)
* vendors/partners and products.
This review will include:
* the collection of documentation from software and hardware manufacturers
* the detailed review of programming code for custom applications
* the physical testing of desktop equipment using software
designed to test for year 2000 compliance
* the examination of key vendors'/partners' year 2000 programs
* the ongoing testing of our products as part of normal quality assurance activities.
We anticipate that we will complete the assessment and remediation phase and begin the testing phase of our year 2000 program by the third quarter of 1999. We have not made estimates for the costs associated with completing our year 2000 program, but will do so after completion of the assessment phase of the project. Costs incurred to date, including costs of personnel, have not been material. We can offer no assurance that we will not experience serious unanticipated negative consequences and/or additional material costs caused by undetected errors or defects in the technology used in our internal systems, or by failures of our vendors/partners to address their year 2000 issues in a timely and effective manner.
Should miscalculations or other operational errors occur as a result of the year 2000 issue, we or the parties on which we depend may be unable to produce reliable information or to process routine transactions. Furthermore, in the worst case, we or the parties on which we depend may be incapable of conducting critical business activities which include, but are not limited to, the production and delivery of our Internet channels, invoicing customers and paying vendors, which could have a material adverse effect on our business, prospects, financial condition and operating results.
Special Note Regarding Forward-Looking Statements and Risk Factors
Certain statements in this Quarterly Report on Form 10-Q contain "forward-looking statements." Forward-looking statements are any statements other than statements of historical fact. Examples of forward-looking statements include projections of earnings, revenues or other financial items, statements of the plans and objectives of management for future operations, statements concerning proposed new products or services, statements regarding future economic conditions or performance and any statement of assumptions underlying any of the foregoing. In some cases, you can identify forward-looking statements by the use of words such as "may," "will," "expects," should, "believes", "plans," "anticipates," "estimates," predicts, "potential" or "continue," and any other words of similar meaning.
The risks, uncertainties and other factors to which forward- statements are subject include, among others, those set forth under the caption "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 1998, which is available from us, from the SEC at prescribed rates and at the web-site www.sec.gov. Such factors include, without limitation, the following: limited operating history; fluctuations in quarterly operating results; failure to compete; risks associated with anticipated growth; risks related to potential Year 2000 problems; risks associated with technological change; availability of key personnel and changes in governmental regulations. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by such factors.
Any or all of our forward-looking statements in this report and in any other public statements we make may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in the discussion in this report will be important in determining future results. Consequently, no forward-looking statement can be guaranteed. Actual future results may vary materially. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our reports to the SEC.
We are exposed to the impact of interest rate changes in the market values of our investments
Interest Rate Risk
Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. We invest our excess cash in debt instruments of the U.S. Government and its agencies, and in high-quality corporate issuers and, by policy, limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk.
Investment in both fixed rate and floating rate interest earning instruments carries a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.
Investment Risk
We invest in equity instruments of information technology companies for business and strategic purposes. These investments are included in marketable securities and are accounted for under the cost method when ownership is less than 20%. Such investments, which are in the Internet industry, are subject to significant fluctuations in fair market value due to the volatility of the stock market.