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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_______________
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 000-27525
DSL.NET, INC.
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 06-1510312
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(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION
NUMBER)
545 LONG WHARF DRIVE, NEW HAVEN, CONNECTICUT 06511 (203) 772-1000
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (TELEPHONE NO.)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.0005 PER SHARE
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 report(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [_] No [X]
The aggregate market value of the common stock held by non-affiliates of
the registrant, as of the last business day of the registrant's most recently
completed second fiscal quarter, was approximately $9,819,759 (based on the
closing price of the registrant's Common Stock of $0.36 per share). The number
of shares outstanding of the registrant's Common Stock, par value $.0005 per
share, as of March 18, 2003, was 64,937,899.
DOCUMENT INCORPORATED BY REFERENCE
The registrant intends to file a definitive proxy statement pursuant to
Regulation 14A within 120 days of the end of the fiscal year ended December 31,
2002. Portions of such proxy statement are incorporated by reference into Part
III of this Form 10-K.
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DSL.NET, INC.
ANNUAL REPORT ON FORM 10-K
YEAR ENDED DECEMBER 31, 2002
TABLE OF CONTENTS
Page No.
Part I
Item 1. Business......................................................... 2
Item 2. Properties....................................................... 14
Item 3. Legal Proceedings................................................ 14
Item 4. Submission of Matters to a Vote of Security Holders.............. 15
Part II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.......................................................... 15
Item 6. Selected Consolidated Financial Data............................. 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................ 21
Item 7A. Quantitative and Qualitative Disclosure About Market Risk........ 56
Item 8. Financial Statements and Supplementary Data...................... 57
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure......................................... 99
Part III
Item 10. Directors and Executive Officers of the Registrant............... 99
Item 11. Executive Compensation........................................... 99
Item 12. Security Ownership of Certain Beneficial Owners and Management... 99
Item 13. Certain Relationships and Related Transactions................... 99
Item 14 Controls and Procedures.......................................... 99
Part IV
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K.. 101
SIGNATURES.................................................................. 105
1
PART I
ITEM 1. BUSINESS
THIS BUSINESS SECTION AND OTHER PARTS OF THIS ANNUAL REPORT ON FORM 10-K
CONTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR
ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE SUCH A DIFFERENCE INCLUDE,
BUT ARE NOT LIMITED TO, THOSE SET FORTH IN "ITEM 7 - MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND ELSEWHERE IN THIS
ANNUAL REPORT ON FORM 10-K. EXISTING AND PROSPECTIVE INVESTORS ARE CAUTIONED NOT
TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS
OF THE DATE HEREOF. WE UNDERTAKE NO OBLIGATION, AND DISCLAIM ANY OBLIGATION, TO
UPDATE OR REVISE THE INFORMATION CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K,
WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR CIRCUMSTANCES OR
OTHERWISE.
GENERAL
DSL.net, Inc. ("DSL.net" or the "Company") provides high-speed data
communications, Internet access and related services to small and medium sized
businesses throughout the United States, primarily utilizing digital subscriber
line, or DSL, technology. Our networks enable data transport over existing
copper telephone lines at speeds of up to 2.0 megabits per second. We were
organized in 1998 as a corporation under the laws of the State of Delaware.
We sell directly to businesses, primarily through our own direct sales
channel. We deploy our own local DSL equipment primarily in select second and
third tier cities, as well as in some first tier cities. As of March 5, 2003, we
operated equipment in 394 cities. In certain markets where we have not deployed
our own equipment, we utilize the local DSL facilities of other carriers to
provide service.
In addition to a number of high-speed, high-performance DSL-based Internet
connectivity solutions specifically designed for business, our product offerings
include T1 service, Web hosting, domain name system management, enhanced e-mail,
on-line data backup and recovery services, firewalls, nationwide dial-up
services and virtual private networks. Our services offer customers high-speed
digital connections and related services at prices that are attractive compared
to the cost and performance of alternative data communications services.
In January 2003, we acquired the majority of Network Access Solutions
Corporation's ("NAS") operations and assets for approximately $14,000,000,
consisting of $9,000,000 in cash and a $5,000,000 note. The acquired NAS assets
include operations and equipment in approximately 300 central offices extending
from Virginia to Massachusetts, and include approximately 11,500 subscriber
lines. We expect that the acquired NAS assets and operations will have a
significant impact on our future operating results.
THE DSL.NET SOLUTION
We provide small and medium sized businesses, as well as branch offices of
large businesses, with high-speed Internet access and data services, primarily
using DSL technology. Key elements of our solution are:
2
HIGH-SPEED CONNECTIONS. We offer Internet access at speeds of up to 2.0
megabits per second. Our network is designed to provide data transmission at the
same speed to and from the customer, known as symmetrical data transmission, and
is also capable of providing service at different speeds to and from the
customers, known as asymmetrical data transmission. We believe that symmetrical
data transmission is best suited for business applications, because business
users require fast connections both to send and receive information, and to host
advanced services and applications.
COMPLETE BUSINESS SOLUTION. We offer our customers a single point of
contact for a complete solution that includes all of the necessary equipment and
services to establish and maintain digital data communications. Our services
include high-speed Internet access, Web hosting, domain name system management,
enhanced e-mail, on-line data backup and recovery services, firewalls,
nationwide dial-up services and virtual private networks. Our network is
designed to enable us to individually configure each customer's service
remotely.
ALWAYS-ON CONNECTIONS. With our service, customers can access the Internet
continuously without having to dial into the network for each use. These
"always-on" connections provide customers with the ability to readily access the
Internet and transfer information. We charge our customers a flat fee per month
for connectivity service rather than billing them based on usage.
ATTRACTIVE VALUE PROPOSITION. Our DSL and T-1 services offer customers
high-speed digital connections at prices that are attractive compared to the
cost and performance of alternative data communications services, such as
multiple dial-up connections, ISDN or frame relay lines. We believe that our
services also increase the productivity of network users by decreasing the time
they spend connecting to the Internet and waiting for information downloads and
transfers.
CUSTOMER SUPPORT. We provide customer support 24 hours a day, seven days a
week. This support is important to many of our small and medium sized business
customers because they do not typically have dedicated internal support staff.
With our remote monitoring and troubleshooting capabilities, we continuously
monitor our network. This enables us to identify and address network problems
promptly, thus enhancing network quality, service and performance.
OUR SERVICES
As part of our service offerings, we function as our customers' Internet
service provider and deliver a range of Internet-based, value-added solutions.
Our services currently include all necessary equipment, software and lines
required to establish and maintain a digital Internet connection. Our primary
services include high-speed Internet access, e-mail, domain name system
management and Web hosting. Other services provided by DSL.net include
firewalls, on-line data backup and recovery services, nationwide dial-up
services and virtual private networks that connect customers' various offices.
Our network is designed to enable us to individually configure each customer's
service remotely.
Customers typically pay an installation charge and a monthly fee for our
service. The monthly fee includes all phone line charges, general Internet
access services, e-mail, and domain name system management, including the
issuance of Internet Protocol (IP) addresses for customers who wish to assign
fixed IP addresses to their network computers. Customers generally contract for
our services for a minimum of one year and are billed for services on a monthly
basis.
3
CUSTOMERS
Our target customers are primarily small and medium sized businesses. We
sell to these customers primarily on a direct basis. In particular, we believe
the following market segments are especially attractive prospective customers:
o businesses currently using other high-speed data communications services,
such as ISDN and frame relay services;
o professional or service-based firms that have multiple Internet service
provider dial-up accounts and phone lines;
o branch office locations that require transmission of large files between
locations; and
o businesses that use data-intensive applications, such as financial
services, technology, and publishing.
No customer accounted for more than 5% of our total revenue during the
years ended December 31, 2000, 2001 and 2002.
SALES AND MARKETING
Our marketing professionals have developed a methodology to identify the
businesses that we believe would most likely benefit from our services. Once we
identify businesses in a specific market, we employ a targeted local marketing
strategy utilizing a variety of mediums but primarily focused on direct mail and
opt-in e-mail. Through inbound and outbound telesales campaigns, we utilize
internal sales professionals to sell our services to prospective customers. We
also partner with local information technology professionals, application
service providers and marketing partners to assist in the sale of our services.
CUSTOMER ACQUISITIONS
In addition to our internal sales and marketing efforts, and our reseller
and referral channels, we have grown our customer base by acquiring end users of
other Internet service providers and companies offering broadband access.
We continuously identify and evaluate acquisition candidates, and in many
cases engage in discussions and negotiations regarding potential acquisitions.
Acquisition candidates include both individual subscriber lines and whole
businesses. Our discussions and negotiations may not result in acquisitions.
Further, if we make any additional acquisitions, we may not be able to operate
any acquired assets or businesses profitably or otherwise successfully implement
our expansion strategy. We intend to continue to seek additional opportunities
for further acquisitions, a strategy which we believe represents a distinct
opportunity to accelerate our growth.
CUSTOMER SUPPORT AND OPERATIONS
Our customer support professionals serve as an information repository to
our customers and work to streamline the ordering, installation and maintenance
processes associated with data communications and Internet access. They provide
our customers with a single point of contact for implementation, maintenance and
operations support.
4
IMPLEMENTATION. We manage the implementation of our service for each
customer. In areas where we have installed our own local DSL facilities, we
lease the copper telephone lines from the local telephone company. These lines
run from our equipment located in the telephone company's central office to our
customer. We test these lines to determine whether they meet our specifications
and work with the local telephone company to correct any problems identified by
our testing. In other areas, we utilize the local DSL facilities of other
carriers, and work with these carriers to provide the DSL service. In both
cases, field service technicians install the modem or router purchased or leased
from us and any necessary wiring at our customers' offices and test the modem or
router and connection over our network to confirm successful installation.
MAINTENANCE. Our network operations center provides network surveillance
for all equipment in our network. We are able to detect and correct many of our
customers' maintenance problems remotely, often before our customer is aware of
the problem. Customer-initiated maintenance and repair requests are managed and
resolved primarily through our customer service department. Our information
management system, which generates reports for tracking maintenance problems,
allows us to communicate maintenance problems from the network operations center
to our customer service center 24 hours a day, seven days a week.
OPERATIONS SUPPORT SYSTEMS. Our operations support systems are intended to
improve many of our business processes, including customer billing, service
activation, inventory control, customer care reports and maintenance reports.
They have been designed to provide us with accurate, up-to-date information in
these areas. Additional enhancements of these systems, including improved
electronic and on-line ordering tools, were made in 2002. We believe that our
operations support systems provide us with the flexibility to support additional
customers and additional services.
OUR NETWORK
Our network has been designed to deliver reliable, secure and scaleable
high-speed, high-performance Internet access and data communication services.
NETWORK DESIGN.
The key design principles of our network are:
o INTELLIGENT END-TO-END NETWORK MANAGEMENT. Our network is designed to
allow us to monitor network components and customer traffic from a
central location. We can perform network diagnostics and equipment
surveillance continuously. From our network operations center, we have
visibility across our entire network, allowing us to identify and
address network problems quickly and to provide quality service and
performance.
o CONSISTENT PERFORMANCE WITH THE ABILITY TO EXPAND. We have designed
our network to leverage the economics of DSL technology, to grow with
our business and to provide consistent performance. We also use
asynchronous transfer mode equipment in our network, which implements
high-speed, high volume transmission of data.
o SECURITY. Our network is designed to reduce the possibility of
unauthorized access and to allow our customers to safely transmit and
receive sensitive information and applications. The modems and routers
we install on our customers' premises are designed to work in
conjunction with installed security systems and network servers in an
effort to provide safe connections to the Internet and a secure
operating environment.
5
NETWORK COMPONENTS. The primary components of our network are:
o MODEMS, ROUTERS AND ON-SITE CONNECTIONS. We purchase modems and
routers and provide either of them to our customers, depending on
their specific needs and contractual service agreements. We configure
the modem or router and arrange for the installation of the modem or
router along with the on-site wiring needed to connect the modem or
router to the copper telephone line. In areas where we have deployed
our own local facilities, we either perform these services ourselves
or we contract with independent field service organizations to perform
these services on our behalf. In areas where we utilize the local
facilities of other carriers, these other carriers provide these
installation services. We will either provide or sell customer premise
equipment (modem or router) to our customers. When we provide the
customer premise equipment, we charge the customer for the use of this
equipment as part of our monthly service fee. These modems and routers
are capitalized and depreciated over their estimated useful life of
three years. Such equipment remains our exclusive property. When we
sell customer premise equipment (modem or router) to the customer, we
recognize the revenue from the sale and expense the cost of this
equipment at the time of sale.
o COPPER TELEPHONE LINES. In areas where we have deployed our own local
DSL facilities, we lease a copper telephone line running to each
customer from our equipment in the local telephone company's central
office under terms specified in our interconnection agreements with
these companies. In areas where we utilize the local DSL facilities of
other carriers, the carrier leases the telephone line from the local
telephone company.
o CENTRAL OFFICE COLLOCATION. Through our interconnection agreements, we
secure space to locate our equipment in certain central offices of
traditional local telephone companies and offer our services from
these locations. These collocation spaces are designed to offer the
same high reliability and availability standards as the telephone
companies' own central office spaces. We install the equipment
necessary to provide high-speed DSL or T1 service to our customers in
these spaces. We have continuous access to these spaces to install and
maintain our equipment located in these central offices. In markets
where we have not deployed our own equipment, we utilize the local
facilities installed in central offices by other carriers, to provide
high-speed connections to our customers.
o CONNECTION TO THE INTERNET. Network traffic gathered at each of our
central offices is routed to one of our regional hubs and then to the
Internet. In certain areas where we offer service from more than one
central office, network traffic is routed from each central office in
that area to a local hub which aggregates its traffic along with the
traffic from the other central offices located in that area and routes
the traffic to a regional hub. At our regional hubs, we also connect
to other carriers' networks via high-speed connections. Our hubs
contain extra equipment and backup power to provide backup facilities
in the event of an equipment failure and are actively monitored from
our network operations center. We lease space for our hubs in
facilities designed to host network equipment. Our hubs are connected
to one another via high-speed data communications lines. We have
agreements with WorldCom, AT&T and other carriers to provide this
service. Internet connectivity is provided by a combination of public
and private peering and transit arrangements. We have a presence at
seven of the largest and newest national "network access points" to
facilitate this high-performance, high-volume external connectivity.
6
o NETWORK OPERATIONS CENTER. Our network is managed from our network
operations center located in New Haven, Connecticut, which is
supplemented by our newly acquired facilities in Herndon, Virginia. We
provide network management 24 hours a day, seven days a week. This
enhances our ability to address performance and service issues before
they affect our customers. From the network operations center, we can
monitor the performance of individual subscriber lines and the
equipment and circuits in our network.
COMPETITION
We face competition from many companies with significantly greater
financial resources, well-established brand names and large installed customer
bases. We expect that the level of competition in our markets may intensify in
the future. We expect competition from:
OTHER DSL PROVIDERS. A number of competitive carriers, including Covad
Communications, Speakeasy, Inc. and New Edge Networks, offer DSL and T1 services
to residential and business customers. The 1996 Telecommunications Act
specifically grants competitive telecommunications companies, including other
DSL providers, the right to negotiate interconnection agreements with
traditional telephone companies, including interconnection agreements which may
be identical in all respects to, or more favorable than, our agreements.
INTERNET SERVICE PROVIDERS. Several national and regional Internet service
providers, including UUNET, EarthLink and MegaPath, offer high-speed access
capabilities, along with other products and services. These companies generally
provide Internet access to residential and business customers through a host of
methods, including DSL and T1.
TRADITIONAL LOCAL TELEPHONE COMPANIES. Many of the traditional local
telephone companies, including BellSouth, SBC Communications, Qwest and Verizon,
are deploying DSL-based services, either directly or through affiliated
companies. These companies have established brand names, possess sufficient
capital to deploy DSL equipment rapidly, have their own copper telephone lines
and can bundle digital data services with their existing voice services to
achieve a competitive advantage in serving customers. In addition, these
companies also offer high-speed data communications services that use other
technologies, including T1 services. We depend on these traditional local
telephone companies to enter into agreements for interconnection and to provide
us access to individual elements of their networks. Although the traditional
local telephone companies are required to negotiate in good faith in connection
with these agreements, future interconnection agreements may contain less
favorable terms and result in a competitive advantage to the traditional local
telephone companies.
NATIONAL LONG DISTANCE CARRIERS. National long distance carriers, such as
AT&T, Sprint, Williams and WorldCom, have deployed large-scale data networks,
sell connectivity to businesses and residential customers, and have high brand
recognition. They also have interconnection agreements with many of the
traditional local telephone companies, and many offer competitive DSL and T1
services.
OTHER FIBER-BASED CARRIERS. Companies such as Allegiance and Choice One
have extensive fiber networks in many metropolitan areas, primarily providing
high-speed data and voice circuits to small and large corporations. They also
have interconnection agreements with the traditional local telephone companies
under which they have acquired collocation space in many large markets, and some
offer competitive DSL and T1 services.
CABLE MODEM SERVICE PROVIDERS. Cable modem service providers, such as AT&T,
Comcast and RCN, offer high-speed Internet access over cable networks primarily
to residential consumers. Where deployed, these networks provide high-speed
local access services, in some cases at speeds higher than DSL service. They
typically offer these services at lower prices than our services, in part by
sharing the capacity available on their cable networks among multiple end users.
7
WIRELESS AND SATELLITE DATA SERVICE PROVIDERS. Several companies, including
Hughes Communications and Teledesic, are emerging as wireless and
satellite-based data service providers. These companies use a variety of new and
emerging technologies to provide high-speed data services.
The most significant competitive factors include: transmission speed,
service reliability, breadth of product offerings, price/performance, network
security, ease of access and use, content and service bundling, customer
support, brand recognition, operating experience, capital availability and
exclusive contracts with customers, including Internet service providers and
businesses with multiple offices. We believe our services compete favorably
within our service markets with respect to transmission speed,
price/performance, ease of access and use and customer support. Many of our
competitors enjoy competitive advantages over us based on their brand
recognition, breadth of product offerings, financial resources, customer bases,
operating experience and exclusive contracts with customers.
INTERCONNECTION AGREEMENTS WITH TRADITIONAL LOCAL TELEPHONE COMPANIES
Under the 1996 Telecommunications Act, the traditional local telephone
companies have a statutory duty to negotiate in good faith with us for
agreements for interconnection and access to certain individual elements of
their networks. This interconnection process is subject to review and approval
by the state regulatory commissions. We have signed interconnection agreements
with BellSouth, Cincinnati Bell, Frontier, SBC Communications, Qwest, Sprint,
and Verizon or their subsidiaries, which govern our relationships in 49 states
and the District of Columbia. These agreements govern, among other things:
o the price and other terms under which we locate our equipment in the
telephone company's central offices,
o the price we pay to lease copper telephone lines,
o the special conditioning of these copper lines that the traditional
telephone company provides to enable the transmission of DSL signals,
o the price we pay to access the telephone company's transmission
facilities, and
o certain other terms and conditions of our relationship with the
telephone company.
We are negotiating renewal agreements with these carriers as the current
agreements expire and are also negotiating amendments to existing agreements.
Future interconnection agreements may contain terms and conditions less
favorable to us than those in our current agreements and could increase our
costs of operations.
During these interconnection negotiations, either the telephone company or
we may submit disputes to the state regulatory commissions for mediation. Also,
after the expiration of the statutory negotiation period set forth in the 1996
Telecommunications Act, we may submit outstanding disputes to the states for
binding arbitration, in which the state regulatory commissions may arbitrate a
new agreement or particular portions thereof.
Under the 1996 Telecommunications Act, states have begun and, in a number
of cases, completed regulatory proceedings to determine the pricing of
individual elements of their networks and services. The results of these
proceedings determine the price we pay for, and whether it is economically
attractive for us to use, these elements and services. These prices may be
subject to change as the result of ongoing and future regulatory proceedings.
8
Our interconnection agreements generally have terms of one or two years.
Therefore, we have renegotiated, and expect to continue to renegotiate, existing
agreements when they expire. Although we expect to renew our interconnection
agreements and believe the 1996 Telecommunications Act limits the ability of
traditional local telephone companies not to renew these agreements, we may not
succeed in extending or renegotiating our interconnection agreements on
favorable terms. In addition, disputes have arisen and will likely arise in the
future as a result of differences in interpretations of the interconnection
agreements. These disputes have, in the past, delayed the deployment of our
networks. Finally, the interconnection agreements are subject to state
regulatory commission, FCC and judicial oversight. These government authorities
may modify the terms of the interconnection agreements in ways that are harmful
to our business.
GOVERNMENT REGULATIONS
Significant portions of the services that we offer are subject to
regulation at the federal and/or state levels. The Federal Communications
Commission, or FCC, and state public utility commissions regulate
telecommunications common carriers, which are companies that offer
telecommunications services to the public or to all prospective users on
standardized rates and terms. Our DSL and other facilities-based data transport
services are common carrier services.
While we serve many of our customers using transport facilities that we own
or lease, in some areas where we do not have the necessary facilities, we
provide our Internet access and other services using the local facilities of
another carrier. The FCC has determined that Internet service providers, such as
us, who are using another carrier's transport facilities, are not acting as
common carriers. Therefore, in those markets where we have not deployed our own
local transport facilities, our services are not subject to common carrier
regulation. Our ability to provide such services, however, is affected by
regulations imposed upon the carriers whose local transport facilities we
utilize.
The FCC exercises jurisdiction over common carriers, and their facilities
and services, to the extent they are providing interstate or international
communications. The various state utility commissions retain jurisdiction over
telecommunications carriers, and their facilities and services, to the extent
they are used to provide communications that originate and terminate within the
same state. The degree of regulation varies from state to state.
In recent years, the regulation of the telecommunications industry has been
in a state of flux as the United States Congress and various state legislatures
have passed laws seeking to foster greater competition in telecommunications
markets. The FCC and state regulatory commissions have adopted many new rules to
implement those new laws and to encourage competition. These changes, which are
still incomplete, have created new opportunities and challenges for us and our
competitors. Certain of these and other existing federal and state regulations
are currently the subject of judicial proceedings, legislative hearings and
administrative proposals which could change, in varying degrees, the manner in
which the telecommunications industry operates. Neither the outcome of these
proceedings nor their impact upon the telecommunications industry or us can be
predicted at this time. Indeed, future federal or state regulations and
legislation may be less favorable to us than current regulations and legislation
and therefore have a material and adverse impact on our business and financial
prospects by undermining our ability to provide DSL services at competitive
prices. In addition, we may expend significant financial and managerial
resources to participate in proceedings setting rules at either the federal or
state level, without achieving favorable results.
9
FEDERAL REGULATION AND LEGISLATION
We must comply with the requirements of a common carrier under the
Communications Act of 1934, as amended, to the extent we provide regulated
interstate services. These requirements include an obligation that our charges,
terms and conditions for communications services must be "just and reasonable"
and that we may not make any "unjust or unreasonable discrimination" in our
charges or terms and conditions. The FCC also has jurisdiction to act upon
complaints against common carriers for failure to comply with their statutory
obligations. We are not currently subject to price cap or rate of return
regulation at the federal level and are not currently required to obtain FCC
authorization for the installation, acquisition or operation of our facilities.
The FCC has established different levels of regulation for dominant and
non-dominant carriers. Of domestic carriers, only the traditional local
telephone companies are classified as dominant carriers and all other providers
of domestic common carrier service, including us, are classified as non-dominant
carriers. As a non-dominant carrier, we are subject to less FCC regulation than
are dominant carriers.
Comprehensive changes to the Communications Act of 1934 were made by the
1996 Telecommunications Act, enacted on February 8, 1996. It represents a
significant milestone in telecommunications policy by establishing competition
in local telephone service markets as a national policy. The 1996
Telecommunications Act removes many state regulatory barriers to competition and
forecloses state and local governments from creating laws preempting or
effectively preempting competition in the local telephone service market.
The 1996 Telecommunications Act places substantial interconnection
requirements on the traditional local telephone companies, including the
following obligations that can be relevant to our business:
o Traditional local telephone companies are required to provide physical
collocation, which allows companies such as us and other
interconnectors to install and maintain their own equipment in the
central offices of traditional local telephone companies. This
requirement is intended to enable us and other competitive carriers to
deploy our equipment on a relatively convenient and economical basis.
o Traditional local telephone companies are required to unbundle certain
components of their local service networks so that other providers of
local service can compete for a wide range of local service customers.
This requirement is designed to provide us flexibility to purchase
only the network elements we require to deliver our services.
o Traditional local telephone companies are required to establish
"wholesale" rates for their retail telecommunications services to
promote resale by competitive local exchange carriers and other
competitors.
o Traditional local telephone companies are required to provide
non-discriminatory access to telephone poles, ducts, conduits and
rights-of-way.
The 1996 Telecommunications Act generally sets forth the rights and
obligations of competing carriers. The FCC issues regulations interpreting the
1996 Telecommunications Act and imposing more specific requirements upon which
we and our competitors rely. The outcome of various ongoing FCC rulemaking
proceedings or judicial appeals of such proceedings could materially affect our
business and financial prospects by increasing the cost or decreasing our
flexibility in providing services.
10
As part of its effort to implement the 1996 Telecommunications Act, in
August 1996, the FCC issued an order governing interconnection, the unbundling
of network elements, and many other aspects of the relationships between new and
traditional telephone companies. The United States Court of Appeals for the
Eighth Circuit vacated many of these rules, and, in January 1999, the United
States Supreme Court reversed elements of the Eighth Circuit's ruling, finding
that the FCC has broad authority to interpret the 1996 Telecommunications Act
and issue rules for its implementation. Following the United States Supreme
Court's decision, in November, 1999, the FCC issued a modified list of the
network elements that must be offered on an unbundled basis by traditional local
telephone companies, including the local copper telephone lines and interoffice
transport which we lease. However, the decision announced the FCC's intention to
revisit these regulations within three years.
The FCC initiated this three-year review in early 2002, and on February 20,
2003, it voted to adopt new regulations pertaining to the unbundling obligations
of the traditional local telephone companies. The FCC has yet to release its
order, and the details of the regulations it will enact therefore remain
unclear. However, based upon our initial evaluation of the press materials
released by the FCC on February 20, 2003, it appears that its new regulations
may have, at a minimum, the following impacts:
o In the course of upcoming state implementation of the new rules later
this year, it is possible that we could lose the right to obtain
unbundled interoffice transport from the traditional local telephone
companies in locations where a certain number of competitive
alternatives are available. This change could have the effect of
increasing our costs of providing service in certain areas.
o The new regulations may result in changes to the formula by which the
rates for unbundled network elements provided to us by the traditional
local telephone companies are calculated, which could result in
significant changes to our costs of providing service, and could
negatively impact our ability to provide our services. New rates would
be developed in each state in new proceedings expected to begin later
this year. In addition, the FCC has suggested informally that it may
revise other aspects of the pricing formula in the near future.
o The FCC announced that it would exempt from unbundling obligations
certain loop transmission facilities that use fiber or new
technologies. It is possible that these rules will apply only in the
residential market, in which we do not presently compete. However,
these limitations may also be imposed on the business enterprise
market either by the upcoming order or in future regulatory
proceedings. Depending on how the new rules are written and
implemented, the traditional local telephone companies may decide to
modify, characterize or replace their facilities in ways that would
qualify them for this exemption and thereby preclude us from accessing
these facilities pursuant to the terms of their interconnection
agreements. Without access to these facilities, we may not be able to
provide service in these areas.
o The FCC will eliminate the traditional local telephone companies'
obligation to provide the high frequency portion of a copper loop to a
competitive DSL provider, known as "line sharing," over the course of
the next three years. Our current business is not directly affected
because we do not use line sharing to provide services to our
customers. Line sharing technology currently does not support the
ability to provide the high-capacity symmetric services desired by
customers in the business market, and therefore was primarily used by
other competing carriers to provide DSL services in the residential
market.
The FCC's decision will likely be subject to petitions for reconsideration and
appeal. We cannot predict the outcome of these proceedings on our ability to
offer services in the future.
11
In addition to this proceeding, the FCC in February 2002 initiated a new
proceeding that will reevaluate the appropriate degree of regulation of
broadband services offered by the traditional local telephone companies,
including whether they should continue to be required to offer network access to
competitors such as us. Any changes to the obligation of the traditional local
telephone companies to provide us with unbundled copper loops and/or interoffice
transport could have significant adverse consequences for our business. A
decision is expected in the spring or summer of 2003.
There is also the possibility that legislation will be proposed in the
United States Congress that would limit our access to certain unbundled network
elements. In 2002, the House of Representatives passed legislation known as the
Tauzin-Dingell bill, that would have amended the 1996 Telecommunications Act to
prohibit state or federal regulation of high-speed data services. While the
legislation was ultimately not enacted, similar legislation may be proposed in
the future. The effect of such legislation would be that the traditional local
telephone companies would no longer be required to provide unbundled elements at
cost-based rates (if at all) if those elements were to be used to provide
high-speed data services.
The traditional local telephone companies have also lobbied numerous state
legislatures to adopt new legislation that would limit, or prohibit, the ability
of their state utility commissions to expand upon certain federal requirements
relating to the obligations of the traditional local telephone companies to
provide access to competitors such as us. Because the existing FCC framework
relies substantially on state implementation, the effect of such state
legislation could be to inhibit effective implementation of the 1996
Telecommunications Act with respect to broadband services, and could negatively
effect our ability to offer services in these states.
In November 1999, the FCC issued an order reaffirming its prior conclusion
that DSL services must be offered for resale at a discount by traditional local
telephone companies to the extent such services are offered at retail to
residential and business customers. The FCC determined, however, that advanced
services provided to Internet service providers would not be subject to resale
at a discount. For the most part, the traditional local telephone companies have
decided to sell DSL only to Internet service providers, including their own
affiliated Internet service providers, such that no DSL service is made
available to competing carriers such as us at the wholesale discount rate
established under the 1996 Telecommunications Act. In February 2002, the FCC
initiated a new proceeding that will, among other things, determine whether the
traditional local telephone companies must make available for resale, at a
wholesale discount, the telecommunications portion of the retail high-speed data
services sold by their affiliated internet service providers. Such a resale
requirement could allow us to more easily enter into new markets for which we do
not presently have facilities, but could also make it easier for other companies
to compete with us. A decision in this proceeding is expected in the spring or
summer of 2003.
Over the past three years, the FCC has granted authority to provide long
distance inter-exchange service to Verizon, SBC, BellSouth and Qwest in many of
the states where we do business, and numerous additional applications are
pending or are expected in the near future. While we do not presently provide
long distance inter-exchange service, this ruling and any future similar rulings
could negatively impact our business. First, the traditional local telephone
companies are now able to offer bundled packages of local, long distance and
data services that may be attractive to some of our existing and potential
customers. Second, the prospect of long distance authority has served as a
powerful incentive for the traditional local telephone companies to comply with
their obligations under the 1996 Telecommunications Act, including the provision
of unbundled network elements and collocation services to competitors such as
us. The traditional local telephone companies may not extend to us the same
level of cooperation once they receive approval to provide long distance
inter-exchange service.
12
Pursuant to the 1996 Telecommunications Act, the FCC requires all
telecommunications carriers providing interstate telecommunications services to
contribute to a universal service fund used to provide subsidies to carriers
that provide service to individuals that live in rural, insular, and high-cost
areas, and to provide telecommunications-related services and facilities for
schools, libraries and certain rural health care providers. The
telecommunications portion of our service is currently subject to this
requirement. For the fourth quarter of 2002, the FCC has established a
contribution rate of 7.2805% of our interstate telecommunications revenues. We
pass the cost of our universal service fund contributions along to our
customers. The FCC's implementation of universal service requirements remains
subject to judicial and additional FCC review. In several new proceedings, the
FCC will consider the degree to which companies providing services such as ours
should be obligated to contribute to this fund. We are unable to predict the
outcome of these proceedings on our business at this time.
DSL.net's subsidiaries are authorized to provide interstate
telecommunications services pursuant to its access tariff filed with the FCC in
April 1999. Although not required for our existing DSL data service offering, on
August 6, 1999 we obtained authority from the FCC to provide international
telecommunications services originating from the United States.
STATE REGULATION
In October 1998, the FCC ruled that DSL and other advanced data services
provided as dedicated access services in connection with interstate services
such as Internet access are interstate services subject to the FCC's
jurisdiction. Accordingly, we could offer DSL services without state regulatory
authority, so long as we do not also provide local or intrastate
telecommunications services via our network. This decision allows us to provide
our DSL services in a manner that potentially reduces state regulatory
obligations. However, the regulatory parameters used to define DSL service are,
directly and indirectly, subject to many pending FCC and judicial proceedings
and could change in the future.
Also, some of our services that are not limited to interstate access
potentially may be classified as intrastate services subject to state
regulation. All of the states where we operate require some degree of state
regulatory commission approval to provide certain intrastate services and
maintain ongoing regulatory supervision. In most states, intrastate tariffs are
also required for various intrastate services, although our services are not
subject to price or rate of return regulation. Actions by state public utility
commissions could cause us to incur substantial legal and administrative
expenses and adversely affect our business.
We have obtained authorizations to provide local exchange and long-distance
telecommunications services in all 50 states, the District of Columbia, and
Puerto Rico.
LOCAL GOVERNMENT REGULATION
In certain instances, we may be required to obtain various permits and
authorizations from municipalities, such as for use of rights-of-way, in which
we operate our own local distribution facilities. Whether various actions of
local governments over the activities of telecommunications carriers such as
ours, including requiring payment of franchise fees or other surcharges, pose
barriers to entry for competitive local exchange carriers which violate the 1996
Telecommunications Act or may be preempted by the FCC is the subject of
litigation. While we are not a party to this litigation, we may be affected by
the outcome. If municipal governments impose conditions on granting permits or
other authorizations or if they fail to act in granting such permits or other
authorizations, the cost of providing our services may increase or it may
negatively impact our ability to expand our network on a timely basis and
adversely affect our business.
13
INTELLECTUAL PROPERTY
We regard our products, services and technology as proprietary and attempt
to protect them with copyrights, trademarks, trade secret laws, restrictions on
disclosure and other methods. For example, we own a federal supplemental
registration and claim rights in the name DSL.net. There can be no assurance
these methods will be sufficient to protect our technology and intellectual
property. We also generally enter into confidentiality agreements with our
employees, consultants and business partners; and generally control access to
and distribution of our documentation and other proprietary information. Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use our proprietary information without authorization, or to develop
similar information independently. Effective patent, copyright, trademark and
trade secret protection may be unavailable or limited in certain foreign
countries, and the global nature of the Internet makes it virtually impossible
to control the ultimate destination of our technology or proprietary
information. There can be no assurance that the steps we have taken will prevent
misappropriation or infringement of our technology or proprietary information.
In addition, litigation may be necessary in the future to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Such litigation could
result in substantial costs and diversion of resources and could have a material
adverse effect on our business, operating results and financial condition. In
addition, some of our information, including our competitive carrier status in
individual states and our interconnection agreements, is a matter of public
record and can be readily obtained by our competitors and potential competitors,
possibly to our detriment.
EMPLOYEES
As of March 18, 2003, we had approximately 230 employees. We believe that
our future success will depend in part on our continued ability to attract, hire
and retain qualified personnel. Competition for qualified personnel can be
intense, and we may be unable to identify, attract and retain such personnel in
the future. In addition, the reductions in workforce that we undertook in 2000,
2001 and 2003 may make it difficult to attract, hire and retain qualified
personnel. None of our employees are represented by a labor union or are the
subject of a collective bargaining agreement. We have never experienced a work
stoppage and believe that our employee relations are good.
ITEM 2. PROPERTIES
Our headquarters consists of approximately 40,600 square feet in an office
building in New Haven, Connecticut. We also lease other offices in Santa Cruz,
California, Minneapolis, Minnesota and Herndon, Virginia. We have vacated and
sublet the office in Santa Cruz, California. See "Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations". We
have also given notice to our landlord that we intend to vacate approximately
9,000 square feet at our New Haven headquarters facility when the lease expires
in April 2003. In addition, we lease space for network equipment installations
in a number of other locations. With respect to our arrangements to use space in
traditional telephone companies' central offices, please see "Business
Interconnection Agreements with Traditional Local Telephone Companies."
ITEM 3. LEGAL PROCEEDINGS
A lawsuit for wrongful termination of employment was filed against us in
the Superior Court in New Haven, Connecticut on July 29, 1999 by a former
officer who was employed by us for less than two months. Plaintiff's claims are
based chiefly on his allegation that we terminated his employment because he
allegedly voiced concerns to senior management about the feasibility of our
second and third tier city business strategy. The plaintiff is principally
seeking compensatory damages for wages and unvested stock options. We deny the
plaintiff's allegations and believe that his claims are without merit. We plan
to defend the case vigorously.
14
We are also a party to legal proceedings related to regulatory approvals.
We are subject to state commission, FCC and court decisions as they relate to
the interpretation and implementation of the 1996 Telecommunications Act and the
interpretation of competitive carrier interconnection agreements in general and
our interconnection agreements in particular. In some cases, we may be deemed to
be bound by the results of ongoing proceedings of these bodies. We therefore may
participate in proceedings before these regulatory agencies or judicial bodies
that affect, and allow us to advance, our business plans.
From time to time, we may be involved in other litigation concerning claims
arising in the ordinary course of our business, including claims brought by
former employees and claims related to acquisitions. We do not currently believe
that any of these legal claims or proceedings will result in a material adverse
effect on our business, financial position, results of operations or cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 2002, we did not submit any matters
to the vote of our security holders.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of March 18, 2003, there were approximately 577 holders of record of our
common stock. Our common stock is listed for quotation on the Nasdaq SmallCap
Market under the symbol "DSLN". Our common stock was listed for quotation on the
Nasdaq National Market under the same symbol until July 22, 2002.
The range of high and low sales prices per share of DSL.net's common stock
as reported on the Nasdaq National Market and the Nasdaq SmallCap Market for the
two most recent fiscal years are shown below. The last trading price of DSL.net
common stock on March 18, 2003 was $ 0.38 per share.
QUARTER ENDED HIGH LOW
------------- ------ ------
March 31, 2001 $4.000 $0.530
June 30, 2001 1.690 0.625
September 30, 2001 1.020 0.140
December 31, 2001 1.490 0.150
March 31, 2002 1.380 0.700
June 30, 2002 1.050 0.290
September 30, 2002 0.450 0.240
December 31, 2002 $0.890 $0.280
On July 22, 2002, the Nasdaq Stock Market, Inc. ("Nasdaq") transferred the
listing of our common stock from the Nasdaq National Market to the Nasdaq
SmallCap Market. We applied for such transfer as a result of our non-compliance
with Nasdaq's Marketplace Rule 4450(a)(5), which required us to maintain a bid
price of $1.00 per share for at least 10 consecutive trading days during the
last ninety day period prior to July 17, 2002 in order to remain qualified for
listing on the Nasdaq National Market. On October 16, 2002, Nasdaq notified us
15
that, while we had not regained compliance by October 15, 2002 with the $1.00
bid price per share requirement generally required for continued listing on the
Nasdaq SmallCap Market, we did continue to meet the initial listing requirements
for the Nasdaq SmallCap Market under Rule 4310(c)(2)(A). As a result, we had an
additional 180 calendar days, or until April 14, 2003, to comply with the
minimum bid price of $1.00 per share for 10 consecutive trading days, or such
greater number of trading days as Nasdaq may determine, in order to remain
listed on the Nasdaq SmallCap Market. On March 11, 2003, the Nasdaq amended its
rules to provide that a company that satisfies the initial listing requirements
for the Nasdaq SmallCap Market under Rule 4310(c)(2)(A) would have an additional
90 days (over the 180 days already contemplated by the Nasdaq SmallCap Market
rules) to comply with the minimum bid price of $1.00 per share. As a result, if
we do not satisfy the minimum bid price of $1.00 per share on April 14, 2003,
but satisfy the Nasdaq SmallCap Market initial listing requirements, we will
have until July 13, 2003 to satisfy the minimum bid price of $1.00 per share. As
of March 27, 2003, we satisfied the initial listing requirements for the Nasdaq
SmallCap Market, but there can be no assurance that we will satisfy these
requirements on April 14, 2003. If we can neither comply with the minimum bid
price requirements nor satisfy the initial Nasdaq SmallCap listing requirements
on April 14, 2003, Nasdaq will provide us notice that our common stock will be
de-listed from the Nasdaq SmallCap Market. In addition, if we satisfy the
initial Nasdaq SmallCap listing requirements on April 14, 2003 but are unable to
satisfy the minimum bid price requirements by July 13, 2003, Nasdaq will provide
us notice that our common stock will be de-listed from the Nasdaq SmallCap
Market. In each case, we would have the opportunity to appeal such determination
to a Listings Qualifications Panel. There can be no assurance that we will be
able to comply with the minimum bid price requirement by April 14, 2003 or July
13, 2003, if at all, or that we will continue to satisfy the other listing
requirements of the Nasdaq SmallCap Market.
Nasdaq has indicated that it intends to submit proposed rules changes to
the SEC which would, among other things, further extend the number of days
during which a company that satisfies the initial listing requirements of the
Nasdaq SmallCap Market may continue to be listed on such market without
complying with the $1.00 minimum bid price requirement. There can be no
assurance that Nasdaq will submit this proposed rule change to the SEC or that
the SEC will approve this proposed rule change, if at all, in time to delay the
possible delisting of our common stock from the Nasdaq SmallCap Market. In
addition, there can be no assurance that we will continue to satisfy the initial
listing requirements of the Nasdaq SmallCap Market.
RECENT SALES OF UNREGISTERED SECURITIES
On March 1, 2002, we sold an additional aggregate of 10,000 shares of
Series X preferred stock for an aggregate purchase price of $10,000,000. At the
option of the holder thereof, each share of Series X preferred stock may be
converted into approximately 5,555.56 shares of common stock, subject to
adjustment for certain subsequent dilutive issuances and stock splits.
On May 30, 2002, we sold 8,531 shares of Series Y Preferred Stock for
$5,000,000 in cash and delivery of promissory notes in the aggregate principal
amount of $3,531,000 for cancellation. At the option of the holder thereof, each
share of Series Y preferred stock may be converted into 2,000 shares of common
stock, subject to adjustment for certain subsequent dilutive issuances and stock
splits.
We entered into a Reimbursement Agreement, dated as of December 27, 2002,
with several private investment funds affiliated with VantagePoint Venture
Partners ("VantagePoint"), Columbia Capital Equity Partners ("Columbia"), The
Lafayette Investment Fund, L.P. and Charles River Partnership, L.P.
(collectively the "Guarantors") and VantagePoint Venture Partners III (Q), L.P.,
as administrative agent. The Guarantors are all holders or affiliates of the
holders of our Series X and Series Y Preferred stock. Pursuant to the terms of
the Reimbursement Agreement, VantagePoint and Columbia issued guarantees in an
16
aggregate amount up to $6,100,000 to support certain of our obligations under a
Credit Agreement we entered into in 2002 with a commercial bank. Pursuant to the
terms of the Reimbursement Agreement, on December 27, 2002, we issued warrants
to purchase 10,379,420 shares of our common stock to VantagePoint and 1,634,473
shares of our common stock to Columbia, in consideration for their guarantees
aggregating $6,100,000. We issued additional warrants to purchase 767,301 shares
of our common stock to VantagePoint and 168,806 shares of our common stock to
Columbia during the first quarter of 2003. All such warrants are exercisable for
ten years at an exercise price of $0.50 per share.
No underwriters were involved in the foregoing sales of securities. Such
sales were made in reliance upon an exemption from the registration provisions
of the Securities Act of 1933, as amended, set forth in Section 4(2) thereof
relative to sales by an issuer not involving any public offering or the rules
and regulations thereunder.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our common stock and
currently intend to retain any future earnings for the future operation and
expansion of our business. In addition, prior to and in preference to any
declaration or payment of any cash dividends on our common stock, the holders of
Series X and Series Y preferred stock are entitled to receive cumulative
dividends of $120.00 per share per annum when and as declared by the DSL.net
board of directors. All such dividends on the Series X and Series Y preferred
stock accrue monthly and are payable in cash, except in the case of the
conversion of the Series X or Series Y preferred stock, as the case may be, into
common stock, in which case dividends may be paid, at the sole option of
DSL.net, in shares of DSL.net common stock. Notwithstanding the foregoing,
accrued but unpaid dividends are payable upon the earliest to occur of:
o the liquidation, dissolution, winding up or change in control of
DSL.net,
o the conversion of the Series X or Series Y preferred stock, as the
case may be, into common stock, and
o the redemption of the Series X or Series Y preferred stock, as the
case may be.
Accordingly, we do not anticipate that any cash dividends will be declared or
paid on our common stock in the foreseeable future.
17
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information as of March 18, 2003 with respect
to the shares of the Company's common stock that may be issued under the
Company's existing equity compensation plans:
- ---------------------------- ------------------- ------------------- -----------------------
Column A Column B Column C
- ---------------------------- ------------------- ------------------- -----------------------
Number of securities
Remaining Available for
Future Issuance Under
Number of Securities Equity Compensation
to be Issued Weighted Average Plans (Excluding
upon Exercise of Exercise Price of Securities Reflected
Plan Category Outstanding Options Outstanding Options in Column A)
- ---------------------------- ------------------- ------------------- -----------------------
Equity Compensation Plans
Approved by Shareholders 23,877,004 $0.98 7,439,394
- ---------------------------- ------------------- ------------------- -----------------------
Equity Compensation Plans
Not Approved by Shareholders -- -- --
- ---------------------------- ------------------- ------------------- -----------------------
Total 23,877,004 $0.98 7,439,394
- ---------------------------- =================== =================== =======================
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
We were incorporated on March 3, 1998 and commenced operations on March 28,
1998. The following historical data for the period from inception (March 3,
1998) through December 31, 1998 and the years ended December 31, 1999, 2000,
2001 and 2002, except for "Other Data," has been derived from our financial
statements audited by PricewaterhouseCoopers LLP, independent accountants. Our
balance sheets at December 31, 2001 and 2002 and the related statements of
operations, changes in stockholders' equity and cash flows for the years ended
December 31, 2000, 2001 and 2002 and notes thereto appear elsewhere in this
annual report on Form 10-K.
You should refer to "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the more complete financial
information included elsewhere in this annual report on Form 10-K.
18
PERIOD FROM
INCEPTION
(MARCH 3,
1998) THROUGH YEAR ENDED DECEMBER 31,
DECEMBER 31, ----------------------------------------------------------
1998 1999 2000 2001 2002
--------------------------------------------------------------------------
(in thousands, except per share data)
STATEMENT OF OPERATIONS DATA:
Revenue $ 32 $ 1,313 $ 17,789 $ 41,969 $ 45,530
Operating expenses:
Network
(excluding stock compensation) 95 2,003 31,651 44,589 33,947
Operations
(excluding stock compensation) 26 5,612 31,060 45,614 7,472
General and administrative
(excluding stock compensation) 231 4,782 17,974 25,229 11,403
Sales and marketing
(excluding stock compensation) 36 6,848 25,263 13,188 6,969
Stock compensation 2,423 4,108 3,192 1,202 1,228
Depreciation and amortization 6 1,831 21,133 28,043 20,332
--------------------------------------------------------------------------
Total operating expenses 2,817 25,184 130,273 157,865 81,351
Operating loss (2,785) (23,871) (112,484) (115,896) (35,821)
Interest (expense) income, net (5) 1,889 6,730 455 (458)
Other (expense) income, net -- (6) (9) (13) 185
--------------------------------------------------------------------------
Net loss $ (2,790) $ (21,988) $ (105,763) $ (115,454) $ (36,094)
Exchange of preferred stock -- (11,998) -- -- --
Dividends on preferred stock -- -- -- (122) (3,573)
Accretion of preferred stock -- -- -- (348) (10,078)
--------------------------------------------------------------------------
Net loss applicable to common stockholders $ (2,790) $ (33,986) $ (105,763) $ (115,924) $ (49,745)
==========================================================================
NET LOSS PER COMMON SHARE DATA:
Net Loss per common share, basic and diluted $ (0.55) $ (2.05) $ (1.75) $ (1.81) $ (0.77)
Shares used in computing net loss per share 5,118 16,550 60,593 63,939 64,858
CASH FLOW DATA:
Used in operating activities $ (154) $ (6,343) $ (74,986) $ (62,990) $ (17,706)
Used in investing activities (290) (49,264) (60,225) (2,921) (2,368)
Provided by financing activities 483 121,142 141,960 12,871 12,106
19
PERIOD FROM
INCEPTION
(MARCH 3,
1998) THROUGH YEAR ENDED DECEMBER 31,
DECEMBER 31, ----------------------------------------------------------
1998 1999 2000 2001 2002
--------------------------------------------------------------------------
(in thousands, except per share data)
OTHER DATA:
Reconciliation of net loss to adjusted EBITDA:
Net loss $ (2,790) $ (21,988) $ (105,763) $ (115,454) $ (36,094)
Add: Interest and other expense (income), net 5 (1,883) (6,721) (442) 273
Depreciation and amortization 6 1,831 21,133 28,043 20,332
Stock compensation 2,423 4,108 3,192 1,202 1,228
--------------------------------------------------------------------------
Adjusted EBITDA (A) (356) (17,932) (88,159) (86,651) $ (14,261)
--------------------------------------------------------------------------
Capital expenditures 290 33,811 55,943 5,345 1,647
DECEMBER 31,
--------------------------------------------------------------------------
1998 1999 2000 2001 2002
--------------------------------------------------------------------------
(in thousands)
BALANCE SHEET DATA:
Cash, cash equivalents, restricted
cash and marketable securities $ 39 $ 79,452 $ 76,435 $ 19,631 $ 11,319
Total assets 370 117,632 194,806 81,024 53,496
Long-term obligations (including
current portion) 433 3,056 14,114 7,463 4,565
Mandatorily Redeemable Convertible
Preferred Stock -- -- -- 470 14,122
Stockholders' equity (deficit) $ (316) $ 100,733 $ 149,417 $ 50,725 $ 20,751
(A) Adjusted EBITDA, shown above under "Other Data", consists of net loss
excluding net interest, taxes, depreciation, amortization of intangibles and
non-cash stock compensation expense. The title of this item has been changed
from EBITDA to conform to the SEC's current policy regarding the definition of
EBITDA; however, the components of this item remain unchanged from our prior
reporting of EBITDA. Other companies, however, may calculate Adjusted EBITDA
differently from us. We have provided Adjusted EBITDA because it is a measure of
financial performance commonly used for comparing companies in the
telecommunications industry in terms of operating performance, leverage, and
ability to incur and service debt. Adjusted EBITDA is not a measure determined
under generally accepted accounting principles. Adjusted EBITDA should not be
considered in isolation from, and you should not construe it as a substitute
for:
o operating loss as an indicator of our operating performance,
o cash flows from operating activities as a measure of liquidity,
o other consolidated statement of operations or cash flows data
presented in accordance with generally accepted accounting principles, or
o as a measure of profitability or liquidity.
20
The above financial data includes the operating results of acquisitions
from their acquisition date, which consequently will effect the comparability of
such financial data from year to year.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND
RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH "ITEM 6 - SELECTED
CONSOLIDATED FINANCIAL DATA" AND "ITEM 8 - FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA" THAT APPEAR ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K.
THIS DISCUSSION AND ANALYSIS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE SUCH A
DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE SET FORTH UNDER "RISK FACTORS"
AND ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K. EXISTING AND PROSPECTIVE
INVESTORS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING
STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE HEREOF. WE UNDERTAKE NO OBLIGATION,
AND DISCLAIM ANY OBLIGATION, TO UPDATE OR REVISE THE INFORMATION CONTAINED IN
THIS ANNUAL REPORT ON FORM 10-K, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE
EVENTS OR CIRCUMSTANCES OR OTHERWISE.
OVERVIEW
We provide high-speed data communications, Internet access, and related
services to small and medium sized businesses, primarily using digital
subscriber line, or DSL, technology. We primarily target select second and third
tier cities, as well as some first tier cities, for the deployment of our own
local DSL and T1 equipment. We began offering commercial service in May 1998
and, as of March 15, 2003, we operated equipment in approximately 394 cities. In
certain other markets where we have not deployed our own equipment, we utilize
the local facilities of other carriers to provide service.
We have incurred operating losses and net losses for each month since our
formation. For the years ended December 31, 2000, 2001, and 2002, we experienced
net cash outflows from operating and investing activities. As of December 31,
2001 and 2002, we had accumulated deficits of approximately $248,397,000 and
$284,491,000, respectively.
In an effort to increase revenue from our installed network and conserve
capital, in the fourth quarter of 2000, we decided to suspend the build-out of
additional central offices and focus our efforts on increasing revenue through
targeted marketing to increase penetration in our existing service areas and by
introducing more services. In addition, in order to reduce costs, we (i)
suspended network connections by shutting off the power and communication
connections to approximately 100 central offices, which were not being used to
service customers at the time, (ii) consolidated operating facilities and
vacated certain leased premises and (iii) significantly reduced staff. We also
began actively pursuing opportunities for additional equity financing.
Near the end of the second quarter of 2001, since we still had not received
additional financing and were continuing to incur significant operating losses,
we initiated further cost reduction actions including (i) additional reductions
in force, (ii) closing our Santa Cruz office and vacating unused office space in
our headquarters building and (iii) closing the 100 non-active central offices
(discussed above), together with approximately 250 then active central offices,
21
which required removal of our equipment and vacating the premises. Closure of
the active central offices also required re-routing a number of customers and
ultimately resulted in our losing approximately 840 customers, or approximately
4% of our customer base. We also had another significant staff reduction during
the fourth quarter of 2001.
All of the above-described actions were designed to significantly reduce
operating costs and cash outflows, but necessitated significant restructuring
charges related to: (i) closing of our central offices and resulting asset
write-offs, (ii) costs related to vacated facilities and (iii) severance costs.
In addition, we incurred impairment write-offs of goodwill pertaining to our
Tycho and Trusted Net acquisitions. These restructuring and impairment charges
are more fully discussed below.
In November and December of 2001, we were successful in securing additional
equity financing from existing and new investor groups in accordance with two
purchase agreements which provided for the sale of up to an aggregate of $35
million in Series X and Y mandatorily redeemable convertible preferred stock. In
accordance with those purchase agreements, in November 2001, we sold an
aggregate of 6,000 shares of Series X preferred stock and in December 2001, we
sold an additional 4,000 shares of Series X preferred stock and 6,469 shares of
Series Y preferred stock for gross proceeds of $16,469,000, before direct
issuance costs. In addition, during December 2001, we issued Promissory Notes to
the Series Y Investors in the aggregate principal amount of $3,531,000 in
exchange for proceeds of $3,531,000. The Promissory Notes provided for an annual
interest rate of 12%. In March 2002, in accordance with the terms of the Series
X Purchase Agreement, we sold an additional 10,000 shares of Series X preferred
stock for an aggregate purchase price of $10,000,000. In May 2002, in accordance
with the terms of the Series Y Purchase Agreement, we sold 8,531 additional
shares of Series Y Preferred Stock for net proceeds of $5,000,000 in cash and
delivery of the Promissory Notes for cancellation. In accordance with the terms
of the Series Y Purchase Agreement, all accrued interest on the Promissory
Notes, of approximately $145,000, was forgiven.
In December of 2002, the U.S. Bankruptcy Court for the District of Delaware
approved our bid to purchase network assets and associated subscriber lines of
Network Access Solutions Corporation ("NAS") for $14,000,000, consisting of
$9,000,000 in cash and $5,000,000 in a note payable to NAS. We closed the
transaction on January 10, 2003, whereby we acquired the majority of NAS's
operations and network assets, associated equipment in approximately 300 central
offices and approximately 11,500 associated subscriber lines. The cash portion
of the purchase price was paid from our existing cash. In connection with the
closing of the NAS transaction, on January 10, 2003, we hired approximately 78
former NAS employees. No pre-closing liabilities were assumed with the NAS
transaction. We expect that the acquired NAS assets and operations will have a
significant impact on our future operating results.
In connection with the integration of the NAS business, on January 17,
2003, we had a reduction in force of approximately 35 employees at our
headquarters facility in New Haven, CT. We paid approximately $62,000 in
severance to the terminated employees. Subsequent to the reduction in force, our
headcount approximated 230 employees.
On February 3, 2003, we borrowed $6,100,000 under our Revolving Credit and
Term Loan Agreement (discussed below). The loan bears interest, payable monthly
in arrears at the bank's "base rate" and any unpaid principal balance will
automatically convert to a term loan on December 12, 2004, after which principal
payments (together with accrued interest on the unpaid principal balance) will
be made in 12 equal installments payable at the end of each calendar quarter
commencing on December 31, 2004. Amounts borrowed under the bank credit line are
guaranteed by the principal holders of our Series X and Series Y Preferred
Stock, with whom we have signed a Reimbursement Agreement (discussed below).
22
In addition to our internal sales and marketing efforts, we have grown our
customer base by acquiring end users of other Internet service providers and
companies offering broadband access. We continuously identify and evaluate
acquisition candidates, and in many cases engage in discussions and negotiations
regarding potential acquisitions. Acquisition candidates include both subscriber
lines and whole businesses. Our discussions and negotiations may not result in
an acquisition. Further, if we make any acquisitions, we may not be able to
operate any acquired assets or businesses profitably or otherwise successfully
implement our expansion strategy. We intend to continue to seek additional
opportunities for further acquisitions, which we believe represents a distinct
opportunity to accelerate our growth.
Our independent accountants have noted in their report that our sustained
operating losses raise substantial doubt about our ability to continue as a
going concern. We believe that our existing cash and cash equivalents, cash
expected to be generated from operations, and funds available under our bank
credit agreement, will be sufficient to fund our operating losses, capital
expenditures, lease payments and working capital requirements into the third
quarter of 2003. We intend to use our cash resources to finance our capital
expenditures and for working capital and other general corporate purposes. We
may also use a portion of our cash resources to acquire complementary
businesses, subscriber lines or other assets. The amounts actually expended for
these purposes will vary significantly depending on a number of factors,
including market acceptance of our services, revenue growth, planned capital
expenditures, cash generated from operations, improvements in operating
productivity, the extent and timing of entry into new markets and availability
and prices paid for acquisitions.
Additional financing will be required during 2003. We do not believe that
our operations will generate sufficient cash to finance our requirements. As a
result, we will need to raise additional financing through some combination of
borrowings, leasing, vendor financing and the sale of equity or debt securities.
These capital requirements may vary based upon the timing and the success of
implementation of our business plan or if:
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make acquisitions;
o we alter the schedule or targets of our business plan implementation; or
o we curtail, reorganize, discontinue or shut down our operations.
There can be no assurance that we will be able to raise sufficient
additional debt, equity or other capital on acceptable terms, if at all. If we
are unable to obtain adequate funds, we may not be able to continue to operate
our network, respond to competitive pressures or fund our operations. As a
result, we may be required to significantly reduce, reorganize, discontinue or
shut down our operations. Our financial statements do not include any
adjustments that might result from this uncertainty.
Our financial performance will vary, and when we achieve profitability or
become cash flow positive will depend on a number of factors, including:
o development of the high-speed data communications industry and our
ability to compete effectively;
o amount, timing and pricing of customer revenue;
23
o availability, timing and pricing of acquisition opportunities, and our
ability to capitalize on such opportunities;
o commercial acceptance of our service and attaining expected
penetration within our target markets;
o our ability to recruit and retain qualified personnel;
o up front sales and marketing expenses;
o cost and utilization of our network components which we lease from other
telecommunications providers, including other competitive carriers;
o our ability to establish and maintain relationships with marketing
partners;
o successful implementation and management of financial, information
management and operations support systems to efficiently and
cost-effectively manage our growth; and
o favorable outcome of federal and state regulatory proceedings and
related judicial proceedings, including proceedings relating to the
1996 Telecommunications Act.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RISKS
Financial Reporting Release No. 60, which was released in December 2001, by
the Securities and Exchange Commission (the "SEC"), requires all companies to
include a discussion of critical accounting policies or methods used in the
preparation of financial statements and the estimates and judgments that are
used by management in applying those accounting policies and methods.
In addition, Financial Reporting Release No. 61, which was released in
December 2001 by the SEC, requires all companies to include a discussion to
address, among other things, liquidity, off-balance sheet arrangements,
contractual obligations and commercial commitments.
Management's discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles. The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, including the
recoverability of tangible and intangible assets, disclosure of contingent
assets and liabilities as of the date of the financial statements, and the
reported amounts of revenues and expenses during the reported period. The
markets for our services are characterized by intense competition, rapid
technological development, regulatory and legislative changes, and frequent new
product introductions, all of which could impact the future value of our assets
and liabilities.
We evaluate our estimates on an on-going basis. The most significant
estimates relate to revenue recognition, goodwill and other long-lived assets,
the allowance for doubtful accounts, income taxes, contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ materially from those estimates.
24
The following is a brief discussion of the more significant accounting
policies and methods and the judgments and estimates used by us in their
application.
REVENUE RECOGNITION
We recognize revenue in accordance with SEC Staff Accounting Bulletin No.
101, (SAB NO. 101) "REVENUE RECOGNITION IN FINANCIAL STATEMENTS", which requires
that four basic criteria must be met before revenue can be recognized: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred or
services rendered; (3) the fee is fixed and determinable; and (4) collectibility
is reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which vary based on the speed of the customer's Internet
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of the equipment installed
at the customer's site and the other services we provide, as applicable. Revenue
that is billed in advance of the services provided is deferred until the
services are rendered. Revenue related to installation charges is also deferred
and amortized to revenue over 18 months. Related direct costs incurred (up to
the amount of deferred revenue) are also deferred and amortized to expense over
18 months. Any excess direct costs over installation charges are charged to
expense as incurred. In certain instances, we negotiate credits and allowances
for service related matters. We establish a reserve for such credits based on
historical experience.
We seek to price our services competitively. The market for high-speed data
communications services and Internet access is rapidly evolving and intensely
competitive. While many of our competitors and potential competitors enjoy
competitive advantages over us, we are pursuing a significant market that, we
believe, is currently under-served. Although pricing is an important part of our
strategy, we believe that direct relationships with our customers and
consistent, high quality service and customer support will be key to generating
customer loyalty. During the past several years, market prices for many
telecommunications services and equipment have been declining, a trend that
might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
We account for our long-lived assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, "ACCOUNTING FOR THE IMPAIRMENT
OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF," which
requires that long-lived assets and certain intangible assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable. If undiscounted expected future cash
flows are less than the carrying value of the assets, an impairment loss is to
be recognized based on the fair value of the assets.
Effective January 1, 2002, we adopted SFAS No. 142, "GOODWILL AND OTHER
INTANGIBLE ASSETS". This statement requires that the amortization of goodwill be
discontinued and instead an impairment approach be applied. The impairment tests
were performed during the first and last quarters of 2002 and will be performed
annually hereafter (or more often if adverse events occur) and are based upon a
fair value approach rather than an evaluation of the undiscounted cash flows. If
impairment exists, under SFAS No. 142, the resulting charge is determined by the
recalculation of goodwill through a hypothetical purchase price allocation of
the fair value and reducing the current carrying value to the extent it exceeds
the recalculated goodwill. We did not record any goodwill impairment adjustments
resulting from our impairment reviews during 2002.
25
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result we may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
primarily sell our services directly to end users mainly consisting of small to
medium sized businesses. We believe that we do not have significant exposure or
concentrations of credit risk with respect to any given customer, as no customer
accounted for more than 5% of annual revenues for the years ended December 31,
2000, 2001 or 2002, respectively. However, if the country or any region we
service, experiences an economic downturn, the financial condition of our
customers could be adversely affected, which could result in their inability to
make payments to us. This could require additional provisions for allowances. In
addition, a negative impact on revenue related to those customers may occur.
With the acquisition of the NAS assets on January 10, 2003, we acquired a
number of subscribers, some of whom we service indirectly through various
Internet service providers ("ISP's"). We sell our services to such ISP's who
then resell such services to the end user subscriber. We expect to have some
increased exposure and concentration of credit risk pertaining to such ISP's
during 2003; however, we currently expect that no single customer or ISP will
account for more than 5% of 2003 annual revenues.
INCOME TAXES
We use the liability method of accounting for income taxes, as set forth in
Statement of Financial Accounting Standards No. 109, "ACCOUNTING FOR INCOME
TAXES". Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of temporary differences between the
carrying amounts and the tax basis of assets and liabilities and net operating
loss carryforwards, all calculated using presently enacted tax rates.
We have not generated any taxable income to date and, therefore, have not
paid any federal income taxes since inception. Our state and federal net
operating loss carryforwards begin to expire in 2004 and 2019, respectively. Use
of our net operating loss carryforwards may be subject to significant annual
limitations resulting from a change in control due to our recent sales of Series
X and Series Y preferred stock. We are currently assessing the potential impact
resulting from these transactions. We have provided a valuation allowance for
the full amount of the net deferred tax asset since management has not
determined that these future benefits will more likely than not be realized.
LITIGATION
From time to time, we may be involved in litigation concerning claims
arising in the ordinary course of our business, including claims brought by
former employees and claims related to acquisitions. We record liabilities when
a loss is probable and can be reasonably estimated. These estimates are based on
an analysis made by internal and external legal counsel who consider information
known at the time. We believe we have made reasonable estimates in the past;
however, court decisions could cause liabilities to be incurred in excess of
estimates.
26
RESULTS OF OPERATIONS
The following table depicts our results of operations data and the
components of net loss as a percentage of revenue:
YEAR ENDED DECEMBER 31,
----------------------------------
2000 2001 2002
-------- -------- --------
Revenue 100.0% 100.0% 100.0%
----------------------------------
Operating expenses:
Network
(excluding stock compensation) 177.9% 106.2% 74.6%
Operations
(excluding stock compensation) 174.6% 108.7% 16.4%
General and administrative
(excluding stock compensation) 101.0% 60.1% 25.0%
Sales and marketing
(excluding stock compensation) 142.0% 31.4% 15.3%
Stock compensation 17.9% 2.9% 2.7%
Depreciation and amortization 118.8% 66.8% 44.7%
----------------------------------
Total operating expenses 732.3% 376.1% 178.7%
Operating loss (632.3)% (276.1)% (78.7)%
Interest income (expense), net (1.0)%
37.8% 1.0%
Other (expense) income, net (0.0)% 0.0% 0.4%
----------------------------------
Net loss (594.5)% (275.1)% (79.3)%
==================================
Net loss applicable to common stockholders:
Net loss (594.5)% (275.1)% (79.3)%
Dividends on preferred stock --% (0.3)% (7.8)%
Accretion of preferred stock --% (0.8)% (22.1)%
----------------------------------
Net loss applicable to common stockholders (594.5)% (276.2)% (109.3)%
==================================
27
REVENUE. Revenue is recognized pursuant to the terms of each contract on a
monthly service fee basis, which varies based on the speed of the connection and
the services ordered. The monthly fee includes all phone line charges, Internet
access charges, the cost of the modem installed at the customer's site and the
other services we provide, as applicable. Revenue that is billed in advance of
the services provided is deferred until the services are rendered. Revenue
related to installation charges is deferred and amortized to revenue over 18
months.
Revenue increased from approximately $17,789,000 for the year ended
December 31, 2000 to approximately $41,969,000 and approximately $45,530,000 for
the years ended December 31, 2001 and 2002, respectively. Revenue increased
primarily due to the expansion of our network, the increased number of customers
subscribing for our services and contributions from acquisitions, primarily
Vector Internet Services, Inc. ("VISI"), Tycho Networks, Inc. ("Tycho") and
certain assets and subscriber lines of Exario Networks, Inc. ("Exario") during
2000, certain subscriber lines of Covad Communications, Inc. ("Covad") under
their Safety Net program, and certain subscriber lines of Zyan Communications,
Inc. ("Zyan") during 2001 and certain subscriber lines of Broadslate Networks,
Inc. ("Broadslate") and Abacus America, Inc. ("Abacus") during 2002. The revenue
attributable to contributions from acquired businesses was approximately
$6,263,000, $5,326,000 and $2,069,000 for the years ended December 31, 2000,
2001 and 2002, respectively. We expect revenue to increase in 2003 as a result
of our acquisition of the NAS assets and associated subscriber lines, and as we
continue our sales and marketing efforts in our new expanded service areas,
introduce additional services and, possibly, acquire additional businesses
and/or subscriber lines.
NETWORK EXPENSES. Our network expenses include costs related to network
engineering and network operations personnel, costs for telecommunications lines
between customers, central offices, network service providers and our network,
costs for rent and power at our central offices, costs to connect to the
Internet, costs of customer line installations and the costs of customer premise
equipment when sold to our customers. We expect our network expenses, including
costs for subscriber lines, to increase as a result of our acquisition of the
NAS assets and associated subscriber lines and as we add customers. We lease
high-speed lines and other network capacity to connect our central office
equipment and our network. In addition, costs incurred to connect to the
Internet are expected to increase as the volume of data communications traffic
generated by our customers increases.
Network expenses increased from approximately $31,651,000 for the year
ended December 31, 2000 to approximately $44,589,000 for the year ended December
31, 2001, and then decreased to approximately $33,948,000 for the year ended
December 31, 2002. The increase in network expenses between 2000 and 2001 was
primarily due to increased telecommunication expenses of approximately
$14,689,000, due to the expansion of our network during 2000 and the increased
number of customers subscribing for our services during 2000 and 2001, which
were partially offset by reductions of approximately $776,000 in salaries and
benefits due to reductions in force, reductions of approximately $593,000 in
professional and consulting services, and reductions of approximately $382,000
in travel and entertainment, recruiting costs, equipment and other expenses,
resulting from our cost reduction initiatives. Reductions during 2002 were
primarily attributable to decreased telecommunications expenses resulting from
our restructuring and cost containment efforts during 2001 (see restructuring
and impairment charges).
OPERATIONS EXPENSES. Our operations expenses include costs related to
customer care, customer provisioning, customer billing, customer technical
assistance, purchasing, headquarters facilities operations, operating systems
maintenance and support and other related overhead expenses. We expect our
operations expenses to increase in 2003 as a result of our acquisition of the
NAS assets and associated subscriber lines.
28
Operations expenses increased from approximately $31,060,000 for the year
ended December 31, 2000 to approximately $45,614,000 for the year ended December
31, 2001, and then decreased to approximately $7,472,000 for the year ended
December 31, 2002. The increase in operations expenses between 2000 and 2001 was
primarily due to increases in restructuring charges (explained below) of
approximately $29,287,000 which were partially offset by reductions of
approximately $4,219,000 in salaries and benefits due to reductions in force,
reductions of approximately $6,583,000 in professional and consulting services,
reductions of approximately $984,000 in taxes and reductions of approximately
$2,947,000 in travel and entertainment, recruiting costs and other expenses due
to our cost containment efforts. Reductions during 2002 were primarily
attributable to decreased expenses resulting from our cost containment efforts
during 2001. These included reductions in restructuring charges of approximately
$31,528,000, reductions of approximately $3,739,000 in salaries and benefits,
reductions of approximately $1,440,000 in professional and consulting services,
reductions of approximately $953,000 in equipment costs and reductions of
approximately $482,000 in travel and entertainment and other expenses due to our
cost containment efforts.
GENERAL AND ADMINISTRATIVE. Our general and administrative expenses consist
primarily of costs relating to human resources, finance, executive,
administrative services, recruiting, insurance, legal and auditing services,
leased office facilities rent and bad debt expenses. We expect our general and
administrative expenses to increase in 2003 as a result of our acquisition of
the NAS assets and associated subscriber lines.
General and administrative expenses increased from approximately
$17,974,000 for the year ended December 31, 2000 to approximately $25,230,000
for the year ended December 31, 2001, and then decreased to approximately
$11,403,000 for the year ended December 31, 2002. The increase from 2000 to 2001
was primarily attributable to increases of approximately $5,880,000 in
restructuring and impairment charges (discussed below) and approximately
$2,289,000 in bad debt expenses, which was partially offset by reductions of
approximately $913,000 in facilities costs, professional and consulting
services, recruiting costs and other expenses resulting from our cost reduction
initiatives. The increase in bad debt expenses was primarily due to (i) a
significant increase in customers and associated revenue, (ii) increased
write-offs associated with customer line acquisitions and (iii) increased loss
of customers due to our closure of approximately 350 central offices and various
brief outages and service interruptions in the latter part of 2001, including
service interruptions associated with the aftermath of the September 11th
events. Reductions during 2002 in general and administrative expenses were
primarily due to decreases resulting from our restructuring and cost containment
efforts during 2001 and included reductions in restructuring and impairment
charges of approximately $6,998,000, professional fees of approximately
$1,897,000, salaries and benefits of approximately $2,000,000, sales, use,
property and other taxes of approximately $1,955,000 (as further discussed
below), bad debt expense of approximately $542,000 and other expenses of
approximately $755,000. These reductions were partially offset by increased
insurance costs of approximately $320,000.
In March 2002, we filed an application with the Connecticut Department of
Revenue Services for research and development expenditure credits for the 1999
and 2000 calendar years. The credits were approved as a reduction against our
corporation business tax. With regard to credits approved for the 2000 calendar
year, we were entitled to elect a cash refund at 65 percent of the approved
credit. We elected to receive the 2000 calendar year credit as a cash refund of
approximately $1,301,000. The 1999 calendar year credit of approximately
$671,000 is available as a carryforward offset to future State of Connecticut
business taxes. In July of 2002, we received the first installment of the cash
refund pertaining to the 2000 calendar year of approximately $1,000,000, with
the $301,000 balance payable in two equal installments in July 2003 and 2004.
Upon receipt of the research and development credits, we were obligated to pay
approximately $402,000 to a professional service provider as a result of a
29
contingent fee arrangement for professional services in connection with
obtaining such credits. For the year ended December 31, 2002, we recorded the
$1,000,000 refund as a reduction in our state corporate franchise tax expenses
which are included in general and administrative expenses, and the $402,000
contingent fee as professional services expenses, also included in general and
administrative expenses.
SALES AND MARKETING. Our sales and marketing expenses consist primarily of
expenses for personnel, the development of our brand name, promotional
materials, direct mail advertising and sales commissions and incentives. We
expect our sales and marketing expenses to increase in 2003 as a result of our
acquisition of the NAS assets and associated subscriber lines.
Sales and marketing expenses decreased from approximately $25,263,000 for
the year ended December 31, 2000, to approximately $13,188,000 and approximately
$6,969,000 for the years ended December 31, 2001 and 2002, respectively.
Reductions during 2001 were primarily due to approximately $3,926,000 in lower
salaries and benefits due to reductions in force, approximately $3,183,000 in
lower marketing and advertising costs, approximately $2,928,000 in lower
professional and consulting services costs, approximately $881,000 in lower
travel and entertainment costs, approximately $668,000 in lower recruiting costs
and approximately $489,000 in lower office and other expenses. The decrease in
sales and marketing expenses during 2002 was primarily due to decreased costs
that resulted from our restructuring and cost containment efforts during 2001,
including reductions in advertising and direct mail marketing expenses of
approximately $2,414,000, salaries and benefits of approximately $1,880,000,
professional and consulting services of approximately $1,752,000 and other
expenses of approximately $173,000.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization is primarily
attributable to the following: (i) depreciation of network and operations
equipment and Company-owned modems and routers installed at customer sites, (ii)
depreciation of information systems and computer hardware and software, (iii)
amortization and depreciation of the costs of obtaining, designing and building
our collocation space and corporate facilities and (iv) amortization of
intangible capitalized costs pertaining to acquired businesses and customer line
acquisitions. We expect our depreciation and amortization expenses to increase
in 2003 as a result of our acquisition of the NAS network assets and associated
subscriber lines.
Depreciation and amortization expenses were approximately $21,133,000,
$28,043,000 and $20,332,000 for the years ended December 31, 2000, 2001 and
2002, respectively. Increases in such expenses during 2001 primarily resulted
from the significant expansion of our network and infrastructure and acquired
businesses during 2000, partially offset by reduced depreciation and
amortization in 2001 from assets written off due to our restructuring and
impairment provisions (discussed below). The decrease in depreciation and
amortization expenses during 2002 primarily resulted from restructuring
write-offs of central office equipment and impairment write-offs of intangible
assets taken during 2001.
During December 2000 and calendar year 2001, we wrote-off approximately
$31.0 million of network equipment and other capitalized costs as part of our
restructuring efforts, and incurred approximately $4.0 million in impairment
charges pertaining to goodwill of acquired companies (see restructuring and
impairment charges).
Also, in accordance with SFAS No. 142 (see Recently Issued Accounting
Pronouncements, discussed below), we discontinued amortization of goodwill
beginning January 1, 2002, and completed an impairment review during the first
and last quarters of 2002. We did not record any impairment adjustments
resulting from these impairment reviews and will continue to make annual
reviews, unless a change in circumstances requires a review in the interim.
Consequently, amortization expense related to our goodwill was approximately
$2,484,000 higher for the year ended December 31, 2001 than for the year ended
December 31, 2002.
30
Depreciation expense pertaining to assets for our network and operations
was approximately $15,119,000, $18,132,000 and $13,719,000 for the years ended
December 31, 2000, 2001 and 2002, respectively. Depreciation and amortization
expenses pertaining to assets related to general and administrative expenses was
approximately $6,014,000, $9,911,000 and $6,613,000 for the years ended December
31, 2000, 2001 and 2002, respectively.
STOCK COMPENSATION. We incurred non-cash stock compensation expenses as a
result of the granting of stock and stock options to employees, directors and
members of our former board of advisors with exercise prices per share
subsequently determined to be below the fair values per share of our common
stock for financial reporting purposes at the dates of grant. The stock
compensation, if vested, was charged immediately to expense, while non-vested
compensation is being amortized over the vesting period of the applicable
options or stock, which is generally 48 months. Unvested options for terminated
employees are cancelled and the value of such options are recorded as a
reduction of deferred compensation with an offset to additional paid-in-capital.
In addition, in fiscal 2000, we recorded $870,000 of non-cash compensation
expense relating to the vesting of stock options held by members of our former
advisory board.
Non-cash stock compensation expenses were approximately $3,192,000,
$1,202,000 and $1,228,000 for the years ended December 31, 2000, 2001 and 2002,
respectively. The unamortized balance as of December 31, 2001 and 2002, of
approximately $1,668,000 and $438,000, respectively, is being amortized over the
remaining vesting period of each grant, and is expected to be fully amortized by
June 30, 2003.
As of December 31, 2001 and 2002, options to purchase 13,877,394 and
23,877,004 shares of common stock, respectively, were outstanding, which were
exercisable at weighted average exercise prices of $1.69 and $0.98 per share,
respectively.
INTEREST INCOME (EXPENSE), NET. For the year ended December 31, 2000, net
interest income of approximately $6,730,000 included $8,538,000 of interest
income partially offset by $1,808,000 of interest expense. Net interest income
of approximately $455,000 for the year ended December 31, 2001 included
$1,718,000 of interest income, partially offset by $1,263,000 of interest
expense. For the year ended December 31, 2002, net interest expense of
approximately $458,000 included approximately $790,000 in interest expense,
partially offset by $332,000 in interest income. The decrease in interest income
in 2001 and 2002 was caused by lower interest rates on significantly lower cash
and investment balances. Lower interest expense in 2001 and 2002 was caused by
reductions in debt and capital lease obligations. We expect interest expense to
increase in 2003 due to our incurrence of increased debt associated with the
acquisition of the NAS assets and associated subscriber lines, and borrowings
under our bank credit line.
RESTRUCTURING AND IMPAIRMENT CHARGES. In December 2000, we initiated a new
business plan strategy designed to conserve our capital, reduce our losses and
extend our cash resources. This strategy included the following actions: (i)
further network expansion was curtailed; (ii) network connections to 100 central
offices were suspended; (iii) certain facilities were vacated and consolidated;
(iv) operating expenses were reduced; and (v) headcount was reduced by
approximately 140 employees. These actions resulted in a restructuring charge of
approximately $3,542,000. The components of the restructuring charge were: (i)
approximately $448,000 relating to severence expense for the 140 employees; (ii)
approximately $1,078,000 for estimated costs resulting from the consolidation of
our office facilities by vacating office space located in Milford, Connecticut,
Santa Cruz, California, Atlanta, Georgia and Chantilly, Virginia, and (iii)
approximat