Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 000-27265
INTERNAP NETWORK SERVICES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE | | 91-2145721 |
(State or Other Jurisdiction of Incorporation or Organization) | | (I.R.S. Employer Identification Number) |
250 Williams Street
Atlanta, Georgia 30303
(Address of Principal Executive Offices, Including Zip Code)
(404) 302-9700
(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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer x Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of July 31, 2007, 49,535,679 shares of the registrant's outstanding common stock, $0.001 par value per share, were issued and outstanding.
INTERNAP NETWORK SERVICES CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2007
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| PART I. FINANCIAL INFORMATION | | |
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| PART II. OTHER INFORMATION | | |
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| SIGNATURES | | |
Some of the statements made under the heading “Management's Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q contain forward-looking statements that reflect our plans, beliefs and current views with respect to, among other things, future events and financial performance. We often identify these forward-looking statements by the use of words such as “believe,” “expect,” “potential,” “continue,” “may,” “will,” “should,” “could,” “would,” “seek,” “predict,” “intend,” “plan,” “estimate,” “anticipate,” or other comparable words.
Specifically, this quarterly report contains, among others, forward-looking statements regarding:
| · | future cash flows, profitability, revenues, and expenses; |
| · | our ability to respond successfully to technological change including the evolution of the high performance Internet connectivity, content delivery, streaming, and related services industries; |
| · | the availability of services from Internet network service providers or network service providers providing network access loops and local loops on favorable terms, or at all; |
| · | the availability of third party suppliers to deliver their products and services on favorable terms, or at all; |
| · | the performance of our network operations centers, network access points or computer systems; |
| · | the ability to successfully integrate the operations of Internap and VitalStream Holdings, Inc., or VitalStream, as well as the impact of this acquisition on our business; |
| · | our ability to protect our intellectual property; |
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| · | the expansion of our data center facilities, including the funding for such expansion; |
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| · | the future recognition of deferred tax assets; and |
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| · | the future demand for IP services, data center services and CDN services. |
Any forward-looking statements contained in this quarterly report are based upon our historical performance and on our current plans, estimates and expectations. You should not regard the inclusion of this forward-looking information as a representation by us or any other person that we will achieve the future plans, estimates or expectations contained in this quarterly report. Such forward-looking statements are subject to various risks and uncertainties. In addition, there are or will be important factors that could cause our actual results to differ materially from those in the forward-looking statements. We believe these factors include, but are not limited to, those described in Part I, Item IA. Risk Factors in our Annual Report on Form 10-K/A for the year ended December 31, 2006, and in Part II, Item 1A. Risk Factors in this Quarterly Report on Form 10-Q.
You should not construe these cautionary statements as exhaustive and should read such statements in conjunction with the other cautionary statements that are included in this quarterly report. Moreover, we operate in a continually changing business environment, and new risks and uncertainties emerge from time to time. We cannot predict these new risks or uncertainties, nor can we assess the impact, if any, that any such risks or uncertainties may have on our business or the extent to which any factor, or combination of factors, may cause actual results to differ from those projected in any forward-looking statement. Accordingly, the risks and uncertainties to which we are subject can be expected to change over time, and we undertake no obligation to update publicly or review the risks or uncertainties described in this quarterly report. We also undertake no obligation to update publicly or review any of the forward-looking statements made in this quarterly report, whether as a result of new information, future developments or otherwise. If one or more of the risks or uncertainties referred to in this quarterly report materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we have projected. Any forward-looking statements contained in this quarterly report reflect our current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, financial condition, growth strategy, and liquidity. You should specifically consider the factors identified in this quarterly report that could cause actual results to differ. We qualify all of our forward-looking statements by these cautionary statements. In addition, with respect to all of our forward-looking statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
As used herein, except as otherwise indicated by the context, references to “we,” “us,” “our,” or the “Company” refer to Internap Network Services Corporation and its subsidiaries.
INTERNAP NETWORK SERVICES CORPORATION AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
| | | | | | | | | |
| | Three months ended June 30, | | Six months ended June 30, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
| | | | | | | | | |
Revenues: | | | | | | | | | |
Internet protocol (IP) services | | $ | 29,345 | | $ | 27,073 | | $ | 58,382 | | $ | 54,119 | |
Data center services | | | 19,927 | | | 13,512 | | | 38,230 | | | 25,237 | |
Content delivery network (CDN) services | | | 5,235 | | | -- | | | 7,287 | | | -- | |
Other | | | 3,987 | | | 3,320 | | | 8,129 | | | 7,174 | |
Total revenues | | | 58,494 | | | 43,905 | | | 112,028 | | | 86,530 | |
Operating expenses: | | | | | | | | | | | | | |
Direct cost of network, sales and services, exclusive | | | | | | | | | | | | | |
of depreciation and amortization shown below: | | | | | | | | | | | | | |
IP services | | | 10,516 | | | 10,192 | | | 20,738 | | | 19,371 | |
Data center services | | | 14,095 | | | 10,723 | | | 28,400 | | | 21,098 | |
CDN services | | | 1,958 | | | -- | | | 2,621 | | | -- | |
Other | | | 3,048 | | | 2,691 | | | 6,486 | | | 5,354 | |
Direct cost of amortization of acquired technology | | | 1,054 | | | 138 | | | 1,708 | | | 275 | |
Direct cost of customer support | | | 4,330 | | | 2,769 | | | 7,718 | | | 5,666 | |
Product development | | | 1,747 | | | 1,158 | | | 3,002 | | | 2,383 | |
Sales and marketing | | | 8,341 | | | 7,072 | | | 14,531 | | | 14,042 | |
General and administrative | | | 8,333 | | | 5,080 | | | 16,165 | | | 10,270 | |
Restructuring and asset impairment | | | 1,178 | | | -- | | | 12,527 | | | -- | |
Acquired in-process research and development | | | -- | | | -- | | | 450 | | | -- | |
Depreciation and amortization | | | 5,912 | | | 3,849 | | | 10,824 | | | 7,643 | |
Gain on disposals of property and equipment | | | -- | | | (117 | ) | | (4 | ) | | (114 | ) |
Total operating costs and expenses | | | 60,512 | | | 43,555 | | | 125,166 | | | 85,988 | |
(Loss) income from operations | | | (2,018 | ) | | 350 | | | (13,138 | ) | | 542 | |
| | | | | | | | | | | | | |
Non-operating (income) expense: | | | | | | | | | | | | | |
Interest income | | | (671 | ) | | (520 | ) | | (1,364 | ) | | (944 | ) |
Interest expense | | | 267 | | | 232 | | | 490 | | | 483 | |
Other, net | | | (20 | ) | | (18 | ) | | (19 | ) | | (147 | ) |
Total non-operating income | | | (424 | ) | | (306 | ) | | (893 | ) | | (608 | ) |
| | | | | | | | | | | | | |
(Loss) income before income taxes and equity in earnings of | | | | | | | | | | | | | |
unconsolidated subsidiary | | | (1,594 | ) | | 656 | | | (12,245 | ) | | 1,150 | |
Provision for income taxes | | | 106 | | | -- | | | 156 | | | -- | |
Equity in earnings of equity-method investment, net of taxes | | | (17 | ) | | (57 | ) | | (24 | ) | | (104 | ) |
Net (loss) income | | $ | (1,683 | ) | $ | 713 | | $ | (12,377 | ) | $ | 1,254 | |
| | | | | | | | | | | | | |
Net (loss) income per share: | | | | | | | | | | | | | |
Basic | | $ | (0.03 | ) | $ | 0.02 | | | (0.28 | ) | $ | 0.04 | |
Diluted | | $ | (0.03 | ) | $ | 0.02 | | $ | (0.28 | ) | $ | 0.04 | |
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Weighted average shares used in per share calculations: | | | | | | | | | | | | | |
Basic | | | 48,515 | | | 34,465 | | | 44,932 | | | 34,384 | |
Diluted | | | 48,515 | | | 35,787 | | | 44,932 | | | 35,003 | |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
INTERNAP NETWORK SERVICES CORPORATION AND SUBSIDIARIES
(In thousands, except per share amounts)
| | | | | |
| | June 30, 2007 | | December 31, 2006 | |
ASSETS | | | | | |
Current assets: | | | | | |
Cash and cash equivalents | | $ | 40,575 | | $ | 45,591 | |
Short-term investments in marketable securities | | | 19,646 | | | 13,291 | |
Accounts receivable, net of allowance of $1,840 and $888, respectively | | | 26,641 | | | 20,282 | |
Inventory | | | 375 | | | 474 | |
Prepaid expenses and other assets | | | 6,456 | | | 3,818 | |
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Total current assets | | | 93,693 | | | 83,456 | |
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Property and equipment, net of accumulated depreciation of $157,145 and $151,269, respectively | | | 62,974 | | | 47,493 | |
Investments | | | 919 | | | 2,135 | |
Intangible assets, net of accumulated amortization of $20,799 and $18,644, respectively | | | 46,130 | | | 1,785 | |
Goodwill | | | 191,100 | | | 36,314 | |
Restricted cash | | | 903 | | | -- | |
Deposits and other assets | | | 1,644 | | | 2,519 | |
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Total assets | | $ | 397,363 | | $ | 173,702 | |
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LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | |
Current liabilities: | | | | | | | |
Notes payable, current portion | | $ | 7,372 | | $ | 4,375 | |
Accounts payable | | | 13,388 | | | 8,776 | |
Accrued liabilities | | | 10,648 | | | 8,689 | |
Deferred revenue, current portion | | | 3,401 | | | 3,260 | |
Capital lease obligations, current portion | | | 765 | | | 347 | |
Restructuring liability, current portion | | | 4,484 | | | 1,400 | |
Other current liabilities | | | 105 | | | 84 | |
| | | | | | | |
Total current liabilities | | | 40,l63 | | | 26,931 | |
| | | | | | | |
Notes payable, less current portion | | | 1,094 | | | 3,281 | |
Deferred revenue, less current portion | | | 1,427 | | | 1,080 | |
Capital lease obligations, less current portion | | | 868 | | | 83 | |
Restructuring liability, less current portion | | | 8,449 | | | 3,384 | |
Deferred rent | | | 10,529 | | | 11,432 | |
Other long-term liabilities | | | 933 | | | 986 | |
| | | | | | | |
Total liabilities | | | 63,463 | | | 47,177 | |
| | | | | | | |
Commitments and contingencies | | | | | | | |
| | | | | | | |
Stockholders' equity: | | | | | | | |
Preferred stock, $0.001 par value, 200,000 shares authorized, no shares issued or outstanding | | | -- | | | -- | |
Common stock, $0.001 par value, 60,000 shares authorized, 49,507 and 35,873 shares issued and outstanding, respectively | | | 50 | | | 36 | |
Additional paid-in capital | | | 1,202,137 | | | 982,624 | |
Accumulated deficit | | | (868,832 | ) | | (856,455 | ) |
Accumulated items of other comprehensive income | | | 545 | | | 320 | |
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Total stockholders' equity | | | 333,900 | | | 126,525 | |
| | | | | | | |
Total liabilities and stockholders' equity | | $ | 397,363 | | $ | 173,702 | |
The accompanying notes are an integral part of these condensed consolidated financial statements.
INTERNAP NETWORK SERVICES CORPORATION AND SUBSIDIARIES
(In thousands)
| | | | | |
| | | |
| | 2007 | | 2006 | |
CASH FLOWS FROM OPERATING ACTIVITIES | | | | | |
Net (loss) income | | $ | (12,377 | ) | $ | 1,254 | |
Adjustments to reconcile net (loss) income to net cash used in operating activities: | | | | | | | |
Asset impairment | | | 3,632 | | | -- | |
Acquired in-process research and development | | | 450 | | | -- | |
Depreciation and amortization | | | 12,532 | | | 7,918 | |
Gain on disposal of assets | | | -- | | | (114 | ) |
Provision for doubtful accounts | | | 626 | | | (119 | ) |
Income from equity method investment | | | (24 | ) | | (104 | ) |
Non-cash changes in deferred rent | | | (1,035 | ) | | 1,603 | |
Stock-based compensation expense | | | 4,415 | | | 3,079 | |
Other, net | | | 77 | | | -- | |
Changes in operating assets and liabilities, excluding effects of acquisition: | | | | | | | |
Accounts receivable | | | (3,644 | ) | | (375 | ) |
Inventory | | | 46 | | | 199 | |
Prepaid expenses, deposits and other assets | | | 184 | | | (725 | ) |
Accounts payable | | | 1,500 | | | 1,931 | |
Accrued expense and other liabilities | | | (2,646 | ) | | (1,086 | ) |
Deferred revenue | | | 375 | | | 64 | |
Accrued restructuring charge | | | 8,149 | | | (742 | ) |
Net cash provided by operating activities | | | 12,260 | | | 12,783 | |
| | | | | | | |
CASH FLOWS FROM INVESTING ACTIVITIES | | | | | | | |
Purchases of property and equipment | | | (17,024 | ) | | (5,543 | ) |
Purchases of short-term investments in marketable securities | | | (17,141 | ) | | (4,215 | ) |
Maturities of short-term investments in marketable securities | | | 10,992 | | | 10,956 | |
Proceeds from disposal of property and equipment | | | -- | | | 127 | |
Cash received from acquisition, net of costs incurred for the transaction | | | 3,203 | | | -- | |
Other, net | | | -- | | | 82 | |
Net cash (used in) provided by investing activities | | | (19,970 | ) | | 1,407 | |
| | | | | |
CASH FLOWS FROM FINANCING ACTIVITIES | | | | | |
Principal payments on notes payable | | | (2,852 | ) | | (2,187 | ) |
Payments on capital lease obligations | | | (1,240 | ) | | (277 | ) |
Proceeds from exercise of stock options, employee stock purchase plan, and exercise of warrants | | | 6,819 | | | 2,149 | |
Other, net | | | (33 | ) | | 30 | |
| | | | | | | |
Net cash provided by (used in) financing activities | | | 2,694 | | | (285 | ) |
Net (decrease) increase in cash and cash equivalents | | | (5,016 | ) | | 13,905 | |
Cash and cash equivalents at beginning of period | | | 45,591 | | | 24,434 | |
| | | | | | | |
Cash and cash equivalents at end of period | | $ | 40,575 | | $ | 38,339 | |
SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION | | | | | | | |
Common stock issued and stock options assumed for acquisition of VitalStream | | $ | 208,293 | | $ | -- | |
The accompanying notes are an integral part of these condensed consolidated financial statements.
INTERNAP NETWORK SERVICES CORPORATION
AND COMPREHENSIVE INCOME (LOSS)
(In thousands)
| | | | | | | | | | | | | | | | | | |
| | Common Stock | | | | | | | | | | | | | | | | |
Six months ended June 30, 2007: | | Shares | | Par Value | | Additional Paid-In Capital | | Deferred Stock Compensation | | Accumulated Deficit | | Accumulated Items of Comprehensive Income | | Total Stockholders' Equity | |
Balance, December 31, 2006 | | | 35,873 | | $ | 36 | | $ | 982,624 | | $ | -- | | $ | (856,455 | ) | $ | 320 | | $ | 126,525 | |
Net loss | | | -- | | | -- | | | -- | | | -- | | | (12,377 | ) | | -- | | | (12,377 | ) |
Change in unrealized gains and losses on investments, net of taxes | | | -- | | | -- | | | -- | | | -- | | | -- | | | 207 | | | 207 | |
Foreign currency translation adjustment | | | -- | | | -- | | | -- | | | -- | | | -- | | | 18 | | | 18 | |
Total comprehensive loss(*) | | | | | | | | | | | | | | | | | | | | | (12,152 | ) |
Stock issued in connection with VitalStream acquisition | | | 12,206 | | | 12 | | | 208,281 | | | -- | | | -- | | | -- | | | 208,293 | |
Stock compensation plans activity | | | 937 | | | 2 | | | 6,817 | | | -- | | | -- | | | -- | | | 6,819 | |
Stock-based compensation | | | 490 | | | -- | | | 4,415 | | | -- | | | -- | | | -- | | | 4,415 | |
Balance, June 30, 2007 | | | 49,506 | | $ | 50 | | $ | 1,202,137 | | $ | -- | | $ | (868,832 | ) | $ | 545 | | $ | 333,900 | |
| | Common Stock | | | | | | | | | | | | | | | | |
Six months ended June 30, 2006: | | Shares | | Par Value | | Additional Paid-In Capital | | Deferred Stock Compensation | | Accumulated Deficit | | Accumulated Items of Comprehensive Income | | Total Stockholders' Equity | |
Balance, December 31, 2005 | | | 34,168 | | $ | 34 | | $ | 970,221 | | $ | (420 | ) | $ | (860,112 | ) | $ | 5 | | $ | 109,728 | |
Net income | | | -- | | | -- | | | -- | | | -- | | | 1,254 | | | -- | | | 1,254 | |
Change in unrealized gains and losses on investments, net of taxes | | | -- | | | -- | | | -- | | | -- | | | -- | | | 94 | | | 94 | |
Foreign currency translation adjustment | | | -- | | | -- | | | -- | | | -- | | | -- | | | 138 | | | 138 | |
Total comprehensive income(*) | | | | | | | | | | | | | | | | | | | | | 1,486 | |
Reclassification of deferred stock compensation resulting from implementation of FAS 123R | | | -- | | | -- | | | (420 | ) | | 420 | | | -- | | | -- | | | -- | |
Stock compensation plans activity | | | 370 | | | 1 | | | 1,746 | | | -- | | | -- | | | -- | | | 1,747 | |
Stock-based compensation | | | 46 | | | -- | | | 3,086 | | | -- | | | -- | | | -- | | | 3,086 | |
Exercise of warrants | | | 62 | | | -- | | | 402 | | | -- | | | -- | | | -- | | | 402 | |
Balance, June 30, 2006 | | | 34,646 | | $ | 35 | | $ | 975,035 | | $ | -- | | $ | (858,858 | ) | $ | 237 | | $ | 116,449 | |
(*) Total comprehensive (loss) income was $(1,502) and $859 for the three months ended June 30, 2007 and 2006, respectively.
The accompanying notes are an integral part of these condensed consolidated financial statements.
INTERNAP NETWORK SERVICES CORPORATION UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. | Nature of Operations and Basis of Presentation |
Internap Network Services Corporation (“Internap,” “we,” “us,” “our,” or the “Company”) delivers high performance and reliable Internet solutions through a suite of network optimization and delivery product and services. These solutions, combined with progressive and proactive technical support, enable companies to confidently migrate business-critical applications, including audio and video streaming and monetization services, to the Internet. Our suite of products and services support a broad range of Internet applications. The Company currently has more than 3,400 customers serving financial services, healthcare, technology, government, retail, travel, and media/entertainment markets. Our customers are located in the United States and abroad and include several Fortune 1000 and mid-tier enterprises. Our product and service offerings are complemented by IP access solutions such as data center services, content delivery networks, or CDN, and managed security. We deliver services through our 44 network access points across North America, London and the Asia-Pacific region, including Tokyo, Japan and Sydney, Australia. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet networks including AT&T, Sprint, Verizon, Savvis, Global Crossing Telecommunications, and Level 3 Communications. We operate and manage the Company in four business segments: IP Services, Data Center Services, CDN Services, and Other.
Our unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC, and include all the accounts of the Company and its wholly owned subsidiaries. Certain information and note disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted pursuant to such rules and regulations. The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of our financial position as of June 30, 2007 and our operating results, cash flows, and changes in stockholders' equity for the interim periods presented. The balance sheet at December 31, 2006 has been derived from our audited financial statements as of that date but does not include all disclosures required by accounting principals generally accepted in the United States of America. These financial statements and the related notes should be read in conjunction with our financial statements and notes thereto contained in our Annual Report on Form 10-K/A for the year ended December 31, 2006 filed with the SEC.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities and revenues and expenses in the financial statements. Examples of estimates subject to possible revision based upon the outcome of future events include, among others, recoverability of long-lived assets and goodwill, depreciation of property and equipment, restructuring allowances, stock-based compensation, the allowance for doubtful accounts, network cost accruals and sales, use and other taxes. Actual results could differ from those estimates.
The results of operations for the three and six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for any future periods or for the year ending December 31, 2007.
On February 20, 2007, we completed the previously announced acquisition of VitalStream Holdings, Inc., or VitalStream, for approximately $214.0 million whereby VitalStream became a wholly owned subsidiary of Internap. VitalStream provides products and services for storing and delivering digital media to large audiences over the Internet and ad insertion and related advertising services to companies that stream digital media over the Internet. VitalStream also enhances our position as a leading provider of high performance route control products and services by adding complementary service offerings in the rapidly growing content delivery and on-line advertising markets. Integrating VitalStream's digital media delivery platform into our portfolio of products and services will enable us to provide customers with one of the most complete product lines in content delivery solutions, content monetization and on-line advertising, while supporting the significant long-term growth opportunities in the network services market. We accounted for the transaction using the purchase method of accounting in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations.” Our results of operations include the activities of VitalStream from February 21, 2007 through June 30, 2007.
Purchase Price
Assets acquired and liabilities assumed were recorded at their fair values as of February 20, 2007. The total $214.0 million purchase price is comprised of the following (in thousands):
| | | |
Value of Internap stock issued | | $ | 197,272 | |
Fair value of options assumed | | | 11,021 | |
Direct transaction costs | | | 5,729 | |
Total purchase price | | $ | 214,022 | |
As a result of the acquisition, we issued approximately 12.2 million shares of Internap common stock based on an exchange ratio of 0.5132 shares of Internap common stock for each outstanding share of VitalStream common stock as of February 20, 2007. This fixed exchange ratio gives effect to the one-for-ten reverse stock split by Internap implemented on July 11, 2006 and the one-for-four reverse stock split by VitalStream implemented on April 4, 2006. The average market price per share of Internap common stock of $16.16 was based on an average of the closing prices for a range of trading days from October 10, 2006 through October 16, 2006, which range spanned the announcement date of the proposed transaction on October 12, 2006.
Under the terms of the merger agreement, each VitalStream stock option that was outstanding and unexercised was converted into an option to purchase Internap common stock and we assumed that stock option in accordance with the terms of the applicable VitalStream stock option plan and terms of the stock option agreement relating to that VitalStream stock option. Based on VitalStream's stock options outstanding at February 20, 2007, we converted options to purchase approximately 3.0 million shares of VitalStream common stock into options to purchase approximately 1.5 million shares of Internap common stock. We determined the fair value of the outstanding options using a Black-Scholes valuation model with the following weighted-average assumptions: volatility of 48.8% to 120.1%; risk-free interest rates ranging from 4.7% to 5.1%; remaining expected lives ranging from 0.18 to 6.25 years and dividend yield of zero.
Purchase Price Allocation
Under the purchase method of accounting, we allocated the total estimated purchase price to VitalStream's net tangible and intangible assets based on their estimated fair values as of February 20, 2007. We recorded the excess purchase price over the value of the net tangible and identifiable intangible assets as goodwill. We determined the fair value assigned to identifiable intangible assets acquired using the income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by management. The allocation of the purchase price and the estimated useful lives are as follows (dollars in thousands):
| | | | Estimated | |
| | Amount | | Useful Life | |
| | | |
Net tangible assets | | $ | 12,286 | | | -- | |
Identifiable intangible assets: | | | | | | | |
Developed technologies | | | 36,000 | | | 8 years | |
Customer relationships | | | 9,000 | | | 9 years | |
Trade name and other | | | 1,500 | | | 3-6 years | |
Acquired in-process research and development | | | 450 | | | -- | |
Goodwill | | | 154,786 | | | -- | |
Total estimated purchase price | | $ | 214,022 | | | | |
During the three months ended June 30, 2007, a net increase of $0.1 million was recorded to goodwill as a result of normal adjustments to certain pre-acquisition assets and liabilities.
Net tangible assets. We reviewed and adjusted VitalStream's tangible assets and liabilities as of February 20, 2007 to their fair value as necessary. Net tangible assets included restricted and unrestricted cash of $9.8 million, accounts receivable of $3.2 million, property and equipment of $11.2 million, other assets of $2.2 million, loan and security agreement and capital lease obligations of $6.1 million, and accounts payable and other liabilities of $8.0 million. The loan and security agreement assumed in the VitalStream acquisition includes a total outstanding balance of $3.5 million due at various times through March 2008. The term loans with the loan and security agreement have variable interest rates of the lender's published prime rate plus 0.5% to 1.0%. In addition, VitalStream pledged substantially all of its assets to secure repayment of the credit facilities under the loan and security agreement.
Identifiable intangible assets. Developed technologies relate to VitalStream products across all of their product lines that have reached technological feasibility and include processes and trade secrets acquired or developed through design and development of their products. Customer relationships represent existing contracts that related primarily to underlying customer relationships. Trade name primarily relates to the VitalStream and other product names. Amortization of identifiable intangibles is on a straight-line basis over their respective useful lives.
In-process research and development. As of the closing date, one project was in development that has not reached technological feasibility and therefore qualifies as in-process research and development. The amount allocated to in-process research and development was charged to the statement of operations in the period the acquisition was consummated, the six months ended June 30, 2007.
Goodwill. We allocated approximately $154.8 million to goodwill for the CDN Services segment. During the three months ended June 30, 2007, we recorded a net increase of $0.1 million to goodwill as a result of normal adjustments to certain pre-acquisition assets and liabilities. Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we will not amortize goodwill but instead will test it for impairment at least annually, or more frequently if certain indicators are present. A total of $18.4 million of goodwill will be deductible for tax purposes.
Pro Forma Results
The following unaudited pro forma consolidated financial information reflects the results of operations of the Company for the three months ended June 30, 2007 and the six months ended June 30, 2007 and 2006 as if the acquisition of VitalStream had occurred at the beginning of each period. Prior to the acquisition, VitalStream was a customer of ours, and for each of the six month periods ended June 30, 2007 and 2006, we recognized revenue of $0.2 million from VitalStream and settled the receivables in the normal course of business. These pro forma results are not necessarily indicative of what the Company's operating results would have been had the acquisition actually taken place at the beginning of each period (in thousands, except per share amounts):
| | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | 2006 | | 2007 | | 2006 | |
| | | | | | | |
Pro forma revenue | $ | 50,101 | | $ | 114,356 | | $ | 98,430 | |
Pro forma net loss | | (2,146 | ) | | (18,191 | ) | | (4,134 | ) |
Pro forma net loss per share, basic and diluted | | (0.05 | ) | | (0.34 | ) | | (0.09 | ) |
The following tables show operating results for our reportable segments, along with reconciliation from segment gross profit to income (loss) from operations, the most directly comparable measure in accordance with generally accepted accounting principles in the United States, or GAAP:
| | Three Months Ended June 30, 2007 | |
| | | | | | | | | | | | | |
| | IP Services | | Data Center | | CDN Services | | Other | | Corporate Allocations | | Total | |
Revenue | | $ | 29,345 | | $ | 19,927 | | $ | 5,235 | | $ | 3,987 | | $ | -- | | $ | 58,494 | |
Direct costs of network, sales and services, exclusive of depreciation and amortization | | | 10,516 | | | 14,095 | | | 1,958 | | | 3,048 | | | -- | | | 29,617 | |
Segment gross profit | | | 18,829 | | | 5,832 | | | 3,277 | | | 939 | | | -- | | | 28,877 | |
| | | | | | | | | | | | | | | | | | | |
Direct costs of amortization of acquired technology | | | 104 | | | -- | | | 950 | | | -- | | | -- | | | 1,054 | |
Direct costs of customer support | | | -- | | | -- | | | -- | | | -- | | | 4,330 | | | 4,330 | |
Depreciation and amortization associated with direct costs of network, sales and services | | | -- | | | -- | | | -- | | | -- | | | 4,833 | | | 4,833 | |
Other depreciation and amortization | | | -- | | | -- | | | -- | | | -- | | | 1,079 | | | 1,079 | |
Other operating costs and expenses | | | -- | | | -- | | | -- | | | -- | | | 19,599 | | | 19,599 | |
Income (loss) from operations | | $ | 18,725 | | $ | 5,832 | | $ | 2,327 | | $ | 939 | | $ | (29,841 | ) | $ | (2,018 | ) |
| | Three Months Ended June 30, 2006 | |
| | | | | | | | | | | | | |
| | IP Services | | Data Center | | CDN Services | | Other | | Corporate Allocations | | Total | |
Revenue | | $ | 27,073 | | $ | 13,512 | | $ | -- | | $ | 3,320 | | $ | -- | | $ | 43,905 | |
Direct costs of network, sales and services, exclusive of depreciation and amortization | | | 10,192 | | | 10,723 | | | -- | | | 2,691 | | | -- | | | 23,606 | |
Segment gross profit | | | 16,881 | | | 2,789 | | | -- | | | 629 | | | -- | | | 20,299 | |
| | | | | | | | | | | | | | | | | | | |
Direct costs of amortization of acquired technology | | | 138 | | | -- | | | -- | | | -- | | | -- | | | 138 | |
Direct costs of customer support | | | -- | | | -- | | | -- | | | -- | | | 2,769 | | | 2,769 | |
Depreciation and amortization associated with direct costs of network, sales and services | | | -- | | | -- | | | -- | | | -- | | | 3,043 | | | 3,043 | |
Other depreciation and amortization | | | -- | | | -- | | | -- | | | -- | | | 806 | | | 806 | |
Other operating costs and expenses | | | -- | | | -- | | | -- | | | -- | | | 13,193 | | | 13,193 | |
Income (loss) from operations | | $ | 16,743 | | $ | 2,789 | | $ | -- | | $ | 629 | | $ | (19,811 | ) | $ | 350 | |
| | Six Months Ended June 30, 2007 | |
| | | | | | | | | | | | | |
| | IP Services | | Data Center | | CDN Services | | Other | | Corporate Allocations | | Total | |
Revenue | | $ | 58,382 | | $ | 38,230 | | $ | 7,287 | | $ | 8,129 | | $ | -- | | $ | 112,028 | |
Direct costs of network, sales and services, exclusive of depreciation and amortization | | | 20,738 | | | 28,400 | | | 2,621 | | | 6,486 | | | -- | | | 58,245 | |
Segment gross profit | | | 37,644 | | | 9,830 | | | 4,666 | | | 1,643 | | | -- | | | 53,783 | |
| | | | | | | | | | | | | | | | | | | |
Direct costs of amortization of acquired technology | | | 208 | | | -- | | | 1,500 | | | -- | | | -- | | | 1,708 | |
Direct costs of customer support | | | -- | | | -- | | | -- | | | -- | | | 7,718 | | | 7,718 | |
Depreciation and amortization associated with direct costs of network, sales and services | | | -- | | | -- | | | -- | | | -- | | | 8,911 | | | 8,911 | |
Other depreciation and amortization | | | -- | | | -- | | | -- | | | -- | | | 1,913 | | | 1,913 | |
Other operating costs and expenses | | | -- | | | -- | | | -- | | | -- | | | 46,671 | | | 46,671 | |
Income (loss) from operations | | $ | 37,436 | | $ | 9,830 | | $ | 3,166 | | $ | 1,643 | | $ | (65,213 | ) | $ | (13,138 | ) |
| | Six Months Ended June 30, 2006 | |
| | | | | | | | | | | | | |
| | IP Services | | Data Center | | CDN Services | | Other | | Corporate Allocations | | Total | |
Revenue | | $ | 54,119 | | $ | 25,237 | | $ | -- | | $ | 7,174 | | $ | -- | | $ | 86,530 | |
Direct costs of network, sales and services, exclusive of depreciation and amortization | | | 19,371 | | | 21,098 | | | -- | | | 5,354 | | | -- | | | 45,823 | |
Segment gross profit | | | 34,748 | | | 4,139 | | | -- | | | 1,820 | | | -- | | | 40,707 | |
| | | | | | | | | | | | | | | | | | | |
Direct costs of amortization of acquired technology | | | 275 | | | -- | | | -- | | | -- | | | -- | | | 275 | |
Direct costs of customer support | | | -- | | | -- | | | -- | | | -- | | | 5,666 | | | 5,666 | |
Depreciation and amortization associated with direct costs of network, sales and services | | | -- | | | -- | | | -- | | | -- | | | 6,012 | | | 6,012 | |
Other depreciation and amortization | | | -- | | | -- | | | -- | | | -- | | | 1,631 | | | 1,631 | |
Other operating costs and expenses | | | -- | | | -- | | | -- | | | -- | | | 26,581 | | | 26,581 | |
Income (loss) from operations | | $ | 34,473 | | $ | 4,139 | | $ | -- | | $ | 1,820 | | $ | (39,890 | ) | $ | 542 | |
4. | Stock-Based Compensation |
During the three months ended June 30, 2007, 0.1 million stock options and 0.2 million unvested restricted common stock awards were granted including annual grants of options and unvested restricted common stock awards to non-employee directors. For the six months ended June 30, 2007, we granted 0.6 million stock options and 0.6 million unvested restricted common stock awards, which includes 0.5 million options and 0.4 million unvested restricted common stock awards granted in conjunction with annual performance evaluations and bonuses. Total stock-based compensation expense was $2.8 million and $1.6 million for the three months ended June 30, 2007 and 2006, respectively, and $4.4 million and $3.1 million for the six months ended June 30, 2007 and 2006, respectively. We use the Black-Scholes option valuation model to determine stock-based compensation expense.
The VitalStream stock option/stock issuance plan provided for the granting of incentive stock options, non-statutory stock options or shares of common stock directly to certain key employees, members of the board of directors, consultants and independent contractors according to the terms of the plan. There were 5.4 million VitalStream shares, or 2.8 million Internap shares on a post-converted basis, reserved for issuance under the plan and 0.5 million VitalStream shares, or 0.3 million Internap shares on a post-converted basis, available for grant. Generally, the assumed options had exercise prices equal to the stock price on the date of grant and had contractual terms of 5 years. Vesting schedules ranged from quarterly periods over one year to four years with 1/4th vesting after one year and 1/16th vesting each quarter thereafter.
5. | Net (Loss) Income Per Share |
We computed basic net (loss) income per share using the weighted average number of shares of common stock outstanding during the period. We compute diluted net (loss) income per share using the weighted average number of common and potentially dilutive shares outstanding during the period. Potentially dilutive shares consist of the incremental common shares issuable upon the exercise of outstanding stock options and warrants and unvested restricted stock using the treasury stock method. The treasury stock method calculates the dilutive effect for only those stock options and warrants for which the sum of proceeds, including unrecognized compensation and any windfall tax benefits, is less than the average stock price during the period presented. This method excludes potentially dilutive shares from the computation of net (loss) income per share if their effect is antidilutive.
Basic and diluted net (loss) income per share for the three and six months ended June 30, 2007, and 2006 are calculated as follows (in thousands, except per share amounts):
| | | | | | | | | | | | | |
| | Three months ended June 30, | | Six months ended June 30, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
Net (loss) income | | $ | (1,683 | ) | $ | 713 | | $ | (12,377 | ) | $ | 1,254 | |
| | | | | | | | | | | | | |
Weighed average shares outstanding, basic | | | 48,515 | | | 34,465 | | | 44,932 | | | 34,384 | |
| | | | | | | | | | | | | |
Effect of dilutive securities: | | | | | | | | | | | | | |
Stock compensation plans | | | -- | | | 1,028 | | | -- | | | 619 | |
Warrants | | | -- | | | 294 | | | -- | | | -- | |
Weighted average shares outstanding, diluted | | | 48,515 | | | 35,787 | | | 44,932 | | | 35,003 | |
| | | | | | | | | | | | | |
Basic net (loss) income per share | | $ | (0.03 | ) | $ | 0.02 | | $ | (0.28 | ) | $ | 0.04 | |
Diluted net (loss) income per share | | $ | (0.03 | ) | $ | 0.02 | | $ | (0.28 | ) | $ | 0.04 | |
| | | | | | | | | | | | | |
Anti-dilutive securities not included in diluted net income (loss) per share calculation: | | | | | | | | | | | | | |
Stock compensation plans | | | 4,411 | | | 1,437 | | | 4,411 | | | 1,961 | |
Warrants to purchase common stock | | | 34 | | | -- | | | 34 | | | 1,385 | |
| | | | | | | | | | | | | |
Total anti-dilutive securities | | | 4,445 | | | 1,437 | | | 4,445 | | | 3,346 | |
6. | Goodwill and Other Intangible Assets |
We perform our annual goodwill impairment test as of August 1 of each calendar year and estimated the fair value of our reporting units utilizing a discounted cash flow method. Based on the results of these analyses, our goodwill was not impaired as of August 1, 2006.
The assumptions, inputs and judgments used in performing the valuation analysis are inherently subjective and reflect estimates based on known facts and circumstances at the time the valuation is performed. The use of different assumptions, inputs and judgments, or changes in circumstances, could materially affect the results of the valuation. Adverse changes in the valuation would necessitate an impairment charge for the goodwill held by us. As of December 31, 2006, the recorded amount of goodwill totaled $36.3 million. In connection with our acquisition of VitalStream on February 20, 2007, we recorded $154.8 million of additional goodwill based on our allocation of the VitalStream purchase price, as discussed in note 2. The total recorded amount of goodwill was $191.1 million and $36.3 million as of June 30, 2007 and December 31, 2006, respectively.
Generally, any adjustments made as a result of the impairment testing are required to be recognized as operating expense. We will continue to perform our annual impairment testing as of August 1 each year absent any impairment indicators that may cause more frequent analysis, as required by SFAS No. 142, “Goodwill and Other Intangible Assets.”
Also in connection with our acquisition of VitalStream on February 20, 2007, we recorded $46.5 million of additional amortizing intangible assets. The components of our amortizing intangible assets are as follows (in thousands):
| | June 30, 2007 | | December 31, 2006 | |
| | Gross Carrying Amount | | Accumulated Amortization | | Gross Carrying Amount | | Accumulated Amortization | |
| | | | | | | | | |
Contract based | | $ | 25,018 | | $ | (14,738 | ) | $ | 14,518 | | $ | (14,291 | ) |
Technology based | | | 41,911 | | | (6,061 | ) | | 5,911 | | | (4,353 | ) |
| | $ | 66,929 | | $ | (20,799 | ) | $ | 20,429 | | $ | (18,644 | ) |
Amortization expense related to intangible assets was $1.4 million and $0.1 million for the three months ended June 30, 2007 and 2006, respectively, and $2.1 million and $0.3 million for the six months ended June 30, 2007 and 2006, respectively. As of June 30, 2007, expected amortization expense in future periods is summarized as follows (in thousands):
Remainder of 2007 | | $ | | |
2008 | | | | |
2009 | | | 6,243 | |
2010 | | | 6,054 | |
2011 | | | 5,728 | |
2012 | | | 5,728 | |
Thereafter | | | 13,012 | |
| | $ | 46,130 | |
7. | Restructuring and Impairment of Long-Lived Assets |
In connection with our preparation of this quarterly report, we incurred an impairment charge as of June 30, 2007, totaling $1.2 million, representing the carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire Aventail for approximately $25 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.
As of March 31, 2007, we incurred a restructuring and impairment charge of $10.3 million. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream and our plan to finalize the overall integration and implementation plan before the end of the first quarter. The charge to expense included $7.8 million for leased facilities, representing both the net present value of costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.2 million for the termination of certain employees and $1.3 million for impairment of assets. Related expenditures are estimated to be $10.7 million, beginning immediately and continuing through December 2016, the last date of the longest lease term. The impairment charge of $1.3 million is related to the leases referenced above and less than $0.1 million for other assets.
We also recorded a $1.1 million impairment during the three months ended March 31, 2007 for the sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.
The following table displays the activity and balances for the restructuring and asset impairment activity (excluding the investment in Aventail and the sales order-through-billing system, in thousands):
| | Restructuring and Impairment Charge | | Cash Reductions | | Non-cash Write- Downs | | Non-cash Plan Adjustments | | June 30, 2007 Restructuring Liability | |
Restructuring costs | | | | | | | | | | | |
Real estate obligations | | $ | 7,755 | | $ | (735 | ) | $ | -- | | $ | 1,346 | | $ | 8,366 | |
Employee separations | | | 1,140 | | | (595 | ) | | -- | | | -- | | | 545 | |
| | | | | | | | | | | | | | | | |
Total restructuring costs | | | 8,895 | | | (1,330 | ) | | -- | | | 1,346 | | | 8,911 | |
| | | | | | | | | | | | | | | | |
Asset impairments | | | | | | | | | | | | | | | | |
Leasehold improvements | | | 897 | | | -- | | | (897 | ) | | -- | | | -- | |
Other | | | 471 | | | -- | | | (471 | ) | | -- | | | -- | |
| | | | | | | | | | | | | | | | |
Total asset impairments | | | 1,368 | | | -- | | | (1,368 | ) | | -- | | | -- | |
| | | | | | | | | | | | | | | | |
Total | | $ | 10,263 | | $ | (1,330 | ) | $ | (1,368 | ) | $ | 1,346 | | $ | 8,911 | |
| | | | | | | | | | | | | | | | |
As reported in our Annual Report on Form 10-K/A for the year ended December 31, 2006, we announced plans in 2001 to exit certain non-strategic real estate lease and license arrangements, consolidate and exit redundant network connections, and streamline the operating cost structure in response to overcapacity created in the Internet connectivity and IP services market. The following tables display the restructuring activity relating to the remaining real estate obligations from the 2001 restructuring charges (in thousands):
| | Six months ended June 30, | |
| | 2007 | | 2006 | |
Balance, beginning of period | | $ | 4,784 | | $ | 6,277 | |
Less: Cash reductions relating to real estate activities | | | (762 | ) | | (742 | ) |
Balance, end of period | | $ | 4,022 | | $ | 5,535 | |
In 2007, the Georgia Department of Revenue approved our 2003 application for the Georgia Headquarters Tax Credit, or the HQC, with a stipulation that we apply the credit against our June payroll tax liability. The HQC is available for corporate taxpayers (a) establishing or relocating their headquarters to Georgia, (b) investing a minimum of $1 million in certain property and (c) employing a minimum number of new full-time employees in the State of Georgia at or above a required wage level. Employers may use this credit for either corporate state income tax or payroll withholding tax. The approved credit was $0.3 million and relates to fiscal year 2003. We are applying for credits for 2004 through 2007, but we cannot determine the amount of potential credit at this time.
The provision for income taxes during the three and six months ended June 30, 2007 consisted of $0.1 million and $0.2 million, respectively. The entire provision is a non-current expense as a result of goodwill amortization for tax purposes from the acquisition of VitalStream.
The noncurrent provision represents an effective tax rate of 2%. The effective tax rate is based on management’s current expectations for the results of operations for the year ending December 31, 2007, in accordance with the interim reporting requirements of SFAS No. 109, “Accounting for Income Taxes” and Accounting Principals Board (APB) Opinion No. 28, “Interim Financial Reporting.”
APB Opinion No. 28 requires that companies report income taxes on interim periods’ financial statements using an estimated annual effective tax rate. Using this method income taxes are computed at the end of each interim period based on the best estimate of the effective rate expected to be applicable for the full fiscal year. To determine the estimated effective rate, we use the actual effective tax rate year-to-date as the best estimate for the annual effective rate.
We continue to maintain a full valuation allowance against our unrealized deferred tax assets of approximately $191.7 million, consisting primarily of net operating loss carryforwards. As a result of the VitalStream acquisition, however, $0.6 million in deferred tax liabilities from goodwill amortization for tax purposes exists as of June 30, 2007. We may recognize deferred tax assets in future periods when they are estimated to be realizable, such as establishing expected continuing profitability of the Company or certain of our foreign subsidiaries. To the extent we may owe income taxes in future periods, we intend to use our net operating loss carryforwards to the extent available to offset taxable income and reduce cash outflows for income taxes.
Effective January 1, 2007, we adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,” or FIN 48. In connection with the adoption, we formalized our policy to recognize income tax related interest and penalties within general and administrative expense. In the aggregate, the adoption did not have a material effect on the financial statements. Subsequently, no uncertain income tax positions have been discovered for the three or six months ended June 30, 2007.
Because we conduct business globally, certain of our subsidiaries file income tax returns in foreign jurisdictions, as well as federal and state jurisdictions of the United States. In the normal course of business we are subject to examination by taxing authorities throughout the world, including the jurisdictions of Australia, Canada, Hong Kong, Japan, the Netherlands, Singapore, the United Kingdom, and the United States.
We are currently under audit by the Internal Revenue Service, or IRS, for the 2004 tax year. The examination phase of the audit likely will conclude in 2007, and an adjustment to our net operating loss carryforward might result. As of June 30, 2007, the IRS has not proposed any adjustments. Tax years 2003 through 2006 remain open to examination by jurisdictions to which we are subject to adjustment upon audit prior to fully utilizing net operating loss carryforwards.
10. | Contingencies and Litigation |
As part of our acquisition of CO Space, Inc. on June 20, 2000, we assumed a pre-acquisition accounts payable liability of $1.3 million. As disclosed in our 2003 financial statements, we wrote off the $1.3 million liability amount, as we believed the obligation no longer existed. In the fourth quarter of 2006, we received an inquiry from the vendor regarding the status of the former $1.3 million payable and on March 19, 2007, ADC Telecommunications, Inc. filed a complaint against us in Minnesota state court. We settled this suit on June 29, 2007 for less than $0.1 million, which we expensed when we incurred the settlement cost and associated legal costs.
From time to time, we may be subject to other legal proceedings, claims and litigation arising in the ordinary course of business. Although the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our financial condition, results of operations or cash flows.
On March 15, 2007, the Board of Directors declared a dividend of one preferred share purchase right, or a Right, for each outstanding share of common stock, par value $0.001 per share, of the Company. The dividend was payable on March 23, 2007 to the stockholders of record on that date. Each Right entitles the registered holder to purchase from the Company 1/1000 of a share of Series B Preferred Stock of the Company, par value $0.001 per share, or the Preferred Shares, at a price of $100.00 per 1/1000 of a Preferred Share, subject to adjustment. Pursuant to the Company’s Certificate of Designation of Rights, Preferences and Privileges of Series B Preferred Stock, 0.5 million shares of Series B Preferred Stock are designated. The description and terms of the Rights are set forth in a Rights Agreement between the Company and American Stock Transfer & Trust Company, as Rights Agent, dated April 11, 2007.
12. | Recent Accounting Pronouncements |
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115,” which permits companies to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis, which is called the fair value option. This statement is effective for our financial statements beginning January 1, 2008. We are currently evaluating the new standard.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value as used in numerous accounting pronouncements, establishes a framework for measuring fair value in generally accepted accounting principles, or GAAP, and expands disclosure related to the use of fair value measures in financial statements. SFAS No. 157 does not expand the use of fair value measures in financial statements, but standardizes its definition and guidance in GAAP. The Standard emphasizes that fair value is a market-based measurement and not an entity-specific measurement based on an exchange transaction in which the entity sells an asset or transfers a liability (exit price). SFAS No. 157 establishes a fair value hierarchy from observable market data as the highest level to fair value based on an entity's own fair value assumptions as the lowest level. The Statement is to be effective for our financial statements issued in 2008; however, FASB encourages earlier application. We are currently evaluating the new standard.
In June 2006 the FASB issued FIN 48, which establishes a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement classification, interest and penalties, accounting in interim periods, disclosure, and transition. The adoption of FIN 48 did not have a material impact on our financial statements.
On July 26, 2007, we announced that we entered into a three-year strategic relationship with Quality Technology Services, or QualityTech. Under the terms of the agreement, we will be the preferred provider of CDN services and the exclusive provider of IP connectivity services to all of QualityTech’s data center facilities and will migrate to our IP connectivity services approximately 350 customers that QualityTech acquired in connection with its purchase of Globix Hosting LLC, a subsidiary of Globix Corporation, in October of 2006. We will also take down approximately 4,500 square feet of space in several of QualityTech’s data center facilities. This strategic relationship represents revenues of approximately $15.0 million for value-added CDN services and IP connectivity services over the three-year term.
INTERNAP NETWORK SERVICES CORPORATION
The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes provided under Part I, Item 1 of this Quarterly Report on Form 10-Q.
Overview
We deliver high performance and reliable Internet solutions through a suite of network optimization and delivery product and services. These solutions, combined with progressive and proactive technical support, enable companies to confidently migrate business-critical applications, including audio and video streaming and monetization services, to the Internet. Our suite of products and services support a broad range of Internet applications. We currently have more than 3,400 customers serving financial services, healthcare, technology, government, retail, travel, and media/entertainment markets. Our customers are located in the United States and abroad and include several Fortune 1000 and mid-tier enterprises. Our product and service offerings are complemented by IP access solutions such as data center services, content delivery networks, or CDN, and managed security. We deliver services through our 44 network access points across North America, London and the Asia-Pacific region, including Tokyo, Japan and Sydney, Australia. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet networks including AT&T, Sprint, Verizon, Savvis, Global Crossing Telecommunications, and Level 3 Communications.
The key characteristic that differentiates us from our competition is our portfolio of patented and patent-pending route optimization solutions that address the inherent weaknesses of the Internet and overcome the inefficiencies of traditional IP connectivity options. Our intelligent routing technology can facilitate traffic over multiple carriers, as opposed to just one carrier's network, to ensure highly reliable performance over the Internet.
We believe our unique managed multi-network approach provides better performance, control and reliability compared to conventional Internet connectivity alternatives. Our service level agreements guarantee performance across the entire Internet in the United States, excluding local connections, whereas providers of conventional Internet connectivity typically only guarantee performance on their own network.
On October 12, 2006, we entered into a definitive agreement to acquire VitalStream Holdings, Inc., or VitalStream, in an all-stock transaction to be accounted for using the purchase method of accounting for business combinations. The transaction closed on February 20, 2007. Our results of operations include the activities of VitalStream from February 21, 2007 through June 30, 2007.
We operate in four business segments: IP Services, Data Center Services, CDN Services and Other. For additional information about these segments, see note 3 to the condensed consolidated financial statements included in Part I, Item 1.
The following is a brief description of each of our reportable business segments.
IP Services
Our patented and patent-pending network performance optimization technologies address the inherent weaknesses of the Internet, allowing enterprises to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners. Our solutions take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. Prior to recommending appropriate network solutions for our customer’s applications, we consider key performance objectives including (1) performance and cost optimization, (2) application control and speed and (3) delivery and reach. Our charges for IP services are based on a fixed-fee, usage or a combination of both fixed fee and usage basis.
Our IP Services segment also includes our flow control platform, or FCP. The FCP provides network performance management and monitoring for companies with redundant Internet connections. The FCP proactively reviews customer network(s) for the best performing route or the most cost-effective and routes according to our customers’ requirements.
We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation and ongoing network configuration. Since the FCP emulates our P-NAP service in many ways, this product affords us the opportunity to serve customers outside of our P-NAP market footprint.
Data Center Services
Our data center services provide a single source for network infrastructure, IP and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by guaranteed service levels and our team of dedicated support professionals. We offer a comprehensive solution in more than 40 domestic and international locations. Data center services also enable us to have a more flexible product offering, including bundling our high performance IP connectivity and managed services, such as content delivery, along with hosting customers' applications. We charge monthly fees for data center services based on the amount of square footage that the customer leases in our facilities. We also have relationships with various providers to extend our P-NAP model into markets with high demand.
CDN Services
Our CDN services enable our customers to quickly and securely stream and distribute video, audio, advertising and software to audiences across the globe through strategically located data centers. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, content is delivered with high quality regardless of audience size or geographic location. Our MediaConsole® content management tool provides our customers the benefit of a single, easy to navigate system featuring Media Asset Management, Digital Rights Management, or DRM, support and detailed reporting tools. With MediaConsole, our customers can use one application to manage and control access to their digital assets, deliver ad campaigns, view network conditions, and gain insight into habits of their viewing audience.
Our CDN and monetization services provide a complete turnkey solution for the monetization of online media. These multi-faceted “live” and “on-demand” ad insertion and ad placement solutions include a full campaign management suite, inventory prediction tools, audience research and metrics, and extensive reporting features to effectively track ad campaigns in real-time. Online advertising solutions enable our customers to offset the costs associated with the creation, transformation, licensing, and management of online content. Prior to our acquisition of VitalStream on February 20, 2007, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services for which revenue and direct costs are included in our Other segment, discussed below.
Other
Our Other segment presents our non-segmented results of operations, including certain reseller and miscellaneous services such as third party CDN services, termination fee revenue, other hardware sales, and consulting services.
Recent Developments
Impairment Charge. In connection with our preparation of this quarterly report, we incurred an impairment charge as of June 30, 2007, totaling $1.2 million, representing the carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire Aventail for approximately $25 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.
Data Center Expansion. On June 12, 2007, we announced that we have approved an investment of up to $40 million to fund the expansion of our data center facilities in several key markets. We anticipate implementing the expansion over the next three to four calendar quarters, with any potential funding to be provided under standard commercial financing arrangements.
Recent Accounting Pronouncements
Recent accounting pronouncements are summarized in note 12 of our Financial Statements.
Results of Operations
Revenue. Revenues are generated primarily from the sale of IP, data center, CDN, and related services. Our revenues typically consist of monthly recurring revenues from contracts with terms of one year or more. These contracts usually have fixed minimum commitments based on a certain level of usage with additional charges for any usage over a specified limit. We also provide premise-based route optimization products and other ancillary services, such as server management and installation services, virtual private networking services, managed security services, data back-up, remote storage, restoration services, and professional services.
Direct cost of network, sales and services. Direct cost of network, sales and services is comprised primarily of:
| · | facility and occupancy costs for housing and operating our and our customers’ network equipment; |
| · | costs of license fees for operating systems software, advertising royalties to content rights owners and advertising distribution costs; |
| · | costs incurred for providing additional third party services to our customers; and |
| · | costs of FCP solution sold. |
To the extent a network access point is located a distance from the respective Internet network service providers, we may incur additional local loop charges on a recurring basis. Connectivity costs vary depending on customer demands and pricing variables, while network access point facility costs are generally fixed in nature. Direct cost of network and sales does not include compensation, depreciation or amortization other than the amortization of technology-based intangible assets.
Direct cost of amortization of acquired technology. Direct cost of amortization of acquired technology is for technology acquired through business combinations that is an integral part of the services and products we sell. The cost of the acquired technology is amortized over original lives of three to eight years.
Direct cost of customer support. Direct cost of customer support consists primarily of employee compensation costs for employees engaged in connecting customers to our network, installing customer equipment into network access point facilities, and servicing customers through our network operations centers. In addition, facilities costs associated with the network operations center are included in direct cost of customer support.
Product development costs. Product development costs consist principally of compensation and other personnel costs, consultant fees and prototype costs related to the design, development and testing of our proprietary technology, enhancement of our network management software, and development of internal systems. Costs for software to be sold, leased or otherwise marketed are capitalized upon establishing technological feasibility and ending when the software is available for general release to customers. Costs associated with internal use software are capitalized when the software enters the application development stage until implementation of the software has been completed. All other product development costs are expensed as incurred.
Sales and marketing costs. Sales and marketing costs consist of compensation, commissions and other costs for personnel engaged in marketing, sales and field service support functions, as well as advertising, trade shows, direct response programs, new service point launch events, management of our website, and other promotional costs.
General and administrative costs. General and administrative costs consist primarily of compensation and other expenses for executive, finance, human resources and administrative personnel, professional fees, and other general corporate costs.
Liquidity. Although we have been in existence since 1996, we have experienced significant operational restructurings in recent years, which include substantial changes in our senior management team, streamlining our cost structure, consolidating network access points, and terminating certain non-strategic real estate leases and license arrangements. We have a history of quarterly and annual period net losses through the year ended December 31, 2005. For the three and six months ended June 30, 2007, we recognized a net loss of $1.7 million and $12.4 million, respectively. As of June 30, 2007, our accumulated deficit was $868.8 million.
Three and Six Months Ended June 30, 2007 and 2006
The following table sets forth, as a percentage of total revenue, selected statement of operations data for the periods indicated:
| | | | | | | | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
Revenues: | | | | | | | | | | | | | |
Internet protocol (IP) services | | | 50.2 | % | | 61.7 | % | | 52.1 | % | | 62.5 | % |
Data center services | | | 34.1 | | | 30.8 | | | 34.1 | | | 29.2 | |
Content delivery network (CDN) services | | | 8.9 | | | -- | | | 6.5 | | | -- | |
Other | | | 6.8 | | | 7.5 | | | 7.3 | | | 8.3 | |
Total revenues | | | 100.0 | | | 100.0 | | | 100.0 | | | 100.0 | |
| | | | | | | | | | | | | |
Operating expenses: | | | | | | | | | | | | | |
Direct cost of network, sales and services, exclusive of | | | | | | | | | | | | | |
depreciation and amortization shown below: | | | | | | | | | | | | | |
IP services | | | 18.0 | | | 23.2 | | | 18.5 | | | 22.4 | |
Data center services | | | 24.1 | | | 24.4 | | | 25.4 | | | 24.4 | |
CDN services | | | 3.3 | | | -- | | | 2.3 | | | -- | |
Other | | | 5.2 | | | 6.1 | | | 5.8 | | | 6.2 | |
Direct cost of amortization of acquired technology | | | 1.8 | | | 0.3 | | | 1.5 | | | 0.3 | |
Direct cost of customer support | | | 7.4 | | | 6.3 | | | 6.9 | | | 6.5 | |
Product development | | | 3.0 | | | 2.7 | | | 2.7 | | | 2.8 | |
Sales and marketing | | | 14.3 | | | 16.1 | | | 13.0 | | | 16.2 | |
General and administrative | | | 14.2 | | | 11.6 | | | 14.3 | | | 11.9 | |
Restructuring and asset impairment | | | 2.0 | | | -- | | | 11.2 | | | -- | |
Acquired in-process research and development | | | -- | | | -- | | | 0.4 | | | -- | |
Depreciation and amortization | | | 10.1 | | | 8.8 | | | 9.7 | | | 8.8 | |
Gain on disposals of property and equipment | | | -- | | | (0.3 | ) | | -- | | | (0.1 | ) |
Total operating costs and expenses | | | 103.4 | | | 99.2 | | | 111.7 | | | 99.4 | |
(Loss) income from operations | | | (3.4 | )% | | 0.8 | % | | (11.7 | )% | | 0.6 | % |
Segment information. We have four business segments: Internet protocol, or IP, services, data center services, content delivery network, or CDN, services, and other services. IP services include managed and premise-based IP and route optimization technologies. Data center services include hosting of customer applications directly on our network to eliminate issues associated with the quality of local connections. Data center services are usually bundled with our high performance IP connectivity services with an increasing number of IP customers also purchasing data center services. CDN services include products and services for storing, delivering and monetizing digital media to large global audiences over the Internet. Prior to our acquisition of VitalStream on February 20, 2007, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services for which revenue and direct costs are included in our Other segment, discussed below.
Our reportable segments are strategic business units that offer different products and services. As of June 30, 2007, our customer base totaled more than 3,400 customers across our 23 metropolitan markets.
IP services. Revenue for IP services increased $2.3 million, or 8%, to $29.3 million for the three months ended June 30, 2007, compared to $27.1 million for the three months ended June 30, 2006. For the six-month periods, IP services revenue increased $4.3 million, or 8%, to $58.4 million as of June 30, 2007, compared to $54.1 million as of June 30, 2006. The increase in IP revenue is driven by an increase in demand, partially offset by declining prices, and an increase in sales of our premise-based FCP products, especially for the three months ended June 30, 2007 compared to the three months ended June 30, 2006. We continue to experience increasing demand for our traditional IP services, with IP traffic for the three months ended June 30, 2007 increasing approximately 55% from the three months ended June 30, 2006. However ongoing industry-wide pricing declines offset a portion of our gains in customers and IP traffic. The increase in IP traffic has resulted from both existing and new customers requiring greater overall capacity due to growth in the usage of their applications, as well as in the nature of applications consuming greater amounts of bandwidth. In particular, we added a number of high-traffic customers through competitive IP pricing and minimum commitments during the three and six months ended June 30, 2007.
Direct cost of IP network, sales and services, exclusive of depreciation and amortization, increased $0.3 million, or 3%, to $10.5 million for the three months ended June 30, 2007, compared to $10.2 million for the three months ended June 30, 2006. For the six-month periods, the related direct costs increased $1.4 million, or 7%, to $20.7 million as of June 30, 2007, compared to $19.4 million as of June 30, 2006. Connectivity costs vary based upon customer traffic and other demand-based pricing variables. Costs for IP services are especially subject to ongoing negotiations for pricing and minimum commitments. As our IP traffic continues to grow, we expect to have greater bargaining power for lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among network service providers.
Data center services. Data center services are a significant source of revenue growth for our business, also contributing to growth in IP revenue through our ability to provide bundled services. Revenue for data center services increased $6.4 million, or 47%, to $19.9 million for the three months ended June 30, 2007, compared to $13.5 million for the three months ended June 30, 2006. For the six-month periods, data center services revenue increased $13.0 million, or 51%, to $38.2 million as of June 30, 2007, compared to $25.2 million as of June 30, 2006.
Data center costs have substantial fixed cost components, primarily for rent, but also significant demand-based pricing variables, such as utilities, which are highest in the summer for cooling the facilities. Direct cost of data centers services, exclusive of depreciation and amortization, increased $3.4 million, or 31%, to $14.1 million for the three months ended June 30, 2007, compared to $10.7 million for the three months ended June 30, 2006. For the six-month periods, the related direct costs increased $7.3 million, or 35%, to $28.4 million as of June 30, 2007, compared to $21.1 million as of June 30, 2006.
The growth in data center services largely follows our expansion of data center space. The demand for data center services is outpacing industry-wide supply, which contributes to our increased adjusted gross margins for data center services.
Utilization of data center space is summarized as follows (square feet, in thousands):
| | As of June 30, | |
| | 2007 | | 2006 | |
| | | | | |
Built-out | | | | | |
Internap facilities | | | 99 | | | 84 | |
Third party facilities | | | 67 | | | 57 | |
Total | | | 166 | | | 141 | |
| | | | | | | |
Occupied | | | | | | | |
Internap facilities | | | 69 | | | 67 | |
Third party facilities | | | 55 | | | 46 | |
Total | | | 124 | | | 113 | |
| | | | | | | |
Utilization | | | | | | | |
Internap facilities | | | 70 | % | | 80 | % |
Third party facilities | | | 82 | | | 81 | |
Total | | | 75 | % | | 80 | % |
During the three months ended June 30, 2007, we began executing our previously announced data center growth initiatives and we completed the build-out of our Seattle facility. We have scaled our data center business so that we can accommodate larger, global customers and ensure a platform for robust traffic growth. This recent expansion has resulted in the lower utilization rate as of June 30, 2007 compared to June 30, 2006.
CDN services. Revenue and direct costs for our CDN services segment were $5.2 million and $2.0 million, respectively, for the three months ended June 30, 2007 and $7.3 million and $2.6 million, respectively, for the six months ended June 30, 2007. This activity represents the operations from our acquisition of VitalStream, which closed on February 20, 2007. As previously noted, we did not offer proprietary CDN services prior to our acquisition of VitalStream, but instead, we were a reseller of third party CDN services. We expect CDN to be an area of significant growth and are expanding related infrastructure, including in Europe and Asia, to serve the industry-wide demand, particularly in those regions.
Other. Revenue and direct cost of network, sales and services for our Other segment primarily includes reseller and miscellaneous services such as third party CDN services, termination fee revenue, other hardware sales, and consulting services. As a result of our acquisition of VitalStream, we expect revenue and direct cost of network, sales and services to decrease substantially as the revenue streams from our third party CDN service provider wind down.
Other operating expenses. Compensation and facilities-related costs have a pervasive impact on operating expenses other than direct cost of network, sales and services. After direct cost of network, sales and services, our most significant expense is compensation and benefits. Cash-basis compensation and benefits increased $3.3 million to $13.6 million from $10.3 million for the three months ended June 30, 2007 and 2006, respectively. Cash-basis compensation and benefits increased $4.7 million to $25.3 million from $20.6 million for the six months ended June 30, 2007 and 2006, respectively. The increases are primarily due to increased headcount, especially the employees added with the VitalStream acquisition, which for the three and six months ended June 30, 2007 account for $2.5 million and $3.3 million of the increase, respectively. Also, we added employees throughout the Company including new employees at the senior management level. Total headcount increased to 431 at June 30, 2007, including employees added with the VitalStream acquisition, compared to 339 at June 30, 2006.
Stock-based compensation increased $1.2 million to $2.8 million from $1.6 million for the three months ended June 30, 2007 and 2006, respectively. For the six months ended June 30, 2007, stock-based compensation increased $1.3 million to $4.4 million from $3.1 million for the six months ended June 30, 2006. The increases are due to annual grants of stock options and unvested restricted common stock to non-employee directors, initial grants and awards to new members of senior management and the stock options assumed in the VitalStream acquisition.
Overall, facility and related costs, including repairs and maintenance, communications and office supplies but excluding direct cost of network and sales, increased $0.2 million to $1.7 million for the three months ended June 30, 2007 compared to $1.5 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, facility and related costs increased $0.2 million to $3.2 million, as compared to $3.0 million for the six months ended June 30, 2006. The increase is primarily due to post-acquisition VitalStream costs partly offset by ongoing cost containment efforts.
Other operating costs are discussed within the financial statement captions below.
Direct cost of amortization of acquired technology. The increase in amortization expense of $0.9 million for the three months ended June 30, 2007 and the increase of $1.4 million for the six months ended June 30, 2007 is primarily due to the amortization of the post-acquisition intangible technology assets of VitalStream.
Direct cost of customer support. Direct cost of customer support increased 56% to $4.3 million for three months ended June 30, 2007 from $2.8 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, direct cost of customer support increased 36% to $7.7 million, as compared to $5.7 million for the six months ended June 30, 2006. The increases for the three and six months ended June 30, 2007 of $1.6 million and $2.1 million, respectively, were primarily due to the addition of post-acquisition VitalStream employees and facilities and related expenses noted above. VitalStream employees accounted for $0.6 million and $0.9 million of added cash-basis compensation and benefits for the three and six months ended June 30, 2007, respectively. For the three and six months ended June 30, 2007 facilities and related expenses also increased $0.3 million and $0.4 million, respectively, based on more accurate data for allocation of costs, primarily from sales and marketing.
Product development. Product development costs for the three months ended June 30, 2007 increased 51% to $1.7 million from $1.2 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, product development costs increased 26% to $3.0 million, as compared to $2.4 million for the six months ended June 30, 2006. The increase of $0.6 million for both the three and six months ended June 30, 2007 is primarily attributable to the addition of post-acquisition VitalStream employees. For the three and six months ended June 30, 2007 these additional employees account for $0.4 million and $0.5 million, respectively, of additional costs.
Sales and marketing. Sales and marketing costs for the three months ended June 30, 2007 increased 18% to $8.3 million from $7.1 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, sales and marketing costs increased 3% to $14.5 million, as compared to $14.0 million for the six months ended June 30, 2006. The increases for the three and six months ended June 30, 2007 of $1.3 million and $0.5 million, respectively, were primarily comprised of post-acquisition VitalStream employee costs. Cash-basis compensation, benefits and commissions related to VitalStream employees accounted for $1.0 million for the three months ended June 30, 2007 and $1.2 million for the six months ended June 30, 2007. The increase for the six months ended June 30, 2007 was partially offset by a $0.4 million decrease in facilities and related expenses. We have also incurred initial costs associated with a rebranding campaign to incorporate our proprietary CDN services. We will reflect the more expensive media development phase in subsequent periods.
General and administrative. General and administrative costs for the three months ended June 30, 2007 increased 64% to $8.3 million from $5.1 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, general and administrative costs increased 57% to $16.2 million, as compared to $10.3 million for the six months ended June 30, 2006. Increases for the three and six months ended June 30, 2007 of $3.3 million and $5.9 million, respectively, are primarily due to increases in cash-based compensation, professional services and stock-based compensation. Cash-basis compensation for the three and six months ended June 30, 2007 increased $1.1 million and $2.5 million, respectively, of which $0.4 million and $0.7 million, respectively, relate to additional VitalStream employees. Furthermore, we are accruing employee bonuses at a higher amount for 2007 than we did for 2006 due to the increase in employees. Professional services for the three and six months ended June 30, 2007 increased $0.8 million and $1.4 million, respectively, primarily due to consultation fees on our information technology systems, compliance activities for domestic and international tax and financial statement requirements, recruiting fees and contract labor to back-fill a number of open job requisitions, and legal fees, including those associated with new proxy disclosure requirements and ongoing litigation as noted in our 10-Q for the quarterly period ended March 31, 2007. The increases in stock-based compensation costs of $0.7 million for the three months ended June 30, 2007 and $0.9 million for the six months ended June 30, 2007 are due to annual grants of stock options and unvested restricted common stock to non-employee directors, initial grants and awards to new members of senior management and the stock options assumed in the VitalStream acquisition.
Restructuring and asset impairment. In connection with our preparation of this quarterly report, we incurred an impairment charge as of June 30, 2007, totaling $1.2 million, representing the carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire Aventail for approximately $25 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.
On March 31, 2007, we incurred a restructuring and impairment charge of $10.3 million. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream and our plan to finalize the overall integration and implementation plan before the end of the first quarter. The charge to expense included $7.8 million for leased facilities, representing both the net present value of costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.2 million for the termination of certain employees and $1.3 million for impairment of assets. Related expenditures are estimated to be $10.7 million, beginning immediately and continuing through December 2016, the last date of the longest lease term. The impairment charge of $1.3 million is related to the leases referenced above and less than $0.1 million for other assets.
There was also a $1.1 million impairment recorded during the three months ended March 31, 2007 for the sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.
Depreciation and amortization. Depreciation and amortization, including other intangible assets, for the three months ended June 30, 2007 increased 54% to $5.9 million compared to $3.8 million for the three months ended June 30, 2006. For the six months ended June 30, 2007, depreciation and amortization, including other intangible assets, increased 42% to $10.8 million, as compared to $7.6 million for the six months ended June 30, 2006. The increases for the three and six months ended June 30, 2007 of $2.1 million and $3.2 million, respectively, primarily relate to post-acquisition depreciation and amortization of VitalStream property and equipment and amortizable intangible assets, excluding amortization of acquired technology. The VitalStream property and equipment and amortizable intangible assets account for $1.6 million for the three months ended June 30, 2007 and $2.3 million for the six months ended June 30, 2007. Other increases in depreciation and amortization are related to the expansion of P-NAPs and data center facilities. The restructuring and asset impairment described above initially reduced depreciation and amortization by approximately $0.1 million per quarter, decreasing to $0 in 2009.
Income taxes. The provision for income taxes was $0.1 million and $0.2 million for the three and six months ended June 30, 2007, respectively, representing an effective tax rate of 2%.
We continue to maintain a full valuation allowance against our unrealized deferred tax assets of approximately $191.7 million, consisting primarily of net operating loss carryforwards. As a result of the VitalStream acquisition, however, $0.6 million in deferred tax liabilities from goodwill amortization for tax purposes exists as of June 30, 2007. We may recognize deferred tax assets in future periods when they are estimated to be realizable. To the extent we may owe income taxes in future periods, we intend to use our net operating loss carryforwards to the extent available to offset taxable income and reduce cash outflows for income taxes.
Liquidity and Capital Resources
Cash Flow for the Six Months ended June 30, 2007 and 2006
Net cash from operating activities.
Net cash provided by operating activities was $12.3 million for the six months ended June 30, 2007, and was primarily due to adjustments for non-cash items of $20.7 million, changes in working capital items of $4.0 million, offset by our net loss of $12.4 million. The non-cash adjustment of $12.5 million for depreciation and amortization is due in part to the amortizable intangible assets acquired through the acquisition of VitalStream on February 20, 2007 and the expansion of our P-NAP and data center facilities. The change in working capital includes an increase in accrued restructuring liability of $8.1 million. Quarterly days sales outstanding at June 30, 2007 increased to 44 days from 43 days as of June 30, 2006. The increase in payables as of June 30, 2007, is primarily related to the timing of payments compared to December 31, 2006, and the integration of VitalStream. We expect to continue to fund ongoing operations with cash provided by operating activities.
Net cash provided by operating activities was $12.8 million for the six months ended June 30, 2006, and was comprised of net income of $1.3 million adjusted for non-cash items of $12.3 million offset by a net use of cash for changes in working capital items of $0.7 million. The principal non-cash items included depreciation and amortization, stock-based compensation expense and non-cash changes in deferred rent. The net cash used for working capital items included $0.4 million for a modest increase in accounts receivable from December 31, 2005 to June 30, 2006 and an increase of $0.7 million in prepaid expenses, deposits and other assets for the same period. The annual renewal of several prepaid expense arrangements contributed to most of the $0.7 million increase in prepaid expenses, deposits and other assets. A net increase of $0.2 million in the liability components of working capital from December 31, 2005 to June 30, 2006 resulted in a net source of cash. The net increase in the liability components was principally a $0.8 million net increase in accounts payable and accrued liabilities, especially for additional network costs, offset by cash payments on restructuring liabilities of $0.7 million.
Net cash from investing activities.
Net cash used in investing activities for the six months ended June 30, 2007 was $20.0 million, primarily due to capital expenditures of $17.0 million and net purchases of short-term investments in marketable securities of $6.1 million. Our capital expenditures were principally for upgrading our P-NAP facilities and the expansion of our data center facilities. We expect total capital expenditures of $45.0 - $55.0 million for the year ended December 31, 2007, funded from both cash from operations and future borrowings from traditional bank financing of up to $30 million.
Net cash provided by investing activities for the six months ended June 30, 2006 was $1.4 million and primarily consisted of the net maturity of marketable securities of $6.7 million. The sources of cash were offset by the purchase of property and equipment of $5.5 million primarily related to the expansion of our data centers and upgrade of our P-NAP facilities.
Net cash from financing activities.
Net cash provided by financing activities for the six months ended June 30, 2007 was $2.7 million. Cash provided by financing activities was primarily due to proceeds from stock compensation plan activity of $6.8 million, partially offset by principal payments on notes payable and capital leases of $4.1 million. As a result of these activities and the VitalStream acquisition, we had $8.5 million in notes payable and $1.6 million in capital lease obligations as of June 30, 2007 with $8.1 million in the notes payable and capital leases scheduled as due within the next 12 months.
Net cash used in financing activities for the six months ended June 30, 2006 was $0.3 million, primarily representing the repayment of notes payable and capital leases of $2.2 million and $0.2 million, respectively. Net cash used was partially offset by the proceeds from stock compensation plan activity of $2.1 million.
Liquidity.
We recorded a net loss of $12.4 million for the six months ended June 30, 2007 and net income of $1.3 million for the six months ended June 30, 2006. As of June 30, 2007, our accumulated deficit was $868.8 million. Our net loss for the six months ended June 30, 2007 includes $13.0 million in charges for restructuring, asset impairment and acquired in-process research and development. We cannot guarantee that we will avoid incurring similar charges in the future that will cause us to record net losses, nor can we guarantee that we will be profitable in the future, given the competitive and evolving nature of the industry in which we operate. We may not be able to sustain or increase profitability on a quarterly basis, and our failure to do so would adversely affect our business, including our ability to raise additional funds.
Although we have experienced positive operating cash flow recently, including for the six months ended June 30, 2007, we have a history of negative operating cash flow and have primarily depended upon equity and debt financings, as well as borrowings under our credit facilities, to meet our cash requirements for most quarters since we began our operations. Furthermore, we cannot guarantee that we will continue to generate positive cash flow as we integrate VitalStream. We expect, however, to meet our cash requirements in 2007 through a combination of cash from operating cash flows, existing cash, cash equivalents and short-term investments in marketable securities, borrowings under our existing credit facilities, possible future bank financing, and remaining proceeds from our public offering in March of 2004. Our capital requirements depend on a number of factors, including the continued market acceptance of our services and products, the ability to expand and retain our customer base and other factors. If our cash requirements vary materially from those currently planned, if our cost reduction initiatives have unanticipated adverse effects on our business or if we fail to generate sufficient cash flow from the sales of our services and products, we may require greater or additional financing sooner than anticipated. We can offer no assurance that we will be able to obtain additional financing on commercially favorable terms, or at all, and provisions in our existing credit facility limit our ability to incur additional indebtedness. Our $5.0 million credit facility will expire on December 27, 2007. We cannot assure you that this credit facility will be renewed upon expiration on commercially favorable terms, or at all. We believe we have sufficient cash and financing opportunities to operate our business for the foreseeable future.
Revolving credit facility. At June 30, 2007, we had a $5.0 million revolving credit facility and a $17.5 million term loan under a loan and security agreement with a bank. The agreement was reviewed and amended as of December 27, 2006, to modify the amount available for borrowing under the revolving credit agreement from $10.0 million to $5.0 million with an additional $5.0 million available as needed, decrease the letter of credit sub-limit from $6.0 million to $4.7 million, extend the expiration date of the revolving credit facility from December 28, 2006 to December 27, 2007, and update the loan covenants.
Availability under the revolving credit facility is based on 85% of eligible accounts receivable. As of June 30, 2007, $3.9 million in letters of credit were issued, and we had available $1.1 million in borrowing capacity under the revolving credit facility.
The credit facility contains certain covenants, including covenants that restrict our ability to incur further indebtedness. As of June 30, 2007, we were in compliance with the various loan covenants.
At June 30, 2007, we also had a loan and security agreement that we assumed in the VitalStream acquisition. The loan and security agreement includes an outstanding balance on a line of credit equal to $2.0 million, due in September 2007 and two term loans with a combined outstanding balance of $1.0 million, due in September 2007 and in March 2008. The expiration date on the line of credit was extended for 90 days from its original due date in June 2007. The loan and security agreement contains certain covenants, including covenants related to future operations. As of June 30, 2007, we were in compliance with the various loan covenants. In addition, VitalStream has pledged substantially all of its assets to secure repayment of the credit facilities under the loan and security agreement.
Notes payable to financial institutions. The $17.5 million term loan discussed with the revolving credit facility above has a fixed interest rate of 7.5% and is due in 48 equal monthly installments of $0.4 million for principal plus interest through September 1, 2008. The balance outstanding at June 30, 2007 was $5.5 million. Proceeds from the loan were used to purchase assets recorded as capital leases under a master agreement with a primary supplier of networking equipment. The loan is secured by all of our assets, except patents.
The term loans discussed above with the loan and security agreement that we assumed in the VitalStream acquisition have variable interest rates of the lender's published prime rate plus 0.5% to 1.0% and are due in September 2007 and in March 2008. Both term loans have monthly principal payments of $0.1 million plus interest. The combined balance outstanding at June 30, 2007 was $1.0 million. VitalStream used proceeds from the loan to finance equipment purchases. The loan is secured by substantially all of VitalStream's assets.
Capital leases. Our future minimum lease payments on remaining capital lease obligations at June 30, 2007 totaled $1.8 million.
Commitments and other obligations. We have commitments and other obligations that are contractual in nature and will represent a use of cash in the future unless the terms of those agreements are modified. Network commitments primarily represent purchase commitments made to our largest bandwidth vendors and contractual payments to license data center space used for resale to customers. Our ability to improve cash used in operations in the future would be negatively impacted if we do not grow our business at a rate that will allow us to offset the service commitments with corresponding revenue growth.
Asset Impairment and Restructuring Costs
As described in note 7 to the financial statements, in connection with our preparation of this quarterly report, we incurred an impairment charge as of June 30, 2007 totaling $1.2 million, representing the carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire Aventail for approximately $25 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.
On March 31, 2007, we incurred a restructuring and impairment charge totaling $10.3 million. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream and our plan to finalize the overall integration and implementation plan before the end of the first quarter. The charge to expense included $7.8 million for leased facilities, representing both the net present value of costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.2 million for the termination of certain employees and $1.3 million for impairment of assets. Related expenditures are estimated to be $10.7 million, beginning immediately and continuing through December 2016, the last date of the longest lease term. The impairment charge of $1.3 million is related to the leases referenced above and less than $0.1 million for other assets.
There was also a $1.1 million impairment recorded during the three months ended March 31, 2007 for the sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.
Cash and cash equivalents. We maintain cash and short-term deposits at our financial institutions. Due to the short-term nature of our deposits, we record them on the balance sheet at fair value.
Other investments. We had a cost-based equity investment with a carrying value of $1.2 million in Aventail Corporation, or Aventail, a privately held company, after reducing the balance for an impairment loss of $4.8 million in 2001. As described in note 7 to the financial statements, we incurred a $1.2 million impairment charge on this asset as of June 30, 2007 to write-off the remaining balance in connection with our preparation of this quarterly report.
We have also invested $4.1 million in Internap Japan Co., Ltd., or Internap Japan, our joint venture with NTT-ME Corporation and another NTT affiliate. This investment is accounted for using the equity-method, and to date we have recognized $3.5 million in equity-method losses, representing our proportionate share of the aggregate joint venture losses and income. Furthermore, the joint venture investment is subject to foreign currency exchange rate risk. The market for services being offered by Internap Japan has not been proven and may never materialize. For the three and six months ended June 30, 2007, we recorded nominal equity in earnings in this equity-method investment.
Notes payable. As of June 30, 2007, we had notes payable recorded at their present value of $8.5 million bearing rates of interest that we believe are commensurate with their associated market risk.
Capital leases. As of June 30, 2007, we had capital lease obligations, including imputed interest, of $1.8 million, reflecting the present value of future minimum lease payments. We believe the interest rates used in calculating the present values of these lease payments are a reasonable approximation of fair value and their associated market risk is minimal.
Credit facilities. As of June 30, 2007, we had $1.1 million available under our revolving credit facility with a bank, and outstanding loan balances of $8.5 million. The interest rate for one loan with an outstanding balance was fixed at 7.5%. The interest rates for the remaining loan balances were variable based on the lender’s published prime rate plus 0.5% to 1.0%. We believe these interest rates are reasonable approximations of fair value and the market risk is minimal.
Interest rate risk. Our objective in managing interest rate risk is to maintain favorable long-term fixed rate or a balance of fixed and variable rate debt that will lower our overall borrowing costs within reasonable risk parameters. Currently, our strategy for managing interest rate risk does not include the use of derivative securities. As of June 30, 2007, we had $3.0 million of outstanding variable interest rate debt at the lender's published prime rate plus 0.5% to 1.0%.
Foreign currency risk. Substantially all of our revenue is currently in United States dollars and from customers primarily in the United States. We do not believe, therefore, that we currently have any significant direct foreign currency exchange rate risk.
Inflation. The effect of inflation and changing prices on net sales and revenues and income from continuing operations has not been material to us.
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2007.
Changes in Internal Control over Financial Reporting
Other than the changes resulting from the VitalStream acquisition, no significant changes occurred in our internal controls over financial reporting during the period covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
ITEM 1. LEGAL PROCEEDINGS
As part of our acquisition of CO Space, Inc. on June 20, 2000, we assumed a pre-acquisition accounts payable liability of $1.3 million. As disclosed in our 2003 financial statements, we wrote off the $1.3 million liability amount, as we believed the obligation no longer existed. In the fourth quarter of 2006, we received an inquiry from the vendor regarding the status of the former $1.3 million payable and on March 19, 2007, ADC Telecommunications, Inc. filed a complaint against us in Minnesota state court. We settled this complaint on June 29, 2007 for less than $0.1 million, which we expensed when we incurred the settlement cost and associated legal costs.
From time to time, we may be subject to other legal proceedings, claims and litigation arising in the ordinary course of business. Although the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our financial condition, results of operations or cash flows.
There have been no material changes from the Risk Factors we previously disclosed in our Form 10-K/A for the year ended December 31, 2006 filed with the Securities and Exchange Commission on March 13, 2007.
(a) | | The annual meeting of stockholders was held on June 21, 2007. |
(b) | | The names of all directors are set forth below. The proxies for the meeting were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. There were no solicitations in opposition to the nominees as listed in the proxy and all such nominees were elected. |
(c) | | A brief description of each matter voted on and the approximate number of votes cast are as follows (on an actual vote cast basis): |
| | Number of Votes |
| | | | | | Withheld/ | | Broker |
Description of Proposals | | For | | Against | | Abstain | | Non-Votes |
Election of Directors for a term expiring in 2010: | | | | | | | | |
James P. DeBlasio | | 26,254,523 | | N/A | | 14,174,869 | | N/A |
Kevin Ober | | 26,221,298 | | N/A | | 14,208,095 | | N/A |
| | | | | | | | |
The following directors, who did not stand for election at the 2007 Annual Meeting, also currently sit on our Board of Directors: Charles Coe and Patricia L. Higgins, whose terms expire in 2009; and Eugene Eidenberg, William Harding and Daniel Stanzione, whose terms expire in 2008. | | | | | | | | |
| | | | | | | | |
Ratification of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2007. | | 39,903,187 | | 499,009 | | 27,195 | | N/A |
Exhibit Number | | Description |
| | |
10.1* | | Employment Agreement effective as of April 16, 2007 between Vincent Molinaro and the Company. |
| | |
10.2* | | Employment Agreement dated April 2, 2007 between Richard Dobb and the Company. |
| | |
10.3 | | Employment Agreement dated May 22, 2007 between Philip N. Kaplan and the Company (incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K, filed on July 6, 2007). |
| | |
31.1* | | Rule 13a-14(a)/15d-14(a) Certification, executed by James P. DeBlasio, President, Chief Executive Officer and Director of the Company. |
| | |
31.2* | | Rule 13a-14(a)/15d-14(a) Certification, executed by David A. Buckel, Vice President and Chief Financial Officer of the Company. |
| | |
32.1* | | Section 1350 Certification, executed by James P. DeBlasio, President, Chief Executive Officer and Director of the Company. |
| | |
32.2* | | Section 1350 Certification, executed by David A. Buckel, Vice President and Chief Financial Officer of the Company. |
* Documents filed herewith. |
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | |
| INTERNAP NETWORK SERVICES CORPORATION (Registrant) |
| | |
| By: | /s/ David A. Buckel |
| David A. Buckel |
| Vice President and Chief Financial Officer |
| (Principal Financial and Accounting Officer) |
| |
| Date: August 9, 2007 |
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