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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2018
or
¨
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: 000-50600
 
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Blackbaud, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
11-2617163
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
2000 Daniel Island Drive
Charleston, South Carolina 29492
(Address of principal executive offices, including zip code)
(843) 216-6200
(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  þ    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 (Section 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  þ    NO  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer    þ
Accelerated filer                      
¨
Non-accelerated filer      ¨ (Do not check if a smaller reporting company)
Smaller reporting company    
¨
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES ¨ NO  þ
The number of shares of the registrant’s Common Stock outstanding as of April 25, 2018 was 48,525,896.








TABLE OF CONTENTS

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

First Quarter 2018 Form 10-Q
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1

Table of Contents

Blackbaud, Inc.

 
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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q, including the documents incorporated herein by reference, contains forward-looking statements that anticipate results based on our estimates, assumptions and plans that are subject to uncertainty. These "forward-looking statements" are made subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements consist of, among other things, trend analyses, statements regarding future events, future financial performance, our anticipated growth, the effect of general economic and market conditions, our business strategy and our plan to build and grow our business, our operating results, our ability to successfully integrate acquired businesses and technologies, the effect of foreign currency exchange rate and interest rate fluctuations on our financial results, the impact of expensing stock-based compensation, the sufficiency of our capital resources, our ability to meet our ongoing debt and obligations as they become due, and potential litigation involving us, all of which are based on current expectations, estimates, and forecasts, and the beliefs and assumptions of our management. Words such as “believes,” “seeks,” “expects,” “may,” “might,” “should,” “intends,” “could,” “would,” “likely,” “will,” “targets,” “plans,” “anticipates,” “aims,” “projects,” “estimates” or any variations of such words and similar expressions are also intended to identify such forward-looking statements. These forward-looking statements are subject to risks, uncertainties and assumptions that are difficult to predict. Accordingly, they should not be viewed as assurances of future performance, and actual results may differ materially and adversely from those expressed in any forward-looking statements.
Important factors that could cause actual results to differ materially from our expectations expressed in forward-looking statements include, but are not limited to, those summarized under “Item 1A. Risk factors” and elsewhere in this report, in our Annual Report on Form 10-K for the year ended December 31, 2017 and in our other SEC filings. Forward-looking statements represent our management's beliefs and assumptions only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to update or revise any forward-looking statements, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statement, whether as a result of new information, future events or otherwise.

2
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First Quarter 2018 Form 10-Q



 
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Blackbaud, Inc.
Consolidated balance sheets
(Unaudited)
(dollars in thousands)
March 31,
2018

December 31,
2017

Assets
 
 
Current assets:
 
 
Cash and cash equivalents
$
25,013

$
29,830

Restricted cash due to customers
170,792

610,344

Accounts receivable, net of allowance of $5,480 and $5,141 at March 31, 2018 and December 31, 2017, respectively
88,911

95,679

Customer funds receivable
6,373

1,536

Prepaid expenses and other current assets
68,474

61,978

Total current assets
359,563

799,367

Property and equipment, net
44,647

42,243

Software development costs, net
57,062

54,098

Goodwill
537,433

530,249

Intangible assets, net
306,776

314,651

Other assets
62,453

57,238

Total assets
$
1,367,934

$
1,797,846

Liabilities and stockholders’ equity
 
 
Current liabilities:
 
 
Trade accounts payable
$
23,619

$
24,693

Accrued expenses and other current liabilities
40,113

54,399

Due to customers
177,165

611,880

Debt, current portion
8,576

8,576

Deferred revenue, current portion
254,877

275,063

Total current liabilities
504,350

974,611

Debt, net of current portion
458,592

429,648

Deferred tax liability
48,080

48,023

Deferred revenue, net of current portion
5,075

3,643

Other liabilities
7,516

5,632

Total liabilities
1,023,613

1,461,557

Commitments and contingencies (see Note 9)


Stockholders’ equity:
 
 
Preferred stock; 20,000,000 shares authorized, none outstanding


Common stock, $0.001 par value; 180,000,000 shares authorized, 59,233,843 and 58,551,761 shares issued at March 31, 2018 and December 31, 2017, respectively
59

59

Additional paid-in capital
362,113

351,042

Treasury stock, at cost; 10,710,248 and 10,475,794 shares at March 31, 2018 and December 31, 2017, respectively
(261,710
)
(239,199
)
Accumulated other comprehensive income (loss)
7,041

(642
)
Retained earnings
236,818

225,029

Total stockholders’ equity
344,321

336,289

Total liabilities and stockholders’ equity
$
1,367,934

$
1,797,846

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

First Quarter 2018 Form 10-Q
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3




Blackbaud, Inc.
Consolidated statements of comprehensive income
(Unaudited)
(dollars in thousands, except per share amounts)
Three months ended 
 March 31,
 
2018

2017

Revenue
 
 
Recurring
$
180,846

$
160,047

One-time services and other
23,338

25,025

Total revenue
204,184

185,072

Cost of revenue
 
 
Cost of recurring
69,079

63,875

Cost of one-time services and other
18,958

21,607

Total cost of revenue
88,037

85,482

Gross profit
116,147

99,590

Operating expenses
 
 
Sales, marketing and customer success
45,477

40,997

Research and development
25,958

22,706

General and administrative
25,051

21,923

Amortization
1,269

691

Restructuring
811


Total operating expenses
98,566

86,317

Income from operations
17,581

13,273

Interest expense
(3,517
)
(2,377
)
Other income, net
160

286

Income before provision for income taxes
14,224

11,182

Income tax benefit
(3,527
)
(1,960
)
Net income
$
17,751

$
13,142

Earnings per share
 
 
Basic
$
0.38

$
0.28

Diluted
$
0.37

$
0.28

Common shares and equivalents outstanding
 
 
Basic weighted average shares
47,019,603

46,501,761

Diluted weighted average shares
48,009,395

47,482,840

Dividends per share
$
0.12

$
0.12

Other comprehensive income
 
 
Foreign currency translation adjustment
6,437

152

Unrealized gain on derivative instruments, net of tax
1,079

182

Total other comprehensive income
7,516

334

Comprehensive income
$
25,267

$
13,476

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

4
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First Quarter 2018 Form 10-Q


Blackbaud, Inc.
Consolidated statements of cash flows
(Unaudited)
 
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

Cash flows from operating activities
 
 
Net income
$
17,751

$
13,142

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
Depreciation and amortization
19,820

18,091

Provision for doubtful accounts and sales returns
1,774

2,738

Stock-based compensation expense
11,092

9,294

Deferred taxes
902

592

Amortization of deferred financing costs and discount
188

239

Other non-cash adjustments
(197
)
(243
)
Changes in operating assets and liabilities, net of acquisition and disposal of businesses:
 
 
Accounts receivable
5,088

(4,027
)
Prepaid expenses and other assets
(10,052
)
(3,195
)
Trade accounts payable
(1,655
)
(1,267
)
Accrued expenses and other liabilities
(14,092
)
(15,536
)
Deferred revenue
(18,866
)
(7,064
)
Net cash provided by operating activities
11,753

12,764

Cash flows from investing activities
 
 
Purchase of property and equipment
(5,771
)
(2,719
)
Capitalized software development costs
(7,103
)
(6,583
)
Purchase of net assets of acquired companies, net of cash and restricted cash acquired
(5,036
)
59

Net cash used in investing activities
(17,910
)
(9,243
)
Cash flows from financing activities
 
 
Proceeds from issuance of debt
81,700

67,600

Payments on debt
(52,875
)
(53,794
)
Employee taxes paid for withheld shares upon equity award settlement
(22,511
)
(14,828
)
Proceeds from exercise of stock options
9

11

Change in due to customers
(434,640
)
(195,999
)
Change in customer funds receivable
(4,783
)

Dividend payments to stockholders
(5,825
)
(5,765
)
Net cash used in financing activities
(438,925
)
(202,775
)
Effect of exchange rate on cash, cash equivalents, and restricted cash
713

26

Net decrease in cash, cash equivalents, and restricted cash
(444,369
)
(199,228
)
Cash, cash equivalents, and restricted cash, beginning of period
640,174

370,673

Cash, cash equivalents, and restricted cash, end of period
$
195,805

$
171,445

The following table provides a reconciliation of cash and cash equivalents and restricted cash reported within the condensed consolidated balance sheets that sum to the total of the same such amounts shown above in the consolidated statements of cash flows:
(dollars in thousands)
March 31,
2018

December 31,
2017

Cash and cash equivalents
$
25,013

$
29,830

Restricted cash due to customers
170,792

610,344

Total cash, cash equivalents and restricted cash in the statement of cash flows
$
195,805

$
640,174

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


First Quarter 2018 Form 10-Q
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5


Blackbaud, Inc.
Consolidated statement of stockholders' equity
(Unaudited)
(dollars in thousands)
Common stock
 
Additional
paid-in
capital

Treasury
stock

Accumulated
other
comprehensive
Income (loss)

Retained
earnings

Total stockholders' equity

Shares

Amount

Balance at December 31, 2017
58,551,761

$
59

$
351,042

$
(239,199
)
$
(642
)
$
225,029

$
336,289

Net income





17,751

17,751

Payment of dividends





(5,825
)
(5,825
)
Exercise of stock options and stock appreciation rights and vesting of restricted stock units
279,422


9




9

Employee taxes paid for 234,454 withheld shares upon equity award settlement



(22,511
)


(22,511
)
Stock-based compensation


11,062



30

11,092

Restricted stock grants
437,878







Restricted stock cancellations
(35,218
)






Other comprehensive income




7,516


7,516

Reclassification upon early adoption of ASU 2018-02




167

(167
)

Balance at March 31, 2018
59,233,843

$
59

$
362,113

$
(261,710
)
$
7,041

$
236,818

$
344,321

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

6
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First Quarter 2018 Form 10-Q

Table of Contents

Blackbaud, Inc.
Notes to consolidated financial statements
(Unaudited)


 
1. Organization
We are the world’s leading cloud software company powering social good. Serving the entire social good community—nonprofits, foundations, corporations, education institutions, healthcare institutions and individual change agents—we connect and empower organizations to increase their impact through software, services, expertise and data intelligence. Our portfolio is tailored to the unique needs of vertical markets, with solutions for fundraising and CRM, marketing, advocacy, peer-to-peer fundraising, corporate social responsibility, school management, ticketing, grantmaking, financial management, payment processing, and analytics. Serving the industry for more than three decades, we are headquartered in Charleston, South Carolina and have operations in the United States, Australia, Canada and the United Kingdom. As of March 31, 2018, we had over 40,000 customers.
2. Basis of Presentation
Unaudited interim consolidated financial statements
The accompanying interim consolidated financial statements have been prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission ("SEC") for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to state fairly the consolidated balance sheets, consolidated statements of comprehensive income, consolidated statements of cash flows and consolidated statements of stockholders’ equity, for the periods presented in accordance with accounting principles generally accepted in the United States ("GAAP"). The consolidated balance sheet at December 31, 2017, has been derived from the audited consolidated financial statements at that date. Operating results and cash flows for the three months ended March 31, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2018, or any other future period. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted in accordance with the rules and regulations for interim reporting of the SEC. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2017, and other forms filed with the SEC from time to time.
Reclassifications
Our revenue from "subscriptions" and "maintenance" and a portion of our "services and other" revenue have been combined within "recurring" revenue beginning in 2018. In order to provide comparability between periods presented, those amounts of revenue have been combined within "recurring" revenue in the previously reported consolidated statements of comprehensive income to conform to presentation of the current period. Similarly, "cost of subscriptions" and "cost of maintenance" and a portion of "cost of services and other" have been combined within "cost of recurring" in the previously reported consolidated statements of comprehensive income to conform to presentation of the current period. "Services and other" revenue has been renamed as "one-time services and other" and consists of revenue that did not meet the description of "recurring" revenue in the consolidated statements of comprehensive income.
Basis of consolidation
The consolidated financial statements include the accounts of Blackbaud, Inc. and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Reportable segment
We report our operating results and financial information in one operating and reportable segment. Our chief operating decision maker uses consolidated financial information to make operating decisions, assess financial performance and allocate resources. Our chief operating decision maker is our chief executive officer ("CEO").

First Quarter 2018 Form 10-Q
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7

Table of Contents

Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


Recently adopted accounting pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. ASU 2014-09 replaces most previous revenue recognition guidance in GAAP and requires the recognition of revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The standard also provides guidance on the recognition of costs related to obtaining and fulfilling customer contracts.
We adopted ASU 2014-09 as of January 1, 2018 utilizing the full retrospective method of transition, which requires that the standard be applied to all periods presented. The impact of adopting ASU 2014-09 on our total revenues for 2017 and 2016 was not material. The primary impacts of adopting ASU 2014-09 relate to the deferral of incremental commission and other costs of obtaining contracts with customers and the increase to the amortization period for those costs. Previously, we deferred only direct and incremental commission costs to obtain a contract and amortized those costs over the contract term, generally three years, as the revenue was recognized. Under the new standard, we defer all incremental commission and related fringe benefit costs to obtain a contract and amortize these costs in a manner that aligns with the expected period of benefit. We utilized the 'portfolio approach' practical expedient in ASC 606-10-10-4, which allows entities to apply the guidance to a portfolio of contracts with similar characteristics because the effects on the financial statements of this approach would not differ materially from applying the guidance to individual contracts. Using the 'portfolio approach' and taking into consideration our customer contracts, our technology and other factors, we determined the expected period of benefit to be five years. We do not generally pay commissions for contract renewals.
Select adjusted unaudited financial statement information, which reflects our adoption of ASU 2014-09 is set forth below.
Consolidated balance sheets:
 
 
 
 
As of December 31, 2017
(dollars in thousands)
As Reported
Adjustments
As Adjusted
Accounts receivable, net of allowance
$
96,293

$
(614
)
$
95,679

Prepaid expenses and other current assets
$
56,099

$
5,879

$
61,978

Other assets
$
24,083

$
33,155

$
57,238

Deferred revenue, current portion
$
276,456

$
(1,393
)
$
275,063

Deferred tax liability
$
37,597

$
10,426

$
48,023

Retained earnings
$
195,649

$
29,380

$
225,029

 
 
 
 
Consolidated statements of comprehensive income:
 
 
 
 
Three months ended March 31, 2017
(dollars in thousands, except per share amounts)
As Reported(1)
Adjustments
As Adjusted
Revenue
 
 
 
Recurring
$
151,960

$
8,087

$
160,047

One-time services and other
31,661

(6,636
)
25,025

Total revenue
$
183,621

$
1,451

$
185,072

Cost of Revenue
 
 
 
Recurring
$
60,908

$
2,967

$
63,875

One-time services and other
24,574

(2,967
)
21,607

Total cost of revenue
$
85,482

$

$
85,482

Operating expenses
 
 
 
Sales, marketing and customer success
$
42,240

$
(1,243
)
$
40,997

Net income
$
11,511

$
1,631

$
13,142

Basic earnings per share
$
0.25

$
0.03

$
0.28

Diluted earnings per share
$
0.24

$
0.04

$
0.28


(1)
See the discussion of our reclassifications of previously reported revenue and costs of revenue above.

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First Quarter 2018 Form 10-Q

Table of Contents

Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)



Our adoption of ASU 2014-09 had no impact on our net cash provided by or used in operating, investing or financing activities for any of the periods reported.
Except for the accounting policies for revenue recognition and deferred commissions (herein referred to as "costs of obtaining contracts") that were updated as a result of adopting ASU 2014-09, there have been no changes to our significant accounting policies described in the Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018, that have had a material impact on our consolidated financial statements.
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”), which allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the U.S. Tax Cuts and Jobs Act (the “Tax Act”) signed into law in December 2017. We early adopted ASU 2018-02 effective January 1, 2018 and recorded an insignificant reclassification for the stranded tax effects resulting from the Tax Act from accumulated other comprehensive loss to retained earnings.
Summary of significant accounting policies
Revenue Recognition
Our revenue is primarily generated from the following sources: (i) charging for the use of our software solutions in cloud-based and hosted environments; (ii) providing payment and transaction services; (iii) providing software maintenance and support services; and (iv) providing professional services, including implementation, consulting, training, analytic and other services. Revenues are recognized when control of these services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services.
We determine revenue recognition through the following steps:
Identification of the contract, or contracts, with a customer;
Identification of the performance obligations in the contract;
Determination of the transaction price;
Allocation of the transaction price to the performance obligations in the contract; and
Recognition of revenue when, or as, we satisfy a performance obligation.
Recurring
Recurring revenue represents stand-ready performance obligations in which we are making our solutions or services available to our customers continuously over time or the value of the contract renews. Therefore, recurring revenue is generally recognized over time on a ratable basis over the contract term, beginning on the date that the solution or service is made available to the customer. Our recurring revenue contracts are generally for a term of three years at contract inception with one to three-year renewals thereafter, billed annually in advance and non-cancelable.
Recurring revenue is comprised of fees for the use of our subscription-based software solutions, which includes providing access to cloud-based solutions, hosting services, online training programs, subscription-based analytic services, such as donor acquisitions and data enrichment, and payment services. Recurring revenue also includes fees from maintenance services for our on-premises solutions, services included in our renewable subscription contracts, subscription-based contracts for professional services and variable transaction revenue associated with the use of our solutions.
Our payment services are offered with the assistance of third-party vendors. In general, when we are the principal in a transaction based on the factors identified in ASC 606-10-55-36 through 55-40, we record the revenue and related costs on a gross basis. Otherwise, we net the cost of revenue associated with the service against the gross revenue (amount billed to the customer) and record the net amount as revenue. For payment and transaction services, we have the right to invoice the customer in an amount that directly corresponds with the value to the customer of our performance to date. Therefore, we recognize revenue for these services over time based on the amount billable to the customer in accordance with the 'as invoiced' practical expedient in ASC 606-10-55-18.

First Quarter 2018 Form 10-Q
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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


One-time services and other
One-time services and other revenue primarily consists of fees for one-time consulting, analytic and onsite training services.
We generally bill consulting services based on hourly rates plus reimbursable travel-related expenses. Fixed price consulting engagements are generally billed as milestones towards completion are reached. Revenue for all consulting services is recognized over time as the services are performed.
We generally recognize analytic services revenue from donor prospect research engagements, the sale of lists of potential donors, data enrichment engagements and benchmarking studies at a point in time (upon delivery).
We sell training at a fixed rate for each specific class at a per attendee price or at a packaged price for several attendees, and recognize the related revenue upon the customer attending and completing training.
Contracts with multiple performance obligations
Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices of our solutions and services are typically estimated based on observable transactions when the solutions or services are sold on a standalone basis.
Costs of obtaining contracts, contract assets and deferred revenue
We pay sales commissions at the time contracts with customers are signed or shortly thereafter, depending on the size and duration of the sales contract. Sales commissions and related fringe benefits earned by our sales force are considered incremental and recoverable costs of obtaining a contract with a customer. These costs are deferred and then amortized in a manner that aligns with the expected period of benefit, which we have determined to be five years. We determined the period of benefit by taking into consideration our customer contracts, including renewals, retention, our technology and other factors. We do not generally pay commissions for contract renewals. The related amortization expense is included in sales, marketing and customer success expense in our consolidated statements of comprehensive income.
Amounts recognized as revenue in excess of amounts billed are recorded as contract assets within prepaid expenses and other current assets on our consolidated balance sheets. To the extent that our customers are billed for our solutions and services in advance of us satisfying the related performance obligations, we record such amounts in deferred revenue.
Recently issued accounting pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) ("ASU 2016-02"). ASU 2016-02 will require lessees to record most leases on their balance sheets but recognize expenses in the income statement in a manner similar to current guidance. The updated guidance also eliminates certain real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs and lease executory costs for all entities. For lessors, the standard modifies the classification criteria and the accounting for sales-type and direct financing leases. All entities will classify leases to determine how to recognize lease-related revenue and expense. Classification will continue to affect amounts that lessors record on the balance sheet. ASU 2016-02 is effective for annual periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. Upon adoption, entities will be required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. We expect ASU 2016-02 will impact our consolidated financial statements and are currently evaluating the extent of the impact that implementation of this standard will have on adoption.

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First Quarter 2018 Form 10-Q

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


3. Goodwill and Other Intangible Assets
The change in goodwill during the three months ended March 31, 2018, consisted of the following:
(dollars in thousands)
Total
Balance at December 31, 2017
$
530,249

Additions related to current year business combinations
4,591

Adjustments related to prior year business combinations
(113
)
Effect of foreign currency translation
2,706

Balance at March 31, 2018
$
537,433


4. Earnings Per Share

We compute basic earnings per share by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares and dilutive potential common shares outstanding during the period. Diluted earnings per share reflect the assumed exercise, settlement and vesting of all dilutive securities using the “treasury stock method” except when the effect is anti-dilutive. Potentially dilutive securities consist of shares issuable upon the exercise of stock options, settlement of stock appreciation rights and vesting of restricted stock awards and units.
The following table sets forth the computation of basic and diluted earnings per share:
  
Three months ended 
 March 31,
 
(dollars in thousands, except per share amounts)
2018

2017

Numerator:
 
 
Net income
$
17,751

$
13,142

Denominator:
 
 
Weighted average common shares
47,019,603

46,501,761

Add effect of dilutive securities:
 
 
Stock-based awards
989,792

981,079

Weighted average common shares assuming dilution
48,009,395

47,482,840

Earnings per share:
 
 
Basic
$
0.38

$
0.28

Diluted
$
0.37

$
0.28

 
 
 
Anti-dilutive shares excluded from calculations of diluted earnings per share
24

199,199



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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


5. Fair Value Measurements
We use a three-tier fair value hierarchy to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:
Level 1 - Quoted prices for identical assets or liabilities in active markets;
Level 2 - Quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable.
Recurring fair value measurements
Financial assets and liabilities measured at fair value on a recurring basis consisted of the following, as of the dates indicated below:
 
Fair value measurement using
 
 
(dollars in thousands)
Level 1

 
Level 2

 
Level 3

 
Total

Fair value as of March 31, 2018
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
Derivative instruments
$

 
$
2,978

 
$

 
$
2,978

Total financial assets
$

 
$
2,978

 
$

 
$
2,978

 
 
 
 
 
 
 
 
Fair value as of March 31, 2018
 
 
 
 
 
 
 
Financial liabilities:
 
 
 
 
 
 
 
Derivative instruments
$

 
$
229

 
$

 
$
229

Total financial liabilities
$

 
$
229

 
$

 
$
229

 
 
 
 
 
 
 
 
Fair value as of December 31, 2017
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
Derivative instruments
$

 
$
1,283

 
$

 
$
1,283

Total financial assets
$

 
$
1,283

 
$

 
$
1,283


Our derivative instruments within the scope of ASC 815, Derivatives and Hedging, are required to be recorded at fair value. Our derivative instruments that are recorded at fair value include interest rate swaps.
The fair value of our interest rate swaps was based on model-driven valuations using LIBOR rates, which are observable at commonly quoted intervals. Accordingly, our interest rate swaps are classified within Level 2 of the fair value hierarchy.
We believe the carrying amounts of our cash and cash equivalents, restricted cash due to customers, accounts receivable, trade accounts payable, accrued expenses and other current liabilities and due to customers approximate their fair values at March 31, 2018 and December 31, 2017, due to the immediate or short-term maturity of these instruments.
We believe the carrying amount of our debt approximates its fair value at March 31, 2018 and December 31, 2017, as the debt bears interest rates that approximate market value. As LIBOR rates are observable at commonly quoted intervals, our debt is classified within Level 2 of the fair value hierarchy.
We did not transfer any assets or liabilities among the levels within the fair value hierarchy during the three months ended March 31, 2018. Additionally, we did not hold any Level 3 assets or liabilities during the three months ended March 31, 2018.

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First Quarter 2018 Form 10-Q

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


Non-recurring fair value measurements
Assets and liabilities that are measured at fair value on a non-recurring basis include intangible assets and goodwill, which are recognized at fair value during the period in which an acquisition is completed, from updated estimates and assumptions during the measurement period, or when they are considered to be impaired. These non-recurring fair value measurements, primarily for intangible assets acquired, are based on Level 3 unobservable inputs. In the event of an impairment, we determine the fair value of the goodwill and intangible assets using a discounted cash flow approach, which contains significant unobservable inputs and, therefore, is considered a Level 3 fair value measurement. The unobservable inputs in the analysis generally include future cash flow projections and a discount rate.
There were no non-recurring fair value adjustments to intangible assets and goodwill during the three months ended March 31, 2018, except for an insignificant business combination accounting adjustment to the initial fair value estimates of the assets acquired and liabilities assumed at the acquisition date from updated information obtained during the measurement period. See Note 3 to these consolidated financial statements for additional details. The measurement period of a business combination may be up to one year from the acquisition date. We record any measurement period adjustments to the fair value of assets acquired and liabilities assumed, with the corresponding offset to goodwill.
6. Consolidated Financial Statement Details
Prepaid expenses and other assets
(dollars in thousands)
March 31,
2018

December 31,
2017

Costs of obtaining contracts(1)
$
79,538

$
77,312

Prepaid software maintenance and subscriptions
19,476

17,402

Taxes, prepaid and receivable
14,674

10,548

Derivative instruments
2,978

1,283

Contract assets
3,533

3,136

Security deposits
2,706

2,305

Other assets
8,022

7,230

Total prepaid expenses and other assets
130,927

119,216

Less: Long-term portion
62,453

57,238

Prepaid expenses and other current assets
$
68,474

$
61,978


(1)
Amortization expense from costs of obtaining contracts was $8.5 million for the three months ended March 31, 2018.

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


Accrued expenses and other liabilities
(dollars in thousands)
March 31,
2018

December 31,
2017

Accrued bonuses
$
7,372

$
16,743

Accrued commissions and salaries
6,701

6,943

Lease incentive obligations
4,434

4,635

Customer credit balances
3,400

4,652

Deferred rent liabilities
4,982

4,548

Taxes payable
3,465

5,517

Unrecognized tax benefit
3,692

1,972

Accrued vacation costs
2,277

2,458

Accrued health care costs
2,975

2,615

Other liabilities
8,331

9,948

Total accrued expenses and other liabilities
47,629

60,031

Less: Long-term portion
7,516

5,632

Accrued expenses and other current liabilities
$
40,113

$
54,399



7. Debt
The following table summarizes our debt balances and the related weighted average effective interest rates, which includes the effect of interest rate swap agreements.
 
Debt balance at
 
 
Weighted average
effective interest rate at
 
(dollars in thousands)
March 31,
2018

December 31,
2017

 
March 31,
2018

December 31,
2017

Credit facility:
 
 
 
 
 
    Revolving credit loans
$
173,700

$
143,000

 
3.26
%
2.84
%
    Term loans
294,375

296,250

 
3.24
%
2.64
%
Other debt
1,076

1,076

 
4.50
%
4.50
%
        Total debt
469,151

440,326

 
3.25
%
2.71
%
Less: Unamortized discount and debt issuance costs
1,983

2,102

 
 
 
Less: Debt, current portion
8,576

8,576

 
3.30
%
3.03
%
Debt, net of current portion
$
458,592

$
429,648

 
3.25
%
2.71
%


In June 2017, we entered into a five-year $700.0 million senior credit facility (the "2017 Credit Facility"). As of March 31, 2018, the required annual maturities related to the 2017 Credit Facility and other debt were as follows:
Years ending December 31,
(dollars in thousands)
Annual maturities

2018 - remaining
$
6,701

2019 
7,500

2020 
7,500

2021 
7,500

2022 
439,950

Thereafter

Total required maturities
$
469,151



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First Quarter 2018 Form 10-Q

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


8. Derivative Instruments
Cash flow hedges
We generally use derivative instruments to manage our variable interest rate risk. In July 2017, we entered into an interest rate swap agreement (the "July 2017 Swap Agreement"), which effectively converts portions of our variable rate debt under our credit facility to a fixed rate for the term of the July 2017 Swap Agreement. The notional value of the July 2017 Swap Agreement was $150.0 million with an effective date beginning in July 2017 through July 2021. We designated the July 2017 Swap Agreement as a cash flow hedge at the inception of the contract.
In February 2018, we entered into an additional interest rate swap agreement (the "February 2018 Swap Agreement"), which effectively converts portions of our variable rate debt under our credit facility to a fixed rate for the term of the February 2018 Swap Agreement. The notional value of the February 2018 Swap Agreement was $50.0 million with an effective date beginning in February 2018 through June 2021. We designated the February 2018 Swap Agreement as a cash flow hedge at the inception of the contract.
The fair values of our derivative instruments were as follows as of:
 
 
Asset Derivatives
 
 
Liability Derivatives
(dollars in thousands)
Balance sheet location
March 31,
2018

December 31,
2017

 
Balance sheet location
March 31,
2018

December 31,
2017

Derivative instruments designated as hedging instruments:
 
 
 
 
 
 
 
Interest rate swaps, current portion
Prepaid expenses
and other current assets
$

$
145

 
Accrued expenses
and other current liabilities
$

$

Interest rate swaps, long-term portion
Other assets
2,978

1,138

 
Other liabilities
229


Total derivative instruments designated as hedging instruments
 
$
2,978

$
1,283

 
 
$
229

$


The effects of derivative instruments in cash flow hedging relationships were as follows:
 
Gain (loss) recognized
in accumulated other
comprehensive
loss as of

Location
of gain (loss)
reclassified from
accumulated other
comprehensive
loss into income
Gain (loss) reclassified from accumulated
 other comprehensive loss into income

(dollars in thousands)
March 31,
2018

Three months ended 
 March 31, 2018

Interest rate swaps
$
2,748

Interest expense
$
20

 
 
 
 
 
March 31,
2017

 
Three months ended 
 March 31, 2017

Interest rate swaps
$
343

Interest expense
$
(119
)

Our policy requires that derivatives used for hedging purposes be designated and effective as a hedge of the identified risk exposure at the inception of the contract. Accumulated other comprehensive income (loss) includes unrealized gains or losses from the change in fair value measurement of our derivative instruments each reporting period and the related income tax expense or benefit. Changes in the fair value measurements of the derivative instruments and the related income tax expense or benefit are reflected as adjustments to accumulated other comprehensive income (loss) until the actual hedged expense is incurred or until the hedge is terminated at which point the unrealized gain (loss) is reclassified from accumulated other comprehensive income (loss) to current earnings. The estimated accumulated other comprehensive income as of March 31, 2018 that is expected to be reclassified into earnings within the next twelve months is insignificant. There were no ineffective portions of our interest rate swap derivatives during the three months ended March 31, 2018 and 2017. See Note 12 to these consolidated financial statements for a summary of the changes in accumulated other comprehensive income (loss) by component.

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


9. Commitments and Contingencies
Leases
Total rent expense was $4.0 million for the three months ended March 31, 2018 and 2017.
Other commitments
The term loans under the 2017 Credit Facility require periodic principal payments. The balance of the term loans and any amounts drawn on the revolving credit loans are due upon maturity of the 2017 Credit Facility in June 2022.
We have contractual obligations for third-party technology used in our solutions and for other services we purchase as part of our normal operations. In certain cases, these arrangements require a minimum annual purchase commitment by us. As of March 31, 2018, the remaining aggregate minimum purchase commitment under these arrangements was approximately $68.7 million through 2023.
Solution and service indemnifications
In the ordinary course of business, we provide certain indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our solutions or services. If we determine that it is probable that a loss has been incurred related to solution or service indemnifications, any such loss that could be reasonably estimated would be recognized. We have not identified any losses and, accordingly, we have not recorded a liability related to these indemnifications.
Legal proceedings
We are subject to legal proceedings and claims that arise in the ordinary course of business. We make a provision for a loss contingency when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Unless otherwise specifically disclosed in this note, we have determined as of March 31, 2018, that no provision for liability nor disclosure is required related to any claim against us because (a) there is not a reasonable possibility that a loss exceeding amounts already recognized (if any) may be incurred with respect to such claim; (b) a reasonably possible loss or range of loss cannot be estimated; or (c) such estimate is immaterial.
All legal costs associated with litigation are expensed as incurred. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us. It is possible, nevertheless, that our consolidated financial position, results of operations or cash flows could be negatively affected in any particular period by an unfavorable resolution of one or more of such proceedings, claims or investigations.

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First Quarter 2018 Form 10-Q

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


10. Income Taxes
Our income tax benefit and effective income tax rates, including the effects of period-specific events, were:
  
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

Income tax benefit
$
(3,527
)
$
(1,960
)
Effective income tax rate
(24.8
)%
(17.5
)%

The decrease in our effective income tax rate during the three months ended March 31, 2018, when compared to the same period in 2017, was primarily due to the impact of the discrete benefit to income tax expense relating to stock-based compensation items, calculated prior to the impact of the U.S. federal corporate tax rate change as a result of the Tax Act. This favorable impact was attributable to an increase in the market price for shares of our common stock, as reported by the Nasdaq Stock Market LLC ("Nasdaq"), as well as an increase in the number of stock awards that vested and were exercised. Most of our equity awards are granted during our first quarter and vest in subsequent years during the same quarter. This discrete benefit to income tax expense relating to stock-based compensation during the three months ended March 31, 2018 was reduced as a result of the decrease in the U.S. corporate tax rate.
The decrease in our effective income tax rate during the three months ended March 31, 2018, as compared to the same period in 2017, was also attributable to the impact of the lower U.S. federal corporate tax rate on pre-tax income.
In December 2017, the Tax Act was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017.
On December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. For the three months ended March 31, 2018, the Company obtained additional information affecting the provisional amount calculated for the transition tax as of December 31, 2017, however, the Company determined that the transition tax is still insignificant.
The Tax Act eliminates the exceptions for performance-based compensation and CFO compensation from the 162(m) calculation. A transition rule allows for the grandfathering of performance-based compensation pursuant to a written binding contract in effect as of November 2, 2017. While there is negative discretion inherent in our performance-based compensation plans, it is our position that the intent is for historic contracts to be written and binding. As a result, we have not adjusted the ending estimated deferred tax assets for the performance-based stock compensation or the bonus accrual in our 2018 income tax provision.
Our estimates of the impact of the Tax Act may change due to a number of additional considerations including, but not limited to, the issuance of additional regulations or guidance and our ongoing analysis of the new law. Any subsequent adjustment to these amounts will be recorded to tax expense in 2018 when the analysis is complete.

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Blackbaud, Inc.
Notes to consolidated financial statements (continued)
(Unaudited)


11. Stock-based Compensation
Stock-based compensation expense is allocated to cost of revenue and operating expenses on the consolidated statements of comprehensive income based on where the associated employee’s compensation is recorded. The following table summarizes stock-based compensation expense:
  
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

Included in cost of revenue:
 
 
Cost of recurring
$
452

$
380

Cost of one-time services and other
643

411

Total included in cost of revenue
1,095

791

Included in operating expenses:
 
 
Sales, marketing and customer success
1,825

1,439

Research and development
2,136

1,717

General and administrative
6,036

5,347

Total included in operating expenses
9,997

8,503

Total stock-based compensation expense
$
11,092

$
9,294


12. Stockholders' Equity
Dividends
Our Board of Directors has adopted a dividend policy, which provides for the distribution to stockholders of a portion of cash generated by us that is in excess of operational needs and capital expenditures. The 2017 Credit Facility limits the amount of dividends payable and certain state laws restrict the amount of dividends distributed.
In February 2018, our Board of Directors approved an annual dividend rate of $0.48 per share to be made in quarterly payments. Dividend payments are not guaranteed and our Board of Directors may decide, in its absolute discretion, at any time and for any reason, not to declare and pay further dividends. The following table provides information with respect to quarterly dividends of $0.12 per share paid on common stock during the three months ended March 31, 2018.
Declaration Date
Dividend
per Share

Record Date
 
Payable Date
February 6, 2018
$
0.12

February 28
 
March 15
On April 30, 2018, our Board of Directors declared a second quarter dividend of $0.12 per share payable on June 15, 2018 to stockholders of record on May 25, 2018.

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Notes to consolidated financial statements (continued)
(Unaudited)


Changes in accumulated other comprehensive income (loss) by component
The changes in accumulated other comprehensive income (loss) by component, consisted of the following:
 
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

Accumulated other comprehensive loss, beginning of period
$
(642
)
$
(604
)
By component:
 
 
Gains and losses on cash flow hedges:
 
 
Accumulated other comprehensive income balance, beginning of period
$
776

$
25

Other comprehensive income before reclassifications, net of tax effects of $(392) and $(71)
1,094

110

Amounts reclassified from accumulated other comprehensive loss to interest expense
(20
)
119

Tax benefit included in provision for income taxes
5

(47
)
Total amounts reclassified from accumulated other comprehensive loss
(15
)
72

Net current-period other comprehensive income
1,079

182

Reclassification upon early adoption of ASU 2018-02
167


Accumulated other comprehensive income balance, end of period
$
2,022

$
207

Foreign currency translation adjustment:
 
 
Accumulated other comprehensive loss balance, beginning of period
$
(1,418
)
$
(629
)
Translation adjustments
6,437

152

Accumulated other comprehensive income (loss) balance, end of period
5,019

(477
)
Accumulated other comprehensive income (loss), end of period
$
7,041

$
(270
)

13. Revenue Recognition
The prior period financial information presented below has been adjusted to reflect our adoption of ASU 2014-09.
Transaction price allocated to the remaining performance obligations
As of March 31, 2018, approximately $619 million of revenue is expected to be recognized from remaining performance obligations. We expect to recognize revenue on approximately 60% of these remaining performance obligations over the next 12 months, with the remainder recognized thereafter.
We applied the practical expedient in ASC 606-10-50-14 and have excluded the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less (one-time services); and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed (payment services and usage).
We also applied the practical expedient in ASC 606-10-65-1-(f)(3), whereby the transaction price allocated to the remaining performance obligations, or an explanation of when we expect to recognize that amount as revenue for all reporting periods presented before the date of the initial application, is not disclosed.

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Notes to consolidated financial statements (continued)
(Unaudited)


Contract balances
Our opening and closing balances of contract assets and deferred revenue were as follows:
(in thousands)
March 31,
2018

December 31,
2017

Contract assets
$
3,533

$
3,136

Total deferred revenue
259,952

278,706



Contract assets remained relatively unchanged during the first quarter of 2018. The decrease in deferred revenue during the first quarter of 2018 was primarily due to less billings for recurring revenue contracts. Historically, due to the timing of customer budget cycles, we have an increase in customer contract renewals in our second and fourth quarters as compared to our first and third quarters. The amount of revenue recognized during the first quarter of 2018 that was included in the deferred revenue balance at the beginning of the period was approximately $123 million. The amount of revenue recognized during the first quarter of 2018 from performance obligations satisfied in prior periods was insignificant.
Disaggregation of revenue
We sell our cloud-based solutions and related services in two primary geographical markets: to customers in the United States, and to customers located outside of the United States. The following table presents our revenue by geographic area based on the address of our customers:
 
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

United States
$
175,923

$
168,894

Other countries
28,261

16,178

Total revenue
$
204,184

$
185,072


The General Markets Group ("GMG"), the Enterprise Markets Group ("EMG"), and the International Markets Group ("IMG") comprise our go-to-market organizations. The following is a description of each market group:
The GMG focuses on sales to all K-12 private schools, faith-based and arts and cultural organizations, as well as emerging and mid-sized prospects in North America;
The EMG focuses on sales to all healthcare and higher education institutions, corporations and foundations, as well as large and/or strategic prospects in North America; and
The IMG focuses on sales to all prospects and customers outside of North America.
The following table presents our revenue by market group:
 
Three months ended 
 March 31,
 
(dollars in thousands)
2018

2017

GMG
$
94,665

$
87,480

EMG
$
90,063

$
87,524

IMG
$
18,324

$
9,058

Other
$
1,132

$
1,010

Total revenue
$
204,184

$
185,072



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Notes to consolidated financial statements (continued)
(Unaudited)


14. Restructuring
During 2017, in an effort to further our organizational objectives including, improved operating efficiency, customer outcomes and employee satisfaction, we initiated a multi-year plan to consolidate and relocate some of our existing offices to highly modern and more collaborative workspaces with short-term financial commitments. These workspaces are also more centrally located for our employees and closer to our customers and prospects. Restructuring costs expected to be incurred consist primarily of costs to terminate existing lease agreements, contractual lease payments, net of estimated sublease income, upon vacating space as part of the plan, as well as insignificant costs to relocate affected employees and write-off leasehold improvement assets that we will no longer use. We currently expect to incur before-tax restructuring costs associated with these activities of between $6.0 million and $8.0 million, with a significant portion of the remaining costs expected to be incurred through 2019. We also expect to incur employee severance costs related to the plan; however, these costs cannot be reasonably estimated at this time.
The following table summarizes our facilities optimization restructuring costs as of March 31, 2018:
 
Costs incurred during the three months ended

 
Cumulative costs incurred as of

(in thousands)
March 31, 2018
 
By component:
 
 
 
Contract termination costs
$
771

 
$
1,366

Other costs
40

 
239

Total
$
811

 
$
1,605


The change in our liability related to our facilities optimization restructuring during the three months ended March 31, 2018, consisted of the following:
 
Accrued at

 
Increases for incurred costs

 
Costs paid

 
Accrued at

(in thousands)
December 31, 2017

 
 
 
March 31, 2018

By component:
 
 
 
 
 
 
 
Contract termination costs
$
691

 
$
771

 
$
(1,124
)
 
$
338

Other costs

 
40

 
(40
)
 

Total
$
691

 
$
811

 
$
(1,164
)
 
$
338


15. Subsequent Events

Reeher acquisition
On April 30, 2018, we acquired all of the outstanding equity securities, including all voting equity interests, of Reeher LLC, a Minnesota limited liability company (“Reeher”), pursuant to a securities purchase agreement. The acquisition expands our fundraising performance management capabilities and is intended to drive more effective fundraising and greater social good outcomes for our customers. We acquired the equity securities for an aggregate purchase price of $43.0 million, subject to certain adjustments set forth in the securities purchase agreement. The purchase price and related expenses were funded primarily through borrowings under the 2017 Credit Facility. As a result of the acquisition, Reeher has become a wholly-owned subsidiary of ours. We will include the operating results of Reeher, as well as any goodwill arising from the acquisition, in our consolidated financial statements from the date of acquisition. During the three months ended March 31, 2018, we incurred insignificant acquisition-related expenses associated with the acquisition, which were recorded in general and administrative expense. Due to the timing of the transaction, the initial accounting for this acquisition, including the measurement of assets acquired, liabilities assumed and goodwill, is not complete and is pending detailed analyses of the facts and circumstances that existed as of the April 30, 2018 acquisition date.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis presents financial information denominated in millions of dollars which can lead to differences from rounding when compared to similar information contained in the consolidated financial statements and related notes which are primarily denominated in thousands of dollars.
Executive Summary
We are the world’s leading cloud software company powering social good. Serving the entire social good community—nonprofits, foundations, corporations, education institutions, healthcare institutions and individual change agents—we connect and empower organizations to increase their impact through software, services, expertise, and data intelligence. Our portfolio is tailored to the unique needs of vertical markets, with solutions for fundraising and CRM, marketing, advocacy, peer-to-peer fundraising, corporate social responsibility, school management, ticketing, grantmaking, financial management, payment processing, and analytics. Serving the industry for more than three decades, we are headquartered in Charleston, South Carolina and have operations in the United States, Australia, Canada and the United Kingdom. As of March 31, 2018, we had over 40,000 customers.
Our revenue is primarily generated from the following sources: (i) charging for the use of our software solutions in cloud-based and hosted environments; (ii) providing payment and transaction services; (iii) providing software maintenance and support services; and (iv) providing professional services, including implementation, consulting, training, analytic and other services.
During the first quarter of 2018, we continued to execute on our four-point growth strategy targeted to drive an extended period of solution and service innovation, quality enhancement, increasing operating efficiency and financial performance:
Four-Point Growth Strategy
1.
Deliver Integrated and Open Solutions in the Cloud
We will continue to transition our business to predominantly serve customers through a subscription-based cloud delivery model, enabling lower cost of entry, greater scalability and lower total cost of ownership to our customers. There is a concerted effort underway to optimize our portfolio of solutions and integrate powerful capabilities — such as built in data, analytics, artificial intelligence, payment processing and tailored user-specific experiences — to bring even greater value and performance to our customers.
We recently introduced Blackbaud Grantmaking™, our newest and most comprehensive grants management solution. Our next generation cloud offering for grantmaking evolves the experience previously available with a product we acquired with MicroEdge called GIFTS Online®. Blackbaud Grantmaking takes advantage of the rapid innovation, modern user experience, and enhanced capabilities made possible by our Blackbaud SKY® cloud platform.
We also recently announced the integration of AcademicWorks® with our Blackbaud SKY powered solutions, bolstering our customers' ability to grant and manage scholarships. Donors funding scholarships, for example, will now have improved visibility given the integration with our digital marketing solutions. Scholarship granting organizations are now able to seamlessly manage the financial tracking and reporting through integration with Financial Edge NXT®, and integration with Raiser's Edge NXT® ensures a holistic view of the donor and granted scholarship. This saves our customers time through automation, and provides them with a more robust set of tools to better enable their organizations for success. We're continuing to rapidly innovate in the cloud which is resulting in gains for both Blackbaud and our customers.

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2.
Drive Sales Effectiveness
We are making investments to increase the effectiveness of our sales organization, with a focus on enabling our expanded sales teams with the processes and tools to accelerate our revenue growth and improve productivity and effectiveness.
We have shifted to selling integrated cloud-solutions instead of individual point-solutions, which is a key competitive differentiator for our sales teams. Our focus is on driving improved productivity within our existing salesforce through common procedures, training, key operating metrics, compensation plans, and reporting. Our sales account executives now lead with a total-solution selling strategy, which we believe results in more products per customer, higher ASP's, and increased customer retention over the long-term. We believe that attaching training, analytics, and payments to a deal improves the customer experience, improves outcomes, drives retention, and extends the customer lifetime value.
3.
Expand TAM into Near Adjacencies through Acquisitions and Product Investments
We continue to evaluate compelling opportunities to acquire companies and acquire or build technologies and services. We are guided by our strategic acquisition criteria for considering attractive assets that expand our total addressable market ("TAM"), provide entry into new and near adjacencies, accelerate our shift to the cloud, accelerate revenue growth, are accretive to margins and present synergistic opportunities.
We have been executing this strategy for several years and have expanded our TAM by roughly $2 billion through acquired businesses over the last two years. During the second quarter of 2017, we acquired AcademicWorks, adding scholarship management and stewardship software to our portfolio. We quickly integrated their back office for consistency and scale and have expanded sales into Canada and the United Kingdom (the "UK") by integrating the solutions into our international sales channels.
During the fourth quarter of 2017, we acquired UK-based JustGiving, one of the world’s leading online giving platforms, broadening our ability to serve both individual donors and nonprofits. We are focused on integrating their operations and we remain active in the evaluation of future opportunities to expand our TAM through acquisitions and internal product development.
4.
Improve Operating Efficiency
We are focused on operational efficiency to strengthen the business and deliver improved profitability. We have made transformational changes in the business, including infrastructure investments, productivity initiatives, and organizational re-alignments, to drive us towards a more scalable operating model that creates efficiency and consistency in how we execute.
Over the last several years, we have created an operational excellence function inside of Blackbaud to focus on maximizing the effectiveness of the business through continuous improvement. We have different courses spanning different functions and levels within the company enabling all of our employees to take ownership of their roles and move the company forward. This has empowered our employees to improve their daily lives, advance the Blackbaud's strategic objectives, and ultimately drive more value to our customers. We have made significant strides to-date improving operating efficiency and we believe there is more opportunity ahead to further optimize the business.
During 2017, in an effort to further our organizational objectives including, improved operating efficiency, customer outcomes and employee satisfaction, we also initiated a multi-year plan to consolidate and relocate some of our existing offices to highly modern and more collaborative workspaces with short-term financial commitments. These workspaces are also more centrally located for our employees and closer to our customers and prospects. Restructuring costs expected to be incurred consist primarily of costs to terminate existing lease agreements as well as contractual lease payments, net of estimated sublease income, upon vacating space as part of the plan. We currently expect to incur before-tax restructuring costs associated with these activities of between $6.0 million and $8.0 million, with a significant portion of the remaining costs expected to be incurred through 2019. We also expect to incur employee severance costs related to the plan; however, these costs cannot be reasonably estimated at this time. We have incurred cumulative before-tax restructuring costs of $1.6 million related to this plan as of March 31, 2018. These restructuring activities are expected to result in future annual before-tax savings of between $3.0 million and $4.0 million beginning in 2020.

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Total revenue
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

Total revenue
$
204.2

$
185.1

10.3
%
The increase in total revenue during the three months ended March 31, 2018, when compared to the same period in 2017, was primarily driven by growth in recurring revenue as we continue to see strong demand from customers across our portfolio of cloud-based solutions. One-time services and other revenue declined during the three months ended March 31, 2018 due to our continued shift in focus towards selling cloud-based subscription solutions. In general, our cloud-based solutions include integrated analytic, training and payments services, and require less implementation services. As a result, we expect one-time services and other revenue to continue to be negatively impacted. In addition, we have also used promotions and discounts for our consulting services as incentives to accelerate the migration of our existing customer base from on-premises solutions toward our cloud-based subscriptions.
Income from operations
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

Income from operations
$
17.6

$
13.3

32.5
%
Income from operations increased during the three months ended March 31, 2018, when compared to the same period in 2017. The positive impact of growth in total revenue driven by recurring subscriptions outpaced the related costs and was partially offset primarily by investments we are making in our sales organization and customer success program and, to a lesser extent, increases in amortization of intangible assets from business combinations of $1.1 million and restructuring costs of $0.8 million.
Customer retention
Our recurring revenue contracts are generally for a term of three years at contract inception with one to three-year renewals thereafter. We anticipate a continued decrease in maintenance contract renewals as we transition our solution portfolio and maintenance customers from a perpetual license-based model to a cloud-based subscription delivery model. In the long term, we also anticipate an increase in recurring subscription contract renewals as we continue focusing on innovation, quality and the integration of our cloud-based solutions, which we believe will provide value-adding capabilities to better address our customers' needs. Due primarily to these factors, we believe a recurring revenue customer retention measure that combines recurring subscription, maintenance and service customer contracts provides an accurate representation of our customers' overall behavior. For the twelve months ended March 31, 2018, approximately 93% of our customers with recurring revenue contracts were retained. This customer retention rate is relatively unchanged from our rate for the full year ended December 31, 2017. In the near term, our recurring revenue customer retention rate may modestly decrease driven by our efforts to rationalize our portfolio of solutions and migrate customers from legacy solutions towards our next generation cloud-based solutions.
Balance sheet and cash flow
At March 31, 2018, our cash and cash equivalents were $25.0 million and the carrying amount of our debt under the 2017 Credit Facility was $466.1 million. Our net leverage ratio was 2.19 to 1.00.
During the three months ended March 31, 2018, we generated $11.8 million in cash flow from operations, had a net increase in our borrowings of $28.8 million, returned $5.8 million to stockholders by way of dividends and had aggregate cash outlays of $12.9 million for purchases of property and equipment and capitalized software development costs. Historically, due to lower revenues in our first quarter, combined with the payment of bonuses from the prior year in our first quarter, our cash flow from operations has been lowest in our first quarter.

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Recent development - Reeher acquisition
On April 30, 2018, we acquired all of the outstanding equity securities, including all voting equity interests, of Reeher LLC, a Minnesota limited liability company (“Reeher”), pursuant to a securities purchase agreement. The acquisition expands our fundraising performance management capabilities and is intended to drive more effective fundraising and greater social good outcomes for our customers. We acquired the equity securities for an aggregate purchase price of $43.0 million, subject to certain adjustments set forth in the securities purchase agreement. The purchase price and related expenses were funded primarily through borrowings under the 2017 Credit Facility.
Results of Operations
Comparison of the three months ended March 31, 2018 and 2017
Reclassifications
Our revenue from "subscriptions" and "maintenance" and a portion of our "services and other" revenue have been combined within "recurring" revenue beginning in 2018. In order to provide comparability between periods presented, those amounts of revenue have been combined within "recurring" revenue in the previously reported consolidated statements of comprehensive income to conform to presentation of the current period. Similarly, "cost of subscriptions" and "cost of maintenance" and a portion of "cost of services and other" have been combined within "cost of recurring" in the previously reported consolidated statements of comprehensive income to conform to presentation of the current period. "Services and other" revenue has been renamed as "one-time services and other" and consists of revenue that did not meet the description of "recurring" revenue in the consolidated statements of comprehensive income.
Adoption of New Revenue Accounting Standard
On January 1, 2018, we adopted ASU 2014-09, using the full retrospective method of transition, which requires that the standard be applied to all periods presented. The impacts of adoption are reflected in the financial information herein. For additional details, see Note 2 to our consolidated financial statements in this report.

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Operating results
Recurring
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

Recurring revenue
$
180.8

$
160.0

13.0
%
Cost of recurring
69.1

63.9

8.1
%
Recurring gross profit(1)
$
111.8

$
96.2

16.2
%
Recurring gross margin
61.8
%
60.1
%
 
(1)
The individual amounts for each year may not sum to recurring gross profit due to rounding.
Recurring revenue is comprised of fees for the use of our subscription-based software solutions, which includes providing access to cloud-based solutions, hosting services, online training programs, subscription-based analytic services, such as donor acquisitions and data enrichment, and payment services. Recurring revenue also includes fees from maintenance services for our on-premises solutions, services included in our renewable subscription contracts, subscription-based contracts for professional services and variable transaction revenue associated with the use of our solutions.
Cost of recurring revenue is primarily comprised of compensation costs for customer support and production IT personnel, third-party contractor expenses, third-party royalty and data expenses, hosting expenses, allocated depreciation, facilities and IT support costs, amortization of intangible assets from business combinations, amortization of software development costs, transaction-based costs related to payments services including remittances of amounts due to third-parties and other costs incurred in providing support and recurring services to our customers.
We continue to experience growth in sales of our cloud-based solutions as we meet the demand of our customers that increasingly prefer cloud-based subscription offerings with integrated analytic, training and payment services. Recurring subscription contracts are typically for a term of three years at contract inception with one to three-year renewals thereafter. We intend to continue focusing on innovation, quality and integration of our cloud-based solutions, which we believe will drive future revenue growth.
The increase in recurring revenue during the three months ended March 31, 2018, when compared to the same period in 2017, was primarily due to strong demand across our portfolio of cloud-based solutions as revenue from subscriptions increased $26.2 million. To a much lesser extent, the inclusion of AcademicWorks and JustGiving contributed to the increase in recurring revenue. The favorable impact from subscriptions was partially offset by a $5.4 million decrease in maintenance revenue during the three months ended March 31, 2018, when compared to the same period in 2017.
The increase in cost of recurring revenue during the three months ended March 31, 2018, when compared to the same period in 2017, was primarily due to an increase in compensation costs of $4.2 million driven by resource additions that are directly related to generating recurring revenue as well as the inclusion of AcademicWorks and JustGiving.
The increase in recurring gross margin for the three months ended March 31, 2018, when compared to the same period in 2017, was primarily the result of the positive economics of new and migrating customers to our next generation cloud-based solutions, a one-time third-party refund related to our integrated payment services and accretive recent business acquisitions, as growth in recurring revenue outpaced the growth in related costs.

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One-time services and other
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

One-time services and other revenue
$
23.3

$
25.0

(6.7
)%
Cost of one-time services and other
19.0

21.6

(12.3
)%
One-time services and other gross profit(1)
$
4.4

$
3.4

28.1
 %
One-time services and other gross margin
18.8
%
13.7
%
 
(1)
The individual amounts for each year may not sum to one-time services and other gross profit due to rounding.
One-time services and other revenue is comprised of fees for one-time consulting, analytic and onsite training services, as well as revenue from the sale of our software sold under perpetual license arrangements, fees from user conferences and third-party software referral fees.
Cost of one-time services and other is primarily comprised of compensation costs for professional services and onsite training personnel, other costs incurred in providing onsite customer training, third-party contractor expenses, data expense incurred to perform one-time analytic services, third-party software royalties, costs of user conferences, allocated depreciation, facilities and IT support costs and amortization of intangible assets from business combinations.
One-time services and other revenue decreased during the three months ended March 31, 2018, when compared to the same period in 2017, primarily due to decreases in one-time consulting and analytics revenue of $0.9 million and $0.6 million, respectively. We expect that the ongoing shift in our go-to-market strategy towards cloud-based subscription offerings, which generally include integrated analytics and require less implementation services, to negatively impact one-time services and other revenue. In addition, we have also used promotions and discounts for our consulting services as incentives to accelerate the migration of our existing customer base from on-premises solutions toward our cloud-based subscriptions.
Cost of one-time services and other decreased during the three months ended March 31, 2018, when compared to the same period in 2017, primarily due to a decrease in compensation costs, which is in line with the ongoing shift in our go-to-market strategy as discussed above. Productivity gains also contributed to the decrease in cost of one-time services and other.
One-time services and other gross margin increased during the three months ended March 31, 2018, when compared to the same period in 2017, primarily due to the declines in analytics and consulting revenue coupled with the larger reductions in costs of one-time services and other discussed above.

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Operating expenses
Sales, marketing and customer success
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

Sales, marketing and customer success expense
$
45.5

$
41.0

10.9
%
% of total revenue
22.3
%
22.2
%
 
Sales, marketing, and customer success expense includes compensation costs, variable-sales commissions, travel-related expenses, advertising and marketing materials, public relations costs, variable reseller commissions and allocated depreciation, facilities and IT support costs.
We continue to make investments to drive sales effectiveness, which is a component of our four-point growth strategy to accelerate revenue growth. We also continue investing in our customer success organization to drive customer outcomes, loyalty, retention, and referrals. The increase in sales, marketing, and customer success expense during the three months ended March 31, 2018, when compared to the same period in 2017, was primarily due to increases in compensation costs, commissions expense and advertising and marketing costs of $1.9 million, $1.1 million and $0.9 million, respectively. Compensation costs increased primarily due to incremental headcount associated with the increase in direct sales, marketing, and customer success efforts of our growing operations. The increase in commission expense was primarily driven by an increase in commissionable sales. Advertising and marketing costs increased as a result of our inclusion of JustGiving.
Sales, marketing and customer success expense as a percentage of total revenue remained relatively unchanged during the three months ended March 31, 2018, when compared to the same period in 2017.
Research and development
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

Research and development expense(1)
$
26.0

$
22.7

14.3
%
% of total revenue
12.7
%
12.3
%
 
(1)
Not included in research and development expense for the three months ended March 31, 2018 and 2017 were $6.9 million and $6.6 million, respectively, of qualifying costs associated with development activities that are required to be capitalized under the internal-use software accounting guidance such as those related to development of our next generation cloud-based solutions. Qualifying capitalized software development costs associated with our cloud-based solutions are subsequently amortized to cost of subscriptions revenue over the related asset's estimated useful life, which generally range from three to seven years.
Research and development expense includes compensation costs for engineering and product management personnel, third-party contractor expenses, software development tools and other expenses related to developing new solutions, upgrading and enhancing existing solutions, and allocated depreciation, facilities and IT support costs.
We continue to make investments to deliver integrated and open solutions in the cloud, which is a component of our four-point growth strategy to accelerate revenue growth. The increases in research and development expense in dollars and as a percentage of total revenue during the three months ended March 31, 2018, when compared to the same period in 2017, were primarily due to increases in compensation costs of $1.8 million and third-party contractor expenses of $1.4 million. The increase in compensation costs was primarily associated with the inclusion of JustGiving's engineering resources. The incremental third-party contractor expenses were intended to help drive our solution development efforts.

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General and administrative
 
 
 
 
Three months ended 
 March 31,
 
(dollars in millions)
2018

2017

Change

General and administrative expense
$
25.1

$
21.9

14.3
%
% of total revenue
12.3
%
11.8
%