EnerNOC, Inc.
ENERNOC INC (Form: 10-Q, Received: 11/09/2010 06:07:10)

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

(Mark One)

 

x                 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2010

 

or

 

o                    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             

 

Commission File Number: 001-33471

 

EnerNOC, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware

 

87-0698303

(State or Other Jurisdiction of

 

(IRS Employer

Incorporation or Organization)

 

Identification No.)

 

 

 

101 Federal Street

 

 

Suite 1100

 

 

Boston, Massachusetts

 

02110

(Address of Principal Executive Offices)

 

(Zip Code)

 

(617) 224-9900

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x   No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  o

 

Accelerated filer  x

 

 

 

Non-accelerated filer  o

 

Smaller reporting company  o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o   No  x

 

There were 24,929,157 shares of the registrant’s common stock, $0.001 par value per share, outstanding as of November 4, 2010.

 

 

 



Table of Contents

 

EnerNOC, Inc.

 

Index to Form 10-Q

 

 

 

 

Page

 

 

 

 

Part I - Financial Information

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Balance Sheets at September 30, 2010 and December 31, 2009

 

3

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2010 and 2009

 

4

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009

 

5

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

6

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

23

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

37

 

 

 

 

Item 4.

Controls and Procedures

 

37

 

 

 

 

Part II - Other Information

 

 

 

 

 

 

Item 1.

Legal Proceedings

 

38

 

 

 

 

Item 1A.

Risk Factors

 

38

 

 

 

 

Item 6.

Exhibits

 

39

 

Signatures

 

40

 

Exhibit Index

 

41

 

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Table of Contents

 

PART I — FINANCIAL INFORMATION

 

EnerNOC, Inc.

 

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

 

(in thousands, except par value and share data)

 

 

 

September 30, 2010

 

December 31, 2009

 

Assets

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

141,321

 

$

119,739

 

Trade accounts receivable, net allowance for doubtful accounts of $114 and $57 at September 30, 2010 and December 31, 2009, respectively

 

33,857

 

17,421

 

Unbilled revenue

 

114,221

 

40,388

 

Prepaid expenses, deposits and other current assets

 

4,356

 

4,725

 

Total current assets

 

293,755

 

182,273

 

Property and equipment, net of accumulated depreciation of $32,682 and $22,420 at September 30, 2010 and December 31, 2009, respectively

 

34,643

 

31,344

 

Goodwill

 

24,653

 

22,553

 

Definite-life intangible assets, net

 

6,166

 

7,075

 

Indefinite-life intangible assets

 

920

 

 

Deposits and other assets

 

4,528

 

3,903

 

Restricted cash

 

177

 

7,874

 

Total assets

 

$

364,842

 

$

255,022

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities

 

 

 

 

 

Accounts payable

 

$

94

 

$

55

 

Accrued capacity payments

 

89,186

 

40,534

 

Accrued payroll and related expenses

 

11,731

 

9,688

 

Accrued expenses and other current liabilities

 

11,245

 

3,706

 

Accrued acquisition contingent consideration

 

1,489

 

1,455

 

Deferred revenue

 

2,363

 

2,119

 

Current portion of long-term debt

 

39

 

36

 

Total current liabilities

 

116,147

 

57,593

 

Long-term liabilities

 

 

 

 

 

Long-term debt, net of current portion

 

7

 

37

 

Deferred tax liability

 

2,330

 

654

 

Deferred revenue, long-term

 

3,109

 

1,200

 

Other liabilities

 

538

 

563

 

Total long-term liabilities

 

5,984

 

2,454

 

Commitments and contingencies (Note 8 and Note 12)

 

 

 

Stockholders’ equity

 

 

 

 

 

Undesignated preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued

 

 

 

Common stock, $0.001 par value; 50,000,000 shares authorized, 24,923,693 and 24,233,448 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively

 

25

 

24

 

Additional paid-in capital

 

289,356

 

272,350

 

Accumulated other comprehensive loss

 

(71

)

(56

)

Accumulated deficit

 

(46,599

)

(77,343

)

Total stockholders’ equity

 

242,711

 

194,975

 

Total liabilities and stockholders’ equity

 

$

364,842

 

$

255,022

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

 

EnerNOC, Inc.

 

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

 

(in thousands, except share and per share data)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Revenues

 

$

162,798

 

$

103,117

 

$

257,467

 

$

163,942

 

Cost of revenues

 

85,062

 

51,440

 

141,164

 

86,232

 

Gross profit

 

77,736

 

51,677

 

116,303

 

77,710

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling and marketing

 

12,893

 

11,602

 

34,173

 

29,481

 

General and administrative

 

13,848

 

12,155

 

40,114

 

33,252

 

Research and development

 

3,197

 

2,111

 

7,748

 

5,524

 

Total operating expenses

 

29,938

 

25,868

 

82,035

 

68,257

 

Income from operations

 

47,798

 

25,809

 

34,268

 

9,453

 

Other income (expense)

 

42

 

89

 

31

 

(6

)

Interest expense

 

(195

)

(47

)

(686

)

(1,511

)

Income before income tax

 

47,645

 

25,851

 

33,613

 

7,936

 

(Provision for) benefit from income tax

 

(3,779

)

786

 

(2,869

)

438

 

Net income

 

$

43,866

 

$

26,637

 

$

30,744

 

$

8,374

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic earnings per common share

 

$

1.76

 

$

1.21

 

$

1.25

 

$

0.40

 

Diluted earnings per common share

 

$

1.67

 

$

1.12

 

$

1.18

 

$

0.38

 

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

24,864,755

 

21,938,427

 

24,650,453

 

20,703,779

 

Diluted

 

26,215,766

 

23,689,477

 

26,013,402

 

22,154,745

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

 

EnerNOC, Inc.

 

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in thousands)

 

 

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

Cash flows from operating activities

 

 

 

 

 

Net income

 

$

30,744

 

$

8,374

 

Adjustments to reconcile net loss to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

10,684

 

8,059

 

Amortization of acquired intangible assets

 

1,109

 

514

 

Stock-based compensation expense

 

11,668

 

9,996

 

Impairment of property and equipment

 

1,308

 

 

Unrealized foreign exchange transaction loss

 

17

 

71

 

Deferred taxes

 

1,250

 

265

 

Non-cash interest expense

 

 

45

 

Loss on disposal of equipment

 

 

19

 

Other, net

 

118

 

14

 

Changes in operating assets and liabilities, net of effects of acquisitions:

 

 

 

 

 

Accounts receivable, trade

 

(16,573

)

(9,054

)

Unbilled revenue

 

(73,831

)

(53,257

)

Prepaid expenses and other current assets

 

1,040

 

(1,809

)

Other assets

 

3

 

(1,615

)

Other noncurrent liabilities

 

1,879

 

217

 

Deferred revenue

 

218

 

1,410

 

Accrued capacity payments

 

48,641

 

35,760

 

Accrued payroll and related expenses

 

2,793

 

5,655

 

Accounts payable and accrued expenses

 

7,594

 

(1,622

)

Net cash provided by operating activities

 

28,662

 

3,042

 

 

 

 

 

 

 

Cash flows from investing activities

 

 

 

 

 

Sales and maturities of marketable securities

 

 

2,000

 

Payments made for acquisitions of businesses, net of cash acquired

 

(2,001

)

(984

)

Purchases of property and equipment

 

(15,283

)

(13,236

)

Change in restricted cash and deposits

 

6,740

 

(5,946

)

Net cash used in investing activities

 

(10,544

)

(18,166

)

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

Proceeds from public offering of common stock, net of issuance costs

 

 

83,485

 

Proceeds from exercises of stock options

 

3,500

 

792

 

Repayment of borrowings and payments under capital leases

 

(27

)

(34

)

Net cash provided by financing activities

 

3,473

 

84,243

 

Effects of exchange rate changes on cash

 

(9

)

25

 

Net change in cash and cash equivalents

 

21,582

 

69,144

 

Cash and cash equivalents at beginning of period

 

119,739

 

60,782

 

Cash and cash equivalents at end of period

 

$

141,321

 

$

129,926

 

 

 

 

 

 

 

Non-cash financing and investing activities

 

 

 

 

 

Issuance of common stock in connection with acquisitions

 

$

1,066

 

$

1,235

 

Issuance of common stock in satisfaction of bonuses

 

$

775

 

$

500

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

 

EnerNOC, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(in thousands, except share and per share data, unless otherwise noted)

 

1.               Description of Business and Basis of Presentation

 

Description of Business

 

EnerNOC, Inc. (the Company) is a service company that was incorporated in Delaware on June 5, 2003. The Company operates in a single segment providing clean and intelligent energy management applications and services, which include comprehensive demand response services, data-driven energy efficiency services, energy price and risk management services and enterprise carbon management services.  The Company uses its Network Operations Center (NOC) and comprehensive demand response application, DemandSMART, to remotely manage and reduce electricity consumption across a growing network of commercial, institutional and industrial customer sites, making demand response capacity available to grid operators and utilities on demand while helping commercial, institutional and industrial end-users of electricity (C&I customers) achieve energy savings, environmental benefits and improved financial results.

 

The Company builds upon its position as a leading demand response services provider by using its NOC and energy management application platform to also deliver a portfolio of additional energy management applications to its customers.  These additional energy management applications include the Company’s SiteSMART, SupplySMART and CarbonSMART applications.  SiteSMART is the Company’s data-driven energy efficiency application that has multiple features, including monitoring-based commissioning tools, commissioning and retro-commissioning authority services, energy consulting and engineering services, distributed generation services, and owner-engineer services.  SupplySMART is the Company’s energy price and risk management application that provides the Company’s 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.  CarbonSMART is the Company’s enterprise carbon management application that supports the measurement, tracking, analysis, reporting and management of greenhouse gas emissions.

 

The Company’s energy management applications and services deliver immediate bottom-line benefits to C&I customers and energy suppliers while helping to create a more reliable and efficient electricity grid for system operators and utilities.

 

Reclassifications

 

Certain reclassifications have been made to the condensed consolidated balance sheet as of December 31, 2009 and the unaudited condensed consolidated statement of cash flows for the nine months ended September 30, 2009 to conform to the September 30, 2010 presentation. The reclassifications include certain receivables, which were previously included in trade accounts receivable, that are not trade in nature.  These certain receivables are now being classified as prepaid expenses, deposits and other current assets in the unaudited condensed consolidated balance sheets.  Additionally, the Company reclassified short term restricted cash to long term restricted cash in the unaudited condensed consolidated balance sheets as of December 31, 2009 and September 30, 2010 as this classification more appropriately describes the nature of this restricted cash.

 

The Company has identified and reclassified certain costs totaling $399 and $457 included in selling and marketing expenses in its unaudited condensed consolidated statements of income for the three months ended March 31, 2010 and June 30, 2010, respectively, as general and administrative expenses for the nine months ended September 30, 2010 to more appropriately reflect the nature of these costs.  The Company has determined that the reclassification was not material to its consolidated financial statements and, in future quarterly filings, will continue to reclassify these costs, resulting in an increase in general and administrative expenses and a corresponding decrease in selling and marketing expenses of $399 and $457 for the three months ended March 31, 2010 and June 30, 2010, respectively.

 

Basis of Consolidation

 

The unaudited condensed consolidated financial statements of the Company include the accounts of its wholly-owned subsidiaries and have been prepared in conformity with accounting principles generally accepted in the United States (GAAP). Intercompany transactions and balances are eliminated upon consolidation.  In the opinion of the Company’s management, the unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of operations for the periods presented.

 

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Subsequent Events Consideration

 

The Company considers events or transactions that occur after the balance sheet date, but prior to the issuance of the financial statements, to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required.  The Company considers all of its demand response event performance prior to the issuance of the financial statements in order to validate its estimate of fees potentially subject to refund.

 

There were no material disclosable or recognizable subsequent events recorded in the September 30, 2010 unaudited condensed consolidated financial statements.

 

Use of Estimates in Preparation of Financial Statements

 

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to SEC rules and regulations. In the opinion of the Company’s management, the unaudited condensed consolidated financial statements and notes have been prepared on the same basis as the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009, and include all adjustments (consisting of normal, recurring adjustments) necessary for the fair presentation of the Company’s financial position at September 30, 2010, statements of income for the three and nine months ended September 30, 2010 and 2009, and statements of cash flows for the nine months ended September 30, 2010 and 2009. Operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results to be expected for any other interim period or the entire fiscal year ending December 31, 2010.

 

The preparation of these unaudited condensed consolidated financial statements requires the Company 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, the Company evaluates its estimates, including those related to revenue recognition, 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 the Company’s net deferred tax assets and related valuation allowance.

 

Although the Company regularly assesses these estimates, actual results could differ materially. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience or other assumptions prove not to be substantially accurate, even if such assumptions are reasonable when made.

 

The Company is subject to a number of risks similar to those of other companies of similar and different sizes both inside and outside its industry, including, but not limited to, rapid technological changes, competition from substitute products and services from larger companies, customer concentration, government regulations, market or program rule changes, protection of proprietary rights and dependence on key individuals.

 

Comprehensive Income

 

Comprehensive income is defined as the change in equity of a business enterprise during a period resulting from transactions and other events and circumstances from non-owner sources. Comprehensive income is composed of net income and foreign currency translation adjustments.

 

Comprehensive income for the three and nine months ended September 30, 2010 and 2009 was as follows:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Net income

 

$

43,866

 

$

26,637

 

$

30,744

 

$

8,374

 

Foreign currency translation adjustments

 

(47

)

(55

)

(15

)

96

 

Total comprehensive income

 

$

43,819

 

$

26,582

 

$

30,729

 

$

8,470

 

 

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Internal Use Software Costs

 

The Company applies the provisions of Accounting Standard Codification (ASC) 350-40,  Internal Use Software (ASC 350-40) . ASC 350-40 requires computer software costs associated with internal use software to be expensed as incurred until certain capitalization criteria are met, and also defines which types of costs should be capitalized and which should be expensed. The Company capitalizes the cost of external consultants and payroll and payroll-related costs of employees who devote time to the development and implementation of internal use computer software. The Company amortizes these costs on a straight-line basis over the estimated useful life of the software, which is generally three years. The Company’s judgment is required in determining the point at which various projects enter the stages where 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.

 

Capitalized internal use software costs were $1,045 and $1,027 for the three months ended September 30, 2010 and 2009, respectively, and $5,063 and $2,922 for the nine months ended September 30, 2010 and 2009, respectively.  The Company capitalized $248 and $1,216 during the three and nine months ended September 30, 2010, respectively, and $387 and $953 during the three and nine months ended September 30, 2009, respectively, related to a company-wide enterprise resource planning systems implementation project.  Additionally, the increase in capitalized software for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009 related to the purchase of certain licenses to support the Company’s energy management applications.  These costs have been capitalized in accordance with ASC 350-40. The capitalized amounts are included as software in property and equipment at September 30, 2010 and December 31, 2009.  Amortization of capitalized internal use software costs was $749 and $599 for the three months ended September 30, 2010 and 2009, respectively, and $2,123 and $1,647 for the nine months ended September 30, 2010 and 2009, respectively.  Accumulated amortization of capitalized internal use software costs was $6,310 and $4,187 as of September 30, 2010 and December 31, 2009, respectively.

 

Impairment of Property and Equipment

 

The Company reviews property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. If these assets are considered to be impaired, the 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 discounted cash flow 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 three months ended September 30, 2010, the Company identified an impairment indicator related to certain demand response equipment as a result of lower than estimated demand response event performance in certain demand response programs and the removal of demand response equipment from service during the three months ended September 30, 2010.  As a result of this impairment indicator, the Company performed an impairment test during the three months ended September 30, 2010 and recognized an impairment charge of $552 during the three months ended September 30, 2010, representing the difference between the carrying value and fair market value of demand response equipment, which is included in cost of revenues in the accompanying unaudited condensed consolidated statements of income. The fair market value was determined utilizing Level 3 inputs, as defined by ASC 820, Fair Value Measurements and Disclosures (ASC 820), based on the projected future cash flows discounted using the estimated market participant rate of return for this type of asset.

 

During the three months ended June 30, 2010, the Company identified an impairment indicator related to certain demand response and back-up generator equipment as a result of lower than estimated demand response event performance by these assets.  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.  The Company 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. The Company 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 the Company determined to represent a market rate of return for the assets being evaluated for impairment.  The Company determined that the fair value of the asset group was $1,543 compared to the carrying value of the asset group of $2,299, and as a result recorded an impairment charge of $756 during the three months ended June 30, 2010, which is reflected in cost of revenues in the accompanying unaudited condensed consolidated statements of income.  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.

 

The recoverability of this demand response and back-up generator equipments’ carrying value is largely dependent on the rates that the Company is compensated for its committed capacity within the programs under which this equipment is being used. These rates represent market rates and can fluctuate based on the supply and demand of capacity. Although these market rates are established up to three years in advance of the service delivery, these market rates have not yet been established for the entire remaining useful life of the demand response equipment. In performing its impairment analysis, the Company estimates the expected

 

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future market rates based on current existing market rates and trends. A decline in the expected future market rates of greater than 10% could result in an additional impairment charge related to this demand response equipment.

 

Industry Segment Information

 

The Company is required to disclose reporting information about operating segments in annual financial statements and required selected information of these segments in interim financial statements. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in making decisions on how to allocate resources and assess performance. The Company’s decision making group is considered to be the team comprised of the chief executive officer and the executive management team. The Company views its operations and manages its business as one operating segment.

 

For the three and nine months ended September 30, 2010 and 2009, operations related to the Company’s international subsidiaries were not material to the accompanying unaudited condensed consolidated financial statements taken as a whole. In addition, as of September 30, 2010 and December 31, 2009, the long-lived assets related to the Company’s international subsidiaries were not material to the accompanying unaudited condensed consolidated financial statements taken as a whole.

 

2.               Acquisitions

 

SmallFoot LLC and ZOX, LLC

 

In March 2010, the Company acquired substantially all of the assets and certain liabilities of SmallFoot LLC (Smallfoot) and ZOX, LLC (Zox), which were companies unaffiliated with the Company but were entities under common control.  Smallfoot was in the process of developing wireless systems that manage and coordinate electricity demand for small commercial facilities and Zox was in the process of developing hardware and software for automated utility meter reading. The total purchase price paid by the Company at closing was approximately $1,360, of which $1,100 was paid in cash and the remainder of which was paid by the issuance of 8,758 shares of the Company’s common stock that had a fair value of approximately $260. These shares were measured as of the acquisition date using the closing price of the Company’s common stock, as reported on The NASDAQ Global Market (NASDAQ) on March 15, 2010.  The Company believes that Smallfoot’s technology will reduce deployment costs and accelerate deeper market penetration into C&I customers, specifically smaller C&I customers.  The Company believes Zox’s smart grid communications and metering technology provides a platform for transforming electric industry legacy meters into smart meters at a substantially lower cost as compared to traditional replacement methods.

 

Although Smallfoot and Zox were development stage entities as of the acquisition close date, these entities met the definition of a business as defined under ASC 805, Business Combinations (ASC 805) , as these entities had inputs and processes that have the ability to provide a return to its owners.  As a result, this acquisition was treated as a business combination in accordance with ASC 805.

 

Transaction costs related to this business combination were not material and have been expensed as incurred.  The transaction costs are included in general and administrative expenses in the accompanying unaudited condensed consolidated statements of income.

 

The allocation of the purchase price is based upon preliminary estimates of the fair value of assets acquired and liabilities assumed as of March 15, 2010. The Company is in the process of gathering information to finalize its valuation of certain assets and liabilities. The purchase price allocation is preliminary and will be finalized once the Company has all necessary information to complete its estimate, but generally no later than one year from the date of acquisition. There were no net tangible assets acquired in connection with this acquisition. The components and initial allocation of the purchase price consists of the following approximate amounts:

 

In-process research and development

 

$

920

 

Patents

 

200

 

Goodwill

 

240

 

Total

 

$

1,360

 

 

As part of the preliminary purchase price allocation, the Company determined that the identifiable intangible assets include two in-process research and development projects and certain acquired patents.

 

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The Company used the cost approach to value the two acquired in-process research and development projects that related to the development of wireless systems that manage and coordinate electricity demand for small commercial facilities and the development of hardware and software for automated utility meter reading, but had not yet reached technological feasibility and had no alternate future uses as of the acquisition date.  The primary basis for determining the technological feasibility of these projects is the completion of a working model that performs all the major functions planned for the product and is ready for initial customer testing, usually identified as beta testing. ASC 805 requires that purchased research and development acquired in a business combination be recognized as an indefinite-lived intangible asset until the completion or abandonment of the associated research and development efforts. The cost approach calculates fair value by calculating the reproduction cost of an exact replica of the subject intangible asset.  The Company calculated the replacement cost based on actual development costs incurred through the date of acquisition.  In determining the appropriate valuation methodology, the Company considered, 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. Given the stage of development as of the acquisition date and the current lack of sufficient information regarding future expected cash flows, the Company determined that the cost approach was the most reliable valuation methodology to determine the fair value of the in-process research and development projects acquired. The Company believes 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. However, if the projects are not successful or completed in a timely manner, the Company may not realize the financial benefits expected for these projects or for the acquisition as a whole.

 

The estimated cost to complete the in-process research and development projects in the aggregate as of September 30, 2010 was approximately $840.

 

The Company used the income approach to value the acquired patents.  The discount rate in connection with this valuation was 25% and was based on the commercial and technical risks related to this asset and on estimated market participant discount rates for a similar asset.

 

The factors contributing to the recognition of goodwill were based upon several strategic and synergistic benefits that were expected to be realized from the combination.

 

Cogent Energy, Inc.

 

In December 2009, the Company acquired all of the outstanding capital stock of Cogent Energy, Inc. (Cogent), a company specializing in comprehensive energy consulting, engineering and building commissioning solutions to C&I customers. The total purchase price paid by the Company at closing was approximately $11,172, of which $6,555 was paid in cash and the remainder of which was paid by the issuance of 114,281 shares of the Company’s common stock that had a fair value of approximately $3,162.  These shares were measured as of the acquisition date using the closing price of the Company’s common stock, as reported on NASDAQ on December 4, 2009.  As a result of gathering information to update the Company’s valuation of certain acquired assets and liabilities, the purchase price was reduced by $94 during the three months ended March 31, 2010.  This reduction in purchase price was settled in April 2010 through the release back to the Company of 3,592 shares of the Company’s common stock that were previously held in escrow in connection with the Cogent acquisition.  Upon release, the Company’s board of directors approved the retirement of these shares.  Therefore, the transaction was accounted for as a treasury stock transaction and related retirement of shares during the three months ended June 30, 2010.

 

In addition to the amounts paid at closing, the Company may be obligated to pay an earn-out amount of $1,500 to the former stockholders of Cogent. The earn-out payment will be based on the achievement of a certain minimum revenue-based milestone and a certain earnings-based milestone of Cogent for the year ending December 31, 2010 and will be paid in cash. Both of these milestones need to be achieved in order for the earn-out payment to occur, and there will be no partial payment if the milestones are not fully achieved. The Company believes that it is remote that the earn-out payment will not be made. The fair value of the earn-out payment of $1,455 was recorded as additional purchase price as of the acquisition date. As the Company believes that it is remote that the earn-out payment will not be made, the Company determined the fair value of the earn-out payment based on the present value of the $1,500, which will be paid in December 2010. The increase in fair value of the contingent consideration from December 31, 2009 to September 30, 2010 was not material.

 

The components and allocation of the purchase price consist of the following approximate amounts:

 

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Net tangible assets acquired as of December 4, 2009

 

$

1,331

 

Customer relationships

 

1,400

 

Non-compete agreements

 

590

 

Trade name

 

200

 

Goodwill

 

7,557

 

Total

 

$

11,078

 

 

Net tangible assets acquired in the acquisition of Cogent primarily related to the following:

 

Cash

 

$

336

 

Accounts receivable

 

1,777

 

Prepaids and other assets

 

77

 

Accounts payable

 

(331

)

Accrued expenses

 

(528

)

Total

 

$

1,331

 

 

eQuilibrium Solutions Corporation

 

In June 2009, the Company acquired substantially all of the assets of eQuilibrium Solutions Corporation (eQ), a software company specializing in the development of enterprise sustainability management products and services. The total purchase price paid by the Company at closing was approximately $751, of which $250 was paid in cash and the remainder of which was paid by the issuance of 21,464 shares of the Company’s common stock that had a value of approximately $501. These shares were measured as of the acquisition date using the closing price of the Company’s common stock, as reported on NASDAQ on June 11, 2009.

 

Transaction costs related to this business combination were not material and were expensed as incurred.  The transaction costs are included in general and administrative expenses. The Company’s consolidated financial statements reflect eQ’s results of operations from June 11, 2009 forward.

 

South River Consulting, LLC

 

In May 2008, the Company acquired 100% of the membership interests of South River Consulting, LLC (SRC), an energy procurement and risk management services provider, for a purchase price equal to $5,524, which consisted of $3,603 in cash, $174 in related expenses and the issuance of 120,000 shares of the Company’s common stock that had a value of approximately $1,747 as of the closing date. In addition to the amounts paid at closing, the Company incurred a contingent obligation to pay to the former holders of SRC membership interests an earn-out amount equal to 50% to 60% of the revenues of SRC’s business during each twelve-month period from May 1, 2008 through April 30, 2010, which would be recognized as additional purchase price when earned. The earn-out payments were based on the achievement of certain minimum revenue-based milestones of SRC, paid in a combination of cash and shares of the Company’s common stock and recorded as additional purchase price. The additional purchase price recorded in the three months ended June 30, 2009, which was related to the May 1, 2008 to April 30, 2009 earn-out period, totaled $1,468, of which $734 was paid in cash during the three months ended June 30, 2009 and the remainder of which was paid by the issuance of 44,776 shares of the Company’s common stock during the three months ended September 30, 2009.  The additional purchase price recorded in the six months ended June 30, 2010, which was related to the May 1, 2009 to April 30, 2010 earn-out period, totaled $1,840, of which $901 was paid in cash during the three months ended June 30, 2010, $39 was settled through a reduction of a receivable due to the Company from the former holders of SRC membership interests and the remainder of which was paid by the issuance of 30,879 shares of the Company’s common stock with a fair value of $900.

 

Pro forma information relating to the above acquisitions has not been provided since the impact to the consolidated financial statements was not material.

 

3.  Impairment of Intangible Assets and Goodwill

 

Intangible Assets

 

The Company amortizes its 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. The Company

 

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reviews its 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, the Company will write-down the carrying value of the intangible asset to its fair value in the period identified. In assessing recoverability, the Company must make assumptions regarding estimated future cash flows and discount rates. If these estimates or related assumptions change in the future, the Company may be required to record impairment charges. The Company generally calculates 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, the Company will amortize the remaining carrying value of the intangible asset prospectively over the revised remaining useful life. There were no indicators of impairment identified during the three and nine months ended September 30, 2010 and 2009 that required an interim impairment test.

 

The following table provides the gross carrying amount and related accumulated amortization of the Company’s definite-life intangible assets as of September 30, 2010 and December 31, 2009:

 

 

 

Weighted Average

 

As of September 30, 2010

 

As of December 31, 2009

 

 

 

Amortization Period
(in years)

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Customer contracts

 

6.53

 

$

4,217

 

$

(1,490

)

$

4,217

 

$

(1,180

)

Employment agreements and non-compete agreements

 

2.60

 

772

 

(267

)

772

 

(118

)

Software

 

1.73

 

120

 

(53

)

120

 

(23

)

Customer relationships

 

6.33

 

3,510

 

(844

)

3,510

 

(333

)

Trade name

 

0.10

 

115

 

(104

)

115

 

(5

)

Patents

 

9.45

 

200

 

(10

)

 

 

Total

 

 

 

$

8,934

 

$

(2,768

)

$

8,734

 

$

(1,659

)

 

The increase in patents from December 31, 2009 to September 30, 2010 was due to the allocation of purchase price related to the Smallfoot and Zox acquisition in the three months ended March 31, 2010.  Amortization expense related to intangible assets amounted to $353 and $1,109, respectively, for the three and nine months ended September 30, 2010 and $182 and $514, respectively, for the three and nine months ended September 30, 2009. These costs are included in general and administrative expenses in the accompanying unaudited condensed consolidated statements of income. The definite-life intangible asset lives range from one to ten years and the weighted average remaining life was 6.03 years at September 30, 2010.

 

In addition to the definite-life intangible assets described above, the Company also has two indefinite-life intangible assets related to in-process research and development projects acquired in connection with the Smallfoot and Zox acquisition (refer to Note 2 for further discussion).  The indefinite-life in-process research and development intangible assets totaled $920 as of September 30, 2010.  There were no indefinite-life intangible assets as of December 31, 2009.

 

Goodwill

 

In accordance with ASC 350,  Intangibles—Goodwill and Other (ASC 350), the Company tests 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.  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. The Company’s annual impairment test date is November 30.

 

In performing the test, the Company utilizes the two-step approach prescribed under ASC 350. The first step requires a comparison of the carrying value of the reporting units, as defined, to the fair value of these units. The Company considers 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. The Company bases the discount rate used to arrive at a present value as the date of the impairment test on its weighted average cost of capital. If the carrying value of its reporting unit exceeds its fair value, the Company 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

 

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compares the implied fair value of a reporting unit’s goodwill to its carrying value. To date, the Company has not been required to perform the second step of the impairment test.

 

The fair value of the entity is determined by use of a market approach based on the quoted market price of its common stock, the number of shares outstanding and a discounted cash flow analysis (DCF) under the income approach. The key assumptions that drive the fair value in the DCF model are the discount rates, i.e., weighted average cost of capital (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, it could result in a reduction of the fair value of the entity. The Company believes that it is not at risk of failing the first step of the goodwill impairment test.

 

The estimate of fair value requires significant judgment. Any loss resulting from an impairment test would be reflected in operating loss in the Company’s consolidated statements of income. 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, the Company may be required to record impairment charges for these assets not previously recorded.

 

The following table shows the change in the carrying amount of goodwill from December 31, 2009 to September 30, 2010:

 

Balance at December 31, 2009

 

$

22,553

 

Acquisition of Smallfoot and Zox

 

240

 

Purchase price adjustments related to Cogent

 

20

 

SRC earn-out

 

1,840

 

Balance at September 30, 2010

 

$

24,653

 

 

4. Net Income Per Share

 

A reconciliation of basic and diluted share amounts for the three and nine months ended September 30, 2010 and 2009 are as follows (shares in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income

 

$

43,866

 

$

26,637

 

$

30,744

 

$

8,374

 

Denominator:

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

24,865

 

21,938

 

24,650

 

20,704

 

Weighted average common stock equivalents

 

1,351

 

1,751

 

1,363

 

1,451

 

Diluted weighted average common shares outstanding

 

26,216

 

23,689

 

26,013

 

22,155

 

 

 

 

 

 

 

 

 

 

 

Basic net income per common share

 

$

1.76

 

$

1.21

 

$

1.25

 

$

0.40

 

Diluted net income per common share

 

$

1.67

 

$

1.12

 

$

1.18

 

$

0.38

 

Weighted average anti-dilutive shares related to:

 

 

 

 

 

 

 

 

 

Stock options

 

945

 

861

 

954

 

1,253

 

Nonvested restricted shares

 

151

 

184

 

170

 

210

 

Restricted stock units

 

391

 

120

 

333

 

103

 

 

In the reporting period in which the Company has reported net income, anti-dilutive shares comprise those common stock equivalents that have either an exercise price above the average stock price for the quarter or the common stock equivalent’s related average unrecognized stock compensation expense is sufficient to “buy back” the entire amount of shares.  In those reporting periods in which the Company has a net loss, anti-dilutive shares comprise the impact of those number of shares that would have been dilutive

 

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had the Company had net income plus the number of common stock equivalents that would be anti-dilutive had the Company had net income.

 

The Company excludes the shares issued in connection with restricted stock awards from the calculation of basic weighted average common shares outstanding until such time as those shares vest.  In addition, in connection with certain of the Company’s business combinations, the Company has issued shares that were held in escrow upon closing of the applicable business combination. The Company excludes shares held in escrow from the calculation of basic weighted average common shares outstanding where the release of such shares is contingent upon an event and not solely subject to the passage of time.

 

5. Disclosure of Fair Value of Financial Instruments

 

The Company’s financial instruments mainly consist of cash and cash equivalents, restricted cash, accounts receivable, and accounts payable and debt obligations. The carrying amounts of the Company’s cash equivalents, restricted cash, accounts receivable and accounts payable approximate their fair value due to the short-term nature of these instruments. At September 30, 2010 and December 31, 2009, there were no amounts outstanding under the loan and security agreement (the Credit Facility) entered into between the Company, one of its subsidiaries and Silicon Valley Bank (SVB).

 

6. Fair Value Measurements

 

ASC 820 establishes a fair value hierarchy that requires the use of observable market data, when available, and prioritizes the inputs to valuation techniques used to measure fair value in the following categories:

 

·                   Level 1—Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange.

 

·                   Level 2—Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market.

 

·                   Level 3—Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s own estimates of assumptions market participants would use in pricing the asset or liability.

 

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis at September 30, 2010:

 

 

 

Fair Value Measurement at September 30, 2010 Using

 

 

 

Totals

 

Quoted Prices in
Active Markets
for Identical
Assets (Level 1)

 

Significant
Other
Observable
Inputs (Level 2)

 

Unobservable
Inputs (Level 3)

 

Money market funds (1)

 

$

108,225

 

$

108,225

 

$

 

$

 

Certificates of deposit

 

177

 

177

 

 

 

 

 

 

 

$

108,402

 

$

108,402

 

$

 

$

 

 


(1)                                   Included in cash and cash equivalents in the accompanying unaudited condensed consolidated balance sheets.

 

At September 30, 2010, the Company had restricted cash of approximately $177 invested in certificates of deposit. All certificates of deposit have contractual maturities of twelve months or less. The Company’s investments in certificates of deposit have a fair value that approximates cost based on current market rates for similar instruments.

 

With respect to assets measured at fair value on a non-recurring basis, which would be impaired long-lived assets, as a result of an indicator of impairment related to certain demand response equipment, the Company was required to perform an impairment test during the three months ended September 30, 2010 and measure the fair value of these assets.  Refer to Note 1 for a discussion of the

 

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measurement of fair value of these assets.  There were no indicators of impairment related to any of the Company’s other long-lived assets during the three and nine months ended September 30, 2010 requiring a fair value measurement of these assets.  Accordingly, these other long-lived assets were not measured at fair value.  With respect to liabilities measured at fair value on a non-recurring basis, which would be contingent consideration liability, refer to Note 2 for a discussion of the determination of fair value of this liability.

 

7. Financing Arrangements

 

Pursuant to the terms of the Credit Facility, SVB will, among other things, make revolving credit and term loan advances and issue letters of credit for the Company’s account. The interest on loans under the Company’s revolving credit loan accrues at interest rates based upon either SVB’s prime rate or the 30, 60 or 90-day LIBOR plus 2.25%, at the Company’s election. The interest on term loans accrues at SVB’s prime rate plus 0.50% or the 30, 60 or 90-day LIBOR plus 2.75%, at the Company’s election. The term advance is payable in thirty-six consecutive equal monthly installments of principal, calculated by SVB, based upon the amount of the term advance and an amortization schedule equal to thirty-six months. All unpaid principal and accrued interest is due and payable in full on February 4, 2011, which is the maturity date. In connection with the issuance or renewal of letters of credit for the Company’s account, the Company is charged a letter of credit fee of 1.25%. The Company expenses the interest and letter of credit fees, as applicable, in the period incurred.

 

The Company’s obligations under the Credit Facility are secured by all of the assets of the Company and its subsidiaries, excluding any intellectual property. The Credit Facility contains customary terms and conditions for credit facilities of this type, including restrictions on the Company’s ability to incur additional indebtedness, create liens, enter into transactions with affiliates, transfer assets, pay dividends or make distributions on, or repurchase, the Company’s stock, consolidate or merge with other entities, or suffer a change in control. In addition, the Company is required to meet certain financial covenants customary with this type of credit facility, including maintaining a minimum specified tangible net worth and a minimum specified ratio of current assets to current liabilities. The Credit Facility contains customary events of default, including 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, the Company’s obligations under the Credit Facility may be accelerated. The Company was in compliance with all financial covenants under the Credit Facility at September 30, 2010 and December 31, 2009.

 

In October 2009, the Company repaid the outstanding borrowings of $4,442 under the Credit Facility. The Company incurred financing costs of $120 in connection with the Credit Facility, which were deferred and are being amortized to interest expense over the life of the Credit Facility, which matures on February 4, 2011. At September 30, 2010, the Company had no borrowings and letters of credit totaling $35,586 outstanding under the Credit Facility.

 

In April 2010, the Company and one of its subsidiaries entered into a second loan modification agreement to the Credit Facility, which increased the Company’s borrowing limit from $35,000 to $50,000, as well as modified certain of the Company’s financial covenant compliance requirements.  In July 2010, the Company and one of its subsidiaries entered into a third loan modification agreement to the Credit Facility, which extended the revolving credit line maturity date of the Credit Facility from August 5, 2010 to February 4, 2011, as well as modified certain of the Company’s financial covenant compliance requirements.  Upon termination of the Credit Facility, if the Company still has letters of credit issued and outstanding under the Credit Facility, the Company would be required to post 105% of the value of the letters of credit in cash with SVB to collateralize those letters of credit.

 

8. Commitments and Contingencies

 

The Company is contingently liable under outstanding letters of credit. Restricted cash balances in the amount of $177 and $7,874 collateralize certain outstanding letters of credit and cover financial assurance requirements in certain of the programs in which the Company participated at September 30, 2010 and December 31, 2009, respectively.  Based on the Company’s demand response event performance in July 2010 under a certain open market demand response program in which the Company participates, approximately $7,697 of restricted cash that collateralized the Company’s performance obligations became unrestricted in July 2010.

 

The Company is subject to performance guarantee requirements under certain utility and grid operator customer contracts and open market bidding program participation rules. The Company had deposits held by certain utility and grid operator customers of $4,026 and $3,024, respectively, at September 30, 2010 and December 31, 2009. These amounts primarily represent up-front payments required by utility and grid operator customers as a condition of participation in certain demand response programs and to ensure that the Company will deliver its committed capacity amounts in those programs. If the Company fails to meet its minimum committed capacity requirements, a portion or all of the deposit may be forfeited. The Company assessed the probability of default under these customer contracts and open market bidding programs and has determined the likelihood of default and loss of deposits to be remote.  In addition, under certain utility and grid operator customer contracts, if the Company does not achieve the required performance guarantee requirements, the customer can terminate the arrangement and the Company would potentially be subject to

 

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termination penalties.  Under these arrangements, the Company defers all fees received up to the amount of the potential termination penalty until the Company has concluded that it can reliably determine that the potential termination penalty will not be incurred or the termination penalty lapses.   As of September 30, 2010, the Company has deferred fees totaling approximately $3,109, which are included in deferred revenue, long-term in the accompanying unaudited condensed consolidated balance sheets.  As of September 30, 2010, the maximum termination penalty that the Company is subject to under these arrangements, which the Company has not deemed probable of incurring, is approximately $4,800.

 

In connection with the Company’s participation in an open market bidding program, the Company entered into an arrangement with a third party during the three months ended June 30, 2009 to bid capacity into the program and provide the corresponding financial assurance required in connection with the bid. The arrangement included an up-front payment by the Company equal to $2,000, of which $1,100 was expensed as interest expense during the three months ended June 30, 2009 and $900 was deferred and will be recognized ratably as a charge to cost of revenues as revenue is recognized over the 2012/2013 delivery year. In addition, the Company will be required to pay the third party an additional contingent fee, up to a maximum of $3,000, based on the revenue that the Company expects to earn in 2012 in connection with the bid. This additional fee will be recognized as a reduction of revenue as earned.

 

The Company includes indemnification provisions in certain of its contracts. These indemnification provisions include provisions indemnifying the customer against losses, expenses, and liabilities from damages that could be awarded against the customer in the event that the Company’s services and related enterprise software platforms are found to infringe upon a patent or copyright of a third party. The Company believes that its internal business practices and policies and the ownership of information limits the Company’s risk in paying out any claims under these indemnification provisions.

 

9. Stock-Based Compensation

 

The Company’s Amended and Restated 2003 Stock Option and Incentive Plan (2003 Plan) and the Amended and Restated 2007 Employee, Director and Consultant Stock Plan (the 2007 Plan, and collectively with the 2003 Plan, the Plans) provide for the grant of incentive stock options, nonqualified stock options, restricted and unrestricted stock awards and other stock-based awards to eligible employees, directors and consultants of the Company. Options granted under the Plans are exercisable for a period determined by the Company, but in no event longer than ten years from the date of the grant. Option awards are generally granted with an exercise price equal to the market price of the Company’s common stock on the date of grant.  Options, restricted stock awards and restricted stock unit awards generally vest ratably over four years, with certain exceptions. The 2003 Plan expired upon the Company’s initial public offering (IPO) in May 2007. Any forfeitures under the 2003 Plan that occurred after the effective date of the IPO are available for future grant under the 2007 Plan up to a maximum of 1,000,000 shares. During the nine months ended September 30, 2010 and 2009, the Company issued 24,681 shares of its common stock and 45,085 shares of its common stock, respectively, to certain executives to satisfy a portion of the Company’s compensation obligations to those individuals. As of September 30, 2010, 2,109,926 shares were available for future grant under the 2007 Plan.

 

For stock options granted prior to January 1, 2009, the fair value of each option was estimated at the date of grant using a Black-Scholes option-pricing model. For stock options granted on or after January 1, 2009, the fair value of each option has been and will be estimated on the date of grant using a lattice valuation model. The lattice model considers characteristics of fair value option pricing that are not available under the Black-Scholes model. Similar to the Black-Scholes model, the lattice model takes into account variables such as expected volatility, dividend yield rate, and risk free interest rate. However, in addition, the lattice model considers the probability that the option will be exercised prior to the end of its contractual life and the probability of termination or retirement of the option holder in computing the value of the option. For these reasons, the Company believes that the lattice model provides a fair value that is more representative of actual experience and future expected experience than that value calculated using the Black-Scholes model.

 

The fair value of options granted was estimated at the date of grant using the following weighted average assumptions:

 

 

 

Nine Months Ended September 30,

 

 

 

2010

 

2009

 

Risk-free interest rate

 

3.5

%

3.2

%

Vesting term, in years

 

2.16

 

2.16

 

Expected annual volatility

 

85

%

86

%

Expected dividend yield

 

%

%

Exit rate pre-vesting

 

5.98

%

4.88

%

Exit rate post-vesting

 

11.29

%

10.89

%

 

Volatility measures the amount that a stock price has fluctuated or is expected to fluctuate during a period.  As there was no public market for the Company’s common stock prior to the effective date of the IPO, the Company determined the volatility based on

 

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an analysis of reported data for a peer group of companies that issued options with substantially similar terms.  The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies, as well as the historical volatility of the Company’s common stock beginning January 1, 2008.  During the three months ended September 30, 2010, the Company determined that it had sufficient history to utilize Company-specific volatility in accordance with ASC 718, Stock Compensation (ASC 718) and is now calculating volatility using a component of implied volatility and historical volatility to determine the value of share-based payments.  The risk-free interest rate is the rate available as of the option date on zero-coupon United States government issues with a term equal to the expected life of the option. The Company has not paid dividends on its common stock in the past and does not plan to pay any dividends in the foreseeable future. In addition, the terms of the Credit Facility preclude the Company from paying dividends.  During the nine months ended September 30, 2010, the Company updated its estimated exit rate pre-vesting and post-vesting applied to options, restricted stock and restricted stock units based on an evaluation of demographics of its employee groups and historical forfeitures for these groups in order to determine its option valuations as well as its stock-based compensation expense.  The changes in estimate of the volatility, exit rate pre-vesting and exit rate post-vesting did not have a material impact on the Company’s stock-based compensation expense recorded in the accompanying unaudited condensed consolidated statements of income for the three or nine months ended September 30, 2010, and the impact is not expected to be material for the fiscal year ending December 31, 2010.

 

The Company accounts for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of such services received or of the equity instruments issued, whichever is more reliably measured.

 

The components of stock-based compensation expense are disclosed below:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Stock option expense

 

$

2,433

 

$

2,669

 

$

7,109

 

$

7,477

 

Restricted stock and restricted stock units

 

1,231

 

1,253

 

4,559

 

2,519

 

Total

 

$

3,664

 

$

3,922

 

$

11,668

 

$

9,996

 

 

Stock-based compensation is recorded in the accompanying unaudited condensed consolidated statements of income, as follows:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Selling and marketing expenses

 

$

1,222

 

$

1,181

 

$

3,403

 

$

3,001

 

General and administrative expenses

 

2,218

 

2,567

 

7,676

 

6,494

 

Research and development expenses

 

224

 

174

 

589

 

501

 

Total

 

$

3,664

 

$

3,922

 

$

11,668

 

$

9,996

 

 

The Company recognized no income tax benefit from stock-based compensation arrangements during the three and nine months ended September 30, 2010 and 2009. In addition, no material compensation cost was capitalized during the three and nine months ended September 30, 2010 and 2009.

 

The following is a summary of the Company’s stock option activity for all stock option plans during the nine months ended September 30, 2010:

 

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Nine Months Ended September 30, 2010

 

 

 

Number of
Shares
Underlying
Options

 

Exercise Price
Per Share

 

Weighted-
Average
Exercise Price
Per Share

 

Aggregate
Intrinsic
Value(1)

 

Outstanding at beginning of period

 

2,503,975

 

$0.17 - $48.06

 

$

10.84

 

$

49,599

 

Granted

 

290,568

 

 

 

29.82

 

 

 

Exercised

 

(517,840

)

 

 

6.73

 

$

12,392

 

Cancelled

 

(103,940

)

 

 

16.36

 

 

 

Outstanding at end of period

 

2,172,763

 

$0.17 - $48.06

 

14.10

 

$

38,104

 

Weighted average remaining contractual life in years: 6.3

 

 

 

 

 

 

 

 

 

Exercisable at end of period

 

1,234,640

 

$0.17 - $48.06

 

$

9.40

 

$

27,463

 

Weighted average remaining contractual life in years: 5.9

 

 

 

 

 

 

 

 

 

Vested or expected to vest at September 30, 2010 (2)

 

2,117,566

 

$0.17 - $48.06

 

$

13.80

 

$

37,763

 

 


(1)                                   The aggregate intrinsic value was calculated based on the positive difference between the estimated fair value of the Company’s common stock on September 30, 2010 of $31.37 and the exercise price of the underlying options.

 

(2)                                   This represents the number of vested options as of September 30, 2010 plus the number of unvested options expected to vest subsequent to September 30, 2010 based on the unvested options outstanding at September 30, 2010, adjusted for the weighted average estimated forfeiture rate of 5.98%.

 

In December 2008, the Company’s board of directors approved a one-time offer to the Company’s employees, including its executive officers, and directors to exchange option grants that had an exercise price per share that was equal to or greater than the higher of $12.00 or the closing price of the Company’s common stock as reported on NASDAQ on January 21, 2009 (the Exchange). The Exchange closed on January 21, 2009, and the Company exchanged options that had exercise prices equal to or greater than $12.00 per share. As a result, an aggregate of 744,401 options, with exercise prices ranging from $12.27 to $48.54 per share, were exchanged for 424,722 options with an exercise price per share of $8.63 for employees who were not also executive officers of the Company, 142,179 options with an exercise price per share of $11.47 for executive officers who were not also directors of the Company and 45,653 options with an exercise price per share of $12.94 for the Company’s directors. On the date of the Exchange, the estimated fair value of the new options did not exceed the fair value of the exchanged stock options calculated immediately prior to the Exchange. As such, there was no incremental fair value of the new options, and the Company will not record additional compensation expense related to the Exchange. The Company will continue to recognize the remaining compensation expense related to the exchanged options over the remaining vesting period of the original options.

 

Additional Information About Stock Options

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Total number of options granted during the period

 

39,293

 

178,100

 

290,568

 

1,093,454

 

Weighted average fair value per share of options granted

 

$

20.98

 

$

17.76

 

$

18.98

 

$

18.12

 

Total intrinsic value of options exercised (1)

 

$

2,431

 

$

3,240

 

$

12,392

 

$

5,855

 

 


(1)           Represents the difference between the market price at exercise and the price paid to exercise the options.

 

Of the stock options outstanding as of September 30, 2010, 2,158,277 options were held by employees and directors of the Company and 14,486 options were held by non-employees.  For outstanding unvested options related to employees as of September 30, 2010, the

 

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Company had $13,022 of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average period of 2.3 years. There were no material unvested non-employee options as of September 30, 2010.

 

Restricted Stock and Restricted Stock Units

 

For non-vested restricted stock and restricted stock units outstanding as of September 30, 2010, the Company had $11,587 of unrecognized stock-based compensation expense, which is expected to be recognized over a weighted average period of 3.0 years.

 

Restricted Stock

 

The following table summarizes the Company’s restricted stock activity during the nine months ended September 30, 2010:

 

 

 

Number of
Shares

 

Weighted Grant
Date Fair Value
Per Share

 

Nonvested at December 31, 2009

 

188,618

 

$

23.42

 

Granted

 

86,375

 

29.67

 

Vested

 

(130,809

)

22.48

 

Cancelled

 

(18,779

)

27.75

 

Nonvested at September 30, 2010

 

125,405

 

$

28.05

 

 

All shares underlying awards of restricted stock are restricted in that they are not transferable until they vest. Restricted stock typically vests ratably over a four-year period from the date of issuance, with certain exceptions. Included in the above table are 1,750 shares of restricted stock granted to certain non-executive employees during the nine months ended September 30, 2010 that were immediately vested.  The fair value of the restricted stock is expensed ratably over the vesting period. The shares of restricted stock have been issued at no cost to the recipients, except for 152,460 shares of restricted stock granted in 2006 that were purchased for $0.51 per share. The Company records any proceeds received for unvested shares of restricted stock in accrued expenses and the amount is amortized into additional paid-in capital as the shares vest. If the employee who received the restricted stock leaves the Company prior to the vesting date for any reason, the shares of restricted stock will be forfeited and returned to the Company.

 

Additional Information About Restricted Stock

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Total number of shares of restricted stock granted during the period

 

1,583

 

22,000

 

86,375

 

40,000

 

Weighted average fair value per share of restricted stock granted

 

$

33.99

 

$

24.38

 

$

29.67

 

$

25.17

 

Total number of shares of restricted stock vested during the period

 

43,482

 

23,617

 

130,809

 

129,899

 

Total fair value of shares of restricted stock vested during the period

 

$

1,387

 

$

644

 

$

3,938

 

$

2,219

 

 

Restricted Stock Units

 

The following table summarizes the Company’s restricted stock unit activity during the nine months ended September 30, 2010:

 

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Table of Contents

 

 

 

Number of
Shares

 

Weighted Grant
Date Fair Value
Per Share

 

Nonvested at December 31, 2009

 

114,000

 

$

11.55

 

Granted

 

326,000

 

28.99

 

Vested

 

(44,083

)

12.07

 

Cancelled

 

 

 

Nonvested at September 30, 2010

 

395,917

 

$

25.85

 

 

Prior to 2009, the Company had not granted any restricted stock units and there were no restricted stock units that vested in 2009.

 

The weighted average grant date fair value of restricted stock units granted during the nine months ended September 30, 2009 was $11.55 per share.  The total fair value of restricted stock units that vested during the nine months ended September 30, 2010 was $1,440.

 

10. Income Taxes

 

The Company accounts for income taxes in accordance with ASC 740,  Income Taxes (ASC 740), which is the asset and liability method for accounting and reporting income taxes. Under ASC 740, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, ASC 740 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

 

ASC 740 also provides criteria for the recognition, measurement, presentation and disclosures of uncertain tax positions. A tax benefit from an uncertain tax position may be recognized if it is “more likely than not” that the position is sustainable based solely on its technical merits. As of September 30, 2010 and December 31, 2009, the Company had no material unrecognized tax benefits.

 

In accordance with ASC 740, each interim period is considered an integral part of the annual period and tax expense is measured using an estimated annual effective tax rate. The Company is required, at the end of each interim reporting period, to make its best estimate of the annual effective tax rate for the full fiscal year and use that rate to provide for income taxes on a current year-to-date basis.  If an enterprise has an ordinary loss for the year to date at the end of an interim period and anticipates ordinary income for the fiscal year, which was the case with the Company through the six months ended June 30, 2010, the enterprise will record an interim period tax benefit based on applying the estimated annual effective tax rate to the ordinary loss as long as the tax benefits are realized during the year or recognizable as a deferred tax asset as of the end of the year.  The Company recorded an income tax provision of $3,779 and $2,869 for the three and nine months ended September 30, 2010, respectively, which included consideration of the tax benefit recognized by the Company from stock option deductions generated during the three and nine months ended September 30, 2010.  Even though the Company’s federal and state net operating loss carryforwards exceed the Company’s estimated taxable income for the fiscal year ending December 31, 2010 (fiscal 2010), the Company’s estimated annual effective tax rate is greater than zero due to the following:

 

·                   estimated foreign taxes resulting from guaranteed profit allocable to the Company’s 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 Company does not have sufficient 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.

 

The Company’s effective tax rate for the three and nine months ended September 30, 2010 was 7.9% and 8.5%, respectively.  The Company’s estimated annual effective tax rate for fiscal 2010 is 8.5%.  However, the estimated annual effective tax rate could be reduced in the fourth quarter of fiscal 2010 as a result of a tax benefit from stock options which are not recognized in the determination of the estimated annual effective rate until they occur.  In addition, the estimated annual effective tax rate could increase in the fourth quarter of fiscal 2010 if certain proposed state legislation is passed that would limit the Company’s ability to utilize its net operating loss carryforwards to offset state taxable income for fiscal 2010.  The Company’s estimated annual effective tax rate is

 

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lower than the statutory rate as a result of the Company’s federal and state net operating loss carryforwards to offset future federal and state taxable income.

 

The Company recorded a deferred tax benefit of $786 and $438 for the three and nine months ended September 30, 2009, respectively, due to tax amortization for indefinite lived intangibles.

 

The Company reviews all available evidence to evaluate the recovery of deferred tax assets, including the recent history of accumulated losses in all tax jurisdictions over the last three years, as well as its ability to generate income in future periods. As of September 30, 2010 and December 31, 2009, due to the uncertainty related to the ultimate use of the Company’s deferred income tax assets, the Company has provided a full valuation allowance on all of its U.S. deferred tax assets.

 

11.  Concentrations of Credit Risk

 

Financial instruments that potentially subject the Company to significant concentrations of credit risk principally consist of cash and cash equivalents, restricted cash and accounts receivable. The Company maintains its cash and cash equivalent balances with highly rated financial institutions and, consequently, such funds are subject to minimal credit risk.

 

The Company’s customers are principally located in the northeastern and PJM Interconnection (PJM) regions of the United States. The Company performs ongoing credit evaluations of the financial condition of its customers and generally does not require collateral. Although the Company is directly affected by the overall financial condition of the energy industry, as well as global economic conditions, management does not believe significant credit risk existed as of September 30, 2010. The Company generally has not experienced any material losses related to receivables from individual customers or groups of customers in the energy industry. The Company maintains an allowance for doubtful accounts based on accounts past due and historical collection experience. The Company’s losses related to collection of trade receivables have consistently been within management’s expectations. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable.

 

The following table sets forth the Company’s significant customers. PJM and ISO-New England, Inc. (ISO-NE) are regional grid operator customers comprised of multiple utilities and were formed to control the operation of a regional power system, coordinate the supply of electricity, and establish fair and efficient markets.

 

 

 

Three Months Ended September 30,

 

 

 

2010

 

2009

 

 

 

Revenues

 

% of Total
Revenues

 

Revenues

 

% of Total
Revenues

 

PJM Interconnection

 

$

127,609

 

78

%

$

75,029

 

73

%

ISO-New England, Inc.

 

9,216

 

6

%

12,390

 

12

%

Total

 

$

136,825

 

84

%

$

87,419

 

85

%

 

 

 

Nine Months Ended September 30,

 

 

 

2010

 

2009

 

 

 

Revenues

 

% of Total
Revenues

 

Revenues

 

% of Total
Revenues

 

PJM Interconnection

 

$

166,806

 

65

%

$

98,216

 

60

%

ISO-New England, Inc.

 

41,466

 

16

%

39,290

 

24

%

Total

 

$

208,272

 

81

%

$

137,506

 

84

%

 

Accounts receivable from these customers was approximately $13,322 and $9,788 at September 30, 2010 and December 31, 2009, respectively.  No other customers represented 10% or greater of accounts receivable at September 30, 2010 and December 31, 2009.  Unbilled revenue related to PJM was $114,221 and $40,388 at September 30, 2010 and December 31, 2009, respectively.  There was no unbilled revenue for any other customers at September 30, 2010 and December 31, 2009.

 

Deposits and restricted cash consist of funds to secure performance under certain utility and grid operator customer contracts and open market bidding programs. Deposits held by utility and grid operator customers were $4,026 and $3,024 at September 30, 2010 and December 31, 2009, respectively.

 

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12. Legal Proceedings

 

The Company is subject to legal proceedings, claims and litigation arising in the ordinary course of business. The Company does not expect the ultimate costs to resolve these matters to have a material adverse effect on the Company’s consolidated financial condition, results of operations or cash flows.

 

13.  Recent Accounting Pronouncements

 

In September 2009, the Financial Accounting Standards Board (FASB) ratified ASC Update No. 2009-13, Multiple-Deliverable Revenue Arrangements (ASU 2009-13).  ASU 2009-13 amends existing revenue recognition accounting pronouncements that are currently within the scope of FASB ASC Subtopic 605-25. ASU 2009-13 provides for two significant changes to the existing multiple element revenue recognition guidance. First, ASU 2009-13 deletes the requirement to have objective and reliable evidence of fair value for undelivered elements in an arrangement and will result in more deliverables being treated as separate units of accounting. The second change in ASU 2009-13 modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. These changes may result in entities recognizing more revenue up-front, and entities will no longer be able to apply the residual method and defer the fair value of undelivered elements. Upon adoption of ASU 2009-13, each separate unit of accounting must have a selling price, which can be based on management’s estimate when there is no other means to determine the fair value of that undelivered item, and the arrangement consideration is allocated based on the elements’ relative selling price. ASU 2009-13 is effective no later than fiscal years beginning on or after June 15, 2010, but may be adopted early as of the first quarter of an entity’s fiscal year. Entities may elect to adopt ASU 2009-13 either through prospective application to all revenue arrangements entered into or materially modified after the date of adoption or through a retrospective application to all revenue arrangements for all periods presented in the financial statements. The Company is currently evaluating the impact of ASU 2009-13, including the period in which the Company will adopt ASU 2009-13.

 

In January 2010, the FASB issued ASU 2010-06,  Improving Disclosure about Fair Value Measurements (ASU 2010-06).  ASU 2010-06 requires additional disclosures regarding fair value measurements, amends disclosures about post-retirement benefit plan assets and provides clarification regarding the level of disaggregation of fair value disclosures by investment class. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for certain Level 3 activity disclosure requirements that will be effective for reporting periods beginning after December 15, 2010. The adoption of ASU 2010-06 did not have a material impact on the Company’s consolidated financial position or results of operations.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, as well as our audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009, as filed with the Securities and Exchange Commission, or the SEC, on March 12, 2010. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Without limiting the foregoing, the words “may,” “will,” “should,” “could,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” “target” and variations of those terms or the negatives of those terms and similar expressions are intended to identify forward-looking statements. All forward-looking statements included in this Quarterly Report on Form 10-Q are based on current expectations, estimates, forecasts and projections and the beliefs and assumptions of our management including, without limitation, our expectations regarding our results of operations, operating expenses and the sufficiency of our cash for future operations. We assume no obligation to revise or update any such forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain important factors, including those set forth below under this Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Part II, Item 1A — “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, as well as in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. You should carefully review those factors and also carefully review the risks outlined in other documents that we file from time to time with the SEC.

 

Overview

 

We are a leading provider of clean and intelligent energy management applications and services, which include comprehensive demand response services, data-driven energy efficiency services, energy price and risk management services and enterprise carbon management services.  Our customers are commercial, institutional and industrial end-users of energy, or C&I customers, as well as electric power grid operators and utilities.

 

We believe that we are the largest demand response service provider to C&I customers in the United States. As of September 30, 2010, we managed over 5,100 megawatts, or MW, of demand response capacity across a C&I customer base of approximately 3,500 accounts and 8,200 sites throughout multiple electric power grids. Demand response is an alternative to traditional power generation and transmission infrastructure projects that enables 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. We use our Network Operations Center, or NOC, and comprehensive demand response application, DemandSMART, to remotely manage and reduce electricity consumption across a growing network of C&I customer sites, making demand response capacity available to grid operators and utilities on demand while helping end-users of electricity achieve energy savings, environmental benefits and improved financial results. To date, we have received substantially all of our revenues from grid operators and utilities, who make recurring payments to us for managing demand response capacity that we share with our C&I customers in exchange for those customers reducing their power consumption when called upon.

 

In providing our demand response services, we match obligation, in the form of MW that we agree to deliver to our utility and grid operator customers, with supply, in the form of MW that we are able to curtail from the electric power grid through our C&I customers. We occasionally reallocate our obligation through open market bidding programs, supplemental demand response programs, auctions or other similar capacity arrangements, open program registrations and bilateral contracts to account for changes in supply and demand forecasts in order to achieve more favorable pricing opportunities. We increase our ability to curtail demand from the electric power grid by deploying a sales team to contract with our C&I customers and by installing our equipment at these customers’ sites to connect them to our network. When we are called upon by our utility or grid operator customers to deliver MW, we use our DemandSMART application to dispatch this network to meet the demands of these utility and grid operator customers. We refer to the above activities as managing our portfolio of demand response capacity.

 

We build upon 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 to our customers.  These additional energy management applications include our SiteSMART, SupplySMART and CarbonSMART applications.  SiteSMART is our data-driven energy efficiency application that has multiple features, including monitoring-based commissioning tools, commissioning and retro-commissioning authority services, energy consulting and engineering services, distributed generation services and owner-engineer services.  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.  CarbonSMART is our enterprise carbon management application that supports the measurement, tracking, analysis, reporting and management of greenhouse gas emissions.

 

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We continue to devote substantially all of our efforts toward the sale of our energy management applications and services. Our net income was $43.9 million and $30.7 million, respectively, for the three and nine months ended September 30, 2010.  Our net income was $26.6 million and $8.4 million, respectively, for the three and nine months ended September 30, 2009.  As of September 30, 2010, our accumulated deficit was $46.6 million.

 

Revenues and Expense Components

 

Revenues

 

We derive recurring revenues from the sale of our energy management applications and services. Our revenues from our demand response services primarily consist of capacity and energy payments, including ancillary services payments. We derive revenues from demand response capacity that we make available in open market programs and pursuant to contracts that we enter into with grid operators and utilities. In open market programs, grid operators and utilities generally seek bids from companies such as ours to provide demand response capacity based on prices offered in competitive bidding. These opportunities are generally characterized by flexible capacity commitments and prices that vary by hour, day, month, bidding period or supplemental, new or modified programs. In certain markets, we enter into contracts with grid operators and utilities, generally ranging from three to 10 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 where 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 call this an energy payment.

 

We do not recognize any revenues until we can determine that persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and we deem collection to be reasonably assured. As program rules may differ for each open market program in which we participate or 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 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 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 will 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.

 

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 September 30, 2010 and December 31, 2009, the incremental direct costs deferred were approximately $0.9 million and $0.9 million, respectively. 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 three and nine months ended September 30, 2010 and 2009, we did not defer any utility contract or open market program origination costs. In addition, we 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 useful life or the term of the contractual arrangement. These capitalized costs are included in property and equipment in our consolidated balance sheets. We believe that this accounting treatment appropriately matches expenses with the associated revenue.

 

As of September 30, 2010, we had over 5,100 MW under management in our demand response network, meaning that we had entered into definitive contracts with our C&I customers representing over 5,100 MW of demand response capacity. We generally begin earning revenues from our MW under management within approximately one month from the date on which we “enable” the MW, or the date on which we can reduce the MW from the electricity grid if called upon to do so. The most significant exception is the PJM Interconnection, or PJM, forward capacity market, which is a market in which we expect to continue to participate and derive

 

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revenues for the foreseeable future. Because PJM operates on a June to May program-year basis, a MW that we enable after June of each year may not begin earning revenue until June of the following year. This results in a longer average revenue recognition lag time in our C&I customer portfolio from the point in time when we consider a MW to be under management to when we earn revenues from the MW. Certain other markets in which we currently participate, such as ISO New England, Inc., or ISO-NE, or 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. Additionally, not all of our MW under management may be enrolled in a demand response program or may earn revenue in a given program period or year based on the way that we manage our portfolio of demand response capacity.

 

Revenues generated from open market sales to PJM, a grid operator customer, accounted for 78% and 73%, respectively, of our total revenues for the three months ended September 30, 2010 and 2009 and 65% and 60%, respectively, of our total revenues for the nine months ended September 30, 2010 and 2009. 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 $114.2 million at September 30, 2010 will be billed and collected through May 31, 2011.

 

Revenues generated from open market sales to ISO-NE, a grid operator customer, accounted for 6% and 12%, respectively, of our total revenues for the three months ended September 30, 2010 and 2009 and 16% and 24%, respectively, of our total revenues for the nine months ended September 30, 2010 and 2009.

 

In addition to demand response revenues, we generally receive either a subscription-based fee, consulting fee or a percentage savings fee for arrangements under which we provide our other energy management applications and services.  Revenues derived from our other energy management applications and services were $4.0 million and $1.9 million, respectively, for the three months ended September 30, 2010 and 2009 and $10.5 million and $5.0 million, respectively, for the nine months ended September 30, 2010 and 2009.

 

Our revenues have historically been higher in our second and third fiscal quarters compared to other quarters in our fiscal year due to seasonal demand related to the demand response market.

 

Cost of Revenues

 

Cost of revenues for our demand response services consists primarily 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 additional 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 capitalized internal-use software costs related to our energy management applications, 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 below during interim periods.  Cost of revenues for our other energy management applications and services include third party services, equipment depreciation and the wages and associated benefits that we pay to our project managers for the performance of their services.

 

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 and services, (b) the selling price of our energy management applications and services, (c) our cost of revenues, (d) the way in which we manage, or are permitted to manage by the relevant grid operator or utility, our portfolio of demand response capacity, (e) the introduction of new clean and intelligent energy management applications and services, (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. Our outcomes in negotiating favorable contracts with our C&I customers, as well as with our utility and grid operator customers, the effective management of our portfolio of demand response capacity and our demand response event performance are the primary determinants of our gross profit and gross margin.

 

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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 370 full-time employees at September 30, 2009 to 465 full-time employees at September 30, 2010. 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. Although we expect our overall operating expenses to increase in absolute dollar terms for the foreseeable future as we grow our MW under management and further increase our headcount, we expect our overall annual operating expenses to decrease as a percentage of total annual revenues as we leverage our existing employee base and continue generating revenues from our MW under 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 increases 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. We expect annual selling and marketing expenses to decrease as a percentage of total annual revenues as we leverage our current sales and marketing personnel.

 

General and Administrative

 

General and administrative expenses consist primarily of (a) salaries and related personnel costs, including costs associated with share-based payment awards, 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. We expect general and administrative expenses to decrease as a percentage of total annual revenues as we leverage our current infrastructure and employee base.  However, amortization expense from intangible assets acquired in future acquisitions could potentially increase our general and administrative expenses in future periods.

 

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 new energy management applications and services and enhancement of existing energy management applications and services, (d) quality assurance and testing and (e) other related overhead. During the three and nine months ended September 30, 2010, we capitalized payroll and benefits-related internal use software costs of $0.4 million and $1.2 million, respectively, and the amounts are included as software in property and equipment. We expect research and development expenses to increase in absolute dollar terms for the foreseeable future as we develop new technologies and to decrease as a percentage of total revenues in the long term as we leverage our existing technology.

 

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 income based on their fair values as of the date of grant. For stock options granted prior to January 1, 2009, the fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model, and for stock options granted on or after January 1, 2009, the fair value of each award is and will be estimated on the date of grant using a lattice valuation model. For the three and nine months ended September 30, 2010, we recorded expenses of approximately $3.7 million and $11.7 million, respectively, in connection with share-based payment awards to employees and non-employees.  For the three and nine months ended September 30, 2009, we recorded expenses of approximately $3.9 million and $10.0 million, respectively, in connection with share-based payment awards to employees and non-employees.  With respect to grants through September 30, 2010, a future expense of non-vested options of approximately $13.0 million is expected to be recognized over a weighted average period of 2.3 years and a future expense of restricted stock and restricted stock unit awards of approximately $11.6 million is expected to be recognized over a weighted average period of 3.0 years.

 

Other Income and Expense, Net

 

Other income and expense consist primarily of interest income earned on cash balances, gain or loss on transactions designated in currencies other than our or our subsidiaries’ functional currency and other non-operating income. We historically have

 

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invested our cash in money market funds, treasury funds, commercial paper, municipal bonds and auction rate securities. We do not currently hold any auction rate securities.

 

Interest Expense

 

Interest expense consists of interest on our capital lease obligations, fees associated with our credit facility with Silicon Valley Bank, or the SVB credit facility, and fees associated with issuing letters of credit and other financial assurances.

 

Consolidated Results of Operations

 

Three and Nine Months Ended September 30, 2010 Compared to the Three and Nine Months Ended September 30, 2009

 

Revenues

 

The following table summarizes our revenues for the three and nine months ended September 30, 2010 and 2009 (dollars in thousands):

 

 

 

Three Months Ended September 30,

 

Dollar

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Change

 

Revenues:

 

 

 

 

 

 

 

 

 

Demand response

 

$

158,836

 

$

101,227

 

$

57,609

 

56.9

%

Other energy management services

 

3,962

 

1,890

 

2,072

 

109.6

%

Total revenues

 

$

162,798

 

$

103,117

 

$

59,681

 

57.9

%

 

 

 

Nine Months Ended September 30,

 

Dollar

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Change

 

Revenues:

 

 

 

 

 

 

 

 

 

Demand response

 

$

246,983

 

$

158,931

 

$

88,052

 

55.4

%

Other energy management services

 

10,484

 

5,011

 

5,473

 

109.2

%

Total revenues

 

$

257,467

 

$

163,942

 

$

93,525

 

57.0

%

 

For the three and nine months ended September 30, 2010, our demand response revenues increased by $57.6 million and $88.1 million, respectively, as compared to the same periods in 2009.  The increase in our demand response revenues was primarily attributable to an increase in our MW under management in the following existing operating areas (dollars in thousands):

 

 

 

Revenue Increase (Decrease):

 

Revenue Increase:

 

 

 

Three months ended
September 30, 2009 to
September 30, 2010

 

Nine months ended
September 30, 2009 to
September 30, 2010

 

PJM

 

$

52,580

 

$

68,590

 

Tennessee Valley Authority

 

1,053

 

5,289

 

New England

 

(3,174

)

2,176

 

New York

 

1,152

 

2,368

 

California

 

1,694

 

2,113

 

Other (1)

 

4,304

 

7,516

 

Total increased demand response revenues

 

$

57,609

 

$

88,052

 

 


(1)          The amounts included in this category relate to increases in various demand response programs, none of which are individually material.

 

In addition to an increase in our MW under management, the increase in our demand response revenues for the three and nine months ended September 30, 2010 compared to the same periods in 2009 was also attributable to the effective management of our

 

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portfolio of demand response capacity and more favorable pricing in certain operating areas.  These increases were offset by the commencement of an ISO-NE program in which we currently participate, which started on June 1, 2010, under which we enrolled fewer MW with lower pricing compared to a prior, similar ISO-NE program in which we participated.

 

For the three months ended September 30, 2010, our other energy management services revenues increased by $2.1 million as compared to the three months ended September 30, 2009.  For the nine months ended September 30, 2010, our other energy management services revenues increased by $5.5 million as compared to the nine months ended September 30, 2009.  These increases were primarily due to our acquisition of Cogent Energy, Inc., or Cogent, a company specializing in comprehensive energy consulting, engineering and building commissioning solutions to C&I customers, which occurred in December 2009.

 

We currently expect our revenues to increase in 2010 compared to 2009 as we further increase our MW under management in all operating regions, enroll new C&I customers in our demand response programs, expand the sales of our other energy management applications and services to our new and existing C&I customers and pursue more favorable pricing opportunities with our C&I customers.  Although we expect a significant increase in our MW under management in the PJM market in 2011 as compared to 2010, until PJM prices return in 2013 to more historical levels, we expect our revenues derived from the PJM market to decrease as a percentage of total annual revenues in 2011 and 2012 as significantly lower capacity prices in this market take effect for those years.  These lower prices in PJM will negatively impact our ability to grow our overall revenues in 2011 and 2012 at levels consistent with prior years.

 

Gross Profit and Gross Margin

 

The following table summarizes our gross profit and gross margin percentages for our demand response and other energy management services for the three and nine months ended September 30, 2010 and 2009 (dollars in thousands):

 

Three Months Ended September 30,

 

2010

 

2009

 

Gross Profit

 

Gross Margin

 

Gross Profit

 

Gross Margin

 

$

 77,736

 

47.7

%

$

51,677

 

50.1

%

 

Nine Months Ended September 30,

 

2010

 

2009

 

Gross Profit

 

Gross Margin

 

Gross Profit

 

Gross Margin

 

$

 116,303

 

45.2

%

$

77,710

 

47.4

%

 

Our gross profit increased during the three and nine months ended September 30, 2010 as compared to the same periods in 2009 primarily due to the substantial increase in our revenues, as well as the effective management of our portfolio of demand response capacity and strong demand response event performance, particularly in the PJM region from which we currently derive a substantial portion of our revenues.

 

Our gross margin decreased during the three and nine months ended September 30, 2010 as compared to the same periods in 2009 primarily due to lower prices in the ISO-NE region, an increase in cost of revenues in a certain demand response program where the associated revenues were deferred and recognition of certain project start-up costs related to an enterprise energy management arrangement pursuant to which revenue recognition has not yet commenced.  Additionally, our gross margin decreased during the three and nine months ended September 30, 2010 as compared to the same periods in 2009 due to increased depreciation and amortization of capitalized costs and an impairment charge of $0.6 million and $1.3 million, respectively, recognized during the three and nine months ended September 30, 2010 related to certain demand response and back-up generator equipment.

 

We currently expect that our gross margin for the year ending December 31, 2010 will be slightly lower as compared to the year ended December 31, 2009, and that our gross margin for the three months ended September 30, 2010 will be the highest gross margin among our four quarterly reporting periods in 2010, consistent with our gross margin pattern in 2009, due to seasonal demand related to the demand response market.  Further, for the year ended December 31, 2009 and nine months ended September 30, 2010, we were able to derive significant gross profits from managing our portfolio of demand response capacity in the PJM incremental auctions, which may not occur at similar levels beyond 2010.  Until the prices in the PJM market improve in 2013, we expect the lower capacity prices that will take effect in the PJM market in 2011 and 2012 to negatively impact our ability to grow our overall gross profits and gross margins in 2011 and 2012 at levels consistent with prior years.

 

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Operating Expenses

 

The following table summarizes our operating expenses for the three and nine months ended September 30, 2010 and 2009 (dollars in thousands):

 

 

 

Three Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Operating Expenses:

 

 

 

 

 

 

 

Selling and marketing

 

$

12,893

 

$

11,602

 

11.1

%

General and administrative

 

13,848

 

12,155

 

13.9

%

Research and development

 

3,197

 

2,111

 

51.4

%

Total

 

$

29,938

 

$

25,868

 

15.7

%

 

 

 

Nine Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Operating Expenses:

 

 

 

 

 

 

 

Selling and marketing

 

$

34,173

 

$

29,481

 

15.9

%

General and administrative

 

40,114

 

33,252

 

20.6

%

Research and development

 

7,748

 

5,524

 

40.3

%

Total

 

$

82,035

 

$

68,257

 

20.2

%

 

In certain forward capacity markets in which we choose to 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. This market feature creates a longer average revenue recognition lag time across our C&I customer portfolio from the point in time when we consider MW to be under management to when we earn revenues from those MW. Because we incur operational expenses, including salaries and related personnel costs, at the time of enablement, we believe there may be a trend of incurring operating expenses associated with enabling our C&I customers in advance of recognizing the corresponding revenues.

 

Selling and Marketing Expenses

 

 

 

Three Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

8,983

 

$

7,938

 

13.2

%

Stock-based compensation

 

1,222

 

1,181

 

3.5

%

Other

 

2,688

 

2,483

 

8.3

%

Total

 

$

12,893

 

$

11,602

 

11.1

%

 

 

 

Nine Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

22,951

 

$

19,872

 

15.5

%

Stock-based compensation

 

3,403

 

3,001

 

13.4

%

Other

 

7,819

 

6,608

 

18.3

%

Total

 

$

34,173

 

$

29,481

 

15.9

%

 

The increase in selling and marketing expenses for the three and nine months ended September 30, 2010 compared to the same periods in 2009 was primarily driven by the payroll and related costs associated with an increase in the number of selling and marketing full-time employees from 138 at September 30, 2009 to 176 at September 30, 2010. The increase in payroll and related costs for the nine months ended September 30, 2010 compared to the same period in 2009 was also attributable to an increase in sales commissions of $0.9 million due to the growth in our business.  The increase in stock-based compensation for the nine months ended September 30, 2010 compared to the same period in 2009 was primarily due to

 

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additional stock-based awards to existing and new employees.  The increase in other selling and marketing expenses for the nine months ended September 30, 2010 as compared to the same period in 2009 was attributable to increases in professional services and marketing costs of $0.6 million due to our rebranding efforts and attendance at conferences and seminars, increases in facility costs of $0.2 million due to the expansion of our existing office space, and technology and communication costs of $0.4 million due to the increased utilization in our data service centers.

 

General and Administrative Expenses

 

 

 

Three Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

7,814

 

$

6,561

 

19.1

%

Stock-based compensation

 

2,218

 

2,567

 

(13.6

)%

Other

 

3,816

 

3,027

 

26.1

%

Total

 

$

13,848

 

$

12,155

 

13.9

%

 

 

 

Nine Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

21,750

 

$

17,199

 

26.5

%

Stock-based compensation

 

7,676

 

6,494

 

18.2

%

Other

 

10,688

 

9,559

 

11.8

%

Total

 

$

40,114

 

$

33,252

 

20.6

%

 

The increase in general and administrative expenses for the three and nine months ended September 30, 2010 compared to the same periods in 2009 was primarily driven by an increase in the number of general and administrative full-time employees from 184 at September 30, 2009 to 232 at September 30, 2010.  The decrease in stock-based compensation for the three months ended September 30, 2010 compared to the same period in 2009 was primarily due to the acceleration of the vesting of a certain portion of our former chief financial officer’s options to purchase shares of our common stock during the three months ended September 30, 2009.  The increase in stock-based compensation for the nine months ended September 30, 2010 compared to the same period in 2009 was primarily due to annual stock-based awards granted to our officers and directors.  The increase in other general and administrative expenses for the three months ended September 30, 2010 compared to the same period in 2009 was primarily attributable to an increase in professional services costs of $0.5 million, an increase in other tax expense of $0.2 million and an increase in bad debt expense of $0.1 million.  The increase in other general and administrative expenses for the nine months ended September 30, 2010 compared to the same period in 2009 was attributable to an increase in professional services of $0.5 million, facility costs of $0.4 million primarily related to increased rent expense due to the expansion of our office space and $0.2 million of other miscellaneous expenses associated with the growth of our business.

 

Research and Development Expenses

 

 

 

Three Months Ended September 30,

 

Percentage

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

1,664

 

$

1,205

 

38.1

%

Stock-based compensation

 

224

 

174

 

28.7

%

Other

 

1,309

 

732

 

78.8

%

Total

 

$

3,197

 

$

2,111

 

51.4

%

 

 

 

Nine Months Ended September 30,

 

Percentage 

 

 

 

2010

 

2009

 

Change

 

Payroll and related costs

 

$

4,437

 

$

3,051

 

45.4

%

Stock-based compensation

 

589

 

501

 

17.6

%

Other

 

2,722

 

1,972

 

38.0

%

Total

 

$

7,748

 

$

5,524

 

40.3

%

 

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The increase in research and development expenses for the three and nine months ended September 30, 2010 compared to the same periods in 2009 was primarily driven by the costs associated with an increase in the number of research and development full-time employees from 48 at September 30, 2009 to 57 at September 30, 2010, as well as higher average salary rates per employee.  The increase in research and development expenses for the nine months ended September 30, 2010 compared to the same period in 2009 was also attributable to lower capitalized internal payroll and related costs of $0.5 million.  The increase in stock-based compensation for the three and nine months ended September 30, 2010 compared to the same periods in 2009 was primarily attributable to stock-based awards granted to certain employees in connection with our acquisition of SmallFoot LLC, or Smallfoot, and ZOX, LLC, or Zox, in March 2010.  The increase in other research and development expenses for the three months ended September 30, 2010 as compared to the same period in 2009 was primarily related to a $0.3 million increase in technology and communications costs related to software licenses and fees used in the development of our various energy management applications and $0.3 million related to professional services for consulting services associated with the development of our various energy management applications. The increase in other research and development expenses for the nine months ended September 30, 2010 as compared to the same period in 2009 was primarily related to a $0.4 million increase in technology and communications related to software licenses and fees used in the development of our various energy management applications and $0.4 million related to professional services costs for consulting services associated with the development of our various energy management applications.

 

Other Income (Expense), Net

 

Other income, net for the three and nine months ended September 30, 2010 was primarily comprised of a nominal amount of interest income and a nominal amount of foreign currency gains related to certain receivables denominated in foreign currencies.  Other income, net for the three months ended September 30, 2009 and other expense, net for the nine months ended September 30, 2009 was primarily comprised of a nominal amount of interest income, as well as a nominal amount of foreign currency gains, for the three months ended September 30, 2009 and a nominal amount of foreign currency losses for the nine months ended September 30, 2009 related to certain receivables dominated in foreign currencies.

 

Interest Expense

 

The increase in interest expense for the three months ended September 30, 2010 compared to the same period in 2009 was primarily due to increased letters of credit origination fees related to certain markets in which we participate.  The decrease in interest expense for the nine months ended September 30, 2010 compared to the same period in 2009 was due to our repayment of outstanding borrowings under the SVB credit facility of $4.4 million during the three months ended December 31, 2009, resulting in no interest expense related to any borrowings under the SVB credit facility during the nine months ended September 30, 2010.  Additionally, the decrease in interest expense for the nine months ended September 30, 2010 compared to the same period in 2009 was due to $1.1 million in fees incurred during the nine months ended September 30, 2009 associated with outstanding letters of credit, primarily attributable to the arrangement we entered into with a third party in May 2009 in connection with bidding capacity into a certain open market program.  Interest expense for the three and nine months ended September 30, 2010 includes interest on our outstanding capital leases and letters of credit origination fees.

 

Income Taxes

 

We recorded a provision for income taxes of $3.8 million and $2.9 million for the three and nine months ended September 30, 2010, respectively, which included consideration of the tax benefit recognized by us from stock option deductions generated during the three and nine months ended September 30, 2010.  Even though our federal and state net operating loss carryforwards exceed our estimated taxable income for the fiscal year ending December 31, 2010, or fiscal 2010, our estimated annual effective tax rate is 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 we do not have sufficient 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 three and nine months ended September 30, 2010 was 7.9% and 8.5%, respectively.  Our estimated annual effective tax rate for fiscal 2010 is 8.5%.  However, the estimated annual effective tax rate could be reduced in the fourth quarter of fiscal 2010 as a result of a tax benefit from stock options which are not recognized in the determination of the

 

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estimated annual effective rate until they occur.  In addition, the estimated annual effective tax rate could increase in the fourth quarter of fiscal 2010 if certain proposed state legislation is passed that would limit our ability to utilize our net operating loss carryforwards to offset state taxable income for fiscal 2010.

 

We recorded an income tax benefit of $0.8 million and $0.4 million for the three and nine months ended September 30, 2009, respectively.  This tax provision was primarily related to the amortization of tax deductible goodwill, which generated 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.

 

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 September 30, 2010 and December 31, 2009, 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. deferred tax assets.

 

Net Income

 

Net income for the three months ended September 30, 2010 was $43.9 million, or $1.76 per basic share and $1.67 per diluted share, compared to a net income of $26.6 million, or $1.21 per basic share and $1.12 per diluted share, for the three months ended September 30, 2009.  Net income for the nine months ended September 30, 2010 was $30.7 million, or $1.25 per basic share and $1.18 per diluted share, compared to a net income of $8.4 million, or $0.40 per basic share and $0.38 per diluted share, for the nine months ended September 30, 2009. Excluding stock-based compensation charges and amortization of expenses related to acquisition-related assets, net of tax effects, non-GAAP net income for the three months ended September 30, 2010 was $47.6 million, or $1.91 per basic share and $1.81 per diluted share, compared to a non-GAAP net income of $30.7 million, or $1.40 per basic share and $1.30 per diluted share, for the three months ended September 30, 2009. Excluding stock-based compensation charges and amortization of expenses related to acquisition-related assets, net of tax effects, non-GAAP net income for the nine months ended September 30, 2010 was $42.4 million, or $1.72 per basic share and $1.63 per diluted share, compared to a non-GAAP net income of $18.9 million, or $0.90 per basic share and $0.85 per diluted share, for the nine months ended September 30, 2009. Please refer to the section below entitled “Use of Non-GAAP Financial Measures” for a reconciliation of non-GAAP measures to the most directly comparable measure calculated and presented in accordance with GAAP.

 

Use of Non-GAAP Financial Measures

 

In this Quarterly Report on Form 10-Q, we provide certain “non-GAAP financial measures.” A non-GAAP financial measure refers to a numerical financial measure that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable financial measure calculated and presented in accordance with GAAP in our financial statements. In this Quarterly Report on Form 10-Q, we provide non-GAAP net income and non-GAAP net income per share data as additional information relating to our operating results. These non-GAAP measures exclude expenses related to stock-based compensation and amortization expense related to acquisition-related assets. Management uses these non-GAAP measures for internal reporting and forecasting purposes. We have provided these non-GAAP financial measures in addition to GAAP financial results because we believe that these non-GAAP financial measures provide useful information to certain investors and financial analysts in assessing our operating performance due to the following factors:

 

·                   we believe that the presentation of non-GAAP measures that adjust for the impact of stock-based compensation expense and amortization expense related to acquisition-related assets provides investors and financial analysts with a consistent basis for comparison across accounting periods and, therefore, are useful to investors and financial analysts in helping them to better understand our operating results and underlying operational trends;

 

·                   although stock-based compensation is an important aspect of the compensation of our employees and executives, stock-based compensation expense is generally fixed at the time of grant, then amortized over a period of several years after the grant of the stock-based instrument, and generally cannot be changed or influenced by management after the grant; and

 

·                   we do not acquire intangible assets on a predictable cycle. Our intangible assets relate solely to business acquisitions. Amortization costs are fixed at the time of an acquisition, are then amortized over a period of several years after the acquisition and generally cannot be changed or influenced by management after the acquisition.

 

Pursuant to the requirements of the SEC, we have provided below a reconciliation of each non-GAAP financial measure used to the most directly comparable financial measure prepared in accordance with GAAP. These non-GAAP financial measures are not prepared in accordance with GAAP. 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. The presentation of this

 

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additional information is not meant to be considered in isolation or as a substitute for net income or net income per share prepared in accordance with GAAP.

 

 

 

Three Months Ended September 30,

 

 

 

2010

 

2009

 

 

 

(In thousands, except share and per share data)

 

GAAP net income

 

$

43,866

 

$

26,637

 

ADD: Stock-based compensation

 

3,664

 

3,922

 

ADD: Amortization expense of acquired intangible assets

 

353

 

182

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(319

)

 

Non-GAAP net income

 

$

47,564

 

$

30,741

 

GAAP net income per basic share

 

$

1.76

 

$

1.21

 

ADD: Stock-based compensation

 

0.15

 

0.18

 

ADD: Amortization expense of acquired intangible assets

 

0.01

 

0.01

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(0.01

)

 

Non-GAAP net income per basic share

 

$

1.91

 

$

1.40

 

GAAP net income per diluted share

 

$

1.67

 

$

1.12

 

ADD: Stock-based compensation

 

0.14

 

0.17

 

ADD: Amortization expense of acquired intangible assets

 

0.01

 

0.01

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(0.01

)

 

Non-GAAP net income per diluted share

 

$

1.81

 

$

1.30

 

Weighted average number of common shares outstanding

 

 

 

 

 

Basic

 

24,864,755

 

21,938,427

 

Diluted

 

26,215,766

 

23,689,477

 

 

 

 

Nine Months Ended September 30,

 

 

 

2010

 

2009

 

 

 

(In thousands, except share and per share data)

 

GAAP net income

 

$

30,744

 

$

8,374

 

ADD: Stock-based compensation

 

11,668

 

9,996

 

ADD: Amortization expense of acquired intangible assets

 

1,109

 

514

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(1,091

)

 

Non-GAAP net income

 

$

42,430

 

$

18,884

 

GAAP net income per basic share

 

$

1.25

 

$

0.40

 

ADD: Stock-based compensation

 

0.47

 

0.48

 

ADD: Amortization expense of acquired intangible assets

 

0.04

 

0.02

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(0.04

)

 

Non-GAAP net income per basic share

 

$

1.72

 

$

0.90

 

GAAP net income per diluted share

 

$

1.18

 

$

0.38

 

ADD: Stock-based compensation

 

0.45

 

0.45

 

ADD: Amortization expense of acquired intangible assets

 

0.04

 

0.02

 

LESS: Income tax effect of Non-GAAP adjustments (1)

 

(0.04

)

 

Non-GAAP net income per diluted share

 

$

1.63

 

$

0.85

 

Weighted average number of common shares outstanding

 

 

 

 

 

Basic

 

24,650,453

 

20,703,779

 

Diluted

 

26,013,402

 

22,154,745

 

 


(1)           Represents the increase in the income tax provision recorded for the three and nine months ended September 30, 2010 based on our effective tax rate for the three and nine months ended September 30, 2010, respectively.

 

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Liquidity and Capital Resources

 

Overview

 

Since inception, we have generated significant cumulative losses. As of September 30, 2010, we had an accumulated deficit of $46.6 million. As of September 30, 2010, our principal sources of liquidity were cash and cash equivalents totaling $141.3 million, an increase of $21.6 million from the December 31, 2009 balance of $119.7 million. As of September 30, 2010, we were contingently liable for $35.6 million in connection with outstanding letters of credit under the SVB credit facility. As of September 30, 2010 and December 31, 2009, we had restricted cash balances of $0.2 million and $7.9 million, respectively, which relate to amounts to collateralize unused outstanding letters of credit and cover financial assurance requirements in certain of the programs in which we participate.

 

At September 30, 2010 and December 31, 2009, our excess cash was primarily invested in money market funds.

 

We believe our existing cash and cash equivalents at September 30, 2010 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 certain of our energy management applications and services to utilities and grid operators and the increasing rate at which letters of credit or security deposits are required by those utilities and grid operators, the introduction and market acceptance of new energy management applications and services, 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 SVB 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. Accordingly, we have filed a shelf r