UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

ý           Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended December 31, 2004

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: 000-27787

DIGITAL IMPACT, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (650) 356-3400

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

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   ý                          No   o

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934:

Yes   o                          No   ý

As of February 10, 2005, there were approximately 36.9 million shares of the Registrant’s Common Stock outstanding.

DIGITAL IMPACT, INC.

INDEX

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PART I.  FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

DIGITAL IMPACT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

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

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DIGITAL IMPACT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

 (Unaudited)

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

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DIGITAL IMPACT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

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

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DIGITAL IMPACT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

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DIGITAL IMPACT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.  The Company

Digital Impact, Inc. (the “Company” or “Digital Impact”) was incorporated in California in October 1997 and reincorporated in Delaware in October 1999. Digital Impact is a leading provider of integrated digital marketing solutions for Global 2000 enterprises. The Company draws on its industry specific expertise, its comprehensive methodology for creating programs to address specific marketing objectives and its proprietary technology platform to deliver marketing campaigns through email as well as website, search and other media.

Digital Impact derives its revenues from the sale of solutions that enable businesses to proactively communicate with its customers online. Primarily, these services have consisted of the design and execution of online direct marketing campaigns, the development and execution of Customer Acquisition programs and additional services provided by the Agency Services organization.

Digital Impact is organized into two segments:  Email Marketing and Agency Services. Email Marketing provides clients with comprehensive solutions for creating and executing online direct marketing programs. The Company’s solutions are designed to enable marketers to drive revenue and deepen customer relationships with a comprehensive process that includes: collecting and managing customer information, analyzing the information to determine ideal segments and offers, and delivering highly relevant, individualized email messages. Agency Services are utilized by clients to enhance marketing programs and improve results. Digital Impact offers clients services in each of the following categories: Strategic Marketing, Search and Acquisition Services, Creative Services, Web Development, Data Management, Measurement and Analytics, Program Delivery and Campaign Automation.

On July 12, 2004, the Company acquired all of the outstanding equity of Marketleap.com, Inc. Total consideration for the acquisition of Marketleap was approximately $3.8 million, consisting of 1.3 million shares of stock and stock options and $1.7 million in cash. The combination of Digital Impact’s strengths in email marketing with Marketleap’s experience in search engine marketing creates a true integrated digital online business. Digital Impact expects to be able to assist clients in managing their customers through the entire lifecycle of awareness, consideration, purchase and loyalty, through a combination of email and search marketing strategy, analytics and campaign execution

On December 29, 2004, the Company entered into an agreement to acquire the assets of KBAMS, Inc. The Company has paid $50,000 in cash for the acquired assets and certain assumed liabilities and will pay KBAMS, Inc. an earnout of 30% of certain future revenues for two years beginning February 2005. The advantage of the acquired technology is its ability to transform basic text emails into vibrant html-based emails containing dynamically generated offers. One key advantage is that our clients can simply redirect their in-house mail servers to our system which performs a set of predefined transformations and forwards the message on to the end recipient in html format with dynamic content. This software is particularly effective at turning bland purchase/shipping confirmations into compelling sales and marketing messages.

Note 2.  Summary of Significant Accounting Policies

Basis of presentation and liquidity

The interim consolidated financial statements include the accounts of Digital Impact and its wholly owned subsidiaries. All significant intercompany accounts and balances have been eliminated.

The accompanying interim consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. The accompanying interim consolidated financial statements are unaudited, but in the opinion of management, contain all the normal, recurring adjustments considered necessary to state fairly the financial position, the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim  periods. Results of operations are not necessarily indicative of the results expected for the full fiscal year or for any future period.

The accompanying interim consolidated financial statements should be read in conjunction with the audited financial statements and the notes thereto included in Digital Impact’s Annual Report on Form 10-K for the fiscal year ended March 31, 2004.

Certain reclassifications have been made to the prior years’ consolidated financial statements to conform to the current year’s presentation. The reclassifications had no effect on prior years’ stockholders’ equity or net loss.

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The Company incurred a net loss of approximately $811,000 and $3.7 million for the three and nine months ended December 31, 2004, respectively. The Company generated net income of approximately $489,000 and $304,000 for the three and nine months ended December 31, 2003, respectively. The Company generated $1.4 million of cash from operating activities for the nine months ended December 31, 2004, compared to $3.8 million provided by operating activities for the nine months ended December 31, 2003.

The Company continues to face risks associated with the execution of its strategy.  Future cash flows and capital requirements depend on numerous factors, including market acceptance of its services, competition from new and existing competitors, the amount of resources it invests in its data center infrastructure and new product development, marketing and selling its products and services and any future acquisitions or divestitures.

The Company’s primary source of liquidity is $25.0 million in cash and cash equivalents.  On October 1, 2004, Digital Impact entered into a Loan and Security Agreement with Silicon Valley Bank that provides for an $8.0 million revolving line of credit. The revolving loans will bear interest at a floating rate of interest equal to the greater of Silicon Valley Bank’s prime rate or 4.0%. On September 30, 2005, the revolving line of credit matures and Silicon Valley Bank’s commitment to extend the revolving loans under the Loan and Security Agreement terminates. The revolving and term loans under the Loan and Security Agreement are collateralized by a first priority lien on substantially all of the assets of Digital Impact, excluding intellectual property. The use of credit also requires the Company to maintain an adjusted quick ratio of not less than 1.50:1.00 and to achieve quarterly minimum revenue goals. The occurrence of an event of default will increase the applicable rate of interest by 2.0% and could result in the acceleration of Digital Impact’s obligations under the Loan and Security Agreement and foreclosure on the collateral securing its obligation under the Loan and Security Agreement. As of December 31, 2004, there have been no borrowings under this agreement, and the Company was in compliance with all financial covenants. The Company believes that it has the necessary financial resources to fund its working capital needs, capital expenditures and other business requirements for at least the next 12 months.

Use of estimates

Preparation of the accompanying financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Significant estimates include those required in the valuation of intangible assets acquired in business combinations, allowances for doubtful accounts and sales allowances. Actual results could differ from those estimates.

Foreign currency translation

The functional currency for the Company’s UK subsidiary is the UK Pound. Assets and liabilities are translated using the exchange rate at the balance sheet date. Revenues, expenses, gains, and losses are translated using the average exchange rate for the month in which the transaction occurred. Translation gains and losses are recorded in accumulated other comprehensive income as a separate component of stockholders’ equity.  Net gains and losses from foreign currency transactions are included in the Consolidated Statement of Operations and were not significant during any of the periods presented.

Revenue Recognition

The Company generates revenue from the sale of solutions that enable businesses to proactively communicate with its customers online.

Digital Impact applies the provisions of Staff Accounting Bulletin 104 “Revenue Recognition” and recognizes revenue when persuasive evidence of an arrangement exists, the service has been delivered, the fee is fixed or determinable and collection of the resulting receivables is reasonably assured. Email Marketing revenues are recognized upon sending the campaigns. Revenues attributable to one-time set-up fees for service initiation are deferred and recognized ratably over the term of the client’s service agreement, typically twelve months. Customer Acquisition revenues, which are part of Agency Services revenues,  are derived primarily from programs that assist clients in growing their email lists and generating leads through the use of third-party providers. Customer Acquisition programs fall into three general categories: list rental, co-registration and search engine marketing programs. List rental programs involve the execution and delivery of email campaigns to a defined number of individuals provided by a third-party list rental or email address marketing service.  Co-registration programs involve the strategic placement of a Digital Impact client offer on a third-party site for the purpose of generating new opt-in email addresses for the client. Search engine marketing involves the expert management of search, placement, traffic flow, and analytical data for our clients. Digital Impact contracts with third-party providers to deliver names of individuals who opt-in to join the

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client’s email list or, in the case of search, to deliver specific content in response to user search queries. Digital Impact is obligated to make payments to third parties for the cost of services associated with the execution of list rental, co-registration and search engine marketing programs. Digital Impact accounts for revenues and costs associated with Customer Acquisition programs in accordance with Emerging Issues Task Force Issue No. 99-19 (EITF 99-19), “Reporting Revenue Gross as a Principal versus Net as an Agent.”  The cost of Customer Acquisition campaigns are recognized in the period that the programs are executed and are netted against program revenue.  The cost of Customer Acquisition campaigns are estimated using Company records of outstanding purchase commitments when final vendor invoices have not been received.

Digital Impact recognizes revenue net of third-party costs because the majority of client and supplier contracts have the following characteristics: most of the time, the supplier, not the Company, is deemed to be the primary obligor in the arrangement, the Company does not maintain any inventory related to Customer Acquisition programs, the Company does not make changes to any data acquired from the supplier, the Company has limited latitude in establishing the price charged to the client, the Company’s credit risk is sometimes mitigated by receiving  reduced credit terms from its clients before ordering from the supplier, and the client approves the supplier selection and the service specifications.

Digital Impact provides other complementary services to clients, which are also part of our Agency Services revenues, such as strategic marketing, campaign automation, web-page development, creative services, data management, measurement and analytics and program delivery. These services are typically billed on an hourly or project basis. The revenue for engagements that support the delivery of future products and services is deferred at the time of delivery and recognized pro-rata over the future periods of usage. The period over which the revenue is recognized varies, generally between one and twelve months, depending on the term of the contract or the estimated period of usage. Management uses their best estimates to determine the appropriate period for revenue deferral.

The Company assesses the probability of collection based on a number of factors, including its past transaction history with the customer and the credit-worthiness of the customer. New customers and certain existing customers are subject to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay according to the original terms of the arrangement. Based on the Company’s review process, if it is determined from the outset or during the term of an arrangement that collection of the resulting receivable is not probable, then revenue is recognized on a cash-collected basis.

Cash, cash equivalents and short-term investments

The Company considers all highly liquid investments with an original maturity, or remaining maturity at the time of purchase, of three months or less to be cash equivalents.

Short-term investments consist of certificates of deposit and are classified as current assets because they have a maturity of less than one year.

Digital Impact classifies short-term investments as available-for-sale.  Accordingly, these investments are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity.  Digital Impact realizes gains or losses when these investments are sold using the specific identification method.  Digital Impact has not recognized any material gains or losses from the sale of short-term investments.

Concentration of credit risk and other risks and uncertainties

Financial instruments and assets subjecting the Company to concentration of credit risk consist primarily of cash and cash equivalents, short-term investments and trade accounts receivable. The Company’s cash and cash equivalents are maintained at major U.S. financial institutions. Deposits in these institutions may exceed the amount of insurance provided on such deposits.

The Company’s customers are primarily concentrated in the United States. The Company performs ongoing credit evaluations and establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of customers, historical trends and other information. For the nine months ended December 31, 2004, two customers represented 11% and 10% of revenue, respectively. For the nine months ended December 31, 2003 two customers represented 12% and 11% of revenue, respectively. As of December 31, 2004 and 2003, one customer represented 10% of accounts receivable, respectively.

Research and development expense

Research and development expenses consist primarily of salary and related personnel expense, consulting fees and

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other operating expenses related to the research and development departments.  The research and development departments perform new product development, enhance and maintain existing products and perform quality assurance.  With the exception of capitalized software development costs, research and development costs are expensed as incurred.

The Company follows the provisions outlined in Statement of Position 98-1 “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” related to the treatment of costs.

The Company capitalizes certain direct costs incurred in the development of internal use software.  For the nine months ended December 31, 2004, the Company capitalized approximately $52,000 in software development costs. These costs are being amortized using the straight-line method over the estimated useful life of the software, generally two years, beginning when the software is ready for use. These amounts are included in property and equipment in the accompanying consolidated balance sheet. For the nine months ended December 31, 2004, the Company amortized approximately $55,000 of software development costs.

Long-lived assets

Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the shorter of the estimated useful lives of the assets, generally three to five years, or the lease term, if applicable. Gains and losses upon asset disposal are taken into Other Income (Expense) in the year of disposition.

Long-lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated discounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated.

Goodwill and other intangible assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill is no longer subject to amortization, but rather is subject to at least an annual assessment for impairment. The Company completed its annual impairment test in March 2004 and determined that no impairment existed.

Income taxes

Deferred tax assets and liabilities are determined based on the differences between financial reporting and tax basis of assets and liabilities, measured at tax rates that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.  As of December 31, 2004, the Company had recorded a full valuation allowance against its deferred tax assets.

Recent accounting pronouncements

On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or, liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments.  The statement eliminates the ability to account for share-based compensation transactions using Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in consolidated statement of income.  The statement encourages companies with adequate exercise history to use the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use to determine the fair value of our options. For public companies, the effective date for adopting Statement No. 123(R) will be fiscal periods beginning after June 15, 2005.  As required by Statement No. 123(R), for the quarter ended September 30, 2005, the Company will begin recording all forms of stock-based compensation expense in the income statement. This will have a significant impact on our consolidated statement of operations as we will expense the fair value of our stock options rather than disclosing the value only within our notes to financial statements as is our current practice. The Company has not yet determined which transition method it will apply.

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In April 2004, the Emerging Issues Task Force issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. EITF 03-06 also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 was effective for fiscal periods beginning after March 31, 2004, and the adoption did not have any effect on our results of operations or net income per share.

Note 3.  Business Combination

On July 12, 2004, the Company acquired all of the outstanding equity of Marketleap.com, Inc. The combination of Digital Impact’s strengths in email marketing with Marketleap’s experience in search engine marketing creates a true integrated digital online business. Digital Impact assists clients in managing their customers through the entire lifecycle of awareness, consideration, purchase and loyalty, through a combination of email and search marketing strategy, analytics and campaign execution. These factors contributed to a purchase price in excess of the fair market value of the net tangible and intangible assets acquired from Marketleap, and as a result the Company has recorded goodwill in conjunction with this transaction. Total consideration for the acquisition of Marketleap was approximately $3.8 million, consisting of 840,000 shares of stock, valued at $1.80 per share, 411,651 stock options, valued at approximately $538,000 in total, and $1.7 million in cash, including $205,000 in fees related to the acquisition. The acquisition was completed under purchase accounting and the purchase price has been allocated as follows:

•              Goodwill of $2.1 million;

•              Deferred stock compensation totaling $1.4 million, which will be amortized over 2.5 years through cost of goods sold and operating expenses;

•              Intangible assets of $191,000 and $46,000 for existing customer base and trade-name, respectively, will be amortized through sales and marketing expenses over the next 3 years. Intangible assets of $88,000 for developed technology will be amortized through cost of goods sold over the next three years.

The amount allocated to purchased intangibles was determined by management with the assistance of an appraisal completed by an independent third party using established valuation techniques. The valuation techniques included a fair value analysis of the acquired balance sheet components, a present value analysis of incremental operating income and incremental free cash flows, an analysis of avoided workforce recruiting and training costs, an analysis of avoided loss of productivity, an analysis of technology replacement cost, and a discounted cash flow analysis of acquired trademarks and a URL.

As part of the Marketleap acquisition agreement, Digital Impact has a contractual obligation to pay up to 200,000 shares of Company’s common stock if certain revenue goals are met. In the event that the revenues of the Company from its Search and Acquisition Services for the fiscal year ending March 31, 2005 are greater than $4.4 million, but less than or equal to $5.0 million, the earnout shares payable to Markeleap stock and option holders will equal 100,000 shares of Company’s common stock.  In the event that the revenues of the Company from its Search and Acquisition Services for the fiscal year ending March 31, 2005 are greater than $5.0 million, the earnout shares will equal 200,000 shares of Company’s common stock. If the earnout shares are paid out, an adjustment to goodwill will be made. Based upon our current forecast, we do not expect to pay any of the earnout.

The following unaudited pro forma revenues, net loss, and net loss per share data for the nine months ended December 31, 2004 and 2003 are based on the respective historical financial statements of the Company and Marketleap. The pro forma data reflects the consolidated results of operations as if the merger with Marketleap had occurred at the beginning of each of the periods indicated and includes the amortization of the resulting intangible assets and stock-based compensation. The pro forma financial data presented are not necessarily indicative of the Company’s results of operations that might have occurred had the transaction been completed at the beginning of the periods specified, and do not purport to represent what the Company’s consolidated results of operations might be for any future period.

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Note 4.  Stock-Based Compensation

SFAS No. 123, “Accounting for Stock-Based Compensation” (“FSAS No. 123”), as amended by SFAS No. 148, permits companies to measure the compensation cost of stock-based awards based on either their intrinsic value or their estimated fair value at the date of grant and recognize the amount over the related service period.  Therefore, as permitted by SFAS No. 123 and SFAS No. 148, the Company accounts for its employee stock option plans under the intrinsic value method, in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. As such, compensation expense related to the granting of employee stock options is recorded over the vesting period only if, on the date of grant, the fair value of the underlying stock exceeds the option’s exercise price. Digital Impact has adopted the disclosure-only requirements of SFAS No. 123, which allows entities to continue to apply the provisions of APB No. 25 for transactions with employees and provide pro forma net income and pro forma earnings per share disclosures for employee stock grants made as if the fair value based method of accounting in SFAS No. 123 had been applied to these transactions.

The Company accounts for its non-employee stock-based-compensation under the fair value based method. The fair value of each option granted is estimated at the date of grant using the Black-Scholes option-pricing model and the remaining unvested options are reevaluated at the end of each reporting period to reflect the fluctuations in the Company’s stock price. The non-employee stock-based-compensation expense is recognized on an accelerated basis over the related service period.

Had the Company determined compensation expense of employee stock options based on the estimated fair value of the stock options at the grant date, consistent with the guidelines of SFAS 123, the net income (loss) would have been changed to the pro forma amounts indicated below (in thousands, except per share amounts):

The fair value for each option granted was estimated at the date of grant using the Black-Scholes option-pricing model, assuming no expected dividends and the following weighted average assumptions:

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The weighted average fair value per share of options granted at fair market value for the three and nine months ended December 31, 2004 was $1.17 and $1.31, respectively, and the weighted average fair value per share of options granted at fair market value for the three and nine months ended December 31, 2003 was $2.59 and $2.46, respectively.

The pro forma impact of options on the net loss for the three and nine months ended December 31, 2004 and 2003, may not be representative of the effects on net income (loss) for future years, as future years will include the effects of additional years of stock option grants.

Note 5.  Net Income (Loss) Per Share Computation

Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of vested common shares outstanding for the period. Diluted net income (loss) per share is calculated giving effect to all dilutive potential common shares, including options and preferred stock. A reconciliation of the numerators and denominators used in the basic and diluted net income (loss) per share amounts follows (amounts in thousands, except per share data):

The following outstanding stock options have been excluded from the calculation of diluted net income (loss) per

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common share because all such securities are antidilutive for all periods presented (in thousands):

Note 6. Restructuring Charges

In the fourth quarter of fiscal 2004, the Company initiated a cost reduction which included the termination of 19 employees and the closure of our Santa Monica office. As of December 31, 2004, all of the severance liability has been paid.

Note 7.  Intangible Assets

Intangible assets consist of the following (in thousands):

In the quarter ended September 30, 2004, the Company recorded $325,000 in intangibles related to the acquisition of Marketleap. These assets will be amortized over three years. Approximately $117,000, $156,000, $49,000 and $3,000 of the amortization will be recognized for the fiscal years 2005, 2006, 2007 and 2008, respectively. Amortization expense was $39,000 for the three months ended December 31, 2004. No amortization expense was recorded for the three months ended December 31, 2003. The intangible assets related to the acquisition of MineShare in July 2000 have been fully amortized as of September 30, 2003. Amortization expense was $78,000 and $214,000 for the nine months ended December 31, 2004 and 2003, respectively.

On December 29, 2004, the Company entered into an agreement to acquire the assets of KBAMS, Inc. The Company paid $50,000 for the acquired assets and assumed liabilities, and $48,000 was allocated to intangible developed technology which will be amortized through cost of goods sold over the next 12 months.

Note 8. Contingencies

In June 2001, a series of putative securities class actions were filed in United States District Court for the Southern District of New York against certain investment bank underwriters for the Company’s initial public offering (“IPO”), the Company, and various of the Company’s officers and directors.  The complaints, which have been consolidated under the caption In re Digital Impact, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-4942, allege undisclosed and improper practices concerning the allocation of the Company’s IPO shares, in violation of the federal securities laws, and seek unspecified damages on behalf of persons who purchased the Company’s stock during the period from November 22, 1999 to December 6, 2000.  The Court has appointed a lead plaintiff for the consolidated cases.  On April 19, 2002, plaintiffs filed an amended complaint.  Other actions have been filed making similar allegations regarding the IPOs of more than 300 other companies.  All of these lawsuits have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92.  Defendants in these cases filed omnibus motions to dismiss on common pleading issues.  Oral argument on these omnibus motions to dismiss was held on November 1, 2002.  The Company’s officers and directors have been dismissed without prejudice in this litigation.  On February 19, 2003, the court granted in part and denied in part the omnibus motion to dismiss. The court’s order did not dismiss any claims against the Company.

A stipulation of settlement for the claims against the issuer-defendants, including the Company, has been submitted to the court. The settlement is subject to a number of conditions, including approval of the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The outcome of this litigation is uncertain and no estimate of liability can be made at this time.

On February 10, 2005, the Company filed a patent infringement lawsuit against Bigfoot Interactive, Inc., a competitor of the Company.  The lawsuit alleges that Bigfoot has infringed and is continuing to infringe the Company’s U.S. Patent No. 6,449,634.  The complaint seeks injunctive relief and unspecified damages.

From time to time, we may be involved in other disputes that arise in the ordinary course of business. Any claims

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against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, and result in the diversion of significant operational resources.

During the ordinary course of business, we have included indemnification provisions within our contracts. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally parties with which we have commercial relations, arising from a breach of representations, warranties or covenants and infringement of a third party’s intellectual property rights. To date, we have not incurred any costs in connection with such indemnification clauses and accordingly believe that the fair value of these indemnification provisions is not material.

Note 9. Segment Reporting

Digital Impact is organized into two segments:  Email Marketing and Agency Services.  These segments were determined in fiscal 2003 based on the alignment of the Company’s organization structure and selected management financial reporting with the nature of the service product offerings.

Email Marketing provides clients with comprehensive solutions for creating and executing online direct marketing programs. The Company’s solutions are designed to enable marketers to drive revenue and deepen customer relationships with a comprehensive process that includes: collecting and managing customer information, analyzing the information to determine ideal segments and offers, and delivering highly relevant, individualized email messages.  Email Marketing represented 73% of revenues for the three months ended December 31, 2004 and 2003, respectively. The gross margin for Email Marketing was 56% and 61% for the three months ended December 31, 2004 and 2003, respectively.

Agency Services are utilized by clients to enhance marketing programs and improve results. Digital Impact offers clients services in each of the following categories: Strategic Marketing, Search and Acquisition Services, Creative Services, Web Development, Data Management, Measurement and Analytics, Program Delivery and Campaign Automation.  Agency Services represented 27% of revenues for the three months ended December 31, 2004 and 2003, respectively.   The gross margin for Agency Services was 31% and 48% for the three months ended December 31, 2004 and 2003, respectively.

The respective revenue and gross profit of each of these segments is as follows (in thousands):

Note 10. Subsequent Events

On January 25, 2005, the Company entered into an Exchange Election and Restricted Stock Agreement (the “Restricted Stock Agreement”) with each of David Oppenheimer, the Company’s Senior Vice President and Chief Financial Officer, Kevin Johnson, Senior Vice President, Products & Marketing, Michael Gorman, Senior Vice President, Search & Acquisition, and five other members of senior management.  Under the terms of the Restricted Stock

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Agreement, the executives were offered the opportunity to cancel certain previous grants of Company stock options in order to obtain new grants of restricted stock.  The restricted stock will vest at the rate of 1/16 per quarter over a four-year period, provided that the executive remains employed by the Company on each vesting date.  Unvested restricted stock held on the date of termination of service will be forfeited.  The restricted stock will be equitably adjusted in the event of certain recapitalizations of the Company. The Company replaced 940,000 shares subject to stock options that were out-of-the-money with 1.2 million shares of restricted stock. The Company will incur approximately $1.8 million of non-cash stock-based compensation charges over the four-year vesting period of these restricted shares.

On February 10, 2005, the Company received a letter from InfoUSA, Inc. proposing to acquire the Company at $2.00 per share in cash.  The Company’s Board of Directors is reviewing this proposal in accordance with their fiduciary obligation.

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

The following discussion contains forward-looking statements that involve risks and uncertainties.  Our actual results could differ materially from those discussed below.  Additional factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled “Certain Factors Which May Impact Operating Results”, included in this Report.  When used in this document, the words “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements.  However, these words are not the exclusive means of identifying such statements.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements.  The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document.  You should read the following discussion in conjunction with our Consolidated Financial Statements and related notes. Unless required by law, we undertake no obligation to update any forward-looking statements in this Report.

Overview

Digital Impact is a leading provider of integrated digital marketing solutions for Global 2000 enterprises.   We draw on our industry specific expertise, our comprehensive methodology for creating programs to address specific marketing objectives and our proprietary technology platform to deliver marketing campaigns through email as well as websites, search and other media.  We derive revenues and cash flows primarily from two business segments:  Email Marketing and Agency Services.

The Email Marketing segment derives revenue from 1) the IMPACT ™ email software platform sold as a subscription-based hosted service (“IMPACT”) and 2) account management services such as email campaign targeting, testing, delivery and reporting.

The Agency Services segment derives revenue from project-based and retainer-based fees for marketing strategy, advanced analytics, data management, creative webpage design, customer acquisition and search engine marketing services.

On July 12, 2004, the Company acquired all of the outstanding equity of Marketleap.com, Inc. The combination of Digital Impact’s strengths in email marketing with Marketleap’s experience in search engine marketing creates a true integrated digital online business. Digital Impact assists clients in managing their customers through the entire lifecycle of awareness, consideration, purchase and loyalty, through a combination of email and search marketing strategy, analytics and campaign execution. Digital Impact expects the acquisition to result in approximately $1.5 million of additional net revenues for fiscal 2005.

On December 29, 2004, the Company entered into an agreement to acquire the assets of KBAMS, Inc. The Company has paid $50,000 in cash for the acquired assets and certain assumed liabilities. The purchase price has been allocated as follows:

•              Net fixed assets, consisting of computer equipment, totals approximately $8,000;

•              Intangible developed technology assets of $48,000 will be amortized through cost of goods sold over the next 12 months;

•              The Company has also assumed liabilities of approximately $6,000 in the form of equipment leases which expire in fourteen months.

The advantage of the acquired technology is its ability to transform basic text emails into vibrant html-based emails containing dynamic offers. One key advantage is that our clients can simply redirect their in-house mail servers to our system which performs a set of predefined transformations and forwards the message on to the end recipient in html format with dynamic content. This software is particularly effective at turning bland purchase/shipping confirmations into compelling sales and marketing messages.

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The KBAMS asset purchase agreement includes a contractual obligation to pay 30% of the revenues recognized by the Company from the transmission of client-originated emails into which the KBAMS service dynamically inserts html content. The earnings period begins February 2005 and expires after two years. The amount of the earnout cannot be reasonably estimated at this time.

Members of our senior management regularly review key financial information including net revenues by segment, operating expenses and margins, net income, earnings per share, and cash flow.  They also review key operating metrics such as service mix, major account trends and email delivery volume. This information allows us to monitor the growth and profitability of our business and to evaluate the effectiveness of investments that we have made and continue to make in the areas of client services, product development, marketing and data center operations.

Critical Accounting Policies and Estimates

Digital Impact’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates, including those related to the revenue recognition, accounting for internal-use software, allowance for doubtful accounts, valuation of long-lived assets and goodwill, and accounting for stock-based compensation. Management bases its estimates on historical experience and various factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes that the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:

•    revenue recognition;

•    estimating valuation allowances, specifically the allowance for doubtful accounts; 

•    accounting for internal-use software;

•    valuation of long-lived assets and goodwill; and

•    accounting for stock-based compensation.

Revenue recognition. We generate revenue from the sale of solutions that enable businesses to proactively communicate with their customers online.

Digital Impact applies the provisions of Staff Accounting Bulletin 104 “Revenue Recognition” and recognizes revenue when persuasive evidence of an arrangement exists, the service has been delivered, the fee is fixed or determinable and collection of the resulting receivables is reasonably assured. Email Marketing revenues are recognized upon sending of the campaigns. Revenues attributable to one-time set-up fees for service initiation are deferred and recognized ratably over the term of the client’s service agreement, typically twelve months. Customer Acquisition revenues, which are part of Agency Services revenues, are derived primarily from programs that assist clients in growing their email lists through the use of third-party providers. Customer Acquisition programs fall into three general categories: list rental programs, co-registration programs, and search engine marketing. List rental programs involve the execution and delivery of email campaigns to a defined number of individuals provided by a third-party list rental or email address matching service. Co-registration programs involve the strategic placement of a Digital Impact client offer on a third-party site for the purpose of generating new opt-in email addresses for the client. Search engine marketing involves assisting clients in the use of search engines to acquire customers. Digital Impact contracts with third-party providers to deliver names of individuals who opt-in to join the client’s email list or, in the use of search, to deliver specific content in response to user search queries. Digital Impact is obligated to make payments to third-parties for the cost of services associated with the execution of list rental, co-registration and search engine marketing programs. Digital Impact accounts for revenues and costs associated with Customer Acquisition programs in accordance with Emerging Issues Task Force Issue No. 99-19 (EITF 99-19), “Reporting Revenue Gross as a Principal versus Net as an Agent.”  The costs of Customer Acquisition campaigns are estimated using work order commitments when final vendor invoices have not been received.  The costs of Customer Acquisition campaigns are recognized in the period that the programs are executed and are netted against program revenue.

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Digital Impact recognizes revenue net of third-party costs because the majority of client and supplier contracts have the following characteristics: most of the time, the supplier, not the Company, is deemed to be the primary obligor in the arrangement, the Company does not maintain any inventory related to Customer Acquisition programs, the Company does not make changes to any data acquired from the supplier, the Company has limited latitude in establishing the price charged to the client, the Company’s credit risk is sometimes mitigated by receiving reduced credit terms from its clients before ordering from the supplier, and the client approves the supplier selection and the service specifications.

Digital Impact provides other complementary services to clients, which are also part of our Agency Services revenues, such as strategic marketing, campaign automation, web-page development, creative services, measurement and analytics, program delivery and data management. These services are typically billed on an hourly rate or as a fixed project price. The revenue for engagements that support the delivery of future products and services is deferred at the time of delivery and recognized pro-rata over the future periods of usage. The period over which the revenue is recognized varies, generally between one and twelve months, depending on the term of the contract or the estimated period of usage. Management uses its best estimates to determine the appropriate period for revenue deferral.

We assess probability of collection based on a number of factors, including our past transaction history with the customer and the credit-worthiness of the customer. New customers and certain existing customers are subject to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay according to the original terms of the arrangement. Based on our review process, if it is determined from the outset or during the term of an arrangement that collection of the resulting receivable is not reasonably assured, then revenue is recognized on a cash-collected basis.

Allowance for doubtful accounts. The preparation of financial statements requires our management to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Specifically, management must make estimates of the uncollectable portion of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debt experience, customer account disputes, customer credit worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $7.2 million, net of allowance for doubtful accounts of $276,000, as of December 31, 2004.

Accounting for internal-use software.  We account for internal-use software in accordance with AICPA Statement of Position
98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.”  Internal-use software costs, including any fees paid to third parties to implement the software, are capitalized beginning when we have determined various factors are present, including among others, that the technology exists to achieve the performance requirements, we have made a decision as to whether we will purchase the software or develop it internally and we have authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software’s estimated useful life (generally two years) using the straight-line method. The estimated useful life is based on technical and marketing management judgment as to the product or feature life cycle. When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, if it is no longer probable that computer software being developed will be placed in service, the asset will be adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on our Consolidated Statement of Operations.  As of December 31, 2004, we believe that no such impairment of internal-use software existed.

Valuation of long-lived assets and goodwill. We assess the impairment of identified intangibles, long-lived assets and goodwill annually and whenever events or a change in circumstances indicate the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

•    significant underperformance relative to expected historical or projected future operating results;

•    significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

•    significant negative industry or economic trends;

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•                                          significant decline in our stock price for a sustained period of time; and

•                                          our market capitalization relative to net book value.

When we determine that the carrying value of intangible assets, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any potential impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.  Long-lived assets and goodwill amounted to $8.7 million as of December 31, 2004.

Accounting for Stock-Based Compensation. The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25).  Under the intrinsic value method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Company’s Consolidated Statement of Operations.  We believe this method is appropriate for the Company because it avoids the volatility of other expense methods which determine stock compensation expense typically by using the Black-Scholes option pricing model which was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable.  In addition, option pricing models require input of highly subjective assumptions including the expected stock price volatility.

We have currently elected to apply the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the provisions of SFAS No. 123, the Company applies APB No. 25, and related interpretations in accounting for its stock option plans.

On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or, liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments.  The statement eliminates the ability to account for share-based compensation transactions using Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in consolidated statement of income. The statement encourages companies with adequate exercise history to use the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use to determine the fair value of our options. For public companies, the effective date for adopting Statement No. 123(R) will be fiscal periods beginning after June 15, 2005.  As required by Statement No. 123(R), for the quarter ended September 30, 2005, the Company will begin recording stock-based compensation expense in the income statement. This will have a significant impact on our consolidated statement of operations as we will be expensing the fair value of our stock options rather than disclosing the impact on our consolidated net loss within our notes as is our current practice. The Company has not yet determined which transition method it will apply.

Results of Operations

The following table sets forth selected data for the periods indicated as a percentage of total revenues.  These operating results are not necessarily indicative of results for any future periods.

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Three Months Ended December 31, 2004 and 2003

Revenues

Our Email Marketing business provides clients with comprehensive solutions for creating and executing online direct marketing programs. Our solutions are designed to enable marketers to drive revenue and deepen customer relationships with a comprehensive process that includes: collecting and managing customer information, analyzing the information to determine optimal segments and offers, and delivering highly relevant, individualized email messages.  Email Marketing represented 73% of revenue for the three months ended December 31, 2004 and 2003, respectively.

The Agency Services group provides expertise to enhance marketing programs and improve results. Digital Impact offers clients services in each of the following categories: Strategic Marketing, Search and Acquisition Services, Creative Services, Web Development, Data Management, Measurement and Analytics, Program Delivery and Campaign Automation. Agency Services represented 27% of revenue for the three months ended December 31, 2004 and 2003, respectively.

Total revenues decreased by 3% to $11.1 million for the three months ended December 31, 2004 from $11.5 million for the three months ended December 31, 2003. Email Marketing revenues decreased $201,000 due to client attrition, price erosion and client mix. Agency Services revenues decreased $176,000 due to a decline in list rental revenues and client attrition, partially offset by search marketing revenues.

For the full fiscal year 2005, we are projecting revenues to be in the range of $42.1 million to $42.7 million.

Cost of Revenues

Cost of revenues consists primarily of expenses relating to the delivery of online direct marketing services, including personnel costs of our Email Marketing and Agency Services staff, the amortization of equipment, purchased and licensed technology, data center expenses, software and hardware maintenance costs and stock-based compensation.

Total cost of revenues increased 15% to $5.7 million for the three months ended December 31, 2004 from $4.9 million for the three months ended December 31, 2003. The increase in cost of revenues was primarily related to higher staffing costs related to our integrated digital marketing strategic initiatives. The increase was also partly the result of a $64,000 increase in stock-based compensation related to the acquisition of Marketleap.

Gross margin decreased to 49% for the three months ended December 31, 2004 from 57% for the three months ended December 31, 2003. The decline in gross margin was primarily the result of lower pricing and higher staffing costs. Gross margin for Email Marketing was 56% and 61% for the three months ended December 31, 2004 and 2003, respectively.  The decrease in gross margin for Email Marketing is primarily the result of the lower pricing and client mix. Gross margin for Agency Services was 31% and 48% for the three months ended December 31, 2004 and 2003, respectively.  This decline is primarily due to higher staffing and the replacement of high margin list rental and campaign automation services with lower gross margin agency services.

We expect that gross margin for fiscal year 2005 will be about 47%, as we maintain our investment in agency services to support potential growth in fiscal 2006.

Operating Expenses

Our operating expenses are classified into three general categories: research and development, sales and marketing, and general and administrative. We classify all charges to these operating expense categories based on the nature of the

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expenditures. Although each category includes expenses that are unique to each operating category, some expenditures, such as compensation, employee benefits, recruiting costs, travel and entertainment costs, facilities costs, third-party professional service fees and non-cash stock-based compensation, occur in each of these categories.

Stock-based compensation was $313,000 and $36,000 for the three months ended December 31, 2004 and 2003, respectively. The increase in stock-based compensation was due to grants associated with the acquisition of Marketleap. For the quarters ended December 31, 2004 and 2003, stock-based compensation was included in cost of revenues, general and administrative, research and development, and sales and marketing expenses.

Amortization of purchased intangibles was $39,000 for the three months ended December 31, 2004, and is attributed to the $325,000 of intangibles acquired through the acquisition of Marketleap. For the three months ended December 31, 2004, $11,000 and $28,000 of the amortization was included in cost of goods sold and sales and marketing expenses, respectively.

We allocate the facilities costs to each functional area based on each area’s relative headcount. These allocated charges include rent and other facility-related costs, communication charges and depreciation expense for furniture and equipment.

Research and Development. Research and development expenses consist primarily of personnel and related costs, consultants and outside contractor costs. Research and development expenses declined by 35% to $0.7 million for the quarter ended December 31, 2004 from $1.1 million for the quarter ended December 31, 2003.  The decline is primarily a result of a $466,000 reduction in personnel and allocated expenses, resulting from lower headcount driven by the closure of Santa Monica research and development facility and completion of version 6.0 of IMPACT. We capitalized $14,000 and $102,000 for internally developed software for the three months ended December 31, 2004 and 2003, respectively. For the three months ended December 31, 2004, the Company amortized approximately $29,000 of the capitalized software development costs. The Company did not amortize any of the software development costs for the three months ended December 31, 2003.

Sales and Marketing.  Sales and marketing expenses consist of personnel and related costs for our direct sales force and marketing staff, and marketing programs, which include trade shows, advertisements, promotional activities and media events. Sales and marketing expenses increased by 18% to $3.6 million for the three months ended December 31, 2004 from $3.1 million for the three months ended December 31, 2003.  The increase was mainly attributable to higher staffing costs and a $186,000 increase in stock-based compensation related to the acquisition of Marketleap. During the fiscal year ending March 31, 2005, we expect sales and marketing expenses to increase about 23% over the prior year as a result of higher staffing and non-cash stock-based compensation due to the acquisition of Marketleap.

General and Administrative.  General and administrative expenses consist primarily of personnel and related costs for general corporate purposes, including information technology, finance, accounting, human resources, facilities and legal.  General and administrative expenses remained approximately the same for the three months ended December 31, 2004 and 2003. A $120,000 decrease in personnel and allocated expenses was offset by a $134,000 increase in accounting audit fee, controls consulting fees and patent legal fees. During the fiscal year ending March 31, 2005, we expect general and administrative expenses to increase modestly in absolute dollars over the prior fiscal year.

Other Income.  Other income was $56,000 for the three months ended December 31, 2004, compared to $53,000 for the three months ended December 31, 2003. Other income relates to interest income on cash, cash equivalents and short-term investments.

Income taxes. No provision for federal and state income taxes was recorded as we incurred net operating losses from inception through December 31, 2004. Due to the uncertainty regarding the ultimate utilization of the net operating loss carryforwards, we have not recorded any benefit for losses and a valuation allowance has been recorded for the entire amount of the net deferred tax asset. The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. If we should have an ownership change, as defined for tax purposes, utilization of the carryforwards could be restricted. In addition, sales of our stock may further restrict our ability to utilize our net operating loss carryforwards.

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Results of Operations

The following table sets forth selected data for the periods indicated as a percentage of total revenues.  These operating results are not necessarily indicative of results for any future periods.