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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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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 MARCH 31, 2000
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ______________
COMMISSION FILE NUMBER: 000-27265
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INTERNAP NETWORK SERVICES CORPORATION
(Exact name of registrant as specified in its charter)
WASHINGTON 91-1896926
(State or other jurisdiction (IRS Employer identification No.)
of
incorporation or organization)
601 UNION STREET, SUITE 1000,
SEATTLE, WASHINGTON 98101
(Address of principal executive offices)
(206) 441-8800
(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 the number of shares outstanding of each of the registrant's
classes of common stock as of the latest practicable date: 134,213,706 shares of
common stock, $.001 par value, outstanding as of April 30, 2000.
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INTERNAP NETWORK SERVICES CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2000
TABLE OF CONTENTS
PAGE
--------
PART I. CONDENSED FINANCIAL INFORMATION
Item 1. Condensed Financial Statements
Condensed Balance Sheet
March 31, 2000 and December 31, 1999...................... 3
Condensed Statement of Operations
Three months ended March 31, 2000 and 1999................ 4
Condensed Statement of Cash Flows
Three months ended March 31, 2000 and 1999................ 5
Condensed Statement of Shareholders' Equity
Three months ended March 31, 2000......................... 6
Notes to Condensed Financial Statements..................... 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 12
Item 3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 16
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K............................ 26
Signatures............................................................ 27
2
INTERNAP NETWORK SERVICES CORPORATION
PART 1. FINANCIAL INFORMATION
ITEM 1. CONDENSED FINANCIAL STATEMENTS
INTERNAP NETWORK SERVICES CORPORATION
CONDENSED BALANCE SHEETS
(UNAUDITED, IN THOUSANDS)
MARCH 31, DECEMBER 31,
2000 1999
---------- -------------
ASSETS
Current assets:
Cash and cash equivalents................................. $ 64,996 $155,184
Short-term investments.................................... 102,154 50,168
Investment income receivable.............................. 2,398 591
Accounts receivable, net of allowance of $370 and $206,
respectively............................................ 6,333 4,084
Prepaid expenses and other assets......................... 456 553
-------- --------
Total current assets.................................... 176,337 210,580
Property and equipment, net................................. 37,776 28,811
Patents and trademarks, net................................. 157 142
Investments................................................. 17,987 5,050
Deposits and other assets, net.............................. 1,281 963
-------- --------
Total assets............................................ $233,538 $245,546
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 6,579 $ 7,278
Accrued liabilities....................................... 3,541 4,209
Deferred revenue.......................................... 217 22
Note payable, current position............................ 1,188 1,021
Line of credit............................................ 1,525 1,525
Capital lease obligations, current portion................ 8,310 6,613
-------- --------
Total current liabilities............................... 21,360 20,668
Note payable, less current portion.......................... 3,049 2,861
Capital lease obligations, less current portion............. 13,880 11,517
-------- --------
Total liabilities....................................... 38,289 35,046
-------- --------
Commitments and contingencies
Shareholders equity:
Common stock, $0.001 par value, 500,000 shares authorized;
133,747 and 132,089 shares issued and outstanding,
respectively............................................ 134 132
Additional paid-in capital................................ 289,534 287,054
Deferred stock compensation............................... (14,154) (17,228)
Accumulated deficit....................................... (80,081) (59,458)
Accumulated comprehensive (loss).......................... (184) --
-------- --------
Total shareholders' equity.............................. 195,249 210,500
-------- --------
Total liabilities and shareholders' equity.............. $233,538 $245,546
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
INTERNAP NETWORK SERVICES CORPORATION
CONDENSED STATEMENT OF OPERATIONS
(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED
MARCH 31,
-------------------
2000 1999
-------- --------
Revenues.................................................... $ 8,891 $ 1,244
-------- -------
Costs and expenses:
Cost of network and customer support...................... 15,326 2,346
Product development....................................... 1,578 565
Sales and marketing....................................... 7,689 2,236
General and administrative................................ 4,388 1,172
Amortization of deferred stock compensation............... 3,074 349
-------- -------
Total operating costs and expenses...................... 32,055 6,668
-------- -------
Loss from operations........................................ (23,164) (5,424)
Other income (expense):
Interest income........................................... 2,926 206
Interest and financing expense............................ (385) (57)
-------- -------
Net loss................................................ $(20,623) $(5,275)
======== =======
Basic and diluted net loss per share........................ $ (0.16) $ (0.79)
======== =======
Weighted average shares used in computing basic and diluted
net loss per share........................................ 132,526 6,674
======== =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
INTERNAP NETWORK SERVICES CORPORATION
CONDENSED STATEMENT OF CASH FLOWS
(UNAUDITED, IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
-------------------
2000 1999
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................. $(20,623) $(5,275)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization........................... 2,609 511
Non-cash interest and financing expense................. -- 4
Provision for doubtful accounts......................... 147 13
Non-cash compensation expense........................... 3,074 349
Changes in operating assets and liabilities:
Accounts receivable..................................... (2,396) (461)
Investment income receivable............................ (1,807) --
Prepaid expenses, deposits and other assets............. (221) (147)
Accounts payable........................................ (865) (84)
Deferred revenue........................................ 195 79
Accrued liabilities..................................... (668) 279
-------- -------
Net cash used in operating activities................. (20,555) (4,732)
-------- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment....................... (6,138) (1,771)
Proceeds from disposal of property and equipment.......... 42 --
Purchase of investments................................... (65,665) (1,000)
Redemption of investments................................. 558 --
Payments for patents and trademarks....................... (17) (19)
-------- -------
Net cash used in investing activities................. (71,220) (2,790)
-------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from shareholder loan............................ -- 1,100
Repayment of shareholder loan............................. -- (1,100)
Principal payments on note payable........................ (238) --
Payments on capital lease obligations..................... (1,374) (295)
Proceeds from equipment leaseback financing............... 717 428
Restriction of cash related to obtaining lease line....... -- (113)
Proceeds from issuance of and exercise of warrants to
purchase preferred stock, net of issuance costs......... 1 32,025
Proceeds from exercise of stock options................... 1,045 --
Proceeds from issuance of employee stock purchase plan
shares.................................................. 1,462 --
Costs of issuance of common stock......................... (26) --
-------- -------
Net cash provided by financing activities............. 1,587 32,045
-------- -------
Net increase (decrease) in cash and cash equivalents...... (90,188) 24,523
Cash and cash equivalents at beginning of period.......... 155,184 275
-------- -------
Cash and cash equivalents at end of period................ $ 64,996 $24,798
======== =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest, net of amounts capitalized........ $ 385 $ 52
======== =======
Purchase of property and equipment financed with capital
leases.................................................. $ 5,310 $ 358
======== =======
Purchase of property and equipment included in accounts
payable................................................. $ 166 $ 268
======== =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
INTERNAP NETWORK SERVICES CORPORATION
CONDENSED STATEMENT OF SHAREHOLDERS' EQUITY
THREE MONTHS ENDED MARCH 31, 2000
(UNAUDITED, IN THOUSANDS)
COMMON STOCK ADDITIONAL DEFERRED ACCUMULATIVE
-------------------- PAID-IN STOCK ACCUMULATED COMPREHENSIVE COMPREHENSIVE
SHARES PAR VALUE CAPITAL COMPENSATION DEFICIT LOSS TOTAL LOSS
-------- --------- ---------- ------------ ----------- ------------- -------- -------------
Balances, December 31,
1999................ 132,089 $132 $287,054 $(17,228) $(59,458) $210,500
Costs of issuance of
common stock........ (26) (26)
Amortization of
deferred stock
compensation........ 3,074 3,074
Exercise of employee
stock options....... 1,234 1 1,044 1,045
Issuance of employee
stock purchase plan
shares.............. 172 1,462 1,462
Exercise of warrants
to purchase common
stock............... 252 1 1
Net loss.............. (20,623) (20,623) $(20,623)
Unrealized loss on
investments......... $(184) (184) (184)
------- ---- -------- -------- -------- ----- -------- --------
Balances, March 31,
2000................ 133,747 $134 $289,534 $(14,154) $(80,081) $(184) $195,249 $(20,807)
======= ==== ======== ======== ======== ===== ======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
INTERNAP NETWORK SERVICES CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION:
The unaudited condensed financial statements have been prepared by InterNAP
Network Services Corporation (the "Company") pursuant to the rules and
regulations of the Securities and Exchange Commission and include all the
accounts of the Company. Certain information and footnote disclosures, normally
included in financial statements prepared in accordance with generally accepted
accounting principles, have been condensed or omitted pursuant to such rules and
regulations. In the opinion of management, the unaudited condensed financial
statements reflect all adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the Company's financial
position at March 31, 2000, its operating results and cash flows for the three
months ended March 31, 2000 and 1999 and its statement of equity for the three
months ended March 31, 2000. The balance sheet at December 31, 1999 has been
derived from audited financial statements as of that date. These financial
statements and the related notes should be read in conjunction with the
Company's financial statements and notes thereto contained in the Company's
annual report on Form 10-K and the Company's registration statement on Form S-1
(File No. 333-95503) filed with the Securities and Exchange Commission.
In December, 1999, the Company incorporated a wholly owned subsidiary in the
United Kingdom, InterNAP Network Services U.K. Limited, but there was no
activity in the subsidiary through March 31, 2000. On January 7, 2000, the
Company paid a 100% share dividend to shareholders of record on December 27,
1999. Accordingly, the number of shares disclosed in the financial statements
and related notes have been adjusted to reflect the stock dividend for all
periods presented.
The results of operations for the three months ended March 31, 2000 are not
necessarily indicative of the results that may be expected for the future
quarters.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates that affect
the reported amounts of assets and liabilities in the financial statements and
disclosure of contingent assets and liabilities at the date of the financial
statements. Examples of estimates subject to possible revision based upon the
outcome of future events include depreciation of property and equipment, income
tax liabilities, the valuation allowance against the deferred tax assets and the
allowance for doubtful accounts. Actual results could differ from those
estimates.
CASH AND CASH EQUIVALENTS
The Company generally considers any highly liquid investments purchased with
an original or remaining maturity of three months or less at the date of
purchase to be cash equivalents.
The Company invests its cash and cash equivalents in deposits with two
financial institutions that may, at times, exceed federally insured limits.
Management believes that the risk of loss is minimal. To date, the Company has
not experienced any losses related to temporary cash investments.
INVESTMENTS
The Company classifies, at the date of acquisition, its marketable
securities into categories in accordance with the provisions of Statement of
Financial Accounting Standards No. 115, "Accounting
7
INTERNAP NETWORK SERVICES CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
for Certain Investments in Debt and Equity Securities." Currently, the Company
classifies its marketable securities as available-for-sale, which are reported
at fair market value with the related unrealized gains and losses included in
shareholders' equity. Realized gains and losses and declines in value of
securities judged to be other than temporary are included in other income
(expense). Interest and dividends on all securities are included in interest
income. The fair value of the Company's marketable securities is based on quoted
market prices. At March 31, 2000, marketable securities consisted of commercial
paper and government securities.
The Company accounts for investments in equity securities without readily
determinable fair values at cost. The Company does not own 20 percent of the
voting stock or exert significant influence over any of its cost basis
investments as of March 31, 2000. Realized gains and losses and declines in
value of securities judged to be other than temporary are included in other
income (expense).
NET LOSS PER SHARE
Basic and diluted net loss per share has been computed using the weighted
average number of shares of common stock outstanding during the period, less the
weighted average number of unvested shares of common stock issued that are
subject to repurchase. The Company has excluded all convertible preferred stock,
warrants, outstanding options to purchase common stock and shares subject to
repurchase from the calculation of diluted net loss per share, as such
securities are antidilutive for all periods presented. Basic and diluted net
loss per share for the three months ended March 31, 2000 and 1999 are calculated
as follows (in thousands, except per share amounts):
THREE MONTHS ENDED
MARCH 31,
-------------------
2000 1999
-------- --------
(UNAUDITED)
Net loss................................................ $(20,623) $ (5,275)
======== ========
Basic and diluted:
Weighted-average shares of common stock outstanding
used in computing basic and diluted net loss per
share............................................... 132,526 6,674
======== ========
Basic and diluted net loss per share.................. $ (0.16) $ (0.79)
======== ========
Antidilutive securities not included in diluted net
loss per share calculation.
Convertible preferred stock......................... -- 98,953
Options to purchase common stock.................... 16,726 9,715
Warrants to purchase common and Series B preferred
stock............................................. 1,671 1,200
Unvested shares of common stock subject to
repurchase........................................ 225 --
-------- --------
18,622 109,868
======== ========
8
INTERNAP NETWORK SERVICES CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
3. PROPERTY AND EQUIPMENT:
Property and equipment consists of the following (in thousands):
MARCH 31, DECEMBER 31,
2000 1999
----------- -------------
(UNAUDITED)
Network equipment.................................... $ 5,979 $ 4,665
Network equipment under capital lease................ 26,076 20,095
Furniture, equipment and software.................... 9,022 6,717
Furniture, equipment and software under capital
lease.............................................. 1,210 1,164
Leasehold improvements............................... 3,935 2,009
------- -------
46,222 34,650
Less: Accumulated depreciation and amortization
($5,928 and $4,851 related to capital leases at
March 31, 2000 and December 31, 1999,
respectively)...................................... (8,446) (5,839)
------- -------
Property and equipment, net.......................... $37,776 $28,811
======= =======
4. INVESTMENTS:
On February 22, 2000, pursuant to an investment agreement, the Company
purchased 588,236 shares of Aventail Corporation ("Aventail") Series D preferred
stock at $10.20 per share for a total cash investment of $6,000,000. The
Series D preferred stock is convertible to common stock at a ratio of one share
of preferred stock to one share of common stock, subject to adjustment for
certain equity transactions. Additionally, the Company and Aventail entered into
a joint marketing agreement which, among other things, granted the Company
certain limited exclusive rights to sell Aventail's managed extranet service and
granted Aventail certain rights to sell the Company's services. In return, the
Company committed to either sell Aventail services or pay Aventail, or a
combination of both, which would result in Aventail's recognition of $3,000,000
of revenue over a two-year period.
5. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
MARCH 31, DECEMBER 31,
2000 1999
----------- -------------
(UNAUDITED)
Compensation payable................................. $3,221 $2,729
Taxes payable........................................ 98 49
Private placement fee................................ -- 1,000
Other................................................ 222 431
------ ------
$3,541 $4,209
====== ======
6. FINANCING ARRANGEMENTS:
During 1999, the Company entered into an equipment financing arrangement
with a financial institution allowing the Company to borrow up to $5.0 million
for the purchase of property and
9
INTERNAP NETWORK SERVICES CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
6. FINANCING ARRANGEMENTS: (CONTINUED)
equipment. The equipment financing arrangement includes sublimits of
$3.5 million for equipment costs and $1.5 million for the acquisition of
software, P-NAP facility and other equipment costs. Loans under the
$3.5 million sublimit require monthly principal and interest payments over a
term of 48 months. This facility bears interest at 7.5% plus an index rate based
on the yield of 4-year U.S. Treasury Notes. This rate was 13.89% at March 31,
2000. Loans under the $1.5 million sublimit require monthly principal and
interest payments over a term of 36 months. This facility bears interest at 7.9%
plus an index rate based on the yield of 3-year U.S. Treasury Notes. This rate
was 13.98% at March 31, 2000. Borrowings under each sublimit must be made prior
to May 1, 2000. During March 2000, the Company borrowed an additional $594,000
for equipment purchases. As of March 31, 2000, the Company had outstanding
borrowings of approximately $4.2 million pursuant to this arrangement.
7. COMMITMENTS AND CONTINGENCIES:
During January 2000, the Company entered into a service commitment contract
with a backbone service provider to provide interconnection services. Monthly
fees are to be calculated on a usage basis subject to minimum payments of
$37,000,000 through April 2003.
8. STOCK BASED COMPENSATION PLANS:
The Company's stock-based compensation plans include the 1999 Equity
Incentive Plan (the "1999 Plan"), the 1998 Stock Option/Stock Issuance Plan (the
"1998 Plan"), the 1999 Non-Employee Directors' Stock Option Plan (the "Director
Plan") and the Employee Stock Purchase Plan (the "ESPP"). During the three
months ended March 31, 2000, the Company granted 2,448,000 options to purchase
common stock pursuant to the 1999 Plan, and 1,233,826 shares of common stock
were issued upon exercise of stock options. On March 31, 2000, employees
purchased 172,053 shares of common stock for $8.50 per share pursuant to the
ESPP.
9. EVENTS SUBSEQUENT TO MARCH 31, 2000:
SECONDARY OFFERING
On April 6, 2000, 7,500,000 shares of the Company's common stock were sold
in a secondary public offering at a price of $43.50 per share. Of these shares,
3,000,000 were sold by the Company and 4,500,000 shares were sold by selling
shareholders. On April 6, 2000, the underwriters exercised their over-allotment
option, resulting in the sale of an additional 1,125,000 shares of common stock
at $43.50 per share. Of these shares, 450,000 were sold by the Company and
675,000 were sold by selling shareholders. The Company did not receive any of
the proceeds from the sale of shares of common stock by the selling
shareholders. The proceeds to the Company from the offering were $142,900,000,
net of underwriting discounts and commissions of $7,100,000.
FINANCING ARRANGEMENT
On April 10, 2000, the Company signed a letter of intent (the "Financing
Agreement") with a financial institution, which will provide the Company up to
$15,000,000 in funding for the purpose of financing capital expenditures. The
Financing Agreement has a thirty-six month term and calls for equal payments of
accrued interest plus 2.1% of the original principal balance over the term of
the agreement with a balloon payment for the residual 27% of principal upon
maturity. Interest is at the
10
INTERNAP NETWORK SERVICES CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
9. EVENTS SUBSEQUENT TO MARCH 31, 2000: (CONTINUED)
London Inter Bank Offered Rate plus 3.70% (9.87% at April 10, 2000) and is
adjusted monthly. In the event the Company's cash and cash equivalent balance is
equal to or less than $60,000,000 at the end of any quarter, the Company will be
required to provide an irrevocable renewable letter of credit in an amount equal
to the balance of the loan.
INVESTMENT
Pursuant to an investment agreement between the Company and
360networks, Inc. ("360networks"), on April 17, 2000, the Company purchased
374,182 shares of 360networks Class A Non-Voting Stock at $5.00 per share and,
on April 26, 2000, the Company purchased 1,122,545 shares of 360networks
Class A Subordinate Voting Stock at $13.23 per share. The total cash investment
was $16,722,180. Additionally, the Company and 360networks entered into a letter
of intent to negotiate a strategic agreement that would provide the Company with
long-haul-fiber-optic bandwidth capacity and provide 360networks with the
Company's Internet connectivity services.
STOCK-BASED COMPENSATION PLAN
During April 2000, the Company adopted the 2000 Non-Officer Equity Incentive
Plan (the "Non-Officer Plan"). The Non-Officer Plan authorizes the issuance of
1,000,000 shares of the Company's common stock. Under the Non-Officer Plan, the
Company may grant stock options only to employees of the Company who are not
officers or directors. Options granted under the Non-Officer Plan are not
intended by the Company to qualify as incentive stock options under the Internal
Revenue Code. Options granted under the Non-Officer Plan generally will be
subject to the same terms and conditions as options granted under the Company's
1999 Equity Incentive Plan.
EQUANT NETWORK CONNECTIVITY AGREEMENT
In May 2000, the Company and Equant Network Services entered into a network
connectivity agreement which, among other things, allows the Company to colocate
equipment in Equant's international locations, grants the Company access to the
international Equant network and requires Equant to use the Company's
connectivity services in cities where the parties colocate equipment, or where
Equant operates a point of presence and the Company operates a P-NAP facility.
In addition, the agreement contains certain marketing and exclusivity covenants.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements in this Quarterly Report on Form 10-Q, including, without
limitation, statements containing the words "believes," "anticipates,"
"estimates," "expects," and the words of similar import, constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. You should not place undue reliance on these
forward-looking statements. Our actual results could differ materially from
those anticipated in these forward-looking statements for many reasons,
including the risks faced by us described below and elsewhere in this Quarterly
Report, and in other documents we file with the Securities and Exchange
Commission.
OVERVIEW
The Company is a leading provider of fast, reliable and centrally managed
Internet connectivity services targeted at businesses seeking to maximize the
performance of mission-critical Internet-based applications. Customers connected
to one of the Company's P-NAP facilities have their data optimally routed to and
from destinations on the Internet in a manner that minimizes the use of
congested public network access points and private peering points. This optimal
routing of data traffic over the multiplicity of networks that comprise the
Internet enables higher transmission speeds, lower instances of data loss and
greater quality of service.
After the Company decides to open a new P-NAP facility, the Company enters
into a deployment phase which typically lasts four to six months, during which
time the Company executes the required steps to make the P-NAP facility
commercially ready for service. Among other things, this usually entails
obtaining co-location space to locate the Company's equipment, entering into
agreements with backbone providers, obtaining local loop connections from local
telecommunications providers, building P-NAP facilities and initiating pre-sales
and marketing activities. Consequently, the Company usually incurs a significant
amount of upfront costs related to making a P-NAP facility commercially ready
for service prior to generating revenues. Therefore, the Company's results of
operations will be negatively affected during times of P-NAP facility
deployment.
As of March 31, 2000, the Company had a total of 16 P-NAP facilities
deployed in the Atlanta, Boston, Chicago, Dallas, Denver, Freemont CA, Houston,
Los Angeles, Miami, New York (two P-NAP facilities), Orange County, CA,
Philadelphia, San Jose, Seattle and Washington D.C. metropolitan areas, and
expects to have a total of 24 P-NAP facilities operational by the end of 2000.
During the years ended December 31, 1998 and 1999, in connection with the
grant of certain stock options to employees, the Company recorded deferred stock
compensation totaling $25.0 million, representing the difference between the
deemed fair value of the Company's common stock on the date such options were
granted and the exercise price. Such amount is included as a component of
shareholders' equity and is being amortized over the vesting period of the
individual options, generally four years, using an accelerated method as
described in Financial Accounting Standards Board Interpretation No. 28. The
Company recorded amortization of deferred stock compensation in the amount of
$3.1 million for the three months ended March 31, 2000. At March 31, 2000, we
had a total of $14.2 million remaining to be amortized over the corresponding
vesting periods of the stock options.
12
RESULTS OF OPERATIONS
The following table sets forth, as a percentage of total revenues, selected
statement of operations data for the periods indicated:
THREE MONTHS
ENDED
MARCH 31,
----------------------
2000 1999
-------- --------
Revenues.................................................... 100% 100%
---- ----
Costs and expenses:
Cost of network and customer support...................... 172 189
Product development....................................... 18 45
Sales and marketing....................................... 86 180
General and administrative................................ 49 94
Amortization of deferred stock compensation............... 35 28
---- ----
Total costs and expenses................................ 360 536
---- ----
Loss from operations...................................... (260) (436)
Other income (expense):
Interest income............................................. 33 17
Interest and financing expense.............................. (4) (5)
---- ----
Net loss.................................................... (231)% (424)%
==== ====
THREE MONTHS ENDED MARCH 31, 2000 AND 1999
Revenues. Revenues increased 642% from $1.2 million for the three-month
period ended March 31, 1999, to $8.9 million for the three-month period ended
March 31, 2000. This increase of $7.7 million was primarily due to increased
Internet connectivity revenues. The increase in Internet connectivity revenues
was attributable to the increased sales at our existing P-NAP facilities and the
deployment of additional P-NAP facilities during 1999 and the first quarter of
2000.
Costs of Network and Customer Support. Costs of network and customer
support increased 565% from $2.3 million for the three-month period ended
March 31, 1999 to $15.3 million for the three-month period ended March 31, 2000.
This increase of $13.0 million was primarily due to increased connectivity costs
related to added connections to Internet backbone providers at each P-NAP
facility and to a lesser extent, additional compensation costs and depreciation
expense related to the equipment at newly deployed P-NAP facilities. Network and
customer support costs as a percentage of total revenues are generally greater
than 100% for newly deployed P-NAP facilities because we purchase Internet
connectivity capacity from the backbone providers in advance of securing new
customers. We expect these costs to increase in absolute dollars as we deploy
additional P-NAP facilities.
Product Development. Product development costs increased 177% from $565,000
for the three-month period ended March 31, 1999, to $1.6 million for the
three-month period ended March 31, 2000. This increase of $1.0 million was
primarily due to compensation costs, facilities costs related to additional
office space and outside consulting fees. We expect product development costs to
increase in absolute dollars for the foreseeable future.
Sales and Marketing. Sales and marketing costs increased 250% from
$2.2 million for the three-month period ended March 31, 1999, to $7.7 million
for the three-month period ended March 31, 2000. This increase of $5.5 million
was primarily due to compensation costs, advertising costs and, to a lesser
extent, facility costs related to the addition of sales offices. As part of our
expanded sales and
13
marketing activities, we hired additional sales and support personnel during
1999 and the first quarter of 2000. We expect sales and marketing costs to
increase in absolute dollars for the foreseeable future.
General and Administrative. General and administrative costs increased 267%
from $1.2 million for the three-months ended March 31, 1999, to $4.4 million for
the three-months ended March 31, 2000. This increase of $3.2 million was
primarily due to compensation costs, professional services costs and increased
depreciation and amortization costs due to the addition of corporate office
space during 1999 and first quarter of 2000. We expect general and
administrative costs to increase in absolute dollars as we deploy additional
P-NAP facilities.
Other Income (Expense). Other income (expense) consists of interest income,
interest and financing expense and other non-operating expenses. Other income
(expense), net, increased from $149,000 of other income for the three-month
period ended March 31, 1999 to $2.5 million of other income for the three-month
period ended March 31, 2000. This increase was primarily due to interest income
earned on the proceeds from the Company's initial public offering.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations primarily
through the issuance of its equity securities, capital leases, equipment
financing and bank loans. As of March 31, 2000, the Company has raised an
aggregate of approximately $261.6 million, net of offering expenses, through the
sale of its equity securities. In January 2000, a 100% stock dividend was paid
on the Company's common stock and, accordingly, all related disclosures have
been revised to reflect the stock dividend for all periods presented.
On February 22, 2000, pursuant to an investment agreement, the Company
purchased 588,236 shares of Aventail Series D preferred stock at $10.20 per
share for a total cash investment of $6.0 million. The Series D preferred stock
is convertible to common stock at a ratio of one share of preferred stock to one
share of common stock, subject to adjustment for certain equity transactions.
Additionally, the Company and Aventail entered into a joint marketing agreement
which, among other things, granted the Company certain limited exclusive rights
to sell Aventail's managed extranet service and granted Aventail certain rights
to sell the Company's services. In return, the Company committed to either sell
Aventail services or pay Aventail, or a combination of both, which would result
in Aventail's recognition of $3.0 million of revenue over a two-year period.
Subsequent to March 31, 2000, 7,500,000 shares of the Company's common stock
were sold in a secondary public offering at a price of $43.50 per share. Of
these shares, 3,000,000 were sold by the Company and 4,500,000 shares were sold
by selling shareholders. On April 6, 2000, the underwriters exercised their
over-allotment option, resulting in the sale of an additional 1,125,000 shares
of common stock at $43.50 per share. Of these shares, 450,000 were sold by the
Company and 675,000 were sold by selling shareholders. The Company did not
receive any of the proceeds from the sale of shares of common stock by the
selling shareholders. The proceeds to the Company from the offering were
$142.9 million, net of underwriting discounts and commissions of $7.1 million.
On April 10, 2000, the Company signed a letter of intent (the "Financing
Agreement") with a financial institution which will provide the Company up to
$15.0 million in funding for the purpose of financing capital expenditures. The
Financing Agreement has a thirty-six month term and calls for equal payments of
accrued interest plus 2.1% of the original principal balance over the term of
the agreement with a balloon payment for the residual 27% of principal upon
maturity. Interest is at the London Inter Bank Offered Rate plus 3.70% (9.87% at
April 10, 2000) and is adjusted monthly. In the event the Company's cash and
cash equivalent balance is equal to or less than $60.0 million at the end of any
quarter, the Company will be required to provide an irrevocable renewable letter
of credit in an amount equal to the balance of the loan.
14
Pursuant to an investment agreement between the Company and
360networks, Inc. ("360networks"), on April 17, 2000, the Company purchased
374,182 shares of 360networks Class A Non-Voting Stock at $5.00 per share and,
on April 26, 2000, the Company purchased 1,122,545 shares of 360networks
Class A Subordinate Voting Stock at $13.23 per share. The total cash investment
was $16.7 million. Additionally, the Company and 360networks entered into a
letter of intent to negotiate a strategic agreement that would provide the
Company with long-haul-fiber-optic bandwidth capacity and provide 360networks
with the Company's Internet connectivity services.
At March 31, 2000, the Company had cash, cash equivalents, and investments
of $185.1 million. The Company has a revolving line of credit with Silicon
Valley Bank under which the Company is allowed to borrow up to $3.0 million, as
limited by certain borrowing base requirements which include maintaining certain
levels of monthly revenues and customer turnover ratios. The line of credit
requires monthly payments of interest only at prime plus 1%, or 10% as of
March 31, 2000, and matures on June 30, 2000. At March 31, 2000, the Company had
outstanding borrowings of $1.5 million on the line of credit.
During 1999, the Company entered into an equipment financing arrangement
with a financial institution allowing the Company to borrow up to $5.0 million
for the purchase of property and equipment. The equipment financing arrangement
includes sublimits of $3.5 million for equipment costs and $1.5 million for the
acquisition of software, P-NAP facility and other equipment costs. Loans under
the $3.5 million sublimit require monthly principal and interest payments over a
term of 48 months. This facility bears interest at 7.5% plus an index rate based
on the yield of 4-year U.S. Treasury Notes. This rate was 13.89% at March 31,
2000. Loans under the $1.5 million sublimit require monthly principal and
interest payments over a term of 36 months. This facility bears interest at 7.9%
plus an index rate based on the yield of 3-year U.S. Treasury Notes. This rate
was 13.98% at March 31, 2000. Borrowings under each sublimit must be made prior
to May 1, 2000. During March 2000, the Company borrowed an additional $594,000
for equipment purchases. As of March 31, 2000, the Company had outstanding
borrowings of approximately $4.2 million pursuant to this arrangement.
During 1999, the Company amended an existing equipment lease credit facility
with a vendor to increase its available credit by $17.5 million to
$35.5 million. As of March 31, 2000, the Company had approximately
$14.4 million available under this credit facility.
Net cash used in operations was $20.6 million for the three months ended
March 31, 2000, and $4.7 million for the three months ended March 31, 1999. Net
cash used in operations for the three months ended March 31, 2000 was primarily
due to funding our operating losses and increases in accounts receivable and
investment income receivable, partially offset by non-cash charges.
Net cash used in investing activities was $71.2 million for the three months
ended March 31, 2000 and $2.8 million for the three months ended March 31, 1999.
Net cash used in investing activities in each period reflects increased
purchases of property and equipment not financed by capital leases. Purchases of
property and equipment were partially financed by capital leases (such purchases
are excluded from the net cash used in investing activities in the statement of
cash flows), and totaled $11.6 million ($5.3 million financed by capital leases)
for the three months ended March 31, 2000. Additionally, for the three-month
period ended March 31, 2000, $65.7 million was used to purchase investments.
Net cash provided from financing activities was $1.6 million for the three
months ended March 31, 2000, and $32.0 million for the three months ended
March 31, 1999. Net cash from financing activities primarily reflects proceeds
from the sales of our equity securities offset by the costs of those proceeds
and payments on capital lease obligations and notes payable.
The Company expects to spend significant additional capital to recruit and
train its customer installation team and the sales force and to build out the
sales facilities related to newly deployed
15
P-NAP facilities. In addition to P-NAP facility deployment, although to a lesser
extent, product development and the development of the Company's internal
systems and software will continue to require significant capital expenditures
in the foreseeable future, as will the expansion of its marketing efforts. The
Company expects to continue to expend significant amounts of capital on property
and equipment related to the expansion of facility infrastructure, computer
equipment and for research and development laboratory and test equipment to
support on-going research and development operations.
The Company believes the net proceeds from its secondary offering together
with its cash and cash equivalents, investments and funds available under its
revolving and capital lease lines will be sufficient to satisfy its cash
requirements for the next 12 months. Depending on its rate of growth and cash
requirements, the Company may require additional equity or debt financing to
meet future working capital needs, which may have a dilutive effect on its then
current shareholders. There can be no assurance that such additional financing
will be available or, if available, that such financing can be obtained on
satisfactory terms. The Company's management intends to invest cash in excess of
current operating requirements in short-term, interest-bearing, investment-grade
securities.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk for the impact of interest rate
changes and changes in the market value of our investments. Substantially all of
the Company's cash equivalents, investments and capital lease obligations are at
fixed interest rates, and therefore the fair value of these instruments is
affected by changes in market interest rates. However, as of March 31, 2000, all
of the Company's cash equivalents mature within three months. As of March 31,
2000, the Company believes the reported amounts of cash equivalents and capital
lease obligations to be reasonable approximations of their fair values.
16
RISK FACTORS
RISKS RELATED TO THE COMPANY'S BUSINESS
THE COMPANY HAS A HISTORY OF LOSSES, EXPECTS FUTURE LOSSES AND MAY NOT
ACHIEVE OR SUSTAIN ANNUAL PROFITABILITY. The Company has incurred net losses in
each quarterly and annual period since the Company began operations. The Company
incurred net losses of $1.6 million, $7.0 million and $49.9 million for the
years ended December 31, 1997, 1998 and 1999, respectively. The Company's net
loss for the three months ended March 31, 2000 was $20.6 million. As of
March 31, 2000, the Company's accumulated deficit was $80.1 million. As a result
of its expansion plans, the Company expects to incur net losses and negative
cash flows from operations on a quarterly and annual basis for at least the next
24 months, and the Company may never become profitable.
THE COMPANY'S LIMITED OPERATING HISTORY MAKES IT DIFFICULT TO EVALUATE ITS
PROSPECTS. The revenue and income potential of the Company's business and
market is unproven, and its limited operating history makes it difficult to
evaluate its prospects. The Company has only been in existence since 1996, and
its services are only offered in limited regions. Investors should consider and
evaluate the Company's prospects in light of the risks and difficulties
frequently encountered by relatively new companies, particularly companies in
the rapidly evolving Internet infrastructure and connectivity markets.
NEGATIVE MOVEMENTS IN THE COMPANY'S QUARTERLY OPERATING RESULTS MAY
DISAPPOINT ANALYSTS' EXPECTATIONS, WHICH COULD HAVE A NEGATIVE IMPACT ON THE
COMPANY'S STOCK PRICE. Should the Company's results of operations from quarter
to quarter fail to meet the expectations of public market analysts and
investors, its stock price could suffer. Any significant unanticipated shortfall
of revenues or increase in expenses could negatively impact its expected
quarterly results of operations should the Company be unable to make timely
adjustments to compensate for them. Furthermore, a failure on the part of the
Company to estimate accurately the timing or magnitude of particular anticipated
revenues or expenses could also negatively impact its quarterly results of
operations.
Because the Company's quarterly results of operations have fluctuated in the
past and will continue to fluctuate in the future, investors should not rely on
the results of any past quarter or quarters as an indication of future
performance in its business operations or stock price. For example, increases in
the Company's quarterly revenues for the quarters ended March 31, 1998, through
March 31, 2000 have varied between 13% and 74%, and total operating costs and
expenses, as a percentage of revenues, have fluctuated between 310% and 609%.
Fluctuations in the Company's quarterly operating results depend on a number of
factors. Some of these factors are industry risks over which the Company has no
control, including the introduction of new services by its competitors,
fluctuations in the demand and sales cycle for its services, fluctuations in the
market for qualified sales and other personnel, changes in the prices for
Internet connectivity the Company pays backbone providers and its ability to
obtain local loop connections to its P-NAP facilities at favorable prices.
Other factors that may cause fluctuations in the Company's quarterly
operating results arise from strategic decisions the Company has made or will
make with respect to the timing and magnitude of capital expenditures such as
those associated with the deployment of additional P-NAP facilities and the
terms of its Internet connectivity purchases. For example, the Company's
practice is to purchase Internet connectivity from backbone providers at new
P-NAP facilities before customers are secured. The Company also has agreed to
purchase Internet connectivity from some providers without regard to the amount
the Company resells to its customers.
IF THE COMPANY IS UNABLE TO MANAGE COMPLICATIONS THAT ARISE DURING
DEPLOYMENT OF NEW P-NAP FACILITIES, THE COMPANY MAY NOT SUCCEED IN ITS EXPANSION
PLANS. Any delay in the opening of new P-NAP facilities would significantly
harm the Company's plans to expand its business. In its effort to deploy new
P-NAP facilities, the Company faces various risks associated with significant
construction
17
projects, including identifying and locating P-NAP facility sites, construction
delays, cost estimation errors or overruns, delays in connecting with local
exchanges, equipment and material delays or shortages, the inability to obtain
necessary permits on a timely basis, if at all, and other factors, many of which
are beyond the Company's control and all of which could delay the deployment of
a new P-NAP facility. The deployment of new P-NAP facilities, each of which
takes approximately four to six months to complete, is a key element of the
Company's business strategy. In addition to its 16 existing locations, the
Company is planning to continue to deploy P-NAP facilities across a wide range
of geographic regions, including foreign countries. Although the Company
conducts market research in a geographic area before deploying a P-NAP facility,
the Company does not enter into service contracts with customers prior to
building a new P-NAP facility.
THE COMPANY WILL INCUR ADDITIONAL EXPENSE ASSOCIATED WITH THE DEPLOYMENT OF
NEW P-NAP FACILITIES AND THE COMPANY MAY BE UNABLE TO EFFECTIVELY INTEGRATE NEW
P-NAP FACILITIES INTO ITS EXISTING NETWORK, WHICH COULD DISRUPT ITS
SERVICE. New P-NAP facilities, if completed, will result in substantial new
operating expenses, including expenses associated with hiring, training,
retaining and managing new employees, provisioning capacity from backbone
providers, purchasing new equipment, implementing new systems, leasing
additional real estate and incurring additional depreciation expense. In
addition, if the Company does not institute adequate financial and managerial
controls, reporting systems, and procedures with which to operate multiple
facilities in geographically dispersed locations, its operations will be
significantly harmed.
BECAUSE THE COMPANY'S REVENUES DEPEND HEAVILY ON A FEW SIGNIFICANT
CUSTOMERS, A LOSS OF MORE THAN ONE OF THESE SIGNIFICANT CUSTOMERS COULD REDUCE
THE COMPANY'S REVENUES. The Company currently derives a substantial portion of
its total revenues from a limited number of customers, and the revenues from
these customers may not continue. For the quarter ended March 31, 2000 revenues
from the Company's five largest customers represented approximately 22% of its
total revenues. Typically, the agreements with the Company's customers are based
on the Company's standard terms and conditions of service and generally have
terms ranging from one year to three years. Revenues from these customers or
from other customers that have accounted for a significant portion of the
Company's revenues in past periods, individually or as a group, may not
continue. If such revenues do continue, they may not reach or exceed historical
levels in any future period. In addition, the Company may not succeed in
diversifying its customer base in future periods. Accordingly, the Company may
continue to derive a significant portion of its revenues from a relatively small
number of customers. Further, the Company has had limited experience with the
renewal of contracts by customers whose initial service contract terms have been
completed and these customers may not renew their contracts with the Company.
IF THE COMPANY IS UNABLE TO CONTINUE TO RECEIVE COST-EFFECTIVE SERVICE FROM
ITS BACKBONE PROVIDERS, THE COMPANY MAY NOT BE ABLE TO PROVIDE ITS INTERNET
CONNECTIVITY SERVICES ON PROFITABLE TERMS AND THESE BACKBONE PROVIDERS MAY NOT
CONTINUE TO PROVIDE SERVICE TO THE COMPANY. In delivering its services, the
Company relies on Internet backbones, which are built and operated by others. In
order to be able to provide optimal routing to its customers through its P-NAP
facilities, the Company must purchase connections from several Internet backbone
providers. There can be no assurance that these Internet backbone providers will
continue to provide service to the Company on a cost-effective basis, if at all,
or that these providers will provide the Company with additional capacity to
adequately meet customer demand. Furthermore, it is very unlikely that the
Company could replace its Internet backbone providers on comparable terms.
Currently, in each of its fully operational P-NAP facilities, the Company
has connections to some combination of the following 11 backbone providers:
AT&T, Cable & Wireless USA, Inc., Global Crossing Telecommunications, Inc., GTE
Internetworking, Inc., ICG Communications, Intermedia Communications Inc.,
PSINet, Inc., Qwest Communications International, Inc., Sprint Internet
Services,
18
UUNET, a MCI WorldCom Company, and Verio, Inc. (which entered into an agreement
to be acquired by NTT Communication Corporation). The Company may be unable to
maintain relationships with, or obtain necessary additional capacity from, these
backbone providers. Furthermore, the Company may be unable to establish and
maintain relationships with other backbone providers that may emerge or that are
significant in geographic areas in which the Company locates its P-NAP
facilities.
COMPETITION FROM MORE ESTABLISHED COMPETITORS WHO HAVE GREATER REVENUES
COULD DECREASE ITS MARKET SHARE. The Internet connectivity services market is
extremely competitive, and there are few substantial barriers to entry. The
Company expects competition from existing competitors to intensify in the
future, and the Company may not have the financial resources, technical
expertise, sales and marketing abilities or support capabilities to compete
successfully in its market. Many of the Company's existing competitors have
greater market presence, engineering and marketing capabilities, and financial,
technological and personnel resources than the Company does. As a result, the
Company's competitors may have several advantages over the Company as it seeks
to develop a greater market presence.
The Company's competitors currently include backbone providers that provide
connectivity services to the Company, including AT&T, Cable & Wireless USA,
Global Crossing, GTE Internetworking, ICG Communications, Intermedia, PSINet,
Qwest Communications International, Sprint, UUNET and Verio, regional Bell
operating companies which offer Internet access, and global, national and
regional Internet service providers.
In addition, if the Company is successful in implementing the Company's
international expansion, the Company expects to encounter additional competition
from international Internet service providers as well as international
telecommunications companies.
COMPETITION FROM NEW COMPETITORS COULD DECREASE THE COMPANY'S MARKET
SHARE. The Company also believes that new competitors will enter its market.
Such new competitors could include computer hardware, software, media and other
technology and telecommunications companies. A number of telecommunications
companies and online service providers have announced plans to offer or expand
their network services. For example, GTE Internetworking, PSINet and Verio
(which entered into an agreement to be acquired by NTT Communication
Corporation) have expanded their Internet access products and services through
acquisition. Further, the ability of some of these potential competitors to
bundle other services and products with their network services could place the
Company at a competitive disadvantage. Various companies are also exploring the
possibility of providing, or are currently providing, high-speed data services
using alternative delivery methods including the cable television
infrastructure, direct broadcast satellites, wireless cable and wireless local
loop. In addition, Internet backbone providers may make technological
developments, such as improved router technology, that will enhance the quality
of their services.
PRICING PRESSURE COULD DECREASE THE COMPANY'S MARKET SHARE. Increased price
competition or other competitive pressures could erode the Company's market
share. The Company currently charges, and expects to continue to charge, more
for its Internet connectivity services than its competitors. For example, the
Company's current standard pricing is approximately 5% more than UUNET's current
standard pricing and approximately 18% more than Sprint's current standard
pricing. By bundling their services and reducing the overall cost of their
solutions, telecommunications companies that compete with the Company may be
able to provide customers with reduced communications costs in connection with
their Internet connectivity services or private network services, thereby
significantly increasing the pressure on the Company to decrease its prices. The
Company may not be able to offset the effects of any such price reductions even
with an increase in the number of its customers, higher revenues from enhanced
services, cost reductions or otherwise. In addition, the Company believes that
the Internet connectivity industry is likely to encounter consolidation in the
future. Consolidation could result in increased pressure on the Company to
decrease its prices.
19
A FAILURE IN THE COMPANY'S NETWORK OPERATIONS CENTER, P-NAP FACILITIES OR
COMPUTER SYSTEMS WOULD CAUSE A SIGNIFICANT DISRUPTION IN THE PROVISION OF ITS
INTERNET CONNECTIVITY SERVICES. Although the Company has taken precautions
against systems failure, interruptions could result from natural disasters as
well as power loss, telecommunications failure and similar events. The Company's
business depends on the efficient and uninterrupted operation of its network
operations center, its P-NAP facilities and its computer and communications
hardware systems and infrastructure. The Company currently has one network
operations center located in Seattle, and it has 16 P-NAP facilities which are
located in the Atlanta, Boston, Chicago, Dallas, Denver, Freemont, CA, Houston,
Los Angeles, Miami, New York (two P-NAP facilities), Orange County, CA,
Philadelphia, San Jose, Seattle and Washington, D.C. metropolitan areas. If the
Company experiences a problem at its network operations center, the Company may
be unable to provide Internet connectivity services to its customers, provide
customer service and support or monitor its network infrastructure and P-NAP
facilities, any of which would seriously harm its business.
BECAUSE THE COMPANY HAS NO EXPERIENCE OPERATING INTERNATIONALLY, ITS
INTERNATIONAL EXPANSION MAY BE LIMITED. Although the Company currently operates
in 15 domestic metropolitan markets, a key component of its strategy is to
expand into international markets. The Company has no experience operating
internationally. The Company may not be able to adapt its services to
international markets or market and sell these services to customers abroad. In
addition to general risks associated with international business expansion, the
Company faces the following specific risks in its international business
expansion plans:
- difficulties in establishing and maintaining relationships with foreign
backbone providers and local vendors, including co-location and local loop
providers; and
- difficulties in locating, building and deploying P-NAP facilities and a
network operations center in foreign countries, including in the United
Kingdom and the Netherlands where the Company plans to deploy facilities
in 2000, and managing P-NAP facilities and network operations centers
across disparate geographic areas.
The Company may be unsuccessful in its efforts to address the risks
associated with its currently proposed international operations, and its
international sales growth may therefore be limited.
THE COMPANY'S BRAND IS RELATIVELY NEW, AND FAILURE TO DEVELOP BRAND
RECOGNITION COULD HURT THE COMPANY'S ABILITY TO COMPETE EFFECTIVELY. To
successfully execute its strategy, the Company must strengthen its brand
awareness. If the Company does not build its brand awareness, its ability to
realize its strategic and financial objectives could be hurt. Many of the
Company's competitors have well-established brands associated with the provision
of Internet connectivity services. To date, the Company's market presence has
been limited principally to the Atlanta, Boston, Chicago, Dallas, Denver,
Freemont CA, Houston, Los Angeles, Miami, New York (two P-NAP facilities),
Orange County, CA, Philadelphia, San Jose, Seattle and Washington D.C.
metropolitan areas. To date, the Company has attracted its existing customers
primarily through a relatively small sales force and word of mouth. In order to
build its brand awareness, the Company intends to increase its marketing efforts
significantly, which may not be successful, and the Company must continue to
provide high quality services. As part of its brand building efforts, the
Company expects to increase its marketing budget substantially as well as its
marketing activities, including advertising, tradeshows, direct response
programs and new P-NAP facility launch events.
THE COMPANY IS DEPENDENT UPON ITS KEY EMPLOYEES AND MAY BE UNABLE TO ATTRACT
OR RETAIN SUFFICIENT NUMBERS OF QUALIFIED PERSONNEL. The Company's future
performance depends to a significant degree upon the continued contributions of
its executive management team and key technical personnel. The loss of any
member of the Company's executive management team or a key technical employee,
such as its Chief Executive Officer, Anthony Naughtin, its Chief Technology
Officer, Christopher Wheeler, or
20
its Chief Financial Officer, Paul McBride, could significantly harm the Company.
Any of the Company's officers or employees can terminate his or her relationship
with the Company at any time. To the extent the Company is able to expand its
operations and deploy additional P-NAP facilities, its workforce will be
required to grow. Accordingly, the Company's future success depends on the
Company's ability to attract, hire, train and retain a substantial number of
highly skilled management, technical, sales, marketing and customer support
personnel. Competition for qualified employees is intense. Consequently, the
Company may not be successful in attracting, hiring, training and retaining the
people the Company needs, which would seriously impede its ability to implement
its business strategy.
IF THE COMPANY IS NOT ABLE TO SUPPORT ITS RAPID GROWTH EFFECTIVELY, ITS
EXPANSION PLANS MAY BE FRUSTRATED OR MAY FAIL. The Company's inability to
manage growth effectively would seriously harm its plans to expand its Internet
connectivity services into new markets. Since the introduction of its Internet
connectivity services, the Company has experienced a period of rapid growth and
expansion, which has placed, and continues to place, a significant strain on all
of its resources. For example, as of December 31, 1996 the Company had one
operational P-NAP facility and nine employees compared to 16 operational P-NAP
facilities and 395 full-time employees as of March 31, 2000. In addition, the
Company had $1.2 million in revenues for the three months ended March 31, 1999,
compared to $8.9 million in revenues for the three months ended March 31, 2000.
The Company expects its growth to continue to strain its management, operational
and financial resources. For example, the Company may not be able to install
adequate financial control systems in an efficient and timely manner, and its
current or planned information systems, procedures and controls may be
inadequate to support its future operations. The difficulties associated with
installing and implementing new systems, procedures and controls may place a
significant burden on the Company's management and its internal resources. The
Company's plans to rapidly deploy additional P-NAP facilities could place a
significant strain on its management's time and resources.
IF THE COMPANY FAILS TO ADEQUATELY PROTECT ITS INTELLECTUAL PROPERTY, THE
COMPANY MAY LOSE RIGHTS TO SOME OF ITS MOST VALUABLE ASSETS. The Company relies
on a combination of patent, copyright, trademark, trade secret and other
intellectual property law, nondisclosure agreements and other protective
measures to protect its proprietary technology. InterNAP and P-NAP are
trademarks of InterNAP which are registered in the United States. The United
States Patent and Trademark Office, or USPTO, issued a patent in September 1999
relating to an initial patent application the Company filed on September 3,
1997. The patent is enforceable for a duration of 20 years from the date of
filing, or until September 3, 2017. There can be no assurance that this patent
or any future issued patent will provide significant proprietary protection or
commercial advantage to the Company or that the USPTO will allow any additional
or future claims. The Company has a second application pending and may file
additional applications in the future. Additional claims that were included by
amendment in the Company's initial application have now been included in its
second patent application. The Company's patent and patent applications relate
to its P-NAP facility technology. In addition, the Company has filed a
corresponding international patent application under the Patent Cooperation
Treaty.
It is possible that any patents that have been or may be issued to the
Company could still be successfully challenged by third parties, which could
result in the Company's loss of the right to prevent others from exploiting the
inventions claimed in those patents. Further, current and future competitors may
independently develop similar technologies, duplicate the Company's services and
products or design around any patents that may be issued to the Company. In
addition, effective patent protection may not be available in every country in
which the Company intends to do business.
In addition to patent protection, the Company believes the protection of its
copyrightable materials, trademarks and trade secrets is important to its future
success. The Company relies on a combination of laws, such as copyright,
trademark and trade secret laws and contractual restrictions, such as
confidentiality agreements and licenses, to establish and protect its
proprietary rights. In
21
particular, the Company generally enters into confidentiality agreements with
its employees and nondisclosure agreements with its customers and corporations
with whom the Company has strategic relationships. In addition, the Company
generally registers its important trademarks with the USPTO to preserve their
value and establish proof of its ownership and use of these trademarks. Any
trademarks that may be issued to the Company may not provide significant
proprietary protection or commercial advantage to the Company. Despite any
precautions that the Company has taken, intellectual property laws and
contractual restrictions may not be sufficient to prevent misappropriation of
its technology or deter others from developing similar technology.
THE COMPANY MAY FACE LITIGATION AND LIABILITY DUE TO CLAIMS OF INFRINGEMENT
OF THIRD PARTY INTELLECTUAL PROPERTY RIGHTS. The telecommunications industry is
characterized by the existence of a large number of patents and frequent
litigation based on allegations of patent infringement. From time to time, third
parties may assert patent, copyright, trademark and other intellectual property
rights to technologies that are important to the Company's business. Any claims
that the Company's services infringe or may infringe proprietary rights of third
parties, with or without merit, could be time-consuming, result in costly
litigation, divert the efforts of the Company's technical and management
personnel or require the Company to enter into royalty or licensing agreements,
any of which could significantly harm its operating results. In addition, in its
customer agreements, the Company agrees to indemnify its customers for any
expenses or liabilities resulting from claimed infringement of patents,
trademarks or copyrights of third parties. If a claim against the Company were
to be successful and the Company were not able to obtain a license to the
relevant or a substitute technology on acceptable terms or redesign its products
to avoid infringement, its ability to compete successfully in its competitive
market would be impaired.
BECAUSE THE COMPANY DEPENDS ON THIRD PARTY SUPPLIERS FOR KEY COMPONENTS OF
ITS NETWORK INFRASTRUCTURE, FAILURES OF THESE SUPPLIERS TO DELIVER THEIR
COMPONENTS AS AGREED COULD HINDER ITS ABILITY TO PROVIDE ITS SERVICES ON A
COMPETITIVE AND TIMELY BASIS. Any failure to obtain required products or
services from third party suppliers on a timely basis and at an acceptable cost
would affect the Company's ability to provide its Internet connectivity services
on a competitive and timely basis. The Company is dependent on other companies
to supply various key components of its infrastructure, including the local
loops between its P-NAP facilities and its Internet backbone providers and
between its P-NAP facilities and its customers' networks. In addition, the
routers and switches used in the Company's network infrastructure are currently
supplied by a limited number of vendors, including Cisco Systems, Inc.
Additional sources of these products may not be available in the future on
satisfactory terms, if at all. The Company purchases these products pursuant to
purchase orders placed from time to time. The Company does not carry significant
inventories of these products, and the Company has no guaranteed supply
arrangements with its vendors. The Company has in the past experienced delays in
receiving shipments of equipment purchased. To date, these delays have neither
been material nor have adversely affected us, but these delays could affect the
Company's ability to deploy P-NAP facilities in the future on a timely basis. If
Cisco Systems does not provide the Company with its routers, or if the Company's
limited source suppliers fail to provide products or services that comply with
evolving Internet and telecommunications standards or that interoperate with
other products or services the Company uses in its network infrastructure, the
Company may be unable to meet its customer service commitments.
THE COMPANY MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE AND MAY NOT BE ABLE
TO SECURE ADEQUATE FUNDS ON TERMS ACCEPTABLE TO THE COMPANY. The expansion and
development of the Company's business will require significant capital, which
the Company may be unable to obtain, to fund its capital expenditures and
operations, including working capital needs. The Company's principal capital
expenditures and lease payments include the purchase, lease and installation of
network equipment such as routers, telecommunications equipment and other
computer equipment. The timing and amount of the Company's future capital
requirements may vary significantly depending on numerous
22
factors, including regulatory, technological, competitive and other developments
in its industry. During the next 12 months, the Company expects to meet its cash
requirements with existing cash, cash equivalents, short-term investments and
cash flow from sales of its services. However, the Company's capital
requirements depend on several factors, including the rate of market acceptance
of the Company's services, the ability to expand its customer base, the rate of
deployment of additional P-NAP facilities and other factors. If the Company's
capital requirements vary materially from those currently planned, or if the
Company fails to generate sufficient cash flow from the sales of its services,
the Company may require additional financing sooner than anticipated or the
Company may have to delay or abandon some or all of its development and
expansion plans or otherwise forego market opportunities.
The Company may not be able to obtain future equity or debt financing on
favorable terms, if at all. In addition, the Company's credit agreement contains
covenants restricting its ability to incur further indebtedness. Future
borrowing instruments such as credit facilities and lease agreements are likely
to contain similar or more restrictive covenants and will likely require the
Company to pledge assets as security for borrowings thereunder. The Company's
inability to obtain additional capital on satisfactory terms may delay or
prevent the expansion of its business.
THE COMPANY MAY FIND IT DIFFICULT TO INTEGRATE POTENTIAL FUTURE
ACQUISITIONS, WHICH COULD DISRUPT ITS BUSINESS, DILUTE SHAREHOLDER VALUE AND
ADVERSELY AFFECT ITS OPERATING RESULTS. The Company may acquire businesses
and/or technology in the future, which would complicate its management's tasks.
The Company may need to integrate widely dispersed operations that have
different and unfamiliar corporate cultures. These integration efforts may not
succeed or may distract management's attention from existing business
operations. The Company's failure to successfully manage future acquisitions
could seriously harm its business. Also, the Company's existing shareholders
would be diluted if the Company financed the acquisitions by issuing equity
securities.
RISKS RELATED TO THE COMPANY'S INDUSTRY
BECAUSE THE DEMAND FOR THE COMPANY'S SERVICES DEPENDS ON CONTINUED GROWTH IN
USE OF THE INTERNET, A SLOWING OF THIS GROWTH COULD HARM THE DEVELOPMENT OF THE
DEMAND FOR THE COMPANY'S SERVICES. Critical issues concerning the commercial
use of the Internet remain unresolved and may hinder the growth of Internet use,
especially in the business market the Company targets. Despite growing interest
in the varied commercial uses of the Internet, many businesses have been
deterred from purchasing Internet connectivity services for a number of reasons,
including inconsistent or unreliable quality of service, lack of availability of
cost-effective, high-speed options, a limited number of local access points for
corporate users, inability to integrate business applications on the Internet,
the need to deal with multiple and frequently incompatible vendors and a lack of
tools to simplify Internet access and use. Capacity constraints caused by growth
in the use of the Internet may, if left unresolved, impede further development
of the Internet to the extent that users experience delays, transmission errors
and other difficulties. Further, the adoption of the Internet for commerce and
communications, particularly by those individuals and enterprises that have
historically relied upon alternative means of commerce and communication,
generally requires an understanding and acceptance of a new way of conducting
business and exchanging information. In particular, enterprises that have
already invested substantial resources in other means of conducting commerce and
exchanging information may be particularly reluctant or slow to adopt a new
strategy that may make their existing personnel and infrastructure obsolete. The
failure of the market for business related Internet solutions to further develop
could cause the Company's revenues to grow more slowly than anticipated and
reduce the demand for its services.
BECAUSE THE INTERNET CONNECTIVITY MARKET IS NEW AND ITS VIABILITY IS
UNCERTAIN, THERE IS A RISK THE COMPANY'S SERVICES MAY NOT BE ACCEPTED. The
Company faces the risk that the market for high performance Internet
connectivity services might fail to develop, or develop more slowly than
expected,
23
or that its services may not achieve widespread market acceptance. This market
has only recently begun to develop, is evolving rapidly and likely will be
characterized by an increasing number of entrants. There is significant
uncertainty as to whether this market ultimately will prove to be viable or, if
it becomes viable, that it will grow. Furthermore, the Company may be unable to
market and sell its services successfully and cost-effectively to a sufficiently
large number of customers. The Company typically charges more for its services
than do its competitors, which may affect market acceptance of its services.
Finally, if the Internet becomes subject to a form of central management, or if
the Internet backbone providers establish an economic settlement arrangement
regarding the exchange of traffic between backbones, the problems of congestion,
latency and data loss addressed by the Company's Internet connectivity services
could be largely resolved and its core business rendered obsolete.
IF THE COMPANY IS UNABLE TO RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO
RAPID TECHNOLOGICAL CHANGE, THE COMPANY MAY LOSE OR FAIL TO ESTABLISH A
COMPETITIVE ADVANTAGE IN ITS MARKET. The Internet connectivity industry is
characterized by rapidly changing technology, industry standards, customer needs
and competition, as well as by frequent new product and service introductions.
The Company may be unable to successfully use or develop new technologies, adapt
its network infrastructure to changing customer requirements and industry
standards, introduce new services or enhance its existing services on a timely
basis. Furthermore, new technologies or enhancements that the Company uses or
develops may not gain market acceptance. The Company's pursuit of necessary
technological advances may require substantial time and expense, and the Company
may be unable to successfully adapt its network and services to alternate access
devices and technologies.
If its services do not continue to be compatible and interoperable with
products and architectures offered by other industry members, the Company's
ability to compete could be impaired. The Company's ability to compete
successfully is dependent, in part, upon the continued compatibility and
interoperability of its services with products and architectures offered by
various other industry participants. Although the Company intends to support
emerging standards in the market for Internet connectivity, there can be no
assurance that the Company will be able to conform to new standards in a timely
fashion, if at all, or maintain a competitive position in the market.
NEW TECHNOLOGIES COULD DISPLACE THE COMPANY'S SERVICES OR RENDER THEM
OBSOLETE. New technologies and industry standards have the potential to replace
or provide lower cost alternatives to the Company's services. The adoption of
such new technologies or industry standards could render the Company's existing
services obsolete and unmarketable. For example, the Company's services rely on
the continued widespread commercial use of the set of protocols, services and
applications for linking computers known as Transmission Control
Protocol/Internetwork Protocol, or TCP/IP. Alternative sets of protocols,
services and applications for linking computers could emerge and become widely
adopted. A resulting reduction in the use of TCP/IP could render the Company's
services obsolete and unmarketable. The Company's failure to anticipate the
prevailing standard or the failure of a common standard to emerge could hurt its
business. Further, the Company anticipates the introduction of other new
technologies, such as telephone and facsimile capabilities, private networks,
multimedia document distribution and transmission of audio and video feeds,
requiring broadband access to the Internet, but there can be no assurance that
such technologies will create opportunities for the Company.
SERVICE INTERRUPTIONS CAUSED BY SYSTEM FAILURES COULD HARM CUSTOMER
RELATIONS, EXPOSE THE COMPANY TO LIABILITY AND INCREASE THE COMPANY'S CAPITAL
COSTS. Interruptions in service to the Company's customers could harm the
Company's customer relations, expose the Company to potential lawsuits and
require the Company to spend more money adding redundant facilities. The
Company's operations depend upon its ability to protect its customers' data and
equipment, its equipment and its network infrastructure, including its
connections to its backbone providers, against damage from human error or "acts
of God." Even if the Company takes precautions, the occurrence of a natural
disaster or other
24
unanticipated problem could result in interruptions in the services the Company
provides to its customers.
CAPACITY CONSTRAINTS COULD CAUSE SERVICE INTERRUPTIONS AND HARM CUSTOMER
RELATIONS. Failure of the backbone providers and other Internet infrastructure
companies to continue to grow in an orderly manner could result in capacity
constraints leading to service interruptions to the Company's customers.
Although the national telecommunications networks and Internet infrastructures
have historically developed in an orderly manner, there is no guarantee that
this orderly growth will continue as more services, users and equipment connect
to the networks. Failure by the Company's telecommunications and Internet
service providers to provide the Company with the data communications capacity
it requires could cause service interruptions.
THE COMPANY'S NETWORK AND SOFTWARE ARE VULNERABLE TO SECURITY BREACHES AND
SIMILAR THREATS WHICH COULD RESULT IN ITS LIABILITY FOR DAMAGES AND HARM ITS
REPUTATION. Despite the implementation of network security measures, the core
of the Company's network infrastructure is vulnerable to computer viruses,
break-ins, network attacks and similar disruptive problems. This could result in
the Company's liability for damages, and its reputation could suffer, thereby
deterring potential customers from working with the Company. Security problems
caused by third parties could lead to interruptions and delays or to the
cessation of service to the Company's customers. Furthermore, inappropriate use
of the network by third parties could also jeopardize the security of
confidential information stored in the Company's computer systems and in those
of its customers.
Although the Company intends to continue to implement industry-standard
security measures, in the past some of these industry-standard measures have
occasionally been circumvented by third parties, although not in its system.
Therefore, there can be no assurance that the measures the Company implements
will not be circumvented. The costs and resources required to eliminate computer
viruses and alleviate other security problems may result in interruptions,
delays or cessation of service to the Company's customers, which could hurt its
business.
SHOULD THE GOVERNMENT MODIFY OR INCREASE ITS REGULATION OF THE INTERNET, THE
PROVISION OF ITS SERVICES COULD BECOME MORE COSTLY. There is currently only a
small body of laws and regulations directly applicable to access to or commerce
on the Internet. However, due to the increasing popularity and use of the
Internet, international, federal, state and local governments may adopt laws and
regulations, which affect the Internet. The nature of any new laws and
regulations and the manner in which existing and new laws and regulations may be
interpreted and enforced cannot be fully determined. The adoption of any future
laws or regulations might decrease the growth of the Internet, decrease demand
for the Company's services, impose taxes or other costly technical requirements
or otherwise increase the cost of doing business on the Internet or in some
other manner have a significantly harmful effect on the Company or its
customers. The government may also seek to regulate some segments of the
Company's activities as it has with basic telecommunications services. Moreover,
the applicability to the Internet of existing laws governing intellectual
property ownership and infringement, copyright, trademark, trade secret,
obscenity, libel, employment, personal privacy and other issues is uncertain and
developing. The Company cannot predict the impact, if any, that future
regulation or regulatory changes may have on its business.
25
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
27.1 Financial Data Schedule (filed only with the electronic submission
of Form 10-Q in accordance with the Edgar requirements).
(b) Reports on Form 8-K:
The Company did not file any reports on Form 8-K during the quarter ended
March 31, 2000.
26
SIGNATURES
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 on this 12th day of May, 2000.
INTERNAP NETWORK SERVICES CORPORATION
(Registrant)
By: /s/ PAUL E. MCBRIDE
----------------------------------------
Paul E. McBride
VICE PRESIDENT AND CHIEF FINANCIAL
OFFICER
(PRINCIPAL FINANCIAL AND ACCOUNTING
OFFICER)
27
EXHIBIT INDEX
EXHIBIT
INDEX TITLE
- --------------------- -----
27.1 Financial Data Schedule.
28