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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 000-27525
DSL.NET, INC.
(Exact name of registrant as specified in its charter)
Delaware 06-1510312
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
545 Long Wharf Drive
New Haven, Connecticut 06511
(Address of principal executive offices) (Zip Code)
(203) 772-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [ ] No [X]
As of November 7, 2003 the registrant had 95,179,736 shares of Common Stock
outstanding.
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DSL.NET, INC.
INDEX
Page
Number
------
Part I - Financial Information
Item 1. Consolidated Financial Statements ...................................2
Consolidated Balance Sheets (unaudited) at December 31, 2002
and September 30, 2003...........................................2
Consolidated Statements of Operations (unaudited) for the
three and nine months ended September 30, 2002 and 2003..........3
Consolidated Statements of Cash Flows (unaudited)
for the nine months ended September 30, 2002 and 2003............4
Notes to Consolidated Financial Statements.........................5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................23
Item 3. Quantitative and Qualitative Disclosures about Market Risk..........41
Item 4. Controls and Procedures.............................................41
Part II - Other Information
Item 2. Change in Securities and Use of Proceeds............................41
Item 4. Submission of Matters to a Vote of Security Holders.................45
Item 6. Exhibits and Reports on Form 8-K....................................48
Signature...................................................................50
Exhibit Index...............................................................51
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
DSL.net, Inc.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
(unaudited)
December 31, September 30,
2002 2003
---------- ----------
ASSETS
Current assets:
Cash and cash equivalents $ 11,318 $ 21,082
Restricted cash 1 4
Accounts receivable (net of allowances of $606 and $1,016
at December 31, 2002 and September 30, 2003, respectively) 4,358 8,038
Inventory 707 558
Deferred costs 615 862
Prepaid expenses and other current assets 726 921
---------- ----------
Total current assets 17,725 31,465
Fixed assets, net 23,066 27,387
Goodwill and other intangible assets 10,656 9,795
Other assets 2,049 1,287
---------- ----------
Total assets $ 53,496 $ 69,934
========== ==========
LIABILITIES, MANDATORILY REDEEMABLE, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,621 $ 3,615
Accrued salaries 1,225 1,346
Accrued liabilities 4,621 11,041
Deferred revenue 3,591 5,982
Current portion of capital leases payable 2,676 110
---------- ----------
Total current liabilities 16,734 22,094
Capital leases payable 1,889 76
Notes payable, net of discount (Note 7) -- 4,519
---------- ----------
Total liabilities 18,623 26,689
---------- ----------
Commitments and contingencies (Note 8)
Preferred stock: 20,000,000 preferred shares authorized (Note 9)
20,000 shares designated as Series X, mandatorily redeemable, convertible
preferred stock, $.001 par value; 20,000 and 20,000 shares issued and outstanding
as of December 31, 2002 and September 30, 2003, respectively (liquidation preference
$22,315 and $24,115 as of December 31, 2002 and September 30, 2003, respectively). 8,741 14,877
15,000 shares designated as Series Y, mandatorily redeemable, convertible
preferred stock, $.001 par value; 15,000 and 5,050 shares issued and outstanding
as of December 31, 2002 and September 30, 2003, respectively (liquidation preference
$16,380 and $5,982 as of December 31, 2002 and September 30, 2003, respectively). 5,381 3,171
Stockholders' equity (Notes 3 and 9)
Common stock, $.0005 par value; 400,000,000 and 400,000,000 shares authorized;
64,929,899 and 95,179,736 shares issued and outstanding 32 48
Additional paid-in capital 305,647 336,694
Deferred compensation (437) --
Accumulated deficit (284,491) (311,545)
---------- ----------
Total stockholders' equity 20,751 25,197
---------- ----------
Total liabilities, preferred stock and stockholders' equity $ 53,496 $ 69,934
========== ==========
The accompanying notes are an integral part of these
consolidated financial statements.
2
DSL.net, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- -----------------------------
2002 2003 2002 2003
------------ ------------ ------------ ------------
Revenue, net $ 11,262 $ 18,227 $ 34,239 $ 53,089
------------ ------------ ------------ ------------
Operating expenses:
Network (excluding $7, $0, $22 and $11
of stock compensation, respectively) 8,079 13,070 25,157 38,412
Operations (excluding $12, $0, $41 and $10
of stock compensation, respectively) 1,966 3,060 6,071 8,935
General and administrative (excluding $58, $0, $226 and $69
of stock compensation, respectively) 2,305 2,618 9,081 8,891
Sales and marketing (excluding $218, $0, $648 and $348
of stock compensation, respectively) 1,870 2,116 4,644 6,238
Stock compensation 295 -- 937 438
Depreciation and amortization 5,138 3,319 15,526 12,654
------------ ------------ ------------ ------------
Total operating expenses $ 19,653 $ 24,183 $ 61,416 $ 75,568
------------ ------------ ------------ ------------
Operating loss $ (8,391) $ (5,956) $ (27,177) $ (22,479)
Interest expense, net (70) (728) (306) (2,139)
Other income (expense), net 2 (2,427) 177 (2,436)
------------ ------------ ------------ ------------
Net loss $ (8,459) $ (9,111) $ (27,306) $ (27,054)
============ ============ ============ ============
Net loss applicable to common stockholders:
Net loss (8,459) (9,111) (27,306) (27,054)
Dividends on preferred stock (1,050) (1,045) (2,523) (3,145)
Accretion of preferred stock, net of issuance costs (3,011) (1,779) (7,068) (7,800)
------------ ------------ ------------ ------------
Net loss applicable to common stockholders $ (12,520) $ (11,935) $ (36,897) $ (37,999)
============ ============ ============ ============
Net loss per share, basic and diluted $ (0.19) $ (0.17) $ (0.57) $ (0.57)
============ ============ ============ ============
Shares used in computing net loss per share, basic and diluted 64,887,681 70,161,057 64,833,595 66,726,872
============ ============ ============ ============
The accompanying notes are an integral part of these
consolidated financial statements.
3
DSL.net, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands, except per share data)
(unaudited)
Nine Months Ended
September 30,
-----------------------------
2002 2003
------------ ------------
Cash flows from operating activities:
Net loss $ (27,306) $ (27,054)
Reconciliation of net loss to net cash provided by (used in)
operating activities:
Depreciation and amortization 15,526 12,654
Bad debt expense 1,979 1,739
Sales credits and allowances 1,094 339
Amortization of deferred debt issuance costs and debt discount 9 7,165
Stock compensation expense 937 438
Loss on sale/write-off of fixed assets 356 134
Gain on note settlement -- (3,500)
Non-cash interest on lease payoff -- 194
Net changes in assets and liabilities, net of acquired assets:
(Increase) in accounts receivable (1,924) (5,692)
Decrease / (increase) in prepaid and other current assets 608 (293)
(Increase) / decrease in other assets (345) 762
(Decrease) in accounts payable (266) (1,006)
(Decrease) / increase in accrued salaries (41) 121
(Decrease) / increase in accrued expenses (3,972) 5,717
(Decrease) / increase in deferred revenue (274) 1,307
------------ ------------
Net cash used in operating activities (13,619) (6,975)
------------ ------------
Cash flows from investing activities:
Purchases of property and equipment (1,328) (1,840)
Proceeds from sales of property and equipment 85 --
Acquisitions of businesses and customer lines (1,150) (8,743)
Decrease / (increase) in restricted cash 63 (3)
------------ ------------
Net cash used in investing activities (2,330) (10,586)
------------ ------------
Cash flows from financing activities:
Proceeds from credit facility -- 6,100
Proceeds from common stock issuance 14 2,270
Proceeds from preferred stock issuance 15,000 --
Proceeds from note issuances -- 30,000
Payments on credit facility -- (6,100)
Principal payments under notes and capital lease obligations (2,224) (4,945)
------------ ------------
Net cash provided by financing activities 12,790 27,325
------------ ------------
Net increase / (decrease) in cash and cash equivalents (3,159) 9,764
Cash and cash equivalents at beginning of period 19,285 11,318
------------ ------------
Cash and cash equivalents at end of period $ 16,126 $ 21,082
============ ============
Supplemental disclosure of non-cash investing activities:
On January 10, 2003, the Company purchased network assets and associated
subscriber lines of Network Access Solutions Corporation (Note 5)
The fair value of the assets acquired was $14,750
On September 8, 2003, the Company purchased network assets and associated
subscriber lines of TalkingNets Holdings, LLC (Note 5)
The fair value of the assets acquired was $796
The accompanying notes are an integral part of these
consolidated financial statements.
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. Summary of Significant Accounting Policies
A. Basis of Presentation
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 the Company's (as defined below) 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 the Company's assets and liabilities. Actual results may differ
from those estimates. Certain prior period amounts have been reclassified to
conform to the 2003 presentation. The consolidated financial statements
("financial statements") at September 30, 2003 and for the three and nine months
ended September 30, 2002 and 2003 are unaudited, but in the opinion of
management, include all adjustments (consisting only of normal recurring
adjustments) that DSL.net, Inc. ("DSL.net" or the "Company") considers necessary
for a fair presentation of its financial position and operating results.
Operating results for the three and nine months ended September 30, 2003 are not
necessarily indicative of results that may be expected for any future periods.
The Company evaluates its 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. Such estimates are based 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.
The Company believes the following critical accounting policies affect the
Company's more significant judgments and estimates used in the preparation of
its consolidated financial statements:
REVENUE RECOGNITION
The Company recognizes 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 have been 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 varies based on the speed of the customer's broadband
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of any leased equipment
installed at the customer's site and the other services, as applicable. Revenue
that is billed in advance of the services provided is deferred until the
services are provided by the
5
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Company. 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, the Company negotiates credits and allowances
for service related matters. The Company establishes a reserve against revenue
for such credits based on historical experience.
The Company seeks to price its services competitively. The market for
high-speed data communications services and Internet access is rapidly evolving
and intensely competitive. While many competitors and potential competitors may
enjoy competitive advantages over the Company, it is pursuing a significant
market that, it believes, is currently under-served. Although pricing is an
important part of the Company's strategy, management believes that direct
relationships with 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, which is a trend that might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
The Company accounts for its 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, the Company adopted SFAS No. 142, "GOODWILL AND
OTHER INTANGIBLE ASSETS" ("SFAS 142"). This statement requires that the
amortization of goodwill be discontinued and instead an impairment approach be
applied. The impairment tests were performed during January and December of 2002
and will be performed annually thereafter (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 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. The Company did not
record any goodwill impairment adjustments resulting from its impairment reviews
during 2002.
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 the Company may be required to recognize impairment charges.
6
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company maintains an allowance for doubtful accounts for estimated
losses resulting from the inability of its customers to make required payments.
The Company principally sells its services directly to end users mainly
consisting of small to medium sized businesses, as opposed to selling to
Internet service providers ("ISPs") who then resell such services. The Company
believes that it does not have significant exposure or concentrations of credit
risk with respect to any given customer. However, if the country or any region
the Company services experiences an economic downturn, the financial condition
of the Company's customers could be adversely affected, which could result in
their inability to make payments to the Company. This could require additional
provisions for allowances. In addition, a negative impact on revenue related to
those customers may occur.
With its acquisition of certain of the assets of Network Access Solutions
Corporation ("NAS") on January 10, 2003, the Company acquired a number of end
users, some of whom it serves indirectly through various ISPs. The Company sells
its services to such ISPs who then resell such services to the end user. The
Company has some increased exposure and concentration of credit risk pertaining
to such ISPs. However, no individual customer accounted for more than 5% of
revenue for the first nine months of 2003.
INCOME TAX
The Company uses the liability method of accounting for income taxes, as
set forth in SFAS 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.
The Company has not generated any taxable income to date and, therefore,
has not paid any federal income taxes or state taxes based on income since
inception. The Company's state and federal net operating loss carryforwards
begin to expire in 2004 and 2019, respectively. Use of the Company's net
operating loss carryforwards may be subject to significant annual limitations
resulting from a change in control due to the Company's sales of Series X
preferred stock (the "Series X Preferred Stock") and Series Y preferred stock
(the "Series Y Preferred Stock") in 2001 and 2002 (Note 9) and from the sale of
$30,000 in notes and warrants in 2003 (Note 7). The Company is currently
assessing the potential impact resulting from these transactions. The Company
has provided a valuation allowance for the full amount of the net deferred tax
asset since it has not determined that these future benefits will more likely
than not be realized.
LITIGATION
From time to time, the Company may be involved in litigation concerning
claims arising in the ordinary course of its business, including claims brought
by former employees and claims related to acquisitions. The Company records
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on analyses made by internal and external legal counsel who
consider information known at the time. The Company believes it has made
reasonable estimates in the past; however, court decisions and other factors
could cause liabilities to be incurred in excess of estimates.
7
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying unaudited interim financial statements have been prepared
with the assumption that users of the interim financial information have either
read or have access to the Company's financial statements for the year ended
December 31, 2002. Accordingly, footnote disclosures that would substantially
duplicate the disclosures contained in the Company's December 31, 2002 audited
financial statements have been omitted from these unaudited interim financial
statements. These financial statements have been prepared in accordance with the
instructions to Form 10-Q and the rules and regulations of the Securities and
Exchange Commission ("SEC"). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
instructions, rules and regulations. While management believes the disclosures
presented are adequate to make these financial statements not misleading, these
financial statements should be read in conjunction with the Company's audited
financial statements and related notes included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002, and with the Company's
unaudited interim financial statements and related notes filed on Forms 10-Q for
the quarterly periods ending March 31, 2003 and June 30, 2003, which have been
filed with the SEC.
B. Earnings (Loss) Per Share
Basic earnings (loss) per share is computed by dividing income or loss
applicable to common stockholders by the weighted average number of shares of
the Company's common stock outstanding during the period, excluding shares
subject to repurchase.
Diluted earnings per share is determined in the same manner as basic
earnings per share except that the number of shares is increased assuming
exercise of dilutive stock options and warrants using the treasury stock method
and dilutive conversion of the Company's outstanding preferred stock. The
diluted earnings per share amount is presented herein as the same as the basic
earnings per share amount because the Company had a net loss during each period
presented, and the impact of the assumed exercise of stock options and warrants
and the assumed conversion of preferred stock would have been anti-dilutive.
As of December 31, 2002, the Company had 64,929,899 shares of common stock
issued and outstanding. As of September 30, 2003, the Company had 95,179,736
shares of common stock issued and outstanding. The increase of 30,249,837 shares
primarily resulted from common stock issued during the third quarter of 2003
(primarily in September, 2003) for preferred stock conversions and for employee
stock option exercises (Note 3). The weighted average number of outstanding
common shares used in computing earnings per share for the three months ended
September 30, 2002 and 2003 was 64,887,681 and 70,161,057, respectively. The
weighted average number of outstanding common shares used in computing earnings
per share for the nine months ended September 30, 2002 and 2003 was 64,833,595
and 66,726,872, respectively.
C. Incentive Stock Award Plans
As of September 30, 2003, the Company had five stock-based employee
compensation plans, which are described more fully in the Company's audited
financial statements and related notes included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002. The Company accounts for
stock-based compensation under the intrinsic value method in accordance with
Accounting Principles Board Opinion No. 25, "ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES" ("APB 25"). Accordingly, compensation expense is not recognized when
options are granted at the fair market value on the date of grant.
8
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company has elected to continue following APB 25 to account for its
stock-based compensation plans. The following table presents the effect on the
Company's net loss and net loss per share as if the Company had applied the fair
value method of accounting for stock-based compensation in accordance with SFAS
No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION" ("SFAS 123"):
Three Months Ended Nine Months Ended
September 30, September30,
2002 2003 2002 2003
-------- -------- -------- --------
Net loss, as reported ($8,459) ($9,111) ($27,306) ($27,054)
Deduct: total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (1,383) (899) (3,905) (3,697)
-------- -------- -------- --------
Pro forma under SFAS 123 ($9,842) ($10,010) ($31,211) ($30,751)
Net loss applicable to common stockholders:
As reported ($12,520) ($11,935) ($36,897) ($37,999)
Pro forma under SFAS 123 ($13,903) ($12,834) ($40,802) ($41,696)
Basic and diluted net loss per common share:
As reported ($0.19) ($0.17) ($0.57) ($0.57)
Pro forma under SFAS 123 ($0.21) ($0.18) ($0.63) ($0.62)
The estimated fair value at date of grant for options granted during the
three and nine months ended September 30, 2002 ranged from $0.25 to $0.94 per
share. The estimated fair value at date of grant for options granted during the
three and nine months ended September 30, 2003 ranged from $0.43 to $0.58 per
share. The minimum value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted average
assumptions:
Three Months Ended Nine Months Ended
------------------ ------------------
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
Risk free interest rate 2.97-3.50% 2.15-3.06% 2.97-4.42% 2.15-3.06%
Expected dividend yield None None None None
Expected life of option 4 Years 4 Years 4 Years 4 Years
Expected volatility 138% 152% 138% 152%
9
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
As additional options are expected to be granted in future periods, and
the options vest over several years, the above pro forma results are not
necessarily indicative of future pro forma results.
D. Recently Issued Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 146, "ACCOUNTING FOR EXIT OR DISPOSAL ACTIVITIES" ("SFAS 146"). SFAS
146 addresses the accounting for costs to terminate a contract that is not a
capital lease, costs to consolidate facilities and relocate employees, and
involuntary termination benefits under one-time benefit arrangements that are
not an ongoing benefit program or an individual deferred compensation contract.
The provisions of the statement are effective for disposal activities initiated
after December 31, 2002. The adoption of this statement did not have a material
affect on the Company's financial position or results of operations.
In December 2002, SFAS No. 148, "ACCOUNTING FOR STOCK-BASED COMPENSATION -
TRANSITION AND DISCLOSURE - AN AMENDMENT OF SFAS NO. 123" ("SFAS 148") was
issued. SFAS 148 amends SFAS 123 to provide alternative methods of transition
for a voluntary change to the fair value based method of accounting for
stock-based employee compensation. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. As
provided for in SFAS 148, the Company has elected not to transition to the fair
value based method of accounting for stock based employee compensation; it has,
however, adopted the amended disclosure requirements provided under SFAS 148 and
incorporated those requirements into its financial statements included in this
Form 10-Q under the heading "Incentive Stock Award Plans".
In November 2002, FASB issued Interpretation No. 45, "GUARANTOR'S
ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT
GUARANTEES OF INDEBTEDNESS OF OTHERS," ("FIN 45"). FIN 45 expands previously
issued accounting guidance and disclosure requirements for certain guarantees.
FIN 45 requires an entity to recognize an initial liability for the fair value
of an obligation assumed by issuing a guarantee. The disclosure requirements of
FIN 45 are effective for all financial statements issued after December 15,
2002. The provision for initial recognition and measurement of the liability
will be applied on a prospective basis to guarantees issued or modified after
December 31, 2002. The adoption of FIN 45 did not have a material affect on the
Company's financial position or results of operations.
In May 2003, FASB issued SFAS No. 150, "ACCOUNTING FOR CERTAIN FINANCIAL
INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY" ("SFAS 150").
SFAS 150 establishes standards for the classification and measurement of certain
financial instruments with characteristics of both liabilities and equity. The
changes are intended to result in a more complete depiction of an entity's
liabilities and equity and will, thereby, assist investors and creditors in
assessing the amount, timing, and likelihood of potential future cash outflows
and equity share issuances. This statement also requires that certain
obligations that could be settled by issuance of an entity's equity but lack
other characteristics of equity be reported as liabilities even though the
obligation does not meet the definition of a liability. The requirements of SFAS
150 became effective for the Company for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. SFAS 150 is to be
implemented by reporting the cumulative effect of a change in an accounting
principle for financial instruments created before the issuance date of the
statement and still existing at the beginning of the interim period of adoption.
The Company has evaluated the impact of SFAS 150 to determine the effect it
10
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
may have on its consolidated results of operations or financial position and has
concluded that the adoption of this statement is not expected to have a material
affect on the Company's financial position or results of operations.
2. Liquidity
As reflected in the Company's audited financial statements and related
notes included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002, the Company incurred operating losses of approximately
$35,821 and negative operating cash flows of approximately $17,706 during the
year ended December 31, 2002. During the nine months ended September 30, 2003,
the Company incurred operating losses of approximately $22,479 and negative
operating cash flows of approximately $6,975. These operating losses and
negative operating cash flows have been financed primarily by proceeds from
equity and note issuances. The Company had accumulated deficits of approximately
$284,491 at December 31, 2002 and approximately $311,545 at September 30, 2003.
The Company expects its operating losses, net operating cash outflows and
capital expenditures to continue through 2003 and into 2004. The Company
successfully completed rounds of private equity and bridge loan financings
totaling approximately $35,000 as follows: approximately $20,000 in the fourth
quarter of 2001, $10,000 in March 2002 and $8,531 in May 2002 (which, after
cancellation of certain bridge loans, yielded net proceeds of approximately
$5,000) (Note 9). In addition, on July 18, 2003, the Company successfully raised
approximately $30,000 in additional financing (Note 7). The Company believes
that its existing cash and cash equivalents and cash expected to be generated
from operations will be sufficient to fund its operating losses, capital
expenditures and working capital requirements through at least the end of 2004,
based on its current business plans and projections. The Company intends to use
these cash resources to finance its capital expenditures and for working capital
and other general corporate purposes. The Company may also use a portion of
these 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
the Company's 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. Failure to generate sufficient revenues, contain certain
discretionary spending or achieve certain other business plan objectives could
have a material adverse affect on the Company's results of operations and
financial position.
3. Stockholders' Equity
During the second quarter of 2003, the Company's remaining unamortized
deferred compensation balance relating to stock options and restricted stock
held by employees and directors became fully amortized. Consequently, there was
no remaining unamortized deferred compensation balance as of September 30, 2003.
During the three months ended September 30, 2003, the Company issued
22,473,078 and 2,445,895 shares of its common stock, respectively, upon the
conversion of 9,950 shares of Series Y Preferred Stock and as payment for
approximately $1,793 of accrued dividends on such converted shares of Series Y
Preferred Stock (Note 9). The Company also issued 4,946,384 and 5,315,484 shares
of common stock, respectively, upon exercises of stock options during the three
and nine months ended September 30, 2003. In addition, the Company issued 7,380
and 15,380 shares of
11
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
common stock, respectively, during the three and nine months ended September 30,
2003 to employees participating in the Company's 1999 Employee Stock Purchase
Plan.
4. Restructuring
During the third quarter of 2003, the Company charged approximately $443
against its restructuring reserves. Of this amount, approximately $315 related
to payment of certain termination fees associated with the closure of certain
central offices during 2001, and approximately $128 related to facilities
expense associated with the Company's vacated offices.
The Company's restructuring reserve balance as of September 30, 2003, of
approximately $422, was included in the Company's accrued liabilities and
represents previously reserved amounts associated with real estate charges for
anticipated costs pertaining to its vacated facilities.
5. Acquisitions
During the quarter ended March 31, 2002, the Company entered into an Asset
Purchase Agreement, dated as of January 1, 2002, with Broadslate Networks, Inc.
("Broadslate") for the purchase of business broadband customer accounts and
certain other assets, including certain accounts receivable related to the
customer accounts. The initial purchase price of $800 was subject to certain
adjustments, which resulted in a $50 reduction in the purchase price. The
Broadslate customer line acquisitions were accounted for under the purchase
method of accounting and, accordingly, the adjusted purchase price of
approximately $750 was allocated to the assets acquired based on their estimated
fair values at the date of acquisition as follows: approximately $28 to net
accounts receivable acquired and approximately $722 to approximately 520
subscriber lines acquired, which amount is being amortized on a straight-line
basis over two years from the date of purchase.
During the quarter ended September 30, 2002, the Company entered into an
Asset Purchase Agreement dated as of July 30, 2002 (the "Abacus Asset Purchase
Agreement") with Abacus America, Inc. ("Abacus") for the purchase of broadband
subscriber lines. The Abacus Asset Purchase Agreement provided for a cash
payment for each successfully migrated broadband customer line, up to a maximum
payment of approximately $844, and required a purchase price deposit of
approximately $211. Ultimately, the Company was able to migrate and acquire
1,066 lines for a purchase price of approximately $543. The Abacus customer line
acquisitions were accounted for under the purchase method of accounting and,
accordingly, the purchase price has been allocated to the subscriber lines
acquired based on their estimated fair values at the date of acquisition. This
amount is being amortized on a straight-line basis over two years from the date
of purchase.
In December of 2002, the U.S. Bankruptcy Court for the District of
Delaware approved the Company's bid to purchase certain network assets,
equipment and associated subscriber lines of NAS for $14,000, consisting of
$9,000 in cash and $5,000 in a note payable to NAS. The Company closed the
transaction on January 10, 2003, whereby it acquired certain of NAS's network
assets, equipment in approximately 300 central offices and approximately 11,500
associated subscriber lines (the "NAS Assets"), pursuant to that certain Amended
and Restated Asset Purchase Agreement, dated as of December 11, 2003, by and
among the Company, NAS, Network Access Solutions LLC, NASOP, Inc., and Adelman,
Lavine, Gold and Levin (the "NAS Asset Purchase Agreement"). Additionally, on
January 10, 2003, the Company hired approximately 78 employees formerly employed
by NAS. No pre-closing liabilities were assumed in connection with the NAS
transaction. The cash portion of the consideration was paid from the Company's
existing cash. In accordance with the NAS Asset Purchase
12
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Agreement, DSL.net negotiated a $1,083 reduction in the cash paid at the
closing, representing DSL.net's portion of January revenue which was billed and
collected by NAS, bringing the net cash paid for the NAS Assets to $7,917.
NAS provided high-speed Internet and virtual private network services to
business customers using digital subscriber line, frame relay and T-1 technology
via its own network facilities in the Northeast and Mid-Atlantic markets. The
NAS acquisition significantly increased the Company's subscriber base and its
facilities-based footprint in one of the largest business markets in the United
States, providing it with increased opportunities to sell more higher-margin
facilities-based services.
The acquisition has been accounted for under the purchase method of
accounting in accordance with SFAS No. 141 "BUSINESS COMBINATIONS" ("SFAS 141").
The results of NAS's operations have been included in the consolidated financial
statements since January 10, 2003 (the acquisition date). The allocated
estimated fair values of the acquired assets at the date of acquisition exceeded
the purchase price and, accordingly, have been written down on a pro-rata basis
by asset group to the purchase price of approximately $14,750 ($14,000 plus
associated direct acquisition costs of approximately $750) as follows: (i)
intangible assets pertaining to approximately 11,500 acquired subscriber lines
of $1,476, and (ii) property and equipment of $13,274. The Company is still in
the process of finalizing certain estimates of certain property and equipment
and, thus, the allocation of the purchase price is subject to further
adjustment. In July, 2003, the Company paid $1,500 into escrow for the
negotiated repurchase and cancellation of the $5,000 note issued by the Company
to NAS as part of the purchase price for the NAS Assets. The payment was subject
to approval by the bankruptcy court presiding over NAS' bankruptcy petition. On
August 25, 2003, the court approved the transaction, and the $1,500 held in
escrow was paid to NAS in full satisfaction of the note.
With the acquisition of the NAS Assets on January 10, 2003, the Company
acquired a number of end users, some of whom it serves indirectly through
various ISPs. The Company sells its services to such ISPs who then resell such
services to the end user. Accordingly, the Company has some increased exposure
and concentration of credit risk pertaining to such ISPs during 2003. However,
no individual customer accounted for more than 5% of revenue for the first nine
months of 2003.
On April 8, 2003, the Company entered into an asset purchase agreement
with TalkingNets, Inc. and TalkingNets Holdings, LLC (collectively,
"TalkingNets") pursuant to which the Company agreed to acquire assets and
subscribers of TalkingNets (the "TalkingNets Assets") for $726 in cash (the
"TalkingNets Asset Purchase Agreement"). As TalkingNets filed a voluntary
petition for Chapter 11 reorganization in February 2003, the TalkingNets Asset
Purchase Agreement was subject to the approval of the U.S. Bankruptcy Court for
the Eastern District of Virginia. On April 9, 2003, the TalkingNets Asset
Purchase Agreement and the transactions contemplated thereby were approved by
the Bankruptcy Court. On April 11, 2003, the Company paid the full purchase
price of $726 into escrow. In accordance with the terms of the TalkingNets Asset
Purchase Agreement, the Company had a transition period of up to 150 days to
integrate TalkingNets' operations into its own operations and obtain all
requisite approvals prior to final closing of the transaction. During the
transition period, the Company was entitled to the cash collections from the
proposed acquired customers and was obligated to reimburse TalkingNets for
certain related operating expenses. The excess of TalkingNet's reimbursed
expenses over cash collections, included in the Company's operating expenses
during the transition period, for the three and nine months ended September 30,
2003, was approximately $159 and $394, respectively.
13
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
On September 8, 2003, in accordance with the TalkingNets Asset
Purchase Agreement, the Company completed its transaction to acquire the
TalkingNets Assets. This acquisition has been accounted for under the purchase
method of accounting in accordance with SFAS No. 141. The results of
TalkingNets' operations have been included in the Company's consolidated
financial statements since September 8, 2003 (the closing date). The allocated
estimated fair values of the acquired assets at the date of acquisition exceeded
the purchase price and, accordingly, have been written down on a pro-rata basis
by asset group to the purchase price of approximately $851 ($726 plus associated
direct acquisition costs of approximately $125) as follows: (i) certain accounts
receivables of $55, (ii) intangible assets pertaining to approximately 90
acquired subscriber lines of $58, and (iii) property and equipment of $738. The
Company is still in the process of finalizing certain estimates of certain
property and equipment and, thus, the allocation of the purchase price is
subject to further adjustment.
The following table sets forth the unaudited pro forma consolidated
financial information of the Company, giving effect to the acquisition of the
Broadslate and Abacus customers and the acquisition of the NAS Assets, as if the
transactions had occurred at the beginning of the periods presented. Inclusion
of the TalkingNets Assets would not materially change the reported unaudited pro
forma results.
PRO FORMA
NINE MONTHS ENDED SEPTEMBER 30,
------------------------------
2002 2003
---------- ----------
Pro forma revenue $ 53,320 $ 53,847
Pro forma operating loss $ (27,721) $ (22,452)
Pro forma net loss $ (29,862) $ (27,073)
Pro forma net loss applicable to common stockholders $ (39,453) $ (38,018)
Pro forma net loss per share, basic and diluted $ (0.61) $ (0.57)
Shares used in computing pro forma net loss per share 64,833,595 66,726,872
The pro forma results are not necessarily indicative of the actual results
of operations that would have been obtained had the acquisitions taken place at
the beginning of the respective periods or the results that may occur in the
future.
The actual revenue attributable to customer lines acquired during the
period was approximately $1,392 and $18,036 for the nine months ended September
30, 2002 and 2003, respectively.
6. Goodwill and Other Intangible Assets
In accordance with SFAS No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS",
which became effective January 1, 2002, the Company has ceased to amortize
approximately $8,482 of goodwill. In lieu of amortization, the Company made an
initial impairment review of its goodwill in January of 2002 and another
impairment review in December of 2002. The Company did not record any goodwill
impairment adjustments resulting from its impairment reviews. The Company will
continue to perform annual impairment reviews, unless a change in circumstances
requires a review in the interim.
14
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company's identified intangible assets consist of customer lists,
which are amortized over two years. Amortization expense of intangible assets
for the three and nine months ended September 30, 2002 was approximately $1,388
and $4,082, respectively. For the three and nine months ended September 30,
2003, amortization expense was approximately $345 and $2,395, respectively.
Accumulated amortization of customer lists as of September 30, 2002 and 2003 was
$14,404 and $18,067, respectively. The expected future amortization of customer
lists as of September 30, 2003 is $350 for the remainder of 2003, $925 in 2004
and $38 in 2005.
7. Debt
In December 2001, in conjunction with the Company's sale of shares of
mandatorily redeemable convertible Series Y Preferred Stock (the "Series Y
Preferred Stock"), the Company issued short-term promissory notes (the
"Promissory Notes") for aggregate proceeds of $3,531 to the holders of the
Series Y Preferred Stock. The Promissory Notes provided for an annual interest
rate of 12%. In May 2002, in accordance with the terms of the Series Y Purchase
Agreement (as defined in Note 9, below), the Company sold an additional 8,531
shares of Series Y Preferred Stock for $5,000 in cash and delivery of the
Promissory Notes for cancellation. All accrued interest on the Promissory Notes,
of approximately $145, was forgiven (Note 9).
On January 10, 2003, the Company issued a $5,000 note to NAS in
conjunction with its acquisition of the NAS Assets (Note 5). The NAS note had a
term of 5 years, bore interest at 12% per annum and was collateralized by the
network equipment acquired from NAS. Interest was payable monthly in arrears on
the unpaid principal balance. The note requires interest-only payments for the
first 21 months after which principal payments were to commence monthly and be
paid in 39 equal monthly installments together with interest on the unpaid
principal balance. In July, 2003, the Company paid $1,500 into escrow for the
negotiated repurchase and cancellation of the $5,000 note issued by the Company
to NAS. The payment was subject to approval by the bankruptcy court. On August
25, 2003, the court approved the transaction, and the $1,500 held in escrow was
paid to NAS in full satisfaction of the Note. The difference between the $5,000
note and the $1,500 settlement amount was recorded as other income in the third
quarter of 2003. Interest expense under the NAS note for the three and nine
months ended September 30, 2003 approximated $68 and $318, respectively.
The Company entered into a Revolving Credit and Term Loan Agreement, dated
as of December 13, 2002 (the "Credit Agreement"), with a commercial bank
providing for a revolving line of credit of up to $15,000 (the "Commitment").
Borrowings and repayments under the Credit Agreement could be made until the
revolving credit maturity date of December 12, 2004, at which time all amounts
outstanding would convert into a term loan payable in 12 quarterly installments.
Interest was payable on all amounts outstanding under the Credit Agreement in
arrears at the end of each calendar quarter at a variable interest rate equal to
the higher of the bank's prime rate equivalent or 0.5% percent above the Federal
Funds Effective rate. The Company's ability to borrow amounts available under
the Credit Agreement was subject to the bank's receipt of a like amount of
guarantees from certain of the Company's investors and/or other guarantors
acceptable to the bank and to certain other conditions set forth in the Credit
Agreement. On February 3, 2003, the Company borrowed $6,100 under the Credit
Agreement. As of March 3, 2003, the Company's investors had guaranteed $9,100
under the Credit Agreement. On July 18, 2003, the Company repaid the $6,100
outstanding balance plus accrued interest and terminated the Credit Agreement.
The Company wrote off approximately $184 of the related unamortized balance of
loan origination fees.
15
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company entered into a Reimbursement Agreement, dated as of December
27, 2002, with several private investment funds affiliated with VantagePoint
Venture Partners (collectively, "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 "Reimbursement Agreement").
The Guarantors were all holders of or affiliates of holders of the Company's
Series X Preferred Stock and Series Y Preferred Stock. Pursuant to the terms of
the Reimbursement Agreement, on December 27, 2002, VantagePoint and Columbia
issued guarantees in an aggregate amount of $6,100 to support certain
obligations of the Company under the Credit Agreement. The Reimbursement
Agreement obligated the Company to reimburse the Guarantors for any payments
they may be required to make in accordance with their guarantees. The Company's
obligations under the Reimbursement Agreement were guaranteed by certain of the
Company's wholly-owned subsidiaries and collateralized by an Agency, Guaranty
and Security Agreement by and among the Company, certain of the Company's
subsidiaries, Deutsche Bank Trust Company Americas, as administrative agent, and
the Investors (as defined below), pursuant to which the Company and certain of
its wholly-owned subsidiaries pledged a significant portion of the Company's
consolidated assets as collateral (the "Security Agreement"). On July 18, 2003,
in connection with the termination of the Credit Agreement, the guarantees,
Reimbursement Agreement and related Security Agreement were terminated.
Pursuant to the terms of the Reimbursement Agreement, on December 27,
2002, the Company issued warrants to purchase an aggregate of 12,013,893 shares
of its common stock to VantagePoint and Columbia, in consideration for their
guarantees aggregating $6,100. All such warrants have a ten year life and an
exercise price of $0.50 per share. On March 26, 2003, the Company issued
additional warrants, exercisable for ten years, to purchase a total of 936,107
shares of its common stock at $0.50 per share to VantagePoint and Columbia,
bringing the total number of warrants issued in connection with the
Reimbursement Agreement to 12,950,000. Pursuant to the terms of the
Reimbursement Agreement, in the event that the Company did not borrow any
amounts under the Credit Agreement on or before March 31, 2003, the Credit
Agreement and all Guarantees issued under the Reimbursement Agreement would have
been terminated and any warrants issued to the Guarantors in connection with the
transactions contemplated by the Reimbursement Agreement would have been deemed
terminated. Since the Company borrowed amounts under the Credit Agreement on
February 3, 2003, the Guarantors' guarantees of the subject loan became
effective on February 3, 2003 and the contingency related to the validation of
the warrants was eliminated.
On February 3, 2003, the Company valued the 12,950,000 warrants at $0.514
each with a total value of approximately $6,656. The valuation was performed
using a Black-Scholes valuation model with the following assumptions: (i) a risk
free interest rate of 4.01% (ten-year Treasury rate), (ii) a zero dividend
yield, (iii) a ten year expected life, (iv) an expected volatility of 153%, (v)
an option exercise price of $0.50 per share and (vi) a current market price of
$0.52 per share (the closing price of the Company's common stock on February 3,
2003). Since the warrants were issued in consideration for loan guarantees,
which enabled the Company to secure financing at below market interest rates,
the Company recorded their value as a deferred debt financing cost which would
be amortized to interest expense over the term of the loan (approximately 57
months) using the "Effective Interest Method" of amortization. On July 18, 2003,
the Company repaid its outstanding loan balance that was secured by these loan
guarantees, and terminated the Credit Agreement. Accordingly, the Company
wrote-off approximately $5,747 of the related unamortized balance of deferred
financing costs to other expense. For the three and nine months ended September
30, 2003, expense relating to amortized deferred financing costs was
approximately $93 and $909, respectively.
16
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
On March 3, 2003, the Company and certain of the Guarantors entered into
Amendment No. 1 to the Reimbursement Agreement, pursuant to which VantagePoint
increased its guarantee by $3,000, bringing the aggregate guarantees by all
Guarantors under the Reimbursement Agreement, as amended, to $9,100. As
consideration for VantagePoint's increased guarantee, if the Company closed an
equity financing on or before December 3, 2003, it was authorized to issue
VantagePoint additional warrants to purchase the type of equity securities
issued by the Company in such equity financing. The number of such additional
warrants would be determined by dividing $1,000 by the per share price of such
equity securities. Accordingly, since the Company closed a financing on July 18,
2003, the Company intends to issue to VantagePoint additional warrants to
purchase 2,260,909 shares of its common stock at a per share price of $0.4423.
On July 18, 2003, the Company entered into a Note and Warrant Purchase
Agreement (the "Note and Warrant Purchase Agreement") with Deutsche Bank AG
London, acting through DB Advisors LLC as Investment Agent ("Deutsche Bank"),
VantagePoint Venture Partners III (Q), L.P., VantagePoint Venture Partners III,
L.P., VantagePoint Communications Partners, L.P. and VantagePoint Venture
Partners 1996, L.P. (collectively, the "Investors") relating to the sale of an
aggregate of (i) $30,000 in senior secured promissory notes (the "Notes") and
(ii) warrants to purchase an aggregate of 157,894,737 shares of the Company's
common stock for a period of three years at an exercise price of $0.38 per share
(the "Warrants"). The aggregate purchase price for the Notes and Warrants was
$30,000.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, the Company issued an aggregate of $30,000 in principal amount of
Notes to the Investors on July 18, 2003. Principal on the Notes is payable in a
single payment on July 18, 2006. The Notes provide for an annual interest rate
of 1.23%, payable in cash quarterly in arrears commencing on October 31, 2003,
unless the Company elects to defer payment of such interest and pay it together
with the principal amount of the Notes at maturity on July 18, 2006. Pursuant to
the terms of the Security Agreement, the Company's obligations under the Notes
are secured by a security interest in a majority of the personal property and
assets of the Company and certain of its subsidiaries. Interest expense accrued
on the Notes for the three and nine months ended September 30, 2003 approximated
$74. The Company elected, on or about October 31, 2003, to defer the interest
payments until further notice.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, the Company issued a warrant (the "Initial Warrant") to purchase
12,950,000 shares of its common stock to Deutsche Bank. Deutsche Bank may not
exercise or transfer the Initial Warrant until the issuance of the Additional
Warrants (as defined below), except in certain circumstances set forth in the
Note and Warrant Purchase Agreement.
The Company agreed to issue to the Investors (or their assignees) the
remaining Warrants (the "Additional Warrants") to purchase an aggregate of
144,944,737 shares of its common stock after the following conditions have been
met:
o Receipt of stockholder approval of (i) amendments to the Company's
certificate of incorporation to, among other things, increase the
authorized number of shares of the Company's common stock, and (ii)
the issuance of the Additional Warrants (collectively, the "Required
Stockholder Approvals"); and
o Receipt of regulatory approvals from certain state public utility
commissions.
17
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
In connection with the Note and Warrant Purchase Agreement, certain
holders of the Company's Series X Preferred Stock and Series Y Preferred Stock
entered into a voting agreement which obligated them to vote in favor of the
Required Stockholder Approvals. The Company obtained the Required Stockholder
Approvals at its 2003 annual meeting of stockholders on October 14, 2003, but
still had not received all required regulatory approvals from certain state
public utility commissions as of that time.
The proceeds from the sale of the Notes and Warrants will be (and portions
already have been) used by the Company for general corporate purposes, including
acquisitions, the roll out of the Company's integrated voice and data service
product offering, the expansion of the Company's sales and marketing activities
and repayment of certain debt and lease obligations. As of September 30, 2003,
the Company has paid approximately $10,200 for the complete repayment of
approximately $14,600 of its debt and lease obligations.
On July 18, 2003, in connection with the Note and Warrant Purchase
Agreement, the Company, the Investors and certain of the stockholders of the
Company entered an Amended and Restated Stockholders Agreement, which provides
for rights relating to the election of directors, the registration of the
Company's common stock and certain protective provisions.
On July 18, 2003, the Company recorded the Note and Warrant transactions
in accordance with Accounting Principals Board Opinion No. 14, "ACCOUNTING FOR
CONVERTIBLE DEBT AND DEBT ISSUED WITH STOCK PURCHASE WARRANTS," whereby a fair
value was ascribed to the 157,894,737 Warrants to be issued to the Investors
(related to the Note and Warrant Purchase Agreement) together with the 2,260,909
warrants to be issued to VantagePoint (related to VantagePoint's increased
guarantee under Amendment No. 1 to the Reimbursement Agreement) using a
Black-Scholes valuation model with the following assumptions: (i) a risk free
interest rate of 2.24% (three-year Treasury rate), (ii) a zero dividend yield,
(iii) a three-year life, (iv) an expected volatility of 152%, (v) a warrant
option price of $0.38 per share for the 157,894,737 Warrants and $0.4423 per
share for the 2,260,909 warrants and (vi) a current market price of $0.83 (the
closing price of the Company's common stock on July 18, 2003) per share. A fair
value was ascribed to the Notes using a present value method with a 19% discount
rate. The relative fair value of the warrants representing 87% of the combined
fair value of the warrants and Notes was applied to the $30,000 proceeds to
determine a note discount of approximately $26,063, which was recorded as a
reduction to the Notes payable and an increase to additional paid in capital.
The note discount will be amortized to interest expense using the "Effective
Interest Method" of amortization over the 36 month term of the Notes. For the
three and nine months ended September 30, 2003, approximately $509 of this note
discount has been amortized to interest expense.
8. Commitments and Contingencies
In certain markets where the Company has not deployed its own local
broadband equipment, the Company utilizes local facilities of wholesale
providers, including Covad Communications, Inc. ("Covad"), in order to provide
service to its end-user customers. These wholesale providers may terminate their
service with little or no notice. The failure of Covad or any of the Company's
other wholesale providers to provide acceptable service on acceptable terms
could have a material adverse effect on the Company's operations. There can be
no assurance that Covad or other wholesale providers will be successful in
managing their operations and business plans.
18
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company transmits data across its network via transmission facilities
that are leased from certain carriers, including Level 3 Communications, Inc.
and MCI (formerly known as WorldCom). The failure of any of the Company's data
transport carriers to provide acceptable service on acceptable terms could have
a material adverse effect on the Company's operations. MCI has filed a voluntary
petition to reorganize under Chapter 11 of the U.S. Bankruptcy Code. While MCI
has announced that it expects to continue with its current operations without
adverse impact on its customers, it may not be able to do so. The Company
believes that it could transition the data transport services currently supplied
by MCI to alternative suppliers in thirty to sixty days, should MCI announce
discontinuance of such services. However, if MCI was to discontinue such
services without providing sufficient advance notice (at least sixty days), the
Company might not be able to transition such services in a timely manner, which
could disrupt service provided by the Company to certain of its customers. This
could result in the loss of revenue, loss of customers, claims brought against
the Company by its customers, or could otherwise have a material adverse effect
on the Company. Even if MCI was to provide adequate notice of any such
discontinuation of service, there can be no assurance that the Company would be
able to transition such service without a material adverse impact on the Company
or its customers, if at all.
Effective May 1, 2003, the Company entered into a 35 month lease for
office space in Herndon, Virginia, with minimum lease payments of approximately
$164 in 2003, $256 in 2004, $268 in 2005 and $68 in 2006.
Under the Company's facility operating leases, minimum office facility
operating lease payments are approximately $1,638 in 2003, $2,000 in 2004, $766
in 2005, $233 in 2006, $169 in 2007 and $28 in 2008. The Company also has
long-term purchase commitments with MCI, AT&T (which commitment ends in October,
2003), Sprint and other vendors for data transport and other services with
minimum payments due even if its usage does not reach the minimum amounts.
Minimum payments under its long-term purchase commitments are approximately
$3,668 in 2003, $2,396 in 2004 and $57 in 2005.
In July, 2003, the Company paid $2,600 in full settlement of certain
outstanding capital lease obligations approximating $3,728. The difference
between the lease carrying value and the purchase price of the assets,
approximately $1,128, was recorded as a reduction of the carrying value of the
assets acquired under the lease obligation.
9. Mandatorily Redeemable Convertible Preferred Stock
As more fully described in the Company's audited financial statements and
related notes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002, the Company entered into a Series X Preferred Stock
Purchase Agreement with VantagePoint on November 14, 2001 (the "Series X
Purchase Agreement"), relating to the sale and purchase of up to an aggregate of
20,000 shares of Series X Preferred Stock at a purchase price of $1,000 per
share. On December 24, 2001, the Company entered into a Series Y Preferred Stock
Purchase Agreement (the "Series Y Purchase Agreement") with Columbia Capital
Equity Partners III, L.P., Columbia Capital Equity Partners II, L.P., The
Lafayette Investment Fund, L.P., Charles River Partnership X, a Limited
Partnership, and N.I.G. Broadslate (collectively with their assigns, the "Series
Y Investors"), relating to the sale and purchase of up to an aggregate of 15,000
shares of Series Y Preferred Stock at a purchase price of $1,000 per share.
19
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Pursuant to the Series X Purchase Agreement, in November and December
2001, the Company sold an aggregate of 10,000 shares of Series X Preferred Stock
to VantagePoint for total proceeds of $10,000, before direct issuance costs of
approximately $189. Pursuant to the Series X Purchase Agreement, on March 1,
2002, the Company sold an additional 10,000 shares of Series X Preferred Stock
to VantagePoint for total proceeds of $10,000.
Pursuant to the Series Y Purchase Agreement, in December 2001, the Company
sold an aggregate of 6,469 shares of Series Y Preferred Stock to the Series Y
Investors for an aggregate purchase price of $6,469, before direct issuance
costs of approximately $300, which costs pertain to all funding transactions
under the Series Y Purchase Agreement.
In addition, in December 2001, the Company issued the Promissory Notes to
the Series Y Investors in the aggregate principal amount of $3,531 in exchange
for proceeds of $3,531. The Promissory Notes provided for an annual interest
rate of 12%. In May 2002, in accordance with the terms of the Series Y Purchase
Agreement, the Company sold 8,531 additional shares of Series Y Preferred Stock
for $5,000 in cash and delivery of the Promissory Notes for cancellation. All
accrued interest on the Promissory Notes, of approximately $145, was forgiven
(Note 7).
The Series X Preferred Stock and Series Y Preferred Stock activity during
the nine months ended September 30, 2002 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
------------------------------------------
SERIES X SERIES Y
-------------------- --------------------
SHARES AMOUNT SHARES AMOUNT
-------- ---------- -------- ----------
Balance December 31, 2001 10,000 $ 436 6,469 $ 34
Issuance of shares 10,000 10,000 8,531 8,531
Discount on Series X and Y Preferred Stock resulting
from a beneficial conversion feature (10,000) (8,531)
Accrued dividends on Series X and Y Preferred Stock 1,600 923
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock 4,431 2,637
-------- ---------- -------- ----------
Balance September 30, 2002 20,000 $ 6,467 15,000 $ 3,594
======== ========== ======== ==========
20
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Series X Preferred Stock and Series Y Preferred Stock activity during
the nine months ended September 30, 2003 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
------------------------------------------
SERIES X SERIES Y
------------------------------------------
SHARES AMOUNT SHARES AMOUNT
-------- ---------- -------- ----------
Balance December 31, 2002 20,000 $ 8,741 15,000 $ 5,381
Conversion of Series Y Preferred Stock to common stock (9,950) (5,226)
Payment of dividends on converted Series Y Preferred Stock (1,793)
Accrued dividends on Series X and Y Preferred Stock 1,800 1,345
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock 4,336 3,464
-------- ---------- -------- ----------
Balance September 30, 2003 20,000 $ 14,877 5,050 $ 3,171
======== ========== ======== ==========
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
As part of the agreements negotiated in conjunction with the Company's
$30,000 financing on July 18, 2003 (Note 7), the Company and holders of a
majority of the Series X Preferred Stock and Series Y Preferred Stock agreed to
extend the redemption dates of the Series X Preferred Stock and Series Y
Preferred Stock from January 1, 2005 to July 18, 2006. Also, as a result of this
financing transaction, on July 18, 2003, in accordance with the terms of the
Series Y Preferred Stock, the Series Y conversion price was adjusted from $0.50
per share (each share of Series Y Preferred stock was convertible into 2,000
shares of common stock) to $0.4423 per share (each share of Series Y Preferred
stock is convertible into approximately 2,260.9 shares of common stock).
During the three months ended September 30, 2003, 88 shares of Series Y
Preferred Stock were converted into 176,000 shares of the Company's common stock
at a conversion price of $0.50 per share and, in accordance with the terms of
the Series Y Preferred Stock, the Company elected to pay accrued dividends
approximating $11 by issuing 22,431 shares of its common stock, based on an
average fair market value for the ten days preceding conversion of approximately
$0.51 per share.
During the three months ended September 30, 2003, 9,862 shares of Series Y
Preferred Stock were converted into 22,297,079 shares of the Company's common
stock at a conversion price of $0.4423 per share and, in accordance with the
terms of the Series Y Preferred Stock, the Company elected to pay accrued
dividends approximating $1,781 by issuing 2,423,465 shares of its common stock,
based on average fair market values for the ten days preceding each conversion,
ranging between approximately $0.70 per share and $0.74 per share.
21
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
10. Related Party Transactions
As of September 30, 2003, primarily resulting from the $30,000 financing
transaction and guarantees issued under the Reimbursement Agreement (Note 7),
VantagePoint had options and warrants issued and to be issued to acquire
approximately 53,364,628 shares of the Company's common stock. In addition,
VantagePoint owned approximately 463,357 shares of the Company's common stock
and 20,000 shares of the Company's Series X Preferred Stock which are
convertible into approximately 111,111,111 shares of common stock (Note 9). As a
result, VanatagePoint beneficially owned the equivalent of approximately
164,939,096 shares of the Company's common stock. Two affiliates of VantagePoint
are members of the Company's Board of Directors.
As of September 30, 2003, as a result of the $30,000 financing
transaction (Note 7), Deutsche Bank has warrants issued and to be issued to
acquire approximately 118,421,053 shares of the Company's common stock. Two
affiliates of Deutsche Bank are members of the Company's Board of Directors.
During the third quarter of 2003, the Series Y Investors (including
Columbia) converted 9,950 shares of Series Y Preferred Stock into approximately
24,572,278 shares of the Company's common stock (including shares issued as
payment for accrued dividends) (Note 9). As of September 30, 2003, the Series Y
Investors (including Columbia) owned 5,050 shares of Series Y Preferred Stock
which are convertible into approximately 11,417,590 shares of common stock (Note
9). In addition, resulting from guarantees issued under the Reimbursement
Agreement (Note 7), Columbia had warrants to acquire approximately 1,803,279
shares of the Company's common stock. An affiliate of Columbia was a member of
the Company's Board of Directors until August 5, 2003.
22
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion of the financial condition and results of
operations of DSL.net should be read in conjunction with the financial
statements and the related notes thereto included elsewhere in this Form 10-Q
and the interim unaudited financial statements and notes thereto filed on Forms
10-Q for the quarterly periods ending March 31, 2003 and June 30, 2003, and the
audited financial statements and notes thereto and Management's Discussion and
Analysis of Financial Condition and Results of Operations included in our Annual
Report on Form 10-K for the year ended December 31, 2002, which has been filed
with the Securities and Exchange Commission (the "SEC").
OVERVIEW
We combine our own facilities, nationwide network infrastructure, and
Internet service capabilities to provide various broadband communications
services to businesses throughout the United States, primarily using digital
subscriber line ("DSL") and T-1 technology. In certain markets where we have not
deployed our own equipment, we utilize the local facilities of other carriers to
provide service. DSL.net product offerings include T-1 and business-class DSL
network connectivity and Internet access services, virtual private networks
(VPNs), frame relay, Web hosting, domain name services management, enhanced
e-mail, online data backup and recovery services, firewalls and nationwide
dial-up services, as well as integrated voice and data offerings in select
markets.
In December of 2002, the U.S. Bankruptcy Court for the District of
Delaware approved our bid to purchase certain network assets, equipment and
associated subscriber lines of Network Access Solutions Corporation ("NAS") for
$14,000, consisting of $9,000 in cash and $5,000 in a note payable to NAS. We
closed the transaction on January 10, 2003, whereby we acquired certain of NAS's
network assets, equipment in approximately 300 central offices and approximately
11,500 associated subscriber lines (the "NAS Assets"), pursuant to that certain
Amended and Restated Asset Purchase Agreement, dated as of December 11, 2003, by
and among the Company, NAS, Network Access Solutions LLC, NASOP, Inc., and
Adelman, Lavine, Gold and Levin (the "NAS Asset Purchase Agreement"). The cash
portion of the purchase price was paid from our existing cash. In accordance
with the NAS Asset Purchase Agreement, we negotiated a $1,083 reduction in the
cash paid at the closing, representing our portion of January revenue which was
billed and collected by NAS, bringing the net cash paid for the NAS Assets to
$7,917. 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 in connection with the NAS transaction. On July 21, 2003 we paid
$1,500 into escrow as the negotiated repurchase and cancellation of the $5,000
note issued by us to NAS. The payment was subject to approval by the bankruptcy
court overseeing the NAS estate. The bankruptcy court approved the transaction
on August 25, 2003 and the amounts were released from escrow to consummate the
transaction. The difference between the $5,000 note and the $1,500 settlement
amount was recorded as other income during the third quarter 2003.
NAS provided high-speed Internet and virtual private network services to
business customers using DSL, frame relay and T-1 technology via its own network
facilities in the Northeast and Mid-Atlantic markets. The acquisition
significantly increased our subscriber base and our facilities-based footprint
in one of the largest business markets in the United States, providing us with
increased opportunities to sell more higher-margin facilities-based services.
The acquisition has been accounted for under the purchase method of
accounting in accordance with Statement of Financial Accounting Standards
("SFAS") No. 141 "BUSINESS COMBINATIONS"
23
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
("SFAS 141"). The results of NAS's operations have been included in our
consolidated financial statements since January 10, 2003 (the acquisition date).
The allocated estimated fair values of the acquired assets at the date of
acquisition exceeded the purchase price and, accordingly, have been written down
on a pro-rata basis by asset group to the purchase price of approximately
$14,750 ($14,000 plus associated direct acquisition costs of approximately $750)
as follows: (i) intangible assets pertaining to approximately 11,500 acquired
subscriber lines of $1,476, and (ii) property and equipment of $13,274. We are
still in the process of finalizing estimates of certain property and equipment
and, thus, the allocation of the purchase price is subject to further
adjustment.
As reflected in our audited financial statements and related notes
included in our Annual Report on Form 10-K for the year ended December 31, 2002,
we incurred operating losses of approximately $35,821 and negative operating
cash flows of approximately $17,706 during the year ended December 31, 2002.
During the nine months ended September 30, 2003, we incurred operating losses of
approximately $22,479 and negative operating cash flows of approximately $6,975.
These operating losses and negative operating cash flows have been financed
primarily by proceeds from equity and note issuances. We had accumulated
deficits of approximately $284,491 at December 31, 2002 and $311,545 at
September 30, 2003.
We expect our operating losses, net operating cash outflows and capital
expenditures to continue through 2003 and into 2004. We successfully completed
rounds of private equity and bridge loan financings totaling approximately
$35,000 as follows: approximately $20,000 in the fourth quarter of 2001, $10,000
in March 2002, and $8,531 in May 2002 (which, after cancellation of the bridge
loans, yielded net proceeds of approximately $5,000). In addition, on July 18,
2003, we raised approximately $30,000 in additional financing. We believe that
our existing cash and cash expected to be generated from operations will be
sufficient to fund our operating losses, capital expenditures, and working
capital requirements into at least the end of 2004, based on our current
business plans and projections. We intend to use these cash resources to finance
our capital expenditures and for our working capital and other general corporate
purposes. We may also use a portion of these cash resources to acquire
complementary businesses, subscriber lines and 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. Failure to generate sufficient
revenues, contain certain discretionary spending or achieve certain other
business plan objectives could have a material adverse affect on our results of
operations and financial position.
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. Note 2 to our audited financial statements
included in our Annual Report on Form 10-K for the year ended December 31, 2002,
which has been filed with the SEC, includes a complete summary of the
significant accounting policies and methods used in the preparation of our
financial statements. The following is a brief discussion of the more
significant accounting policies and methods used by us.
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.
24
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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.
Management believes the following critical accounting policies affect our
more significant judgments and estimates used in the preparation of our
consolidated financial statements:
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 have been 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 varies based on the speed of the customer's broadband
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of any leased 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 provided. 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
against revenue 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, which is a trend
that might continue.
25
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
GOODWILL AND OTHER LONG-LIVED ASSETS
We account for our long-lived assets in accordance with 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" ("SFAS 142"). This statement requires that the amortization
of goodwill be discontinued and instead an impairment approach be applied. The
impairment tests were performed during January and December 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 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.
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
principally sell our services directly to end users mainly consisting of small
to medium sized businesses, as opposed to selling to Internet service providers
("ISPs") who then resell such services. We believe that we do not have
significant exposure or concentrations of credit risk with respect to any given
customer. 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 end-users, some of whom we serve indirectly through various ISPs. We
sell our services to such ISPs who then resell such services to the end user. We
have some increased exposure and concentration of credit risk pertaining to such
ISPs. However, no individual customer accounted for more than 5% of revenue for
the first nine months of 2003.
INCOME TAX
We use the liability method of accounting for income taxes, as set forth
in SFAS No. 109, "ACCOUNTING FOR INCOME TAXES." Under this method, deferred tax
assets and liabilities are
26
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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 or state taxes based on income, 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 sales of Series X Preferred Stock and Series Y Preferred Stock in 2001
and 2002 and from the sale of $30,000 in notes and warrants in 2003. 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 customers and claims related to acquisitions. We record
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on analyses 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 and other factors could cause
liabilities to be incurred in excess of estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 146, "ACCOUNTING FOR EXIT OR DISPOSAL ACTIVITIES" ("SFAS 146"). SFAS
146 addresses the accounting for costs to terminate a contract that is not a
capital lease, costs to consolidate facilities and relocate employees, and
involuntary termination benefits under one-time benefit arrangements that are
not an ongoing benefit program or an individual deferred compensation contract.
The provisions of the statement will be effective for disposal activities
initiated after December 31, 2002. The adoption of this statement did not have a
material affect on our financial position or results of operations.
In December 2002, SFAS No. 148 "ACCOUNTING FOR STOCK-BASED COMPENSATION -
TRANSITION AND DISCLOSURE - AN AMENDMENT OF SFAS NO. 123" ("SFAS 148") was
issued. SFAS 148 amends SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION"
("SFAS 123"), to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS
123 to require prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee compensation
and the effect of the method used on reported results. As provided for in SFAS
148, we have elected not to transition to the fair value based method of
accounting for stock based employee compensation; we have, however, adopted the
amended disclosure requirements provided under SFAS 148 and incorporated those
requirements into our financial statements included in this Form 10-Q under the
heading "Incentive Stock Award Plans".
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT
GUARANTEES OF INDEBTEDNESS OF OTHERS," ("FIN 45"). FIN 45 expands previously
issued accounting guidance and disclosure requirements for certain guarantees.
FIN 45 requires an entity to recognize an initial liability for the fair value
of an obligation assumed by issuing a guarantee. The disclosure requirements of
FIN 45 are effective for all financial statements issued after December 15,
2002. The provision for initial
27
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
recognition and measurement of the liability will be applied on a prospective
basis to guarantees issued or modified after December 31, 2002. The adoption of
FIN 45 did not have a material adverse impact on our financial position or
results of operations.
In May 2003, the FASB issued SFAS No. 150, "ACCOUNTING FOR CERTAIN
FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY"
("SFAS 150"). SFAS 150 establishes standards for the classification and
measurement of certain financial instruments with characteristics of both
liabilities and equity. The changes are intended to result in a more complete
depiction of an entity's liabilities and equity and will, thereby, assist
investors and creditors in assessing the amount, timing, and likelihood of
potential future cash outflows and equity share issuances. This Statement also
requires that certain obligations that could be settled by issuance of an
entity's equity but lack other characteristics of equity be reported as
liabilities even though the obligation does not meet the definition of a
liability. The requirements of SFAS 150 became effective for us for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. SFAS 150 is to be implemented by reporting the cumulative effect of a
change in an accounting principle for financial instruments created before the
issuance date of the statement and still existing at the beginning of the
interim period of adoption. We have evaluated the impact of SFAS 150 to
determine the effect it may have on our consolidated results of operations,
financial position and have concluded that the adoption of this statement is not
expected to have a material affect on our financial position or results of
operations.
RESULTS OF OPERATIONS
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 customer's
broadband connection and the services ordered by the customer. The monthly fee
includes all phone line charges, Internet access charges, the cost of any leased
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 provided. Revenue related to installation
charges is 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
against revenue for such credits based on historical experience.
Revenue for the three months ended September 30, 2003 increased by 62% to
approximately $18,227, from approximately $11,262 for the three months ended
September 30, 2002. Revenue for the nine months ended September 30, 2003
increased by 55% to approximately $53,089, from approximately $34,239 for the
nine months ended September 30, 2002. The increase in revenue in 2003 was
primarily due to an increase in subscriber lines resulting from our acquisition
of the NAS Assets. The actual revenue attributable to customer lines acquired
for the three months ended September 30, 2002 and 2003 was approximately $608
and $5,925, respectively. For the nine months ended September 30, 2002 and 2003,
actual revenue attributable to customer lines acquired was approximately $1,392
and $18,036, respectively. We expect revenue to continue to increase in 2003 as
compared to 2002 as a result of our acquisition of the NAS Assets, and as we
continue our sales and marketing efforts, introduce additional services,
including our integrated voice and data service offering, and, possibly, acquire
additional businesses and/or subscriber lines.
NETWORK EXPENSES. Our network expenses include costs related to network
engineering and network field 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
28
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
premise equipment when sold to our customers. We lease high-speed lines and
other network capacity to connect our central office equipment and our network.
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 for the three months ended September 30, 2003 increased
approximately 62%, to approximately $13,070, compared to approximately $8,079
for the three months ended September 30, 2002. This increase of approximately
$4,991 was primarily attributable to increased telecommunications expenses of
approximately $4,514 and increased network engineering and field operations
personnel expenses of approximately $309 resulting from our acquisition of the
NAS Assets, as well as increased subcontract labor and consulting fees of
approximately $301, partially offset by decreased other expenses of
approximately $133. For the nine months ended September 30, 2003, network
expenses increased approximately 53%, to approximately $38,412, compared to
approximately $25,157 for the nine months ended September 30, 2002. This
increase of approximately $13,255 was primarily attributable to increased
telecommunications expenses of approximately $12,039 and increased network
engineering and field operations personnel expenses of approximately $874
resulting from our acquisition of the NAS Assets. The increase was also
attributable to increased subcontract labor and consulting fees of approximately
$579 related to increased customer installations and the elimination of certain
duplicate central offices, and was partially offset by net decreases in
miscellaneous other expenses of approximately $237. We expect our network
expenses, including costs for subscriber lines, to increase in 2003, as compared
to 2002, as a result of our acquisition of the NAS Assets, and as we add
customers.
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.
Operations expenses for the three months ended September 30, 2003 were
approximately $3,060, compared to operations expenses for the three months ended
September 30, 2002 of approximately $1,966. This 56% increase of approximately
$1,094 was primarily due to increases in operations personnel expenses of
approximately $543, other outside services of approximately $374 and other
miscellaneous expenses of approximately $177. Operations expenses for the nine
months ended September 30, 2003 were approximately $8,935, compared to
operations expenses for the nine months ended September 30, 2002 of
approximately $6,071. This 47% increase of approximately $2,864 was primarily
due to increases in operations personnel expenses of approximately $1,701, other
outside services of approximately $716 and other miscellaneous expenses of
approximately $447. We expect our operations expenses to continue to increase in
future periods, as compared to 2002, as a result of increased costs associated
with our acquisition of the NAS Assets.
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.
General and administrative expenses were approximately $2,618 for the
three months ended September 30, 2003, compared to general and administrative
expenses for the three months ended September 30, 2002 of approximately $2,305.
This 14% increase of approximately $313 was primarily due to increases in
property and corporate related taxes of approximately $867 (as further discussed
below) and increases in m