filings.toolsItem 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included in "Financial Statements and Supplementary Data." Some of the information contained in this discussion and analysis, including information with respect to our plans and strategies for our business, includes forward-looking statements involving significant risks and uncertainties. As a result of many factors, such as those set forth in "Risk Factors," our actual results may differ materially from the results described in, or implied by, these forward-looking statements.
(Throughout this discussion and analysis, dollars are in millions, excluding ARPU or unless otherwise noted.)
Overview
We are the global market leader in domain registration. Securing a domain is a necessary first step to creating a digital identity and our domain products often serve as the starting point in our customer relationships. As of December 31, 2017, approximately 92% of our customers had purchased a domain from us and we had approximately 75.0 million domains under management. Based on information reported in VeriSign's Domain Name Industry Brief, we had over 22% of the world's domains registered as of December 31, 2017.
We also offer hosting, presence and business applications products and services enhancing our value proposition to our customers by enabling them to create, manage and syndicate their, or their customers', digital identities. While these products are often purchased in conjunction with, or subsequent to, an initial domain registration, they are also frequently the starting points in our customer relationships. As we have grown, our hosting, presence and business applications products have become increasingly important parts of our business, constituting nearly 53% of total revenue in 2017.
Financial Highlights
Below are our key financial highlights for 2017, with comparisons to 2016.
| • | Total revenue of $2,231.9 million, an increase of 20.8%. |
| • | International revenue of $727.4 million, an increase of 46.1%. |
| • | Total bookings(1) of $2,618.2 million, an increase of 21.5%. |
| • | Net income of $139.8 million. |
| • | Total customers increased 17.6% to 17.3 million. |
| • | ARPU increased 7.4% to $139. |
| • | Net cash provided by operating activities of $475.6 million, an increase of 23.1%. |
(1) A reconciliation of total bookings to total revenue, its most directly comparable GAAP financial measure, is set forth in "Selected Financial Data—Reconciliation of Bookings."
Our Financial Model
We have developed a stable and predictable business model driven by efficient customer acquisition, high customer retention rates and increasing lifetime spend. We grew our total customers from 13.8 million as of December 31, 2015 to 17.3 million as of December 31, 2017, primarily through a combination of our industry leading products built on a single cloud platform, brand advertising, direct marketing efforts, customer referrals and world-class customer care. We also added approximately 1.6 million customers from our acquisition of HEG in April 2017. In each of the five years ended December 31, 2017, our customer retention rate exceeded 85% and our retention rate for customers who had been with us for over three years was approximately 91%. We believe the breadth and depth of our product offerings and the high quality and responsiveness of our Customer Care team build strong relationships with our customers and are key to our high level of customer retention.
We generate bookings and revenue from sales of product subscriptions, including domain products, hosting and presence offerings and business applications, as described below. We offer our product subscriptions on a variety of terms, which are typically one year, but can range from monthly to multi-annual terms of up to ten years depending on the product. We monitor total bookings as we typically collect payment at the time of sale and recognize revenue ratably over the term of our customer contracts. Accordingly, we believe total bookings is an indicator of the expected growth in our revenue and the operating performance of our business. See "Selected Financial Data—Reconciliation of Bookings" for a reconciliation of total revenue to total bookings.
Domains. We generated 47% of our 2017 total revenue from the sale of domain products, primarily from domain registrations and renewals, domain add-ons such as privacy and aftermarket sales. Total revenue from domain products grew at a CAGR of 11.5% over the three years ended December 31, 2017.
Hosting and Presence. We generated 38% of our 2017 total revenue from the sale of hosting and presence products, primarily from a variety of website hosting offerings, website builder products, security products and e-commerce products. These products generally have higher margins than conventional domain registrations. Total revenue from hosting and presence products grew at a CAGR of 18.6% over the three years ended December 31, 2017.
Business Applications. We generated 15% of our 2017 total revenue from the sale of business applications products, primarily from productivity tools such as domain-specific email accounts, which generally also have higher margins than conventional domain registrations. Total revenue from business applications products grew at a CAGR of 41.2% over the three years ended December 31, 2017.
Revenue derived from each of our product categories has increased in each of the last three years ended December 31, 2017, with our hosting, presence and business applications products growing faster in recent periods. This mix shift has favorably impacted our margins.
In each of the five years ended December 31, 2017, greater than 85% of our total revenue, excluding the impact of purchase accounting, was generated by customers who were also customers in the prior year. To track our growth and the stability of our customer base, we monitor, among other things, revenue, retention rates and ARPU generated by our annual customer cohorts over time, as well as corresponding marketing and advertising spend. We define an annual customer cohort to include each customer who first became a customer during a calendar year. For example, in calendar year 2010, we acquired 2.3 million customers, who we collectively refer to as our 2010 cohort. During the same time period, we spent $94 million in marketing and advertising expenses. By the end of 2017, the 2010 cohort had generated an aggregate of $1,250 million of total bookings, and we expect this cohort will continue to generate bookings and revenue in the future. For the six years ended December 31, 2017, the average bookings retention rate of the 2010 cohort was approximately 93%. Over this period, ARPU, excluding the impact of purchase accounting, for the 2010 cohort grew from $91 in 2012 to $170 in 2017, representing a CAGR of 13%. We selected the 2010 cohort for this analysis because we believe the 2010 cohort is representative of the spending patterns and revenue impact of our other cohorts. We believe our cohort analysis is important to illustrate the long-term value of our customers.
Key Metrics
As described in "Selected Financial Data," we monitor the following key metrics to help us evaluate our business and assess operational performance. These operational measures are supplemental to our GAAP results and we believe they are useful in evaluating our business. A reconciliation of total bookings to total revenue, its most directly comparable GAAP financial measure, is set forth in "Selected Financial Data—Reconciliation of Bookings."
| Year Ended December 31, | |||||||||||
| 2017 | 2016 | 2015 | |||||||||
| (unaudited; customers in thousands) | |||||||||||
| Total bookings | $ | 2,618.2 | $ | 2,155.5 | $ | 1,914.2 | |||||
| Total customers at period end | 17,339 | 14,740 | 13,774 | ||||||||
| Average revenue per user | $ | 139 | $ | 130 | $ | 121 |
Total bookings. Total bookings increased 12.6% from $1,914.2 million in 2015 to $2,155.5 million in 2016 and increased 21.5% to $2,618.2 million in 2017. These increases were primarily driven by increases in total customers and domains under management, continued increases in aftermarket domain sales, broadened customer adoption of non-domain products and an increased growth rate associated with our greater international presence, partially offset by the impact of adverse movements in foreign currency exchange rates. Additionally, the acquisition of HEG in April 2017 contributed to our bookings growth in 2017.
Total customers. As of December 31, 2017, 2016 and 2015, we had 17,339, 14,740 and 13,774 total customers, respectively. Our customer growth primarily resulted from our increased international presence, our ongoing marketing and advertising initiatives, our enhanced and expanded product offerings and approximately 1.6 million customers added from our acquisition of HEG in April 2017.
Average revenue per user. ARPU increased 6.8% from $121 in 2015 to $130 in 2016 and increased 7.4% to $139 in 2017, primarily due to broadened customer adoption of our products resulting in increased customer spend and revenue from acquired businesses, partially offset by the impact of adverse movements in foreign currency exchange rates. Our ARPU growth in 2017 is muted by the impact of the acquisition of HEG as our trailing 12 month revenue includes only nine months of HEG's results, while all of the customers acquired from HEG are included in the average customers calculation.
Results of Operations
The following table sets forth our consolidated results of operations for the periods presented and as a percentage of our total revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.
| Year Ended December 31, | |||||||||||||||||
| 2017 | 2016 | 2015 | |||||||||||||||
| $ | % of Total Revenue | $ | % of Total Revenue | $ | % of Total Revenue | ||||||||||||
| Revenue: | |||||||||||||||||
| Domains | $ | 1,057.2 | 47.4 | % | $ | 927.8 | 50.2 | % | $ | 840.8 | 52.3 | % | |||||
| Hosting and presence | 847.9 | 38.0 | % | 678.7 | 36.7 | % | 592.0 | 36.8 | % | ||||||||
| Business applications | 326.8 | 14.6 | % | 241.4 | 13.1 | % | 174.5 | 10.9 | % | ||||||||
| Total revenue | 2,231.9 | 100.0 | % | 1,847.9 | 100.0 | % | 1,607.3 | 100.0 | % | ||||||||
| Costs and operating expenses: | |||||||||||||||||
| Cost of revenue (excluding depreciation and amortization) | 775.5 | 34.7 | % | 657.8 | 35.6 | % | 565.9 | 35.2 | % | ||||||||
| Technology and development | 355.8 | 15.9 | % | 287.8 | 15.5 | % | 270.2 | 16.8 | % | ||||||||
| Marketing and advertising | 253.2 | 11.3 | % | 228.8 | 12.4 | % | 202.2 | 12.6 | % | ||||||||
| Customer care | 292.3 | 13.1 | % | 242.1 | 13.1 | % | 221.5 | 13.8 | % | ||||||||
| General and administrative | 282.4 | 12.8 | % | 221.2 | 12.0 | % | 219.7 | 13.7 | % | ||||||||
| Depreciation and amortization | 205.8 | 9.2 | % | 160.1 | 8.7 | % | 158.8 | 9.9 | % | ||||||||
| Total costs and operating expenses | 2,165.0 | 97.0 | % | 1,797.8 | 97.3 | % | 1,638.3 | 102.0 | % | ||||||||
| Operating income (loss) | 66.9 | 3.0 | % | 50.1 | 2.7 | % | (31.0 | ) | (2.0 | )% | |||||||
| Interest expense | (83.0 | ) | (3.7 | )% | (57.2 | ) | (3.1 | )% | (69.2 | ) | (4.3 | )% | |||||
| Loss on debt extinguishment | (7.3 | ) | (0.3 | )% | — | — | % | (21.4 | ) | (1.3 | )% | ||||||
| Tax receivable agreements liability adjustment | 123.2 | 5.5 | % | (12.5 | ) | (0.7 | )% | — | — | % | |||||||
| Other income (expense), net | 7.0 | 0.3 | % | (1.9 | ) | (0.1 | )% | 1.0 | 0.1 | % | |||||||
| Income (loss) from continuing operations before income taxes | 106.8 | 4.8 | % | (21.5 | ) | (1.2 | )% | (120.6 | ) | (7.5 | )% | ||||||
| Benefit (provision) for income taxes | 18.9 | 0.8 | % | (0.4 | ) | — | % | 0.2 | — | % | |||||||
| Income (loss) from continuing operations | 125.7 | 5.6 | % | (21.9 | ) | (1.2 | )% | (120.4 | ) | (7.5 | )% | ||||||
| Income from discontinued operations, net of income taxes | 14.1 | 0.6 | % | — | — | % | — | — | % | ||||||||
| Net income (loss) | 139.8 | 6.2 | % | (21.9 | ) | (1.2 | )% | (120.4 | ) | (7.5 | )% | ||||||
| Less: net income (loss) attributable to non-controlling interests | 3.4 | 0.1 | % | (5.4 | ) | (0.3 | )% | (44.8 | ) | (2.8 | )% | ||||||
| Net income (loss) attributable to GoDaddy Inc. | $ | 136.4 | 6.1 | % | $ | (16.5 | ) | (0.9 | )% | $ | (75.6 | ) | (4.7 | )% |
Comparison of Years Ended December 31, 2017, 2016 and 2015
Revenue
We generate substantially all of our revenue from sales of product subscriptions, including domain registrations and renewals, hosting and presence offerings and business applications. Our subscription terms are typically one year, but can range from monthly to multi-annual terms of up to ten years depending on the product. We generally collect the full amount of subscription fees at the time of sale, but recognize revenue ratably over the applicable contract term.
Domains revenue primarily consists of revenue from the sale of domain registration subscriptions, domain add-ons and aftermarket domain sales. Domain registrations provide a customer with the exclusive use of a domain during the applicable contract term. After the contract term expires, unless renewed, the customer can no longer access the domain.
Hosting and presence revenue primarily consists of revenue from the sale of subscriptions for our website hosting products, website building products and services, website security products, an online shopping cart and online visibility products.
Business applications revenue primarily consists of revenue from the sale of subscriptions for third-party productivity applications, email accounts and email marketing tools.
Revenue is presented net of refunds, and we maintain a reserve to provide for refunds granted to customers. Our reserve is an estimate based on historical refund experience. Refunds reduce deferred revenue at the time they are granted and result in a reduced amount of revenue recognized over the applicable subscription terms compared to the amount originally expected.
The following table presents our revenue for the periods indicated:
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Domains | $ | 1,057.2 | $ | 927.8 | $ | 840.8 | $ | 129.4 | 14 | % | $ | 87.0 | 10 | % | |||||||||||
| Hosting and presence | 847.9 | 678.7 | 592.0 | 169.2 | 25 | % | 86.7 | 15 | % | ||||||||||||||||
| Business applications | 326.8 | 241.4 | 174.5 | 85.4 | 35 | % | 66.9 | 38 | % | ||||||||||||||||
| Total revenue | $ | 2,231.9 | $ | 1,847.9 | $ | 1,607.3 | $ | 384.0 | 21 | % | $ | 240.6 | 15 | % |
2017 compared to 2016
Total revenue increased $384.0 million, or 20.8%, from $1,847.9 million in 2016 to $2,231.9 million in 2017. The increase was primarily driven by $155.1 million in total revenue from our acquisition of HEG in April 2017 as well as growth in total customers and ARPU. The increase in customers impacted each of our revenue lines, as the additional customers purchased subscriptions across our product portfolio.
Domains. Domains revenue increased $129.4 million, or 13.9%, from $927.8 million in 2016 to $1,057.2 million in 2017. This increase was primarily driven by our acquisition of HEG, the increase in domains under management from 63.5 million as of December 31, 2016 to 75.0 million as of December 31, 2017, international growth, strong renewals and increased aftermarket domain sales. Domains under management in 2017 includes approximately 1.0 million .uk domains for which we provided free initial registration to the owners of the associated third-level domains (e.g. .co.uk) following the 2017 launch of the .uk ccTLD.
Hosting and presence. Hosting and presence revenue increased $169.2 million, or 24.9%, from $678.7 million in 2016 to $847.9 million in 2017. The increase was primarily driven by our acquisition of HEG as well as increased revenue from our website hosting, website building and website security products and services.
Business applications. Business applications revenue increased $85.4 million, or 35.4%, from $241.4 million in 2016 to $326.8 million in 2017. The increase was primarily driven by increased customer adoption of our expanded email and productivity solutions.
2016 compared to 2015
Total revenue increased $240.6 million, or 15.0%, from $1,607.3 million in 2015 to $1,847.9 million in 2016. The increase was primarily driven by growth in total customers and ARPU, as well as revenue from acquired businesses. The increase in customers impacted each of our revenue lines, as the additional customers purchased subscriptions across our product portfolio.
Domains. Domains revenue increased $87.0 million, or 10.3%, from $840.8 million in 2015 to $927.8 million in 2016. This increase was primarily attributable to the 3.1% increase in domains under management from 61.6 million as of
December 31, 2015 to 63.5 million as of December 31, 2016 driven by our international growth and strong renewals. Increased aftermarket domain sales driven by our domain portfolio acquisitions also contributed to the revenue increase.
Hosting and presence. Hosting and presence revenue increased $86.7 million, or 14.6%, from $592.0 million in 2015 to $678.7 million in 2016. The increase was primarily attributable to increased revenue from our website hosting, website building and website security products and services.
Business applications. Business applications revenue increased $66.9 million, or 38.3%, from $174.5 million in 2015 to $241.4 million in 2016. The increase was primarily driven by increased customer adoption of our expanded email and productivity solutions.
Costs and Operating Expenses
Cost of revenue
Costs of revenue are the direct costs we incur in connection with selling an incremental product to our customers. Substantially all cost of revenue relates to domain registration fees paid to the various domain registries, payment processing fees, third-party commissions and licensing fees for third-party productivity applications. Similar to our billing practices, we pay domain costs at the time of purchase for the life of each subscription, but recognize the costs of service ratably over the term of our customer contracts. The terms of registry pricing are established by agreements between registries and registrars, and can vary significantly depending on the TLD. We expect cost of revenue to increase in absolute dollars in future periods as we expand our domains business, increase our sales of third-party productivity applications, increase our customer base and expand our international presence. Cost of revenue may increase or decrease as a percentage of total revenue, depending on the mix of products sold in a particular period and the sales and marketing channels used.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Cost of revenue | $ | 775.5 | $ | 657.8 | $ | 565.9 | $ | 117.7 | 18 | % | $ | 91.9 | 16 | % |
2017 compared to 2016. Cost of revenue increased $117.7 million, or 17.9%, from $657.8 million in 2016 to $775.5 million in 2017. This increase was primarily attributable to our acquisition of HEG, increased domain costs driven by the increase in domains under management, higher registration costs associated with many new gTLDs and increased aftermarket domain sales, increased software licensing fees primarily related to increased sales of email and productivity solutions and increased third-party commissions driven by the increased aftermarket domain sales.
2016 compared to 2015. Cost of revenue increased $91.9 million, or 16.2%, from $565.9 million in 2015 to $657.8 million in 2016. This increase was primarily attributable to increased domain costs driven by the increase in domains under management, higher registration costs associated with many new gTLDs and increased aftermarket domain sales, increased software licensing fees primarily related to increased sales of email and productivity solutions, increased third-party commissions driven by increased aftermarket domain sales as well as increased payment processing fees due to the overall bookings increase.
Technology and development
Technology and development expenses represent the costs associated with the creation, development and distribution of our products and websites. These expenses primarily consist of personnel costs associated with the design, development, deployment, testing, operation and enhancement of our products, as well as costs associated with the data centers and systems infrastructure supporting those products, excluding depreciation expense. We expect technology and development expense to increase in absolute dollars as we continue to enhance existing products, develop new products and geographically diversify our data center footprint. Technology and development expenses may increase or decrease as a percentage of total revenue depending on our level of investment in additional personnel and the expansion of our global infrastructure footprint. Our investments in additional technology and development expenses are made to enhance our integrated technology infrastructure and to support our new and enhanced product offerings and the overall growth of our business.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Technology and development | $ | 355.8 | $ | 287.8 | $ | 270.2 | $ | 68.0 | 24 | % | $ | 17.6 | 7 | % |
2017 compared to 2016. Technology and development expenses increased $68.0 million, or 23.6%, from $287.8 million in 2016 to $355.8 million in 2017. This increase was primarily attributable to our acquisition of HEG as well as increased compensation-related costs driven by higher average headcount associated with the continued growth of our business.
2016 compared to 2015. Technology and development expenses increased $17.6 million, or 6.5%, from $270.2 million in 2015 to $287.8 million in 2016. This increase was primarily attributable to increased compensation-related costs driven by increased average headcount associated with the continued growth of our business.
Marketing and advertising
Marketing and advertising expenses represent the costs associated with attracting and acquiring customers, primarily consisting of fees paid to third parties for marketing and advertising campaigns across television and radio, search engines, online display, social media and event sponsorships. These expenses also include personnel costs and affiliate program commissions. We expect marketing and advertising expenses to fluctuate both in absolute dollars and as a percentage of total revenue depending on both the mix of internal and external marketing resources used and the size and scope of our future campaigns, particularly related to new product introductions and the growth of our international business.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Marketing and advertising | $ | 253.2 | $ | 228.8 | $ | 202.2 | $ | 24.4 | 11 | % | $ | 26.6 | 13 | % |
2017 compared to 2016. Marketing and advertising expenses increased $24.4 million, or 10.7%, from $228.8 million in 2016 to $253.2 million in 2017. The increase was primarily attributable to increased discretionary advertising spend driven by our international growth and new product launches as well as our acquisition of HEG.
2016 compared to 2015. Marketing and advertising expenses increased $26.6 million, or 13.2%, from $202.2 million in 2015 to $228.8 million in 2016. The increase was primarily attributable to increased discretionary advertising spend driven by our international growth and new product launches.
Customer Care
Customer care expenses represent the costs to advise and service our customers, primarily consisting of personnel costs. We expect these expenses to increase in absolute dollars in the future as we expand our domestic and international Customer Care teams due to increases in total customers. We expect Customer Care expenses to fluctuate as a percentage of total revenue depending on the level of personnel required to support the continued growth of our business.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Customer care | $ | 292.3 | $ | 242.1 | $ | 221.5 | $ | 50.2 | 21 | % | $ | 20.6 | 9 | % |
2017 compared to 2016. Customer care expenses increased $50.2 million, or 20.7%, from $242.1 million in 2016 to $292.3 million in 2017. The increase was primarily driven by headcount additions to support the continued growth of our business and our international expansion as well as our acquisition of HEG.
2016 compared to 2015. Customer care expenses increased $20.6 million, or 9.3%, from $221.5 million in 2015 to $242.1 million in 2016. The increase was primarily driven by the continued growth of our business as well as increased costs associated with the continued expansion of our international third-party Customer Care locations.
General and administrative
General and administrative expenses primarily consist of personnel costs for our administrative functions, professional service fees, office rent for all locations, all employee travel expenses, acquisition-related expenses and other general costs. We expect general and administrative expenses to increase in absolute dollars in the future as a result of our overall growth, increased personnel costs and public company expenses.
In 2015, general and administrative expenses include $29.7 million of additional expenses related to certain payments made following the completion of the IPO, including $26.7 million paid to the Sponsors in connection with the termination of the transaction and monitoring fee agreement and $3.0 million paid to Bob Parsons in connection with the termination of the executive chairman services agreement. Following these payments, we were no longer obligated to make future payments under either of these agreements.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| General and administrative | $ | 282.4 | $ | 221.2 | $ | 219.7 | $ | 61.2 | 28 | % | $ | 1.5 | 1 | % |
2017 compared to 2016. General and administrative expenses increased $61.2 million, or 27.7%, from $221.2 million in 2016 to $282.4 million in 2017. The increase was primarily due to our acquisition and integration of HEG, increased professional service fees primarily associated with our debt financings and the sale of PlusServer, increased compensation-related costs associated with the continued growth of our business as well as an increase in indirect tax accruals associated with our international operations.
2016 compared to 2015. General and administrative expenses increased $1.5 million, or 0.7%, from $219.7 million in 2015 to $221.2 million in 2016. Excluding the termination payments discussed above, general and administrative expenses increased $31.2 million, or 16.4%, from $190.0 million in 2015 to $221.2 million in 2016. This increase was primarily due to increased compensation-related costs driven by increased average headcount associated with the continued growth of our business as well as increased acquisition-related expenses.
Depreciation and amortization
Depreciation and amortization expenses consist of charges relating to the depreciation of the property and equipment used in our operations and the amortization of acquired intangible assets. Depreciation and amortization may increase or decrease in absolute dollars in future periods depending on our future level of capital investments in hardware and other equipment as well as amortization expense associated with future acquisitions.
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Depreciation and amortization | $ | 205.8 | $ | 160.1 | $ | 158.8 | $ | 45.7 | 29 | % | $ | 1.3 | 1 | % |
2017 compared to 2016. Depreciation and amortization expenses increased $45.7 million, or 28.5%, from $160.1 million in 2016 to $205.8 million in 2017. This increase primarily results from the finite-lived intangible assets and property and equipment acquired as part of our acquisition of HEG in April 2017.
2016 compared to 2015. There were no material changes in depreciation and amortization expense.
Interest expense
| Year Ended December 31, | 2017 to 2016 | 2016 to 2015 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | $ change | % change | $ change | % change | |||||||||||||||||||
| Interest expense | $ | 83.0 | $ | 57.2 | $ | 69.2 | $ | 25.8 | 45 | % | $ | (12.0 | ) | (17 | )% |
2017 compared to 2016. Interest expense increased $25.8 million, or 45.1%, from $57.2 million in 2016 to $83.0 million in 2017. The increase was primarily driven by additional interest from the Acquisition Term Loan entered into in April
2017 to finance a portion of our acquisition of HEG, partially offset by interest savings resulting from the refinancing of our debt in February and November 2017 as well as the benefit from our cross-currency and interest rate swaps.
2016 compared to 2015. Interest expense decreased $12.0 million, or 17.3%, from $69.2 million in 2015 to $57.2 million in 2016, primarily driven by interest savings resulting from our repayment of a $300.0 million senior note to YAM in April 2015.
Loss on debt extinguishment
In 2017, we recognized a $7.3 million loss on debt extinguishment related to the refinancings of our term loans and the August 2017 prepayment of the Bridge Loan. See Note 10 to our consolidated financial statements for additional discussion.
In April 2015, we recognized a $21.4 million loss on debt extinguishment as a result of the repayment of a senior note to YAM, which consisted of prepayment premium of $13.5 million and the write-off of $7.9 million of unamortized original issue discount and deferred debt issuance costs.
Liquidity and Capital Resources
Overview
Other than the receipt of proceeds from our IPO in April 2015, our principal sources of liquidity have been cash flow generated from operations, long-term debt borrowings and stock option exercises. Our principal uses of cash have been to fund operations, acquisitions and capital expenditures, as well as make interest payments and mandatory principal payments on our long-term debt. We have also used our cash to repurchase LLC Units and make distributions to holders of LLC Units.
In general, we seek to deploy our capital in a systematically prioritized manner focusing first on requirements for operations, then on growth investments, and finally on equity holder returns. Our strategy is to deploy capital from any potential source, whether debt, equity or internally generated cash, depending on the adequacy and availability of the source of capital and which source may be used most efficiently and at the lowest cost at such time. Therefore, while cash from operations is our primary source of operating liquidity and we believe our internally-generated cash flows are sufficient to support our day-to-day operations, we may use a variety of capital sources to fund our needs for less predictable investment decisions such as strategic acquisitions and share repurchases.
We have incurred significant long-term debt, as described below, to fund acquisitions and for our working capital needs. As a result of our debt, we are limited as to how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities, strategic acquisitions or share repurchases. However, the restrictions under our debt agreements are subject to a number of qualifications and may be amended with lender consent.
We believe our existing cash and cash equivalents and internally-generated cash flows will be sufficient to meet our anticipated operating cash needs for at least the next 12 months. However, our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support domestic and international development efforts, continued brand development and advertising spend, the expansion of Customer Care and general and administrative activities, the introduction of new and enhanced product offerings, the costs to support new and replacement capital equipment, the completion of strategic acquisitions or share repurchases. Should we pursue additional strategic acquisitions or share repurchases, we may need to raise additional capital, which may be in the form of additional long-term debt or equity financings.
Acquisition of HEG
On April 3, 2017, we completed the acquisition of HEG, as described in Note 3 to our consolidated financial statements, for €1.7 billion. The acquisition was financed using the Acquisition Term Loan and the Bridge Loan, both of which are discussed below.
Credit Facility
Our Credit Facility consists of the Term Loan and the Acquisition Term Loan, both maturing on February 15, 2024, and the Revolving Credit Loan maturing on February 15, 2022. See further discussion of the Credit Facility in Note 10 to our consolidated financial statements.
The Credit Facility is subject to customary fees for loan facilities of this type, including a commitment fee on the Revolving Credit Loan. The term loans are required to be repaid in quarterly installments of 0.25% of the original principal, with the balance due at maturity. The term loans must be repaid with proceeds from certain asset sales and debt issuances and with a portion of our excess cash flow, up to 50.0%, depending on our net leverage ratio. The Credit Facility is guaranteed by all of our material domestic subsidiaries and is secured by substantially all of our and such subsidiaries' real and personal property.
The Credit Facility contains covenants restricting, among other things, our ability, or the ability of our subsidiaries, to incur indebtedness, issue certain types of equity, incur liens, enter into fundamental changes including mergers and consolidations, sell assets, make restricted payments including dividends, distributions and investments, prepay junior indebtedness and engage in operations other than in connection with acting as a holding company, subject to customary exceptions. The refinanced Revolving Credit Loan also contains a financial covenant requiring us to maintain a maximum net leverage ratio of 5.75:1.00 when our usage exceeds 35.0% of the maximum capacity. The net leverage ratio is calculated as the ratio of first lien secured debt less cash and cash equivalents to consolidated EBITDA (as defined in the Credit Facility). As of December 31, 2017, we were in compliance with all such covenants and had no amounts drawn on the Revolving Credit Loan.
As further discussed in Note 11 to our consolidated financial statements, we have hedged a portion of our long-term debt through the use of cross-currency and interest rate swap derivative instruments. These instruments help us manage and mitigate our risk of exposure to changes in foreign currency exchange rates and interest rates. See "Quantitative and Qualitative Disclosures About Market Risk" for additional discussion of our hedging activities.
Bridge Loan and Sale of PlusServer
On April 3, 2017, we entered into the Bridge Loan to finance a portion of the HEG acquisition, as described in Note 10 to our consolidated financial statements. In connection with the acquisition, we committed to a formal plan to sell PlusServer as its business model differs from ours, and therefore its operating results are reported within discontinued operations. The terms of the Bridge Loan required that, in the event of a sale or other disposition of PlusServer, 100% of the net cash proceeds from such sale or disposition be used to prepay the Bridge Loan. As described in Note 4 to our consolidated financial statements, on August 31, 2017, we sold all of the outstanding shares of PlusServer, receiving net proceeds of $447.7 million. As a result of the sale, we recorded a gain on disposal of $33.2 million, which is included in discontinued operations. The proceeds, in combination with an additional $148.9 million of our existing cash and cash equivalents, were used to prepay the Bridge Loan in its entirety. Following this prepayment, the underlying bridge credit agreement was canceled. In addition, we have recorded an income tax liability of approximately €19.0 million owed under German income tax laws as a result of the sale. We expect to pay this tax in 2018.
Secondary Offerings and LLC Unit Repurchase
As discussed in Note 6 to our consolidated financial statements, we have completed several underwritten public offerings in which certain stockholders, including the Sponsors, YAM and certain of our executive officers sold shares of our Class A common stock. We did not receive any proceeds from the shares sold by the selling stockholders in these offerings. We used the net proceeds from the shares sold by us to pay expenses incurred in connection with the offerings. Each offering included the exchange of LLC Units (together with the corresponding shares of Class B common stock) for Class A common stock by the selling stockholders, which resulted in increases in additional paid-in capital, with offsetting reductions in non-controlling interests, and material increases to the liability under the TRAs.
In May 2017, we repurchased 7.3 million LLC units from the Sponsors and YAM for an aggregate of $275.0 million, or $37.44 per share, which is the same per share price, net of discounts and commissions, paid by the underwriters to the selling stockholders in the offering. In connection with this repurchase, the corresponding shares of Class B common stock held by the Sponsors and YAM were canceled. The repurchase did not result in an incremental liability under the TRAs; however, it did increase the per unit basis of the remaining LLC Units held by each of the selling stockholders. This results in a deferral of the recording of the liability under the TRAs until the future exchange of LLC Units by such selling stockholders.
Tax Cuts and Jobs Act of 2017
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 was signed into law making significant changes to the Internal Revenue Code, including a U.S. federal corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017. This rate decrease resulted in an $86.2 million reduction in the liability under the TRAs, as described in Note 15 to our consolidated financial statements, and a $7.9 million net benefit for income taxes, as described in Note 14 to our consolidated financial statements.
Tax Receivable Agreements
As described in "Critical Accounting Policies and Estimates—Payable to Related Parties Pursuant to the TRAs," we are a party to five TRAs. As of December 31, 2017, the liability under the TRAs was $153.0 million, as described in Note 15 to our consolidated financial statements. We currently do not expect to begin making payments related to the existing liability under the TRAs until 2021.
We may record additional liabilities under the TRAs when LLC Units are exchanged in the future and as our estimates of the future utilization of the tax attributes, NOLs and other tax benefits change. We expect to make payments under the TRAs, to the extent they are required, within 150 days after our U.S. federal income tax return is filed for each fiscal year. Interest on such payments will begin to accrue from the due date (without extensions) of such tax return at a rate equal to the one-year LIBOR plus 100 basis points. Under the TRAs, to avoid interest charges, we have the right, but not the obligation, to make TRA payments in advance of the date the payments are otherwise due.
Because we are a holding company with no operations, we rely on Desert Newco to provide us with funds necessary to meet any financial obligations. If we do not have sufficient funds to pay TRA, tax or other liabilities or to fund our operations (as a result of Desert Newco's inability to make distributions to us due to various limitations and restrictions or as a result of the acceleration of our obligations under the TRAs), we may have to borrow funds and thus our liquidity and financial condition could be materially and adversely affected. To the extent we are unable to make payments under the TRAs for any reason, such payments will be deferred and will accrue interest at a rate equal to one-year LIBOR plus 500 basis points until paid.
Tax Distributions to Desert Newco's Owners
Tax distributions are required under the terms of Desert Newco's limited liability company agreement. Any required payments are calculated each quarter based on a number of variables, including Desert Newco's taxable income or loss, allocations of taxable income among Desert Newco's owners based on principles detailed within the Treasury Regulations, tax deductions for stock option exercises and vested RSUs and changing ownership percentages among Desert Newco's owners. In addition, under the tax rules, Desert Newco is required to allocate taxable income disproportionately to its unit holders. Because tax distributions are determined based on the holder of LLC Units who is allocated the largest amount of cumulative taxable income on a per unit basis, but are made pro rata based on ownership, Desert Newco is required to make tax distributions that, in the aggregate, will likely exceed the amount of taxes Desert Newco would have otherwise paid.
During 2017 and 2016, Desert Newco paid total distributions of $10.0 million and $18.4 million, respectively, as discussed in Note 18 to our consolidated financial statements. Distributions paid in 2015 were not material. An accrual for tax distributions was not required at December 31, 2017.
Cash Flows
The following table summarizes our cash flows for the periods indicated:
| Year Ended December 31, | |||||||||||
| 2017 | 2016 | 2015 | |||||||||
| Net cash provided by operating activities | $ | 475.6 | $ | 386.5 | $ | 259.2 | |||||
| Net cash used in investing activities | (1,570.1 | ) | (183.4 | ) | (144.4 | ) | |||||
| Net cash provided by financing activities | 1,107.5 | 15.1 | 94.4 | ||||||||
| Effect of exchange rate changes on cash and cash equivalents | 3.6 | (0.1 | ) | (0.2 | ) | ||||||
| Net increase in cash and cash equivalents | $ | 16.6 | $ | 218.1 | $ | 209.0 |
Operating Activities
Our primary source of cash from operating activities has been cash collections from our customers. We expect cash inflows from operating activities to be primarily affected by increases in total bookings. Our primary uses of cash from operating activities have been for domain registration costs paid to registries, personnel costs, discretionary marketing and advertising costs, technology and development costs and interest payments. We expect cash outflows from operating activities to be affected by the timing of payments we make to registries and increases in personnel and other operating costs as we continue to grow our business and increase our international presence.
Net cash provided by operating activities increased $89.1 million from $386.5 million in 2016 to $475.6 million in 2017, primarily resulting from our bookings growth and the contribution from HEG.
Net cash provided by operating activities increased $127.3 million from $259.2 million in 2015 to $386.5 million in 2016, driven by our bookings growth and a reduction in interest payments primarily resulting from the repayment of a senior note to YAM in April 2015.
Investing Activities
Our investing activities primarily consist of strategic acquisitions and purchases of property and equipment related to growth in our data centers and to support the overall growth of our business and our increased international presence. We expect our investing cash flows to be affected by the timing of payments we make for capital expenditures and the strategic acquisition or other growth opportunities we decide to pursue.
Net cash used in investing activities increased $1,386.7 million from $183.4 million in 2016 to $1,570.1 million in 2017. This increase was primarily due to a $1,758.4 million increase in business acquisitions, a $50.7 million increase in purchases of intangible assets and a $21.7 million increase in capital expenditures, partially offset by $447.7 million in net proceeds received from the sale of PlusServer in August 2017.
Net cash used in investing activities increased $39.0 million from $144.4 million in 2015 to $183.4 million in 2016. This increase was primarily due to a $53.8 million increase in business acquisitions and a $5.7 million increase in capital expenditures, partially offset by $23.5 million of intangible assets purchased in 2015.
Financing Activities
Excluding our IPO proceeds, our financing activities primarily consist of long-term debt borrowings, repurchases of LLC Units from the Sponsors and YAM, the repayment of principal on long-term debt, stock option activity and the payment of tax distributions to holders of LLC Units.
Net cash provided by financing activities increased $1,092.4 million from $15.1 million in 2016 to $1,107.5 million in 2017. The increase was driven by net proceeds from the issuance of the Acquisition Term Loan and Bridge Loan of $1,421.4 million and $531.7 million, respectively, and $22.9 million related to sales of Class A common stock in 2017. These inflows were offset by the $596.6 million prepayment of the Bridge Loan in August 2017, $275.0 million of LLC Unit repurchases in May 2017 and $39.7 million in payments of financing-related costs associated with our debt financings in 2017.
Net cash provided by financing activities decreased $79.3 million from $94.4 million in 2015 to $15.1 million in 2016. This decrease was primarily due to the receipt of net IPO proceeds of $482.4 million in 2015 and an $18.0 million increase in tax distribution payments, partially offset by the repayment of long-term debt of $375.0 million in 2015, the payment of debt extinguishment fees of $13.5 million in 2015 and a $35.8 million increase in proceeds received from stock option and warrant exercises and our employee stock purchase plan.
Deferred Revenue
Deferred revenue consists of sales of products not yet recognized as revenue at the end of a period. Deferred revenue as of December 31, 2017 was $1,861.6 million, and is expected to be recognized as revenue as follows:
| 2018 | 2019 | 2020 | 2021 | 2022 | Thereafter | Total | |||||||||||||||||||||
| Domains | $ | 638.5 | $ | 174.1 | $ | 70.3 | $ | 40.9 | $ | 22.6 | $ | 33.4 | $ | 979.8 | |||||||||||||
| Hosting and presence | 444.7 | 120.2 | 42.0 | 11.2 | 5.1 | 4.7 | 627.9 | ||||||||||||||||||||
| Business applications | 181.6 | 47.2 | 16.7 | 4.8 | 2.1 | 1.5 | 253.9 | ||||||||||||||||||||
| $ | 1,264.8 | $ | 341.5 | $ | 129.0 | $ | 56.9 | $ | 29.8 | $ | 39.6 | $ | 1,861.6 |
Contractual Obligations
The following table summarizes our material contractual obligations and commitments as of December 31, 2017:
| Payments due by period | |||||||||||||||
| 1 year | 2-3 years | 4-5 years | 5+ years | ||||||||||||
| Long-term debt, including current maturities(1) | $ | 25.0 | $ | 50.0 | $ | 50.0 | $ | 2,357.3 | |||||||
| Interest on long-term debt(2) | 95.8 | 188.9 | 184.7 | 102.3 | |||||||||||
| Lease financing obligation(3) | 3.2 | 6.7 | 7.2 | 8.4 | |||||||||||
| Operating leases(4) | 28.8 | 42.1 | 27.1 | 41.7 | |||||||||||
| Capital leases(5) | 5.1 | 4.6 | — | — | |||||||||||
| Service agreements(6) | 27.6 | 23.6 | 6.8 | 1.3 | |||||||||||
| TRA payments(7) | — | — | 40.7 | 112.3 |
| (1) | See Note 10 to our consolidated financial statements for information regarding the terms of our long-term debt agreements. |
| (2) | Interest on long-term debt excludes both the amortization of deferred debt issuance costs and original issue discount and the expected benefits associated with our interest rate swap. Interest on our variable rate debt is calculated using the rate in effect at December 31, 2017. |
| (3) | See Note 12 to our consolidated financial statements for information regarding the terms of our lease financing obligation. |
| (4) | We lease office and data center space (including commitments for specified levels of power) under non-cancelable operating leases expiring at various dates through March 2028. |
| (5) | We lease certain computer equipment and software under capital leases. The lease payments above include the amounts representing interest. |
| (6) | We have long-term agreements with certain vendors to provide for software and equipment maintenance, specified levels of bandwidth and other services. |
| (7) | Reflects the estimated timing of TRA payments as of December 31, 2017. Such payments could be due later than estimated depending on the timing of our use of the underlying tax attributes. As of December 31, 2017, we have recorded a liability of $153.0 million payable to the related parties under the TRAs, reflecting limitations on the use of the favorable tax attributes due to limitations of taxable income. The estimated amounts payable under the TRAs do not consider any future exchanges of LLC Units, which will have a material impact on this liability. See "Risk Factors-Risks Related to Our Company and Our Organizational Structure" and Note 15 to our audited consolidated financial statements for additional information regarding our liability under the TRAs. |
Off-Balance Sheet Arrangements
As of December 31, 2017 and 2016, we had no off-balance sheet arrangements that had, or which are reasonably likely to have, a material effect on our consolidated financial statements.
Critical Accounting Policies and Estimates
We prepare our consolidated financial statements in accordance with GAAP, and in doing so, we have to make estimates, assumptions and judgments affecting the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosure of contingent assets and liabilities. We base our estimates, assumptions and judgments on historical experience and on various other factors we believe to be reasonable under the circumstances, and we evaluate these estimates, assumptions and judgments on an ongoing basis. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change our results from those reported. We refer to estimates, assumptions and judgments of this type as our critical accounting policies and estimates, which we discuss further below. We review our critical accounting policies and estimates with the audit committee of our board of directors on an annual basis.
See Note 2 to our consolidated financial statements for a summary of our significant accounting policies.
Revenue Recognition
We recognize revenue over the period during which products or services are delivered to the customer. Customers are billed for products, generally in advance, based on their selected contract term. Cash received in advance of the provision of products is recorded as deferred revenue.
We commence revenue recognition when all of the following conditions are satisfied:
| • | there is persuasive evidence of an arrangement; |
| • | the service has been or is being provided to the customer; |
| • | the collection of the fees is reasonably assured; and |
| • | the amount of fees to be paid by the customer is fixed or determinable. |
We may sell multiple products to customers at the same time. For example, we may design a customer website and separately offer other products such as hosting and an online shopping cart, or a customer may combine a domain registration with other products such as private registration or email. Revenue arrangements with multiple deliverables are divided into separate units of accounting if each deliverable has stand-alone value to the customer. The majority of our revenue arrangements consist of multiple-element arrangements, with revenue for each unit of accounting recognized as the product or service is delivered to the customer.
Consideration is allocated to each deliverable at the inception of an arrangement based on relative selling prices. We determine the relative selling price for each deliverable based on our vendor-specific objective evidence of selling price (VSOE), if available, or our best estimate of selling price (BESP), if VSOE is not available. We establish VSOE for certain of our products when a consistent number of stand-alone sales of these products have been priced within a reasonably narrow range. We are unable to establish VSOE when we lack pricing consistency, primarily related to our marketing strategies and variability in pricing due to promotional activity.
Our process for determining BESP requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. For products where VSOE is not available, we determine BESP by considering our overall pricing objectives and market conditions. Significant factors taken into consideration include historical and expected discounting practices, the size, volume and term length of transactions, customer demographics, the geographic areas in which our products are sold and our overall go-to-market strategy.
We have determined third-party evidence of selling price (TPE) is not a practical alternative due primarily to the significant variability among available third-party pricing information for similar products and differences in the features of our product offerings compared to other parties.
We sell our products directly to customers and also through a network of resellers. In certain cases, we act as a reseller of products provided by others. The determination of gross or net revenue recognition is reviewed on a product by product basis and is dependent on whether we act as principal or agent in the transaction.
We maintain a reserve to provide for refunds granted to customers. Our reserve is an estimate based on historical refund experience. Refunds reduce deferred revenue at the time they are granted and result in a reduced amount of revenue recognized over the contract term of the applicable product compared to the amount originally expected. Our annual refund rate has ranged from 7.2% to 6.5% of total bookings from 2015 to 2017.
See Notes 2 and 8 to our consolidated financial statements for additional information regarding revenue recognition and deferred revenue, including discussion regarding the impact of the new revenue recognition standard, which we will adopt effective January 1, 2018.
Equity-Based Compensation
Our equity-based awards are comprised of options and restricted stock units (RSUs) and are accounted for using the fair value method. We grant options at exercise prices equal to the fair market value of our Class A common stock as reported on the NYSE on the date of grant. We measure and recognize compensation expense for equity-based awards made to employees and directors based on the grant date fair values of the awards. RSUs are measured based on the fair market value of the underlying common stock on the date of grant. For options with service or performance-based vesting conditions, the grant date fair value is estimated using the Black-Scholes option-pricing model, which requires management to make assumptions and apply judgment in determining the grant date fair value.
The most significant assumptions and judgments include estimating the expected option term, the expected stock price volatility and the risk-free interest rates. The assumptions used in our option pricing model represent management's best estimates. If factors change and different assumptions are used, our equity-based compensation expense could be materially different in the future.
In addition to the above assumptions, we also estimate a forfeiture rate for our awards, which is based on an analysis of historical forfeitures. We will continue to evaluate the appropriateness of the forfeiture rate based on our actual forfeiture experience, analysis of employee turnover and other factors. Changes in our estimated forfeiture rate can have a significant impact on our equity-based compensation expense since the cumulative effect of adjusting the forfeiture rate is recognized in the
period in which the estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made resulting in a decrease to the equity-based compensation expense previously recognized. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made resulting in an increase to the equity-based compensation expense previously recognized.
On a quarterly basis, we estimate when and if performance-based awards will be earned. Equity-based compensation expense is recognized only for awards considered probable of being earned. The grant date fair value of each award ultimately expected to vest is recognized as equity-based compensation expense, net of estimated forfeitures, over the requisite service period.
We will continue to use judgment in evaluating the assumptions related to our equity-based awards on a prospective basis. As we continue to accumulate additional data related to our awards, we may refine our estimates, which could materially impact our future equity-based compensation expense.
See Notes 2 and 7 to our consolidated financial statements for additional information regarding equity-based compensation.
Business Combinations
We include the results of operations of acquired businesses in our consolidated financial statements as of the respective dates of acquisition. Accounting for business combinations requires us to make significant estimates and assumptions, especially at the acquisition date, with respect to tangible and intangible assets acquired, liabilities assumed and pre-acquisition contingencies. The purchase price of acquisitions, including estimates of the fair value of contingent consideration when applicable, is allocated to the tangible and intangible assets acquired and the liabilities assumed based on their estimated fair values on the respective acquisition dates, with the excess recorded as goodwill. We use our best estimates and assumptions to assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date. The estimates are inherently uncertain and subject to refinement. We continue to collect information and reevaluate these estimates and assumptions quarterly and record any qualifying adjustments to the preliminary estimates to goodwill provided we are within the measurement period. Contingent consideration is adjusted to fair value in subsequent periods as an increase or decrease in general and administrative expenses. Acquisition-related costs are expensed as incurred.
See Notes 2 and 3 to our consolidated financial statements for additional information regarding business combinations.
Goodwill and Indefinite-Lived Intangible Assets
We make estimates, assumptions and judgments when valuing goodwill and other intangible assets in connection with the initial purchase price allocations of our acquisitions, as well as when evaluating the recoverability of our goodwill and other intangible assets on an ongoing basis. We assess our goodwill and indefinite-lived intangible assets for impairment at least annually during the fourth quarter. We will also perform an assessment at other times if and when events or changes in circumstances indicate the carrying value of these assets may not be recoverable.
We first make a qualitative assessment of whether it is more-likely-than-not our single reporting unit's fair value is less than its carrying value to determine whether it is necessary to perform a quantitative impairment test. The qualitative assessment includes considering various factors including macroeconomic conditions, industry and market conditions and our historical and projected operating results. We are only required to perform the quantitative test if our qualitative assessment determines our single reporting unit's fair value is not greater than its carrying value. We may elect to perform the quantitative test without considering such qualitative factors.
Our qualitative analyses during 2017, 2016 and 2015 did not indicate any impairment of our goodwill and indefinite-lived intangible assets, and accordingly, no impairment was recorded. As of December 31, 2017, we believe such assets are recoverable; however, there can be no assurances these assets will not be impaired in future periods. Any future impairment charges could adversely impact our results of operations.
See Notes 2 and 5 to our consolidated financial statements for additional information regarding goodwill and indefinite-lived intangible assets.
Income Taxes
We are subject to U.S. federal, state and foreign income taxes. We are a controlling member in Desert Newco, which has been, and will continue to be, treated as a partnership for U.S. income tax purposes. Under these provisions, Desert Newco is considered a pass-through entity and generally does not pay income taxes on its taxable income in most jurisdictions. Instead, Desert Newco's members, of which we are one, are liable for income taxes based on their taxable income. Desert Newco is liable for income taxes in certain foreign jurisdictions, in those states not recognizing its pass-through status and for certain subsidiaries not taxed as pass-through entities. We have acquired the outstanding stock of various entities taxed as corporations, which are now wholly-owned by us or our subsidiaries. Where required or allowed, these subsidiaries file and pay tax as a consolidated group for U.S. federal and state income tax purposes and internationally, primarily within the United Kingdom and Germany. We anticipate this structure to remain in existence for the foreseeable future.
We account for income taxes under the asset and liability method, which requires the recognition of DTAs and DTLs for the expected future tax consequences of events included in the financial statements. Under this method, we determine DTAs and DTLs on the basis of the differences between the financial statements and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on DTAs and DTLs is recognized in income in the period in which the enactment date occurs.
We recognize DTAs to the extent we believe these assets are more-likely-than-not to be realized. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent results of operations.
We recognize tax benefits from uncertain tax positions only if it is more-likely-than-not the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are measured based on the largest benefit having a greater than 50% likelihood of being realized upon ultimate settlement.
See Notes 2 and 14 to our consolidated financial statements for additional information regarding income taxes.
Payable to Related Parties Pursuant to the TRAs
We are a party to five TRAs. Under four of these agreements, we are generally required to pay to certain pre-IPO owners approximately 85% of the amount of calculated tax savings, if any, we are deemed to realize (using the actual applicable U.S. federal income tax rate and an assumed combined state and local income tax rate) as a result of (1) any existing tax attributes associated with LLC Units acquired in the pre-IPO organizational transactions, the benefit of which is allocable to us as a result of such transactions (including the allocable share of Desert Newco's existing tax basis in its assets), (2) NOLs available as a result of the such transactions and (3) tax benefits related to imputed interest.
Under the fifth of these agreements, we are generally required to pay our other pre-IPO owners approximately 85% of the amount of the calculated tax savings, if any, we are deemed to realize (using the actual applicable U.S. federal income tax rate and an assumed combined state and local income tax rate) as a result of (1) any step-up in tax basis created as a result of exchanges of their LLC Units (together with the corresponding shares of Class B common stock) for shares of our Class A common stock, (2) any existing tax attributes associated with their LLC Units, the benefit of which is allocable to us as a result of such exchanges (including the allocable share of Desert Newco's existing tax basis in its assets), (3) tax benefits related to imputed interest and (4) payments under the TRA.
The TRAs allow our pre-IPO owners to transfer their rights under the TRAs to third parties, who would then succeed to the rights of our pre-IPO owners under the TRAs. In the event of such a transfer, we would be required to make the payments described above to the new TRA parties in accordance with the terms of the TRAs.
When LLC Units are exchanged, we receive certain tax attributes, including the OBAs created from the original acquisition of the LLC Units plus any anticipated basis adjustments. The OBAs entitle us to the depreciation and amortization previously allocable to the original owner of such units. The anticipated basis adjustments will increase, for tax purposes, our depreciation and amortization deductions. To the extent these deductions are used to reduce our taxable income, thereby resulting in actual tax savings, we will be required to pay the original owners approximately 85% of such savings, which is recorded as an additional liability under the TRAs. This increase in tax basis also creates additional DTAs and may also decrease gains, or increase losses, on future dispositions of certain assets to the extent tax basis is allocated to those assets.
For purposes of calculating the income tax savings we are deemed to realize under the TRAs, we will calculate the federal income tax savings using the actual applicable U.S. federal income tax rate and will calculate the state and local income tax savings using 5% for the assumed combined state and local tax rate, which represents an approximation of our combined state and local income tax rate, net of federal income tax benefits.
The term of the TRAs commenced upon the completion of our IPO and will continue until all such tax benefits have been utilized or expire, unless we exercise our rights to terminate the agreements or payments under the agreements are accelerated in the event we materially breach any of our material obligations under the agreements.
In the pre-IPO reorganization transactions, we received certain tax attributes, including the OBAs and NOL carryforwards, from certain of our pre-IPO owners, which entitle us to the depreciation and amortization previously allocable to such parties. These deductions are allowed prior to the utilization of any NOL or tax credit carryforwards against income taxes.
Based on current projections of taxable income, and before deduction of any specially allocated depreciation and amortization, we anticipate having enough taxable income to utilize a portion of these specially allocated deductions related to the OBAs. Accordingly, as of December 31, 2017 and 2016, our liability under the TRAs was $153.0 million and $202.6 million, respectively.
The projection of future taxable income involves significant judgment. Actual taxable income may differ from our estimates, which could significantly impact the liability under the TRAs. We have determined it is more-likely-than-not we will be unable to utilize all of our DTAs subject to TRAs; therefore, we have not recorded a liability under the TRAs related to the tax savings we may realize from the utilization of NOL carryforwards and the amortization related to basis adjustments under Code Section 754 created by exchanges of LLC Units, including those associated with secondary offerings. If utilization of these DTAs becomes more-likely-than-not in the future, at such time, we will record liabilities under the TRAs of up to an additional $559.5 million as a result of basis adjustments under Code Section 754 and up to an additional $224.4 million related to the utilization of NOL and credit carryforwards, which will be recorded through charges to our statements of operations. However, if the tax attributes are not utilized in future years, it is reasonably possible no amounts would be paid under the TRAs. In this scenario, the reduction of the liability under the TRAs would result in a benefit to our statements of operations.
See Notes 2 and 15 to our consolidated financial statements for additional information regarding the payable to related parties pursuant to the TRAs.
The TRAs are subject to a number of risks and uncertainties. For a description of these risks, see "Risk Factors—Risks Related to Our Company and Our Organizational Structure."
Indirect Taxes
We are subject to indirect taxation in some, but not all, of the various states and foreign jurisdictions in which we and our subsidiaries conduct business. Laws and regulations attempting to subject communications and commerce conducted over the Internet to various indirect taxes are becoming more prevalent, both in the U.S. and internationally, and may impose additional burdens on us in the future. Increased regulation could negatively affect our business directly, as well as the businesses of our customers. Taxing authorities may impose indirect taxes on the Internet-related revenue we generate based on regulations currently being applied to similar, but not directly comparable, industries. There are many transactions and calculations where the ultimate indirect tax determination is uncertain. In addition, domestic and international indirect taxation laws, or interpretations thereof, are subject to change. We may be audited in the future, which could result in changes to our indirect tax estimates. We continually evaluate those jurisdictions in which nexus exists, and believe we maintain adequate indirect tax accruals.
As of December 31, 2017, our accrual for estimated indirect tax liabilities was $18.8 million, reflecting our best estimate of the probable liability, based on an analysis of our business activities, revenues subject to indirect taxes and applicable regulations. Although we believe our indirect tax estimates and associated liabilities are reasonable, the final determination of indirect tax audits, litigation or settlements could be materially different than the amounts established for indirect tax contingencies. Due to the complexity and uncertainty surrounding indirect tax laws in certain international locations, we believe it is reasonably possible, based on currently available information and analysis, that we may incur additional losses related to indirect taxes, which management estimates to be within the range of $0 to $10.0 million as of December 31, 2017.
See Note 12 to our consolidated financial statements for additional information regarding indirect taxes.
Loss Contingencies
We are subject to the possibility of various loss contingencies arising from uncertain and unresolved matters in the ordinary course of business and from events or actions by others having the potential to result in a future loss. Such contingencies may include, but are not limited to, intellectual property claims, labor and employment claims, breach of contract claims, regulatory proceedings, product service level commitments and losses resulting from other events and developments. We consider the likelihood of loss, the impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies.
When a loss is considered probable and reasonably estimable, we record a liability in the amount of our best estimate for the ultimate loss. When there appears to be a range of possible costs with equal likelihood, a liability is recorded based on the low-end of such range. However, the likelihood of a loss with respect to a particular contingency is often difficult to predict and determining a meaningful estimate of the loss or a range of loss may not be practicable based on the information available and the potential effect of future events and decisions by third parties impacting the ultimate resolution of the contingency. It is also not uncommon for such matters to be resolved over many years, during which time relevant developments and new information must be continuously evaluated to determine both the likelihood of potential loss and whether it is possible to reasonably estimate a range of possible loss. When a loss is probable but a reasonable estimate cannot be made, disclosure is provided.
Disclosure is also provided when it is reasonably possible a loss will be incurred, or when it is reasonably possible the amount of a loss will exceed the recorded amounts. We regularly review all contingencies to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or range of loss can be made. As discussed above, development of a meaningful estimate of loss, or a range of potential loss, is complex when the outcome is directly dependent on negotiations with, or decisions by, third parties such as regulatory agencies, court systems in various jurisdictions and other interested parties. Such factors bear directly on whether it is possible to reasonably estimate a range of potential loss and boundaries of high and low estimates.
See Note 12 to our consolidated financial statements for additional information regarding loss contingencies.
Recent Accounting Pronouncements
See Note 2 to our consolidated financial statements for information regarding recent accounting pronouncements.
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