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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 11.4 million pages viewed daily during the third quarter of 1999.
Results of Operations
Revenues
Total Revenues
Total revenues were $28.4 million and $14.7 million for the three months and $74.0 million and $37.9 million for the nine months ended September 30, 1999 and 1998, respectively.
Internet Revenues
Total Internet revenues were $26.8 million and $12.9 million for the three months and $69.0 million and $32.4 million for the nine months ended September 30, 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 advertiser's Internet network. Performance based programs include revenues generated from lead-based compensation from our shopping services, which commenced in the fourth quarter of 1998. 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.
The increase in Internet revenues of $13.9 million for the three month and $36.6 million for the nine month periods ended September 30, 1999 compared to the same periods in 1998 were attributable to increased pages delivered, increased advertisements sold on our network and an increase in our average revenue yield per page delivered. Also contributing to our increased revenues and increased revenue yield per page were performance-based advertising on our shopping services. These lead-based programs which were offered during the three and nine month periods ended September 30, 1999, were not offered during the same periods in 1998. In addition, average daily pages delivered on our network were approximately 11.4 million for the three month and 10.6 for the nine month periods ended September 30, 1999 as compared to 6.8 million for the three month and 6.5 million for the nine month periods ended September 30, 1998, or an increase of 68% and 63%, respectively. The increased traffic from the three and nine month periods ended September 30, 1998 to the three and nine month periods ended September 30, 1999 was primarily related to an increase in the number of users of our network.
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. Revenues related to barter transactions were $1.5 million and $1.1 million for the three months and $4.2 million and $2.2 million for the nine months ended September 30, 1999 and 1998, respectively.
Television Revenues
Television revenues were $1.6 million and $1.8 million for the three months and $5.0 million and $5.4 million for the nine months ended September 30, 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 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, which was scheduled to expire on June 30, 1999, was extended through September 30, 1999 and USA Networks paid a fee of $1.0 million to carry the programming for the three month period. The agreement with USA Networks was subsequently extended through December 31, 1999 and will decrease the number of programs produced under the Digital Domain from four to two. USA Networks will pay a fee of $500,000 to carry programming for the fourth quarter of 1999. The contract with USA Networks will not be extended beyond December 31, 1999.
In May 1999 we entered into an agreement with the National Broadcasting Company ("NBC") whereby NBC granted certain rights to CNBC, Inc. ("CNBC") to carry the sixty minute television program we will produce called "CNET News.com". The term of the agreement is from October 1, 1999 through September 30, 2002, subject to the completion of the Plan of Merger between CNET, XOOM.com, Inc. and SNAP! LLC. CNBC will pay us a annual fee based on the cost of production, not to exceed exceed $2.5 million. We also have the right to sell certain commercial commercial time available on the program.
We also produce a television program, TV.com, which is exclusively distributed by Trans World International ("TWI"). We sell advertisements on TV.com and pay a distribution fee to TWI.
Internet operations accounted for 94% and 88% of total revenues and television operations accounted for 6% and 12% of total revenues for the three months ended September 30, 1999 and 1998, respectively. Internet operations accounted for 93% and 86% of total revenues and television operations accounted for 7% and 14% of total revenues for the nine months ended September 30, 1999 and 1998, respectively. We expect to experience fluctuations in television and Internet revenues in the future as a result of 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 $11.5 million and $7.2 million for the three months and $29.3 million and $21.9 million for the nine months ended September 30, 1999 and 1998, respectively. Cost of revenues include costs associated with the production and delivery of our Internet channels and our television programming. The principal elements of cost of revenues for our Internet operations have been payroll and related expenses for the editorial, production and technology staff, and costs for facilities and equipment. 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.
Cost of Internet Revenues
Cost of Internet revenues were $9.2 million and $5.5 million for the three months and $23.6 million and $16.7 million for the nine months ended September 30, 1999 and 1998, respectively, representing 34%, 42%, 34% and 51% of the related revenues, respectively. The increase of $3.7 million and $6.9 million for the three month and nine month periods ended September 30, 1999 as compared to the same periods in 1998 was primarily attributable to increases in personnel and personnel related costs. In addition, costs of approximately $1.3 million and $2.5 million were recognized in the three month and nine month periods ended September 30, 1999 which related to cost of revenues associated with the acquisitions of Netventures, Inc., a California corporation, AuctionGate Interactive, Inc., a California corporation, substantially all of the assets of Jenesys LLC, a Washington limited liability company ("Winfiles"), KillerApp corporation, a California corporation and Sumo, Inc., a Florida corporation, GDT and Nordby.
Cost of Television Revenues
Cost of television revenues were $2.3 million and $1.7 million for the three month periods and $5.7 million and $5.2 million for the nine months ended September 30, 1999 and 1998, representing approximately 148%, 94%, 114% and 96% of the related revenues. The increase of $656,000 and $494,000 for the three month and nine month periods ended September 30, 1999 as compared to the same periods in 1998 related primarily to costs associated with the cancellations of two of the programs produced for USA Networks.
Sales and Marketing
Sales and marketing expenses consist primarily of payroll and related expenses, consulting fees and advertising expenses. Sales and marketing expenses were $33.0 million and $4.0 million for the three months and $45.1 million and $9.7 million for the nine months ended September 30, 1999 and 1998, respectively, representing 116%, 27%, 65% and 26% of total revenues for each of the periods. Sales and marketing expenses increased $29.0 million and $35.4 million for the three month and nine month periods ended September 30, 1999 respectively, compared to the same periods in 1998.
Effective July 1, 1999 we launched a multi-media advertising campaign. We expect to spend approximately $100.0 million over a nine to eighteen month period beginning July 1, 1999, depending on the effectiveness of the campaign. Expenses related to this advertising campaign were $24.4 million and $24.8 million for the three and nine month periods ended September 30, 1999, respectively.
Other advertising expenses, including barter, increased by approximately $2.7 million and $5.5 million for the three and nine month periods ended September 30, 1999 as compared to the similar periods in 1998. The remaining increases in sales and marketing expenses were primarily related to additional personnel in marketing, sales and sales support roles and related costs.
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 $1.9 million and $688,000 for the three months and $5.1 million and $2.1 million for the nine months ended September 30, 1999 and 1998, respectively, representing 7%, 5%, 7% and 6% of total revenues for each of the periods. The increase in development expenses of $1.2 million for the three months and $3.0 million for the nine months ended September 30, 1999 as compared to the same periods in 1998 were primarily attributable to additional 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 $4.9 million and $1.7 million for the three months and $10.0 million and $4.8 million for the nine months ended September 30, 1999 and 1998, respectively, representing 17%, 12%, 14% and 13% of total revenues, respectively. General and administrative expenses increased $3.1 million and $5.1 million for the three month and nine month periods ended September 31, 1999, respectively, compared to the same periods in 1998. The increase in general and administrative expenses were primarily related to additional personnel costs and other costs related to facilitating our growth.
Goodwill Amortization
During 1999, we acquired three companies for which we are using the purchase method of accounting. On February 26, 1999 we acquired Winfiles.com ("Winfiles") for a total purchase price of $11.5 million, on July 27, 1999 we acquired GDT for a total purchase price of $50.0 million and on July 29, 1999 we acquired Nordby for a total purchase price of $20.0 million. Goodwill attributable to each of the acquisitions was $11.0 million, $49.4 million, and $20.0 million for Winfiles, GDT and Nordby, respectively. We are amortizing the goodwill related to the purchase of these companies over three years.
Other Income (Expense)
Total other income (expense) was $97.5 million and $2.7 million for the three months and $122.5 million and $(676,000) for the nine months ended September 30, 1999 and 1998, respectively. Other income (expense) consists of equity losses, gain on investment sales and net interest income (expense).
Equity losses in 1998 included our interest in SNAP! LLC ("snap"). Pursuant to an agreement in June 1998 between NBC Multimedia and us, snap was formed as a limited liability company. Based on the structure of the Board of snap and considering that we have no obligation for future funding of snap, we do not control snap and accordingly do not consolidate its results. We have recorded snap's financial results using the equity method of accounting effective January 1, 1998. We had no equity losses for the three and nine months ended September 30, 1999, and equity losses were $3.1 million for the three months and $11.8 million for the nine months ended September 30, 1998. All of the equity losses in 1998 were related to snap.
Gain on investment sales were $97.8 million and $5.3 million for the three months and $122.4 million and $10.5 million for the nine months ended September 30, 1999 and 1998, respectively. The gain on investment sales of $97.8 million for the three month period ended September 30, 1999 related to the sale of a portion of our holdings of Vignette Corporation. The gain on investment sales of $122.4 million for the nine month period ended September 30, 1999 included the gain related to the sale of the Vignette shares and a gain of approximately $19.9 million related 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.com. We recorded a gain related to shares we received on the date of the merger. Our investment in beyond.com is classified as available for sale and fluctuations in the value of this investment are recorded as other comprehensive income in the stockholders' equity section of our balance sheet, net of taxes.
Income Taxes
Income taxes were $40.2 million and zero for both the three and nine month periods ended September 30, 1999 and 1998, respectively. Income tax was recorded based on an estimated effective tax rate of 40% for the year ended December 31, 1999. The estimated effective tax rate has taken into consideration the estimated gain to be realized in the fourth quarter of 1999 from the pending transaction relating to our ownership interest in snap.
Income (Loss)
We recorded net income of $29.3 million or $0.35 per diluted share and $3.9 million or $0.05 per diluted share for the three months ended September 30, 1999 and 1998, respectively. We recorded net income of $60.3 million or $0.76 per diluted share for the nine months ended September 30, 1999 compared to a net loss of $1.4 million or 0.02 per share for the comparable period in 1998. Net income increased $25.4 million for the three months and $61.7 million for the nine months ended September 30, 1999 as compared to the comparable periods in 1998, respectively.
Liquidity and Capital Resources
As of September 30, 1999, we had cash and cash equivalents of $117.4 million and investments and marketable securities of $240.9 million. Cash used by operating activities of $2.6 million for the nine months ended September 30, 1999 was primarily due to earnings of $60.3 million, depreciation, goodwill amortization and the amortization of program costs of $18.6 million, an investment for services provided of $3.4 million, a gain on investments of $122.4 million, an increase in accounts receivable and other current assets of $16.1 million and increases in accounts payable, accrued liabilities, accrued income taxes and benefits from exercises of stock options of $59.9 million. Cash provided by operating activities of $635,000 for the nine months ended September 30, 1998 was primarily attributable to net losses in the period of $1.4 million, depreciation and amortization and the amortization of programming costs of $8.7 million and an increase in accounts receivable of $8.3 million. Net cash used in investing activities of $103.1 million for the nine months ended September 30, 1999 was primarily attributable to purchases of marketable securities of $136.5 million, proceeds from the sale of marketable securities and investments of $12.3 million and $101.7 million, respectively, equity investments of $21.0 million, cash paid related to the acquisitions of Winfiles, GDT and Nordby of $39.1 million, and purchases of equipment and and programming assets of $19.9 million. Net cash used in investing activities of $7.7 million for the nine months ended September 30, 1998 were primarily attributable to purchases of equipment and programming assets. Cash flows provided by financing activities of $171.6 million in 1999 consisted primarily of the issuance of convertible debt with net proceeds of $166.9 million. Cash flows provided by financing activities in 1998 consisted primarily of proceeds from the issuance of common stock. 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 September 30, 1999 we had obligations outstanding under notes payable totaling $184.8 million. Notes payable include $173 million of 5% Convertible Subordinated Notes, due 2006. Such obligations were incurred to obtain proceeds for general corporate purchases, to finance acquisitions and increases in marketing expenditures.
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 are currently in the testing and deployment phase of our year 2000 program. As part of this phase, we are completing our testing of critical systems and will begin deploying upgrades or other fixes as determined necessary.
We anticipate that we will complete both the testing and deployment phase relating to critical systems by November 30, 1999. We have not made estimates for the costs associated with completing our year 2000 program. 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 Securities and Exchange Commission 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. Also note that we provide the following cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our businesses. These are factors that we think could cause our actual results to differ materially from expected and historical results. Other factors besides those listed here could also adversely affect us. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to the impact of interest rate changes and changes in the market values of our investments.
Interest Rate Risk Our exposure to market rate risk for changes in interest rate relates primarily to our marketable securities portfolio. We invest our excess cash in our marketable securities portfolio. We have not used derivative financial instruments in our marketable securities 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, limits the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk.
Investments 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 income from these marketable securities may fall short of expectations due to changes in interest rates or we may suffer losses in principal if force to sell securities which have declined in market value due to changes in interest rates.
Investment Risk
We invest in equity instruments of publicly and privately-held, information technology companies for business and strategic purposes. Investments in publicly owned companies are included in investments, which are part of current assets, and privately held investments are included in long term assets. These investments are accounted for under the cost method when ownership is less than 20%. For these non-quoted investments, our policy is to regularly review the assumptions underlying the operating performance and cash flow forecasts in assessing the carrying values. We identify and record impairment losses on long-lived assets when events and circumstances indicate that such assets might be impaired. In 1999, two of the privately held investments became marketable equity securities when the investees completed an initial public offering. Such investments in the Internet industry are subject to significant fluctuations in fair market value due to the volatility of the stock market, and are recorded as available-for-sale securities.