CarParts.com, Inc. - Quarter Report: 2009 October (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended October 3, 2009

OR

For the transition period from              to             

Commission file number: 001-33264

U.S. AUTO PARTS NETWORK, INC.

(Exact name of registrant as specified in its charter)

17150 South Margay Avenue

Carson, CA 90746

(Address of Principal Executive Office) (Zip Code)

(310) 735-0085

(Registrant’s telephone number, including area code)

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

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

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

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

As of November 6, 2009, the registrant had 29,850,507 shares of common stock, $0.001 par value, outstanding.

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U.S. AUTO PARTS NETWORK, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THIRTEEN AND THIRTY-NINE WEEK PERIOD ENDED OCTOBER 3, 2009

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Unless the context requires otherwise, as used in this report, the terms “U.S. Auto Parts,” the “Company,” “we,” “us” and “our” refer to U.S. Auto Parts Network, Inc. and its subsidiaries, and the terms “Partsbin” refers to All OEM Parts, Inc., ThePartsBin.com, Inc. and their affiliated companies, which we acquired in May 2006.

U.S. Auto Parts^®, and PartsTrain^® are our United States registered marks. U.S. Auto Parts Network™, Partsbin™, Kool-Vue™ Auto-Vend™ and AutoPartsGiant™ are our United States common law trademarks. All other trademarks and trade names appearing in this report are the property of their respective owners.

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements that do not relate strictly to historical or current facts, and anticipate results based on management’s beliefs and assumptions and on information currently available to management. These statements are forward looking statements for the purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act of 1933 (the “Securities Act”). In some cases, you can identify forward-looking statements by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would,” “will likely continue,” “will likely result” and similar expressions intended to identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding our anticipated sales, revenue, expenses, profits and losses, capital needs, capital deployment, liquidity, contracts, litigation, product offerings, customers, acquisitions, competition and the status of our facilities. Forward-looking statements, no matter where they occur in this document or in other statements attributable to the Company involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. We discuss many of these risks in greater detail under the heading “Risk Factors” in Part II, Item 1A of this report. Given these uncertainties, you should not place undue reliance on these forward-looking statements. You should read this report and the documents that we reference in this report and have filed as exhibits to the report completely and with the understanding that our actual future results may be materially different from what we expect. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this report. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

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PART I. FINANCIAL INFORMATION

U.S. AUTO PARTS NETWORK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts and par value)

See accompanying notes to unaudited condensed consolidated financial statements.

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U.S. AUTO PARTS NETWORK, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

See accompanying notes to unaudited condensed consolidated financial statements.

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U.S. AUTO PARTS NETWORK, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Summary of Significant Accounting Policies

Basis of Presentation

The condensed consolidated financial statements of U.S. Auto Parts Network, Inc. (collectively with its subsidiaries, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and with the instructions to U.S. Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, necessary to present fairly the consolidated financial position of the Company as of October 3, 2009 and December 31, 2008, and the consolidated results of operations for the thirteen and thirty-nine weeks ended October 3, 2009 and three and nine months ended September 30, 2008, and cash flows for the thirty-nine weeks and nine months ended October 3, 2009 and September 30, 2008. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to the rules and regulations of the SEC. The Company’s results of operations for the thirteen and thirty-nine weeks ended October 3, 2009 are not necessarily indicative of those to be expected for the entire year. The accompanying consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, which was filed with the SEC on March 26, 2009.

Change in Fiscal Year

The Company changed its fiscal year from a calendar year ending on December 31 to a 52/53 week fiscal year ending on the first Saturday following December 31. The change in the Company’s fiscal year took effect on January 1, 2009; therefore, there was no transition period in connection with this change in the Company’s fiscal year end. As a result, the first, second, and, third quarters of 2009 consisted of the thirteen weeks ended April 4, 2009, July 4, and October 3, 2009, respectively. The first, second, and, third quarters of 2008 consisted of the three months ended March 31, 2008, June 30, and September 30 2008.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make 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 reporting period. Significant estimates made by management include, but are not limited to, the valuation of investments, the valuation of inventory, valuation of deferred tax assets and liabilities, estimated useful lives of property, equipment and software, valuation of intangible assets, including goodwill, recoverability of software development costs, estimation of sales returns and allowances, and the provision for doubtful accounts. These estimates are based on current facts, historical experience and various other factors that the Company believes to be reasonable under the circumstances. Actual results could differ from these estimates.

Recent Accounting Pronouncements

During the third quarter of 2009, the Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The ASC is the single official source of authoritative, nongovernmental U.S. GAAP, other than guidance issued by the SEC. The Company’s adoption of the ASC did not have any impact on the financial statements included herein.

In August 2009, the FASB issued Accounting Standards Update (ASU) No. 2009-05 (“ASU 2009-05”), an update to ASC 820, Fair Value Measurements and Disclosures. ASU 2009-05 amends ASC 820 by providing additional guidance (including illustrative examples) clarifying the measurement of liabilities at fair value. When a quoted price in an active market for the identical liability is not available, the amendments in ASU 2009-05 require that the fair value of a liability be measured using one or more of the listed valuation techniques that should maximize the use of relevant observable inputs and minimize the use of unobservable inputs. In addition, the amendments in ASU 2009-05 clarify that when estimating the fair value of a liability, an entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. The amendments also clarify how the price of a traded debt security, (i.e., an asset value) should be considered in estimating the fair value of the issuer’s liability. The amendments in ASU 2009-05 are effective the first reporting period (including interim periods) beginning after its issuance, or as of October 4, 2009 for the Company. The Company does not expect the adoption will have a material impact to the financial statements.

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Subsequent Events

The Company has been advised that Robert J. Majteles, Chairman of the Board of the Company, intends to enter into a written sales plan in the near future, which is intended to comply with the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934 (the “Plan”) to sell shares of the Company’s common stock both held directly by Mr. Majteles and to be issued upon the exercise of stock options granted by the Company to Mr. Majteles. The Plan will be established during an “open window” consistent with the Company’s insider trading policy, and when Mr. Majteles is not in possession of material non-public information.

Shares may be sold under the Plan at any time that the Company’s stock attains certain pre-arranged minimum prices as set forth in the Plan, which prices are at a significant premium to the current trading price for our common stock. Sales may take place beginning as early as the next open trading window and will terminate upon the earlier of the sale of all the shares in the plan or December 31, 2014, or as otherwise may be provided under the Plan. Mr. Majteles will have no control over the timing of any sales under the Plan, and there is no guarantee that the shares covered by the Plan will actually be sold. The Plan covers up to 375,000 shares, which represents all of Mr. Majteles’ holdings as of November 2, 2009, including his unvested options.

Actual sales made pursuant to the Plan will be disclosed publicly through Form 4 and Form 144 filings with the SEC.

Certain legal proceedings are described in Note 5 of Notes to Unaudited Consolidated Financial Statements, included in Part 1, Item 1 of this Report.

The Company has evaluated all subsequent events through November 6, 2009, the date the financial statements were issued.

Note 2—Fair Value

As of October 3, 2009, the Company held the following securities and investments, recorded at either fair value or cost (in thousands).

US Treasury Bills are classified as Short-term investments with maturities of less than 12 months and it is the intention of Management to hold these securities to maturity.

Fair Value Measurements

In April 2009, the FASB released ASC 820, Fair Value Measurements and Disclosures, (formerly SFAS No. 157, “Fair Value Measurements”) that defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP, and expands disclosures about fair value measurements. This guideline was to be effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. In February 2008, the FASB delayed the effective date to fiscal years beginning after November 15, 2008 for all non-financial assets and non-financial liabilities, except for those that are recognized or disclosed at fair value in the financial statements on a recurring basis. As of January 1, 2009, the Company has adopted the provisions for all non-financial assets and non-financial liabilities.

This ASC 820 guideline establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:

Level 1- defined as observable inputs such as quoted prices in active markets;

Level 2- defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and

Level 3- defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Financial Assets Valued on a Recurring Basis

As of October 3, 2009, the Company held certain assets that are required to be measured at fair value on a recurring basis. These included the Company’s financial instruments, including investments associated with the auction rate preferred securities (“ARPS”). The Company measures the following financial assets at fair value on a recurring basis. The fair value of these financial assets was determined using the following inputs at October 3, 2009 and December 31, 2008 (in thousands):

Before utilizing Level 3 inputs in our fair value measurement, the Company considered significant Level 2 observable inputs of similar assets in active and inactive markets. The Company’s broker dealer received estimated market values from an independent pricing service as of the balance sheet date which carry these investments at par value due to the overall quality of the underlying investments and the anticipated future market for such investments. Further evidence includes the fact that these investments consist solely of collateralized debt obligations supported by municipal and state agencies; do not include mortgage-backed securities or student loans; have redemption features that call for redemption at 100% of par value; and have a current credit rating of A or AAA. However, the fact that there is not an active market to liquidate these investments was considered in classifying them as Level 3. Due to the uncertainty with regard to the short-term liquidity of these securities, the Company determined that it could not rely on par value to represent fair value. Therefore, the Company estimated the fair values of these securities utilizing a discounted cash flow valuation model as of October 3, 2009. This analysis considered the collateralization underlying the security investments, the creditworthiness of the counterparty, the timing of expected future cash flows, and the expectation the security will have a successful auction or market liquidity. These securities were also compared, when possible, to other observable market data with similar characteristics to the securities held by the Company.

As a result of the temporary declines in fair value for the Company’s ARPS, which the Company attributes to liquidity issues rather than credit issues, the Company recorded an unrealized loss of $99,000 to accumulated other comprehensive income (loss) in 2009. Due to the Company’s belief that the market for these collateralized instruments may take in excess of twelve months to fully recover, the Company has classified these investments as noncurrent and has included them in investments on the unaudited Condensed Consolidated Balance Sheet at October 3, 2009. As of October 3, 2009, the Company continues to earn interest on all of its ARPS instruments. Any future fluctuation in fair value related to these instruments that the Company deems to be temporary, including any recoveries of previous write-downs, would be recorded to accumulated other comprehensive income (loss). If the Company determined that any future valuation adjustment was other-than-temporary, it would record a charge to earnings as appropriate. The Company is not certain how long it may be required to hold each security. However, given the Company’s current cash position, liquid cash equivalents and expected cash provided by operations, it believes it has the ability to hold, and intends to continue to hold the ARPS as long-term investments until the market stabilizes.

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following tables present the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at October 3, 2009 and December 31, 2008:

Note 3—Inventory

Inventories consist of finished goods available-for-sale and are stated at the lower of cost or market value, determined using the first in, first out (“FIFO”) method. The Company purchases inventory from suppliers both domestically and internationally, and routinely enters into supply agreements with U.S. based suppliers and its primary drop-ship vendors. The Company believes that its inventoried products are generally available from more than one supplier and seeks to maintain multiple sources for its products, both internationally and domestically.

The Company primarily purchases products in bulk quantities to take advantage of quantity discounts and to improve inventory availability. Inventory is reported net of inventory reserves for excess or obsolete products, which are established based on specific identification of slow moving items and the evaluation of inventory levels and the relative anticipated sales levels. Gross inventory, inventory reserves and net inventory at October 3, 2009 and December 31, 2008 are as follows (in thousands):

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Note 4—Intangibles

During the quarter ended October 3, 2009, the Company acquired certain websites and domain names for the purchase price of $730,000, of which $625,000 was preliminarily allocated to amortizable intangibles. Amortization of intangibles is expensed on a straight-line basis over five years and totaled $60,000 and $365,000 for the quarter ended October 3, 2009 and September 30, 2008, respectively.

Intangibles, excluding goodwill, consisted of the following at October 3, 2009 and December 31, 2008 (in thousands):

Note 5—Contingencies

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur, the potential loss, if any, of such matters cannot be reasonably estimated. However, the Company believes that the final disposition of such matters will not have a material adverse effect on the financial position, results of operations or cash flow of the Company. The Company maintains liability insurance coverage to protect the Company’s assets from losses arising out of or involving activities associated with ongoing and normal business operations. On June 25, 2009, we filed a lawsuit in United States District Court, Central District of California against PartsGeek LLC, its shareholders and several of its employees (“Defendant”), alleging that they have misappropriated trade secrets, breach of contract and unfair competition. We requested collectively both monetary and injunctive relief from the Defendant. The Company learned on November 4, 2009 that it was a defendant in a lawsuit initiated by Parts Geek LLC against the Company and Google on November 2, 2009 in the United States District Court for the District of New Jersey, alleging trademark infringement and related unfair advertising practices, as well as web crawling. The Company believes that the lawsuit is without merit and intends to vigorously defend against the claims. Outside of litigation costs, the outcome is neither probable nor estimable.

Note 6—Comprehensive Income (Loss)

The Company reports comprehensive income (loss) in accordance with ASC 220, Comprehensive Income (formerly SFAS 130, “Reporting Comprehensive Income,”) which defines comprehensive income (loss) as net income (loss) affected by non-stockholder changes in equity. Comprehensive income (loss) for each of the thirteen weeks and thirty-nine weeks ended October 3, 2009 and the three, and nine months ended September 30, 2008, respectively, includes the following:

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Note 7—Reserve for Sales Returns

Sales discounts are recorded in the period in which the related sale is recognized. Credits are issued to customers for returned products which totaled $14.4 million for the thirty-nine weeks ended October 3, 2009. The Company’s sales returns and allowances reserve totaled $676,000 and $662,000 at October 3, 2009 and December 31, 2008, respectively.

The following table provides an analysis of the reserve for the Company’s sales returns:

Note 8—Income Taxes

For the thirteen and thirty-nine weeks ended October 3, 2009, the effective tax rate for the Company was 43.6% and 76.9%, respectively. For the three and nine months ended September 30, 2008, the effective tax rate for the Company was 42.4% and 40.0%, respectively. The Company’s effective tax rate is higher than the U.S. federal statutory rate primarily as a result of state income taxes and other non-deductible permanent differences. The increase in income tax provision during the year 2009 was primarily due to a $1.1 million tax effect of stock option forfeitures and other non-deductible permanent differences.

As of October 3, 2009, the Company had no material unrecognized tax benefits, interest or penalties related to various federal and state income tax matters. The Company’s policy is to recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense.

The Company is subject to U.S. federal income tax as well as income tax of foreign and state tax jurisdictions. During 2008, the Company was under audit by the Internal Revenue Service for the years ended December 31, 2006 and 2007; however, the audit was resolved through payment of an immaterial sum of money. The 2008 tax year remains open to examination by the IRS. The Company’s foreign and state income tax returns are open to audit under the statute of limitations for the tax years 2004 through 2008. The Company does not anticipate a significant change to the total amount of unrecognized tax benefits within the next twelve months.

Note 9—Net Income (Loss) Per Share

Net income (loss) per share has been computed in accordance with ASC 260 (formerly SFAS 128) guidelines for calculating earnings per share. The following table sets forth the computation of basic and diluted net income (loss) per share:

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U.S. AUTO PARTS NETWORK, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Note 10—Share-Based Compensation

The Company accounts for share-based compensation in accordance with ASC 505-50 (formerly SFAS 123(R)) “Share-Based Payment”, which was adopted on January 1, 2006. No stock options were granted prior to January 1, 2006. All stock options issued to employees are recognized as share-based compensation expense in the financial statements based on their respective grant date fair values, and are recognized within the statement of operations as general and administrative, marketing, fulfillment or technology expense, based on employee departmental classifications.

Under these guidelines, the fair value of each share-based payment award is estimated on the date of grant using an option pricing model that meets certain requirements. The Company currently uses the Black-Scholes option pricing model to estimate the fair value of share-based payment awards, with the exception of options granted containing market conditions, which the Company estimates the fair value using a Monte Carlo model. The determination of the fair value of share-based payment awards utilizing the Black-Scholes and Monte Carlo models is affected by the Company’s stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. As of October 3, 2009, the Company did not have an adequate history of market prices of its common stock as the Company only recently became a public company in February 2007, and as such, the Company estimates volatility using historical volatilities of similar public entities. The expected life of the awards is based on a simplified method which defines the life as the average of the contractual term of the options and the weighted average vesting period for all open tranches. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of awards. The dividend yield assumption is based on the Company’s expectation of paying no dividends. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The Company accounts for equity instruments issued in exchange for the receipt of goods or services from other than employees and non-employee directors in accordance with ASC 505-50 (formerly SFAS 123(R)), “Share-Based Payment” and the conclusions reached by the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services”. Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services as defined by EITF 96-18.

The Company granted an aggregate of 1,910,000 stock options to purchase shares of the Company’s common stock under the Company’s 2007 Omnibus Incentive Plan and 2007 New Employee Incentive Plan (collectively, the “Plans”). As of the thirty-nine weeks ended October 3, 2009, weighted-average exercise price was $2.09 per share. The Company had $5.1 million of unrecognized share-based compensation expense related to stock options outstanding as of October 3, 2009, which expense is expected to be recognized over a weighted-average period of 2.76 years. Stock options for an aggregate of 3,750 shares were exercised during the quarter ended October 3, 2009.

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Cautionary Statement

You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2008 and subsequent reports on Forms 10-Q and 8-K, which discuss our business in greater detail. The section entitled “Risk Factors” set forth below, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, results of operations and financial condition in the future. You should carefully consider those risks, in addition to the other information in this report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.

Overview

We are one of the largest online providers of aftermarket auto parts, including body parts, engine parts, performance parts and accessories. Our user-friendly websites provide customers with a broad selection of Stock Keeping Units, or SKUs, with detailed product descriptions and photographs. Our proprietary product database maps our SKUs to product applications based on vehicle makes, models and years. We principally sell our products to individual consumers through our network of websites and online marketplaces. Our flagship websites are located at www.autopartswarehouse.com and www.partstrain.com. We believe our strategy of disintermediating the traditional auto parts supply chain and selling products directly to customers over the Internet allows us to more efficiently deliver products to our customers while generating higher margins.

Our History. We were formed in 1995 as a distributor of aftermarket auto parts and launched our first website in 2000. We rapidly expanded our online operations, increasing the number of SKUs sold through our e-commerce network, adding additional websites, acquiring the Partsbin business, improving our Internet marketing proficiency and commencing sales in online marketplaces. As a result, our business has grown since 2000, generating net sales of $153.4 million for the year ended December 31, 2008.

International Operations. In April 2007, we entered into a purchase agreement to bring in-house certain sales and customer service employees based in the Philippines who were providing support to us through our outsourced call center provider, Access Worldwide. As of the closing of this transaction, approximately 171 of the Access Worldwide employees had agreed to transition over to direct employment by our Philippines subsidiary. The purchase price for the right to acquire this assembled workforce was approximately $1.7 million. We had 735 employees in our Philippines operations as of October 3, 2009. In addition to our Philippines operations, we own a Canadian subsidiary to facilitate sales of our products in Canada which currently has no employees. We believe that the cost advantages of our offshore operations provide us with the ability to grow our business in a cost-effective manner, and we expect to continue to add headcount and infrastructure to our offshore operations.

Acquisitions. From time to time, we may acquire certain businesses, websites, domain names or other assets. During 2008, we acquired several websites and domain name assets. In May 2006, we completed the acquisition of Partsbin, which expanded our product offering and enhanced our ability to reach more customers. The Partsbin acquisition significantly increased our net sales and added a complementary, drop-ship order fulfillment method, and operations in Canada. In the third quarter of 2009, we completed the acquisition of AutoPartsGiant.com which further expanded and enhanced our product offering and our ability to reach more customers. We believe the AutoPartsGiant.com acquisition will increase our net sales and internet traffic. We may pursue additional acquisition opportunities in the future to increase our share of the aftermarket auto parts market or expand our product offerings. 

Change in Fiscal Year

We changed our fiscal year from a calendar year ending on December 31 to a 52/53 week fiscal year ending on the first Saturday following December 31st. The change in the fiscal year took effect on January 1, 2009. Therefore, there was no transition period in connection with this change in our fiscal year end. As a result, the first, second, and third quarters of 2009 consisted of the thirteen weeks ended April 4, 2009, July 4, 2009 and October 3, 2009, respectively. The first, second and third quarters of 2008 consisted of the three months ended March 31, 2008, June 30, 2008 and September 30, 2008, respectively.

Stock Option Exchange Program

Our Annual Meeting of the Stockholders was held on May 5, 2009. At the meeting, the stockholders approved a stock option exchange program, pursuant to which up to 1,486,464 outstanding options would be exchanged for up to 743,232 new options. The Compensation Committee of the Company’s Board of Directors has elected not to commence this program at this time. In the event the Company elects to implement a stock exchange program in the future, it plans to seek stockholder approval of such program at that time.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, uncollectible receivables, intangible and other long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe 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. There were no significant changes to our critical accounting policies during the quarter ended October 3, 2009, as compared to those policies disclosed in our annual report on Form 10-K for the fiscal year ended December 31, 2008.

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Results of Operations

The following table sets forth certain unaudited statements of operations data for the periods indicated:

Estimated Impact of the Change in Fiscal Year to a 52/53 Week on the First Nine Months of 2009

Thirteen and Thirty-nine Weeks Ended October 3, 2009 Compared to Three and Nine Months Ended September 30, 2008

Net Sales and Gross Margin

Net sales increased 28.7% to $47.0 million and increased 9.1% to $130.5 million for the thirteen and thirty- nine weeks ended October 3, 2009, respectively, compared to the three and nine months ended September 30, 2008. The year over year increase for the quarter was primarily due to a 29.3% increase in our internet business, which consists of our e-commerce and online marketplaces channels. Our e-commerce channel includes a network of e-commerce websites, supported by our call-center sales agents who generate cross-sell and up-sell opportunities. We also sell our products through our online marketplaces, which primarily consist of auction and other third-party websites. The thirty-nine week or nine month year over year increase was primarily due to a 10.8% increase in our internet business, partially offset by a 14.9% decline in our offline business, which consists of our Kool-Vue^™ and wholesale operations. Excluding the three additional days, net sales on a calendar basis would have been $129.1 million for the current nine month period or a 7.9% increase over the prior year.

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E-commerce net sales increased $9.9 million or 35.2% from $28.1 million for the three months ended September 30, 2008 to $38.0 million for the thirteen weeks ended October 3, 2009. The total number of placed orders in our e-commerce channel increased from 291,000 orders in the third quarter of 2008 to 386,000 orders in the third quarter of 2009 primarily due to an increase in unique visitors and a higher conversion rate. E-commerce sales increased $12.7 million or 13.9% from $91.4 million for the nine months ended September 30, 2008 to $104.1 million for the thirty-nine weeks ended October 3, 2009. The 13.9% growth was primarily due to increased unique visitors and a higher conversion rate, partially offset by a lower average order value. Excluding the three additional days, e-commerce sales on a calendar basis would have been $103.1 million for the current nine month period or a 12.8% increase over the prior year.

Online marketplace net sales decreased $0.1 million or 2.6% from $5.3 million for the three months ended September 30, 2008 to $5.2 million for the thirteen weeks ended October 3, 2009. This decrease was primarily due to lower unique visitors in 2009. Online marketplace net sales decreased 7.5% from $16.2 million for the nine months ended September 30, 2008 to $15.0 million for the thirty-nine weeks ended October 3, 2009. The 7.4% decrease was due to less traffic on our eBay auctions in 2009. Excluding the three additional days, online marketplace net sales on a calendar basis would have been $14.8 million for the current nine month period or an 8.6% decrease over the prior year.

Net sales from our offline business, which consist of sales from our Kool-Vue^TM and wholesale operations, increased $0.2 million or 8.2% to $2.9 million for the thirteen weeks ended October 3, 2009 due to an increase in our customer base. Offline sales decreased $1.6 million or 14.9% to $9.0 million for the thirty-nine weeks ended October 3, 2009 primarily due to the loss of sales to a large customer in the third quarter of 2008. We anticipate that sales from our offline operations will decline as a percentage of net sales in the future due to our continued focus in growing our online business. Excluding the three additional days, offline net sales on a calendar basis would have been $8.9 million for the current nine month period or a 15.6% decrease over the prior year.

We have historically experienced seasonality in our business which generally has resulted in higher sales in winter and summer months. While our revenues for the thirteen weeks ended October 3, 2009 were higher than our historically strongest second quarter; we expect seasonality to continue in future years as automobile collisions during inclement weather create increased demand for body parts in winter months, and consumers often undertake projects to maintain and enhance the performance of their automobiles in the summer months. We anticipate that seasonality will continue to have a material impact on our financial condition and results of operations during any given year.

Gross profit increased during the thirteen and thirty-nine weeks ended October 3, 2009 due to an increase in sales from our e-commerce channel related to increased unique visitors, higher conversion and better revenue capture, which is the amount of actual dollars retained after taking into consideration credit card declines, returns and product fulfillment. Gross margins increased by 290 basis points to 35.9% and 250 basis points to 36.3% for the thirteen and thirty-nine weeks ended October 3, 2009, respectively, compared to the three and nine months ended September 30, 2008. The increase in gross margins for both periods was primarily due to lower outbound freight expense.

Marketing Expense

Marketing expense increased $1.1 million or 21.2% and decreased $0.5 million or 2.7% for the thirteen and thirty-nine weeks ended October 3, 2009, respectively from the three and nine months ended September 30, 2008. Marketing expense as a percentage of net sales decreased 0.8% for the thirteen weeks ended October 3, 2009 from the three months ended September 30, 2008 primarily due to fixed cost leverage on higher sales. Marketing expense as a percentage of net sales decreased 1.6% for the thirty-nine weeks ended October 3, 2009 from the nine months ended September 30, 2008 primarily due to lower personnel-related costs, lower depreciation expense and a lower online advertising spend rate. Excluding the three additional days, online advertising spend excluding marketing co-op on a calendar basis would have been $8.5 million for the current nine month period or a 1.3% increase over the prior year.

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General and Administrative Expense

General and administrative expenses increased $1.0 million or 23.1% and $1.3 million or 9.9%, respectively for the thirteen and thirty-nine weeks ended October 3, 2009, from the three and six months ended September 30, 2008. The increase in the current quarter was primarily due to a $0.4 million increase in depreciation and amortization associated with software investments, $0.3 million increase in personnel-related expenses related to incentive programs from improved company performance, and $0.2 million increase in legal services to protect our intellectual property. The increase for the thirty-nine weeks ended October 3, 2009 was primarily due to a $0.7 million increase in personnel-related expenses related to incentive programs from improved company performance, $0.8 million increase in depreciation and amortization related to software investments, partially offset by an $0.8 million reduction in professional fees. During the thirteen and thirty-nine weeks ended October 3, 2009, we recognized $0.9 million and $2.7 million, respectively, of share-based compensation, net of capitalized internally developed software. Based on options outstanding as of October 3, 2009, we expect to recognize approximately $5.0 million in additional share-based compensation expense over a weighted average period of 2.7 years.

Fulfillment Expense

Fulfillment expense increased $0.6 million or 26.0% and $1.6 million or 23.6%, respectively, for the thirteen and thirty-nine weeks ended October 3, 2009 from the three and nine months ended September 30, 2008. This increase was primarily due to an increase in personnel-related costs and facility expenses to support the opening of our new distribution center on the East Coast in the first quarter of 2009 and an increase in shipment volume related to higher sales.

Technology Expense

Technology expense increased $0.1 million or 6.0% and $0.9 million or 34.3% for the thirteen and thirty-nine weeks ended October 3, 2009, respectively, from the three and nine months ended September 30, 2008 primarily due to increased communication bandwidth to support growth.

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Amortization of Intangibles and Impairment Loss

Amortization of intangibles and impairment loss decreased by $0.3 million to $0.1 million and $22.4 million to $0.6 million for the thirteen and thirty-nine weeks ended October 3, 2009, respectively. The decrease in the current quarter is the result of full amortization of certain assets. The decrease for the thirty-nine weeks ended October 3, 2009 is primarily due to a non-cash impairment charge recorded in the second quarter of 2008, totaling $18.4 million on intangible assets associated with the Partsbin business, which we acquired in May 2006. We estimate aggregate amortization expense for the remaining thirteen weeks ending January 2, 2010 will be $81,000, and for the fiscal years ending 2011, 2012, 2013 and thereafter to be approximately $323,000, $323,000, $323,000 and $393,000, respectively.

Other Income, Net

The decrease in other income, net during the thirteen and thirty-nine weeks ended October 3, 2009 was primarily related to less interest income received due to lower interest rates compared to the three and nine months ended September 30, 2008.

Income Tax Provision (Benefit)

The effective tax rate for the thirteen and thirty-nine weeks ended October 3, 2009 was 43.6% and 76.9%, respectively. For the three and nine months ended September 30, 2008, the effective tax rate for the Company was 42.4% and 40.0% respectively. The Company’s effective tax rate is higher than the U.S federal statutory rate primarily as a result of state income taxes and other non-deductible permanent differences. The increase in income tax provision for 2009 is primarily due to a $1.1 million tax effect of stock option forfeitures and other non-deductible permanent differences.

Liquidity and Capital Resources

Sources of Liquidity

We have historically funded our operations from cash generated from operations, credit facilities, bank and stockholder loans, an equity financing and capital lease financings.

Cash Flows

We had cash and cash equivalents of $33.6 million as of October 3, 2009, representing a $1.1 million increase from $32.5 million of liquid assets as of December 31, 2008. The increase in our cash and cash equivalents as of October 3, 2009 was primarily due to cash generated from operations less our investment in property and equipment.

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Operating Activities

We generated $10.3 million of net cash from operating activities for the 39 weeks ended October 3, 2009. The significant components of cash flows from operating activities were net income of $0.7 million $4.0 million in non-cash depreciation and amortization expense; $2.7 million of non-cash share-based compensation expense; and a decrease of $2.7 million in deferred tax assets primarily related to the tax effect of stock option forfeitures and other non-deductible permanent differences;.

Investing Activities

Cash used in investing activities for the 39 weeks ended October 3, 2009 totaled $9.3 million, of which $7.4 million was related to purchases of property and equipment related to technology investments to improve our websites, operating systems, back-end platforms and the acquisition of AutoPartsGiant.com, as well as the opening of our East Coast distribution center. Additionally $4.1 million purchases of short-term investments were partially offset by $2.2 million of redemptions of our ARPS.

Financing Activities

Cash used in financing activities for the 39 weeks ended October 3, 2009 totaled $46,000 primarily due to repayments made on short-term financing and partially offset by proceeds from the exercise of stock options of $12,000.

Funding Requirements

We had working capital of $40.0 million as of October 3, 2009, which was primarily due to the cash generated from our initial public offering. The historical seasonality in our business during the fourth and first calendar quarters of each year cause cash and cash equivalents, inventory and accounts payable to be generally higher in these quarters, resulting in fluctuations in our working capital. We anticipate that funds generated from operations and cash on hand will be sufficient to meet our working capital needs and expected capital expenditures for at least the next twelve months. Our future capital requirements may, however, vary materially from those now planned or anticipated. Changes in our operating plans, lower than anticipated net sales, increased expenses, continued or worsened economic conditions, or other events, including those described in “Risk Factors,” may cause us to seek additional debt or equity financings in the future. Financings may not be available on acceptable terms, on a timely basis, or at all, and our failure to raise adequate capital when needed could negatively impact our growth plans and our financial condition and results of operations. In addition, our $4.3 million (fair value) of ARPS investments as of October 3, 2009 remain classified as long-term investments as a result of failed auctions and market liquidity issues. We may not have immediate access to those funds.

We opened a new distribution center on the East Coast in the first quarter of 2009. We are also accelerating our technology investments in an effort to improve our websites, operating systems and back-end platforms. We anticipate these decisions will increase our technology costs as a percentage of sales, as well as increase our capitalized software and website development costs over the next several quarters.

Seasonality

We believe our business is subject to seasonal fluctuations. We have historically experienced higher sales of body parts in winter months when inclement weather and hazardous road conditions typically result in more automobile collisions. Engine parts and performance parts and accessories have historically experienced higher sales in the summer months when consumers have more time to undertake elective projects to maintain and enhance the performance of their automobiles and the warmer weather during that time is conducive for such projects. We expect the historical seasonality trends to continue to have a material impact on our financial condition and results of operations in subsequent periods.

Inflation

Inflation has not had a material impact upon our operating results, and we do not expect it to have such an impact in the near future. We cannot assure you that our business will not be affected by inflation in the future.

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial commodity market prices and rates. We are exposed to market risk primarily in the area of changes in United States interest rates and conditions in the credit markets. We also have some exposure related to foreign currency fluctuations. We do not have other derivative financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to increase the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in investment grade securities.

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Interest Rate Risk. All of our investments are classified as available-for-sale and therefore reported on the balance sheet at market value. Our investment securities consist of high-grade auction rate preferred securities. As of October 3, 2009, our long-term investments included $4.3 million (fair value) of investments in ARPS, which consist of high-grade (A or AAA rated) collateralized debt obligations issued by municipalities and state agencies. Our ARPS have an interest rate that is reset in short intervals through auctions. The recent conditions in the global credit markets have prevented some investors from liquidating their holdings of ARPS because the amount of securities submitted for sale has exceeded the amount of purchase orders for these securities. If there is insufficient demand for the securities at the time of an auction, the auction may not be completed and the interest rates may be reset to predetermined higher rates. When auctions for these securities fail, the investments may not be readily convertible to cash until a future auction of these investments is successful or they are redeemed or mature. If the credit ratings of the security issuers deteriorate and any decline in market value is determined to be other-than-temporary, we would be required to adjust the carrying value of the investment through an impairment charge.

On February 13, 2008, we were informed that there was insufficient demand at auctions for four of our high-grade ARPS, representing approximately $7.8 million. As a result, these affected securities are currently not liquid and the interest rates have been reset to the predetermined higher rates. For the period February 13, 2008 through October 3, 2009, we have received partial redemptions at par on all four ARPS totaling $3.4 million with a remaining principal balance on our ARPS of $4.4 million.

In the event we need to access the funds that are in an illiquid state, we will not be able to do so without the possible loss of principal until a future auction for these investments is successful or they are redeemed by the issuer. At this time, management has not obtained sufficient evidence to conclude that these investments are impaired or that they will not be settled in the short term, although the market for these investments is presently uncertain. If we are unable to sell these securities in the market or they are not redeemed, then we may be required to hold them indefinitely. We do not have a need to access these funds for operational purposes for the foreseeable future. We will continue to monitor and evaluate these investments on an ongoing basis for impairment. Based on our ability to access our cash and other short-term investments, our expected cash flows, and our other sources of cash, we do not anticipate that the potential illiquidity of these investments will affect our ability to execute our current business plan. However, due to the illiquidity in the market, we have recorded $99,000 of unrealized losses on our investment portfolio as of October 3, 2009.

Foreign Currency Risk. Our purchases of auto parts from our Asian suppliers are denominated in U.S. Dollars; however a change in the foreign currency exchange rates could impact our product costs over time. Our financial reporting currency is the U.S. Dollar and changes in exchange rates significantly affect our reported results and consolidated trends. For example, if the U.S. Dollar weakens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit, and operating expenses will be higher than if currencies had remained constant. Likewise, if the U.S. Dollar strengthens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit and operating expenses will be lower than if currencies had remained constant. Our operating expenses in the Philippines are generally paid in Philippine Pesos and as the exchange rate fluctuates, it adversely or favorably impacts our operating results. In light of the above, we believe that a fluctuation of 10% in the Peso/U.S. Dollar exchange rate would have approximately a $0.6 million impact on our operating expenses for the thirty-nine week period ended October 3, 2009. Our Canadian website sales are denominated in Canadian Dollars; however, fluctuations in exchange rates from these operations are only expected to have a nominal impact on our operating results. We also believe it is important to evaluate our operating results and growth rates before and after the effect of currency changes.

Evaluation of Disclosure Controls and Procedures

We carried out an evaluation required by the Securities Exchange Act of 1934 (the “1934 Act”), under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the 1934 Act, as of the end of the period covered by this report.

Disclosure controls and procedures provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the 1934 Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based on this evaluation, our CEO and CFO have concluded that, as of such date, our disclosure controls and procedures were effective to meet the objectives for which they were designed.

Changes in Internal Control Over Financial Reporting

During the most recent fiscal quarter, there has not occurred any change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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Inherent Limitations on Internal Controls

Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives as specified above. Management does not expect, however, that our disclosure controls and procedures will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.

PART II. Other Information

The information set forth under Note 5 of Notes to Unaudited Condensed Consolidated Financial Statements, included in Part I, Item 1 of this report, is incorporated herein by reference.

Our business is subject to a number of risks, some of which are discussed below. Other risks are presented elsewhere in this report and in the information incorporated by reference into this report. You should consider carefully the following risks in addition to the other information contained in this report and our other filings with the SEC, including our report on Form 10-K and our subsequent reports on Forms 10-Q and 8-K, and amendments thereto, before deciding to buy, sell or hold our common stock. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently believe are not important may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected, the value of our common stock could decline and you may lose all or part of your investment.

Risks Related To Our Business

Purchasers of aftermarket auto parts may not choose to shop online, which would prevent us from acquiring new customers who are necessary to the growth of our business.

The online market for aftermarket auto parts is less developed than the online market for many other business and consumer products. Our success will depend in part on our ability to attract new customers and to convert customers who have historically purchased auto parts through traditional retail and wholesale operations. Furthermore, we may have to incur significantly higher and more sustained advertising and marketing expenditures or may need to price our products more competitively than we currently anticipate in order to attract additional online consumers and convert them into purchasing customers. Specific factors that could prevent prospective customers from purchasing from us include:

If the online market for auto parts does not gain widespread acceptance, our sales may decline and our business and financial results may suffer.

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We depend on search engines and other online sources to attract visitors to our websites, and if we are unable to attract these visitors and convert them into customers in a cost-effective manner, our business and results of operations will be harmed.

Our success depends on our ability to attract online consumers to our websites and convert them into customers in a cost-effective manner. We are significantly dependent upon search engines, shopping comparison sites and other online sources for our website traffic. We are included in search results as a result of both paid search listings, where we purchase specific search terms that will result in the inclusion of our listing, and algorithmic searches that depend upon the searchable content on our sites. Algorithmic listings cannot be purchased and instead are determined and displayed solely by a set of formulas utilized by the search engine. Search engines, shopping comparison sites and other online sources revise their algorithms from time to time in an attempt to optimize their search results. If one or more of the search engines, shopping comparison sites or other online sources on which we rely for website traffic were to modify its general methodology for how it displays or selects our websites, resulting in fewer consumers clicking through to our websites, our financial results could be adversely affected. We operate a multiple website platform that generally allows us to provide multiple search results for a particular algorithmic search. If the search engines were to limit our display results to a single result or entirely eliminate our results from the algorithmic search, our website traffic would significantly decrease and our business would be materially harmed. If any free search engine or shopping comparison site on which we rely begins charging fees for listing or placement, or if one or more of the search engines, shopping comparison sites and other online sources on which we rely for purchased listings, modifies or terminates its relationship with us, our expenses could rise, we could lose customers and traffic to our websites could decrease. In addition, our success in attracting visitors who convert to customers will depend in part upon our ability to identify and purchase relevant search terms, provide relevant content on our sites, and effectively target our other marketing programs such as e-mail campaigns and affiliate programs. If we are unable to attract visitors to our websites and convert them to customers in a cost-effective manner, then our sales may decline and our business and financial results may be harmed.

Future acquisitions could disrupt our business and harm our financial condition.

As part of our growth strategy, we expect that we will selectively pursue acquisitions of businesses, technologies or services in order to expand our capabilities, enter new markets or increase our market share. Integrating any newly acquired businesses’ websites, technologies or services is likely to be expensive and time consuming. For example, our acquisition of Partsbin resulted in significant costs, including a material impairment charge, a write-down of goodwill associated with the acquisition, and a number of challenges, including retaining employees of the acquired company, integrating our order processing and credit processing, integrating our product pricing strategy, and integrating the diverse technologies and differing e-commerce platforms and accounting systems used by each company. If we are unable to successfully complete the integration of acquisitions, we may not realize the synergies from such acquisition, and our business and results of operations could suffer. To finance any future acquisitions, it may also be necessary for us to raise additional capital through public or private financings or to obtain bank financing. Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our stockholders. Future acquisitions by us could also result in large and immediate write-offs, assumption of debt and unforeseen liabilities and significant adverse accounting charges, any of which could substantially harm our business, financial condition and results of operations.

If we are unable to manage the challenges associated with our international operations, the growth of our business could be limited and our business could suffer.

We maintain business operations in the United States and the Philippines. These international operations include development and maintenance of our websites, Internet marketing personnel, and sales and customer support services. We also operate a Canadian subsidiary to facilitate sales in Canada. We are subject to a number of risks and challenges that specifically relate to our international operations. Our international operations may not be successful if we are unable to meet and overcome these challenges, which could limit the growth of our business and may have an adverse effect on our business and operating results. These risks and challenges include: