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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended: December 31, 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.
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(Exact Name of registrant as specified in its charter)
DELAWARE 06-1510312
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
545 Long Wharf Drive, New Haven, Connecticut 06511 (203) 772-1000
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(Address of principal executive offices) (Zip Code) (Telephone No.)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.0005 per share
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such report(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [_] No [X]
The aggregate market value of the Common Stock held by non-affiliates of
the registrant, as of the last business day of the registrant's most recently
completed second fiscal quarter, was approximately $19,801,538 (based on the
closing price of the registrant's Common Stock of $0.52 per share). The number
of shares outstanding of the registrant's Common Stock, par value $.0005 per
share, as of April 6, 2004, was 144,119,957.
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DSL.net, Inc.
ANNUAL REPORT ON FORM 10-K
YEAR ENDED DECEMBER 31, 2003
TABLE OF CONTENTS
Page
No.
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Part I
Item 1. Business.............................................................2
Item 2. Properties..........................................................17
Item 3. Legal Proceedings...................................................17
Item 4. Submission of Matters to a Vote of Security Holders.................18
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities...................18
Item 6. Selected Consolidated Financial Data................................22
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations...........................................24
Item 7A. Quantitative and Qualitative Disclosure About Market Risk...........64
Item 8. Financial Statements and Supplementary Data.........................65
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure...............................................111
Item 9A. Controls and Procedures............................................111
Part III
Item 10. Directors and Executive Officers of the Registrant.................111
Item 11. Executive Compensation.............................................114
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters....................................121
Item 13. Certain Relationships and Related Transactions.....................124
Item 14 Principal Accountant Fees and Services.............................127
Part IV
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K....128
SIGNATURES...................................................................134
1
PART I
ITEM 1. BUSINESS
THIS BUSINESS SECTION AND OTHER PARTS OF THIS ANNUAL REPORT ON FORM 10-K
CONTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR
ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE SUCH A DIFFERENCE INCLUDE,
BUT ARE NOT LIMITED TO, THOSE SET FORTH IN "ITEM 7 - MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND ELSEWHERE IN THIS
ANNUAL REPORT ON FORM 10-K. EXISTING AND PROSPECTIVE INVESTORS ARE CAUTIONED NOT
TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS
OF THE DATE HEREOF. WE UNDERTAKE NO OBLIGATION, AND DISCLAIM ANY OBLIGATION, TO
UPDATE OR REVISE THE INFORMATION CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K,
WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR CIRCUMSTANCES OR
OTHERWISE.
GENERAL
DSL.net, Inc. ("DSL.net" or the "Company") provides high-speed data
communications, Internet access, and related services to small and medium sized
businesses and branch offices of larger businesses and their remote office
users, throughout the United States, primarily utilizing digital subscriber line
("DSL," generally, or "SDSL," in reference to symmetrical DSL service) and T-1
technology ("T-1" refers to a digital transmission link, provisioned via DS-1
(i.e., North American Digital Signal Level One) or substantially equivalent
technology). In September of 2003, we expanded our service offerings to include
integrated voice and data services using voice over Internet protocol ("VoIP")
to business customers in select Mid-Atlantic and Northeast markets. Our networks
enable data transport over existing copper telephone lines at speeds of up to
1.5 megabits per second. We were organized in 1998 as a corporation under the
laws of the State of Delaware.
We sell directly to businesses, primarily through our own direct sales
force, and to third party resellers whose end users are typically business-class
customers. We deploy our own local communications equipment primarily in select
first and second tier cities. As of March 1, 2004, we operated equipment in
approximately 340 cities in the United States. In certain markets where we have
not deployed our own equipment, we utilize the local facilities of other
carriers to provide service.
In addition to a number of high-speed, high-performance DSL-based data
communications and Internet connectivity solutions specifically designed for
businesses, our product offerings include T-1 Internet connectivity and data
communications services, integrated voice and data services (provisioned over
SDSL or T-1 lines), Web hosting, domain name system management, enhanced e-mail,
on-line data backup and recovery services, firewalls, nationwide dial-up
services, private frame relay services and virtual private networks. Our
services offer customers high-speed digital connections and related services at
prices that are attractive compared to the cost and performance of alternative
data communications services.
In January 2003, we acquired the majority of Network Access Solutions
Corporation's ("NAS") operations and assets. The acquired NAS assets included
operations and equipment in
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approximately 300 central offices extending from Virginia to Massachusetts, and
included approximately 11,500 subscriber lines. This acquisition significantly
increased 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.
In September of 2003 we acquired substantially all of the assets and
subscribers of TalkingNets, Inc., a voice and data communications provider that
offered soft switched-based VoIP and high-speed data services to businesses.
This acquisition was strategically significant as it gave us the capability to
offer business customers in the business-intensive Mid-Atlantic and Northeast
regions a carrier-class integrated voice and data service which utilizes VoIP.
In December of 2003 we introduced an expanded range of VoIP products in
the Washington, D.C. metropolitan region. In February of 2004 we introduced our
full suite of VoIP and data bundles in the New York City metropolitan area.
THE DSL.NET SOLUTION
We provide small and medium sized businesses and branch offices of larger
businesses and their remote office users, with high-speed Internet access and
data communications services, and integrated voice and data services, primarily
using DSL and T-1 technology. Key elements of our solution are:
HIGH-SPEED CONNECTIONS. We offer Internet access and private network
services at speeds of up to 1.5 megabits per second, via SDSL and T-1
technology. Our network is designed to provide data transmission at the same
speed to and from the customer, known as symmetrical data transmission, and is
also capable of providing service at different speeds to and from the customers,
known as asymmetrical data transmission. We believe that symmetrical data
transmission is best suited for business applications, because business users
require fast connections both to send and receive information, and to host
advanced services and applications.
VOICE OVER INTERNET PROTOCOL. We offer a full suite of VoIP-based
telephone services in conjunction with our high speed data connections. Each
bundle includes unlimited local, unlimited regional, and unlimited domestic
long-distance calling (subject to certain limitations set forth in our service
agreement). Multiple voice and data bundles varying by the number of phone lines
and broadband speeds are available to meet the needs of a variety of business
types and sizes. Our VoIP services are offered over a "quality of service"
("QoS") controlled network to ensure that telephone calls are delivered with
carrier-grade quality.
COMPLETE BUSINESS SOLUTION. We offer our customers a single point of
contact for a complete solution that includes all of the necessary equipment and
services to establish and maintain digital data communications. Our services
include high-speed Internet access and data communications services, integrated
voice and data services, frame relay, Web hosting, domain name system
management, enhanced e-mail, on-line data backup and recovery services,
firewalls, nationwide dial-up services and virtual private networks. Our network
is designed to enable us to individually configure each customer's service
remotely.
ALWAYS-ON CONNECTIONS. With our high-speed service, customers can access
the Internet continuously without having to dial into the network for each use.
These "always-on" connections provide customers with the ability to readily
access the Internet and transfer information. We charge our customers a flat fee
per month for high-speed connectivity service rather than billing them based on
usage.
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ATTRACTIVE VALUE PROPOSITION. Our DSL and T-1 services offer customers
high-speed digital connections at prices that are attractive compared to the
cost and performance of alternative data communications services, such as
multiple dial-up connections, ISDN or traditional frame relay lines. We believe
that our services also increase the productivity of network users by decreasing
the time they spend connecting to the Internet and waiting for information
downloads and transfers. The ability to bundle multiple services, such as
Internet access, data communications and voice, over the same access line allows
us to offer our services at price points which are significantly less than those
of the same communications services if purchased separately.
CUSTOMER SUPPORT. We provide customer support 24 hours a day, seven days a
week. This support is important to many of our small and medium sized business
customers because they do not typically have dedicated internal support staff.
With our remote monitoring and troubleshooting capabilities, we continuously
monitor our network. This enables us to identify and address network problems
promptly, thus enhancing network quality, service and performance.
OUR SERVICES
As part of our service offerings, we function as our customers' Internet
service provider and voice carrier, and deliver a range of Internet-based,
value-added solutions. Our services currently include all necessary equipment,
software and lines required to establish and maintain a digital Internet
connection and carrier-class voice service. Our primary services include
high-speed data communications, with or without Internet access, integrated
voice and data services, e-mail, domain name system management and Web hosting.
Other services provided by DSL.net include firewalls, on-line data backup and
recovery services, nationwide dial-up services, private frame relay and virtual
private networks that connect customers' various offices.
Customers typically pay an installation charge and a monthly fee for our
service. Revenue related to installation charges is deferred and amortized to
revenue over 18 months, which is the average customer life of the existing
customer base. The monthly fee for our data communications services includes all
phone line charges, general Internet access services, e-mail, and domain name
system management, including the issuance of Internet protocol ("IP") addresses
for customers who wish to assign fixed IP addresses to their network computers.
The monthly fee for our integrated voice and data service includes all phone
line charges, general Internet access services, local and domestic long distance
phone service (subject to subscription bundles and other restrictions set forth
in the customer's service agreement), caller ID, call waiting, call forwarding,
e-mail, and domain name system management, including the issuance of IP
addresses. Customers generally contract for our services for a minimum of 12 or
24 months, depending upon the service, and are billed for services on a monthly
basis.
CUSTOMERS
Our target customers are primarily small and medium sized businesses and
branch locations of larger enterprises and their remote office users. We sell to
these customers primarily on a direct basis. In particular, we believe the
following market segments are especially attractive prospective customers:
o businesses currently using other high-speed data communications
services, such as ISDN and frame relay services;
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o professional or service-based firms that have multiple Internet service
provider dial-up accounts and phone lines;
o branch office locations that require transmission of large files
between locations;
o businesses that use data-intensive applications, such as financial
services, technology, and publishing; and
o businesses that cannot afford to pay the costs for maintaining
high-speed connections for voice and data services separately, but can
justify the cost of a high-speed connection if shared for voice and
data services.
No customer accounted for more than 5% of our total revenue during the
years ended December 31, 2003, 2002 and 2001.
SALES AND MARKETING
Our marketing professionals have developed a methodology to identify the
businesses that we believe would most likely benefit from our services. Once we
identify businesses in a specific market, we employ a targeted local marketing
strategy utilizing a variety of media but primarily focused on telemarketing
efforts, direct mail and opt-in e-mail. Through inbound and outbound telesales
campaigns, we utilize internal sales professionals to sell our services to
prospective customers. We also partner with various resellers and referral
channels, including local information technology professionals, application
service providers and marketing partners to assist in the sale of our services.
CUSTOMER ACQUISITIONS
In addition to our internal sales and marketing efforts, and our reseller
and referral channels, we have grown our customer base by acquiring end users of
other Internet service providers and companies offering broadband access. We
continuously identify and evaluate acquisition candidates, and in many cases
engage in discussions and negotiations regarding potential acquisitions.
Acquisition candidates include both individual subscriber lines and whole
businesses. Our discussions and negotiations may not result in acquisitions.
Further, if we make any additional acquisitions, we may not be able to operate
any acquired assets or businesses profitably or otherwise successfully implement
our expansion strategy. We intend to continue to seek additional opportunities
for further acquisitions, a strategy which we believe represents a distinct
opportunity to accelerate our growth.
CUSTOMER SUPPORT AND OPERATIONS
Our customer support professionals serve as an information repository to
our customers and work to streamline the ordering, installation and maintenance
processes associated with data and voice communications and Internet access.
They provide our customers with a single point of contact for implementation,
maintenance and operations support.
IMPLEMENTATION. We manage the implementation of our service for each
customer. In areas where we have installed our own local communications
facilities, we lease the copper telephone lines from the local telephone
company. These lines run from our equipment located in the telephone company's
central office to our customer. We test these lines to determine whether
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they meet our specifications and work with the local telephone company to
correct any problems identified by our testing. In other areas, we utilize the
local communications facilities of other carriers, and work with these carriers
to provide the service. In both cases, field service technicians install the
modem or router purchased or leased from us and any necessary wiring at our
customers' offices and test the modem or router and connection over our network
to confirm successful installation.
MAINTENANCE. Our network operations center provides network surveillance
for all equipment in our network. We are able to detect and correct many of our
customers' maintenance problems remotely, often before our customer is aware of
the problem. Customer-initiated maintenance and repair requests are managed and
resolved primarily through our customer service department. Our information
management system, which generates reports for tracking maintenance problems,
allows us to communicate maintenance problems from the network operations center
to our customer service center 24 hours a day, seven days a week.
OPERATIONS SUPPORT SYSTEMS. Our operations support systems are intended to
improve many of our business processes, including customer billing, service
activation, inventory control, customer care reports and maintenance reports.
They have been designed to provide us with accurate, up-to-date information in
these areas. Additional enhancements of these systems, including improved
automation and support for voice services, were made in 2003. We believe that
our operations support systems provide us with the flexibility to support
additional customers and additional services.
OUR NETWORK
Our network has been designed to deliver reliable, secure and scaleable
high-speed, high-performance Internet access data communication services, local
phone service as well as domestic and international long distance.
NETWORK DESIGN. The key design principles of our network are:
o INTELLIGENT END-TO-END NETWORK MANAGEMENT. Our network is designed to
allow us to monitor network components and customer traffic from a
central location. We can perform network diagnostics and equipment
surveillance continuously. From our network operations center, we have
visibility across our entire network, allowing us to identify and
address network problems quickly and to provide quality service and
performance.
o NEXT GENERATION VOIP TECHNOLOGY. We have deployed the latest in
"session initiation protocol" ("SIP")-based, soft-switching technology
to deliver voice services over our existing network backbone. In
contrast to certain other VoIP services, our voice services are
provided over a facilities-based, fully controlled, QoS-enabled
network. This quality-of-service approach is designed to assure that
adequate bandwidth is always available for the voice service and that
the voice quality is equivalent to traditional voice services.
o CONSISTENT PERFORMANCE WITH THE ABILITY TO EXPAND. We have designed our
network to leverage the economics of DSL technology, to grow with our
business and to provide consistent performance. We also use
asynchronous transfer mode equipment in our network, which enables
high-speed, high volume transmission of data.
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o SECURITY. Our network is designed to reduce the possibility of
unauthorized access and to allow our customers to safely transmit and
receive sensitive information and applications. The modems and routers
we sell or lease to our customers for use in support of subscribed
services are designed to work in conjunction with installed security
systems and network servers in an effort to provide safe connections to
the Internet and a secure operating environment.
NETWORK COMPONENTS. The primary components of our network are:
o MODEMS, ROUTERS AND ON-SITE CONNECTIONS. We purchase modems and routers
and provide them to our customers, as appropriate, depending on their
specific needs and contractual service agreements. We configure the
modem or router and arrange for the installation of the modem or router
along with the on-site wiring needed to connect the modem or router to
the copper telephone line. In areas where we have deployed our own
local facilities, we either perform these services ourselves or we
contract with independent field service organizations to perform these
services on our behalf. In areas where we utilize the local facilities
of other carriers, these other carriers (or their contractors) provide
these installation services. We will either lease or sell customer
premise equipment (modem or router) to our customers. When we lease the
customer premise equipment, we charge the customer for the use of this
equipment as part of our monthly service fee. These modems and routers
are capitalized and depreciated over their estimated useful life of
three years. Such leased equipment remains our exclusive property. When
we sell customer premise equipment (modem or router) to the customer,
we recognize the revenue from the sale and expense the cost of this
equipment at the time of sale.
o SOFT SWITCH, GATEWAYS AND MEDIA SERVERS. In support of our integrated
voice and data offerings, we have deployed our own soft switching
equipment, comparable in functionality to traditional Class 4 and Class
5 switches, to deliver business-class, line-side features to customers.
We are directly interconnected to the public switched telephone network
("PSTN"), and do not rely on other service providers for access to the
PSTN. Our integrated voice and data network uses soft switches,
routers, and gateways from Cisco Systems. In addition, we utilize
additional software applications to provide voice features and enhanced
services.
o COPPER TELEPHONE LINES. In areas where we have deployed our own local
communications facilities, we lease a copper telephone line running to
each customer from our equipment in the local telephone company's
central office under terms specified in our interconnection agreements
with these companies. In areas where we utilize the local
communications facilities of other carriers, the carrier leases the
telephone line from the local telephone company and makes that line
available to us for our customer's use.
o CENTRAL OFFICE COLLOCATION. Through our interconnection agreements, we
secure space to locate our equipment in certain central offices of
traditional local telephone companies and offer our services from these
locations. These collocation spaces are designed to offer the same high
reliability and availability standards as the telephone companies' own
central office spaces. We install the equipment necessary to provide
high-speed DSL or T-1 service to our customers in these spaces. We have
continuous access to these spaces to install and maintain our equipment
located in these central offices. In markets where
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we have not deployed our own equipment, we utilize the local facilities
installed in central offices by other carriers, to provide high-speed
connections to our customers.
o NETWORK BACKBONE; CONNECTION TO THE INTERNET. Network traffic gathered
at each of our central offices is directed to one of our regional hubs,
if applicable in support of the customer's service, and then to the
Internet. In certain areas where we offer service from more than one
central office, network traffic is directed from each central office in
that area to a local hub which aggregates its traffic along with the
traffic from the other central offices located in that area and directs
the traffic to a regional hub. At our regional hubs, we also connect to
other carriers' networks via high-speed connections. Our hubs contain
extra equipment and backup power to provide backup facilities in the
event of an equipment failure and are actively monitored from our
network operations center. We lease space for our hubs in facilities
designed to host network equipment. Our hubs are connected to one
another via high-speed data communications lines. We have agreements
with MCI, Level 3 Communications and other carriers to provide this
service. Internet connectivity is provided by various transit
arrangements.
o NETWORK OPERATIONS CENTER. Our network is managed from our network
operations centers located in New Haven, Connecticut, and in Herndon,
Virginia. We provide network management 24 hours a day, seven days a
week. This enhances our ability to address performance and service
issues before they affect our customers. From the network operations
centers, we can monitor the performance of individual subscriber lines
and the equipment and circuits in our network.
COMPETITION
We face competition from many companies with significantly greater
financial resources, well-established brand names and large installed customer
bases. We expect that the level of competition in our markets may intensify in
the future. We expect competition from:
OTHER CARRIERS. A number of competitive carriers, including Covad
Communications and New Edge Networks, offer DSL and T-1 services to residential
and business customers. The Telecommunications Act of 1996 (the
"Telecommunication Act") specifically grants competitive telecommunications
companies, including other DSL providers, the right to negotiate interconnection
agreements with traditional telephone companies, including interconnection
agreements which may be identical in all respects to, or more favorable than,
our agreements.
INTERNET SERVICE PROVIDERS. Several national and regional Internet service
providers, including UUNET, EarthLink and MegaPath, offer high-speed access
capabilities, along with other products and services. These companies generally
provide Internet access to residential and business customers through a host of
methods, including DSL and T-1 services. These companies leverage wholesale
arrangements to resell broadband access they purchase from facility-based
broadband providers.
NEXT GENERATION VOICE AND DATA PROVIDERS. A number of competitive
carriers, including Cbeyond Communications, LLC and DSLi, offer converged voice
and data products to residential and business customers. These companies provide
services over a single data connection primarily using DSL and T-1 access
methods.
TRADITIONAL LOCAL TELEPHONE COMPANIES. Many of the traditional local
telephone companies, including BellSouth, SBC Communications, Qwest and Verizon,
are deploying DSL-based
8
services, either directly or through affiliated companies. These companies have
established brand names, possess sufficient capital to deploy DSL equipment
rapidly, have their own copper telephone lines and can bundle digital data
services with their existing voice services to achieve a competitive advantage
in serving customers. In addition, these companies also offer high-speed data
communications services that use other technologies, including T-1 services. We
depend on these traditional local telephone companies to enter into agreements
for interconnection and to provide us access to individual elements of their
networks. Although the traditional local telephone companies are required to
negotiate in good faith in connection with these agreements, future
interconnection agreements may contain less favorable terms and result in a
competitive advantage to the traditional local telephone companies.
NATIONAL LONG DISTANCE CARRIERS. National long distance carriers, such as
AT&T, Sprint, Williams and MCI, have deployed large-scale data networks, sell
connectivity to businesses and residential customers, and have high brand
recognition. They also have interconnection agreements with many of the
traditional local telephone companies, and many offer competitive DSL and T-1
services.
OTHER FIBER-BASED CARRIERS. Companies such as XO Communications and Choice
One have extensive fiber networks in many metropolitan areas, primarily
providing high-speed data and voice circuits to small and large corporations.
They also have interconnection agreements with the traditional local telephone
companies under which they have acquired collocation space in many large
markets, and some offer competitive DSL and T-1 services.
CABLE MODEM SERVICE PROVIDERS. Cable modem service providers, such as
Time-Warner Cable, Comcast and RCN, offer high-speed Internet access over cable
networks primarily to residential consumers. Where deployed, these networks
provide high-speed local access services, in some cases at speeds higher than
DSL service. They typically offer these services at lower prices than our
services, in part by sharing the capacity available on their cable networks
among multiple end users.
WIRELESS AND SATELLITE DATA SERVICE PROVIDERS. Several companies,
including Hughes Communications and Teledesic, are emerging as wireless and
satellite-based data service providers. These companies use a variety of new and
emerging technologies to provide high-speed data services.
The most significant competitive factors include: transmission speed,
service reliability, breadth of product offerings, price/performance, network
security, ease of access and use, content and service bundling, customer
support, brand recognition, operating experience, capital availability and
exclusive contracts with customers, including Internet service providers and
businesses with multiple offices. We believe our services compete favorably
within our service markets with respect to transmission speed,
price/performance, ease of access and use and customer support. Many of our
competitors enjoy competitive advantages over us based on their brand
recognition, breadth of product offerings, financial resources, customer bases,
operating experience and exclusive contracts with customers.
INTERCONNECTION AGREEMENTS WITH TRADITIONAL LOCAL TELEPHONE COMPANIES
Under the 1996 Telecommunications Act, the traditional local telephone
companies (which are often also referred to as "regional Bell operating
companies" and "incumbent local exchange carriers") have a statutory duty to
negotiate in good faith with us for agreements for interconnection and access to
certain individual elements of their networks. This interconnection
9
process is subject to review and approval by the state regulatory commissions.
We have signed interconnection agreements with BellSouth, Cincinnati Bell,
Frontier, SBC Communications, Qwest, Sprint, and Verizon, or their subsidiaries,
which govern our relationships in 49 states and the District of Columbia. These
agreements govern, among other things:
o the price and other terms under which we locate our equipment in the
telephone company's central offices,
o the prices we pay both to direct the installment of, and to lease,
copper telephone lines,
o the special conditioning of these copper lines that the traditional
telephone company provides to enable the transmission of DSL signals,
o the price we pay to access the telephone company's transmission
facilities, and
o certain other terms and conditions of our relationship with the
telephone company.
We are negotiating renewal agreements with these carriers as the current
agreements expire and are also negotiating amendments to existing agreements.
Future interconnection agreements may contain terms and conditions less
favorable to us than those in our current agreements and could increase our
costs of operations, particularly if, in the wake of the recent decision of the
D.C. Circuit Court in the action UNITED STATES TELECOM ASSOCIATION V. FEDERAL
COMMUNICATIONS COMMISSION AND UNITED STATES OF AMERICA, CONSOLIDATED CASE NO.
00-1012, WL 374262 (D.C. CIR. MAR. 2 2004), the Federal Communications
Commission (the "FCC") promulgates rules that discontinue, qualify or mitigate
the current requirements regarding services and access that traditional local
phone companies must provide and the pricing for such services and access. The
decision is subject to future judicial review, and various parties, including
the FCC and various state commissions, may seek a stay of the order and a
rehearing and appeal of the decision. The FCC may re-issue sections of its
Triennial Review Order, an order governing interconnection, the unbundling of
network elements, and many other aspects of the relationships between new and
traditional telephone companies. Any new rules may be less favorable to us, than
the existing rules and may cause us to incur increased operating costs or
significantly alter or curtail our operations.
During our interconnection agreement negotiations, either the telephone
company or we may submit disputes to the state regulatory commissions for
mediation. Also, after the expiration of the statutory negotiation period set
forth in the 1996 Telecommunications Act, we may submit outstanding disputes to
the states for binding arbitration, in which the state regulatory commissions
may arbitrate a new agreement or particular portions thereof.
Under the 1996 Telecommunications Act, states have begun and, in a number
of cases, completed, regulatory proceedings to determine the pricing of
individual elements of networks and services. The results of these proceedings
determine the price we pay for, and whether it is economically attractive for us
to use, these elements and services. These prices may be subject to change as
the result of ongoing and future regulatory proceedings.
Our interconnection agreements generally have terms of one or two years.
Therefore, we have renegotiated, and expect to continue to renegotiate, existing
agreements when they expire. Although we expect to renew our interconnection
agreements and believe the 1996 Telecommunications Act limits the ability of
traditional local telephone companies not to renew
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these agreements, we may not succeed in extending or renegotiating our
interconnection agreements on favorable terms. In addition, the traditional
local telephone companies may seek to materially increase the pricing of the
network elements that we lease from them and that are necessary for us to
service our new and existing customers. Further, disputes have arisen and will
likely arise in the future as a result of differences in interpretations of the
interconnection agreements. These disputes have, in the past, delayed the
deployment of our networks. Finally, the interconnection agreements are subject
to state regulatory commission, FCC and judicial oversight. These government
authorities may modify the terms of the interconnection agreements in ways that
are harmful to our business.
GOVERNMENT REGULATIONS
Significant portions of the services that we offer are subject to
regulation at the federal and/or state levels. The FCC, and state public utility
commissions regulate telecommunications common carriers, which are companies
that offer telecommunications services to the public or to all prospective users
on standardized rates and terms. Our DSL and other facilities-based data
transport services are common carrier services.
While we serve many of our customers using transport facilities that we
own or lease, in some areas where we do not have the necessary facilities, we
provide our Internet access and other services using the local facilities of
another carrier. The FCC has determined that Internet service providers, such as
us, who are using another carrier's transport facilities, are not acting as
common carriers. Therefore, in those markets where we have not deployed our own
local transport facilities, our services are not subject to common carrier
regulation. Our ability to provide such services, however, is affected by
regulations imposed upon the carriers whose local transport facilities we
utilize.
The FCC exercises jurisdiction over common carriers, and their facilities
and services, to the extent they are providing interstate or international
communications. The various state utility commissions retain jurisdiction over
telecommunications carriers, and their facilities and services, to the extent
they are used to provide communications that originate and terminate within the
same state. The degree of regulation varies from state to state.
In recent years, the regulation of the telecommunications industry has
been in a state of flux as the United States Congress and various state
legislatures have passed laws seeking to foster greater competition in
telecommunications markets. The FCC and state regulatory commissions have
adopted many rules to implement those laws and to encourage competition. These
changes, which are still incomplete, have created new opportunities and
challenges for us and our competitors. However, certain of these and other
existing federal and state regulations remain the subject of judicial
proceedings, legislative hearings and administrative proposals, any or all of
which could change, in varying degrees, the manner in which the
telecommunications industry operates. For example, on March 2, 2004, the D.C.
Circuit Court invalidated many sections of the FCC's Triennial Review Order (an
order governing interconnection, the unbundling of network elements, and many
other aspects of the relationships between new and traditional telephone
companies), and, depending upon the outcome of certain stays and likely appeals,
that decision could negatively impact the availability and pricing of various
network elements and services which the traditional local telephone companies
have previously offered to us. Neither the outcome of these various proceedings
nor their impact upon the telecommunications industry or us can be predicted at
this time. Indeed, future federal or state regulations and legislation may be
less favorable to us than current regulations and legislation and therefore have
a material and adverse impact on our business and financial prospects by
undermining our ability to provide
11
services at competitive prices. In addition, we may expend significant financial
and managerial resources to participate in legislative, regulatory, or judicial
proceedings at the federal and/or state level, without achieving favorable
results.
FEDERAL REGULATION AND LEGISLATION
We must comply with the requirements of a common carrier under the
Communications Act of 1934, as amended, to the extent we provide regulated
interstate services. These requirements include an obligation that our charges,
terms and conditions for communications services must be "just and reasonable"
and that we may not make any "unjust or unreasonable discrimination" in our
charges or terms and conditions. The FCC also has jurisdiction to act upon
complaints against common carriers for failure to comply with their statutory
obligations. We are not currently subject to price cap or rate of return
regulation at the federal level and are not currently required to obtain FCC
authorization for the installation, acquisition or operation of our facilities.
The FCC has established different levels of regulation for dominant and
non-dominant carriers. Of domestic carriers, only the traditional local
telephone companies are classified as dominant carriers and all other providers
of domestic common carrier service, including us, are classified as non-dominant
carriers. As a non-dominant carrier, we are subject to less FCC regulation than
are dominant carriers.
Comprehensive changes to the Communications Act of 1934 were made by the
1996 Telecommunications Act, enacted on February 8, 1996. It represents a
significant milestone in telecommunications policy by establishing competition
in local telephone service markets as a national policy. The 1996
Telecommunications Act removes many state regulatory barriers to competition and
forecloses state and local governments from creating laws preempting or
effectively preempting competition in the local telephone service market.
The 1996 Telecommunications Act places substantial interconnection
requirements on the traditional local telephone companies, including the
following obligations that are, to varying degrees and/or at varying times
relevant to our business:
o Traditional local telephone companies are required to provide physical
collocation, which allows companies such as us and other
interconnectors to install and maintain their own equipment in the
central offices of traditional local telephone companies. This
requirement is intended to enable us and other competitive carriers to
deploy our equipment on a relatively convenient and economical basis
and is integral to our business.
o Traditional local telephone companies are required to unbundle certain
components of their local service networks so that other providers of
local service can compete for a wide range of local service customers.
This requirement is designed to provide us flexibility to purchase only
the network elements we require to deliver our services and is integral
to our business.
o Traditional local telephone companies are required to establish
"wholesale" rates for their retail telecommunications services to
promote resale by competitive local exchange carriers and other
competitors.
o Traditional local telephone companies are required to provide
non-discriminatory access to telephone poles, ducts, conduits and
rights-of-way, and this requirement is integral to our business.
12
The 1996 Telecommunications Act generally sets forth the rights and
obligations of competing carriers. The FCC issues regulations interpreting the
1996 Telecommunications Act and imposing more specific requirements upon which
we and our competitors rely. The outcome of various ongoing FCC rulemaking
proceedings or judicial appeals of such proceedings could materially affect our
business and financial prospects by increasing the cost or decreasing our
flexibility in providing services.
As part of its effort to implement the 1996 Telecommunications Act, in
August 1996, the FCC issued an order governing interconnection, the unbundling
of network elements, and many other aspects of the relationships between new and
traditional telephone companies. The United States Court of Appeals for the
Eighth Circuit vacated many of these rules, and, in January 1999, the United
States Supreme Court reversed elements of the Eighth Circuit's ruling, finding
that the FCC has broad authority to interpret the 1996 Telecommunications Act
and issue rules for its implementation. Following the United States Supreme
Court's decision, in November, 1999, the FCC issued a modified list of the
network elements that must be offered on an unbundled basis by traditional local
telephone companies, including the local copper telephone lines and interoffice
transport which we lease. However, the decision announced the FCC's intention to
revisit these regulations within three years.
The FCC initiated this three-year review in early 2002, and on February
20, 2003, it voted to adopt new regulations pertaining to the unbundling
obligations of the traditional local telephone companies. The FCC's Triennial
Review Order (the "TRO") was released on August 21, 2003 and became effective
October 3, 2003. However, the D.C. Circuit Court's March 2, 2004 decision
vacated much of the TRO and remanded proceedings back to the FCC on certain
issues. At this time we are unable to determine what requirements the FCC will
include in its final rules or when those rules will be definitively promulgated
(and when they will ultimately take effect, after challenge by various potential
litigants). Nevertheless, the Court's order and the conclusions and directives
contained in the order's accompanying opinion may have an adverse effect on the
Company's ability to obtain the use of certain other facilities, equipment and
services from the traditional local phone companies at prices substantially
similar to those we currently pay.
Several other issues that the TRO had addressed in a manner that was
either favorable or neutral to the Company are now subject to uncertainty. Some
of those issues ultimately may be determined in a manner unfavorable to the
Company's interests and could have the effect of increasing our costs.
Prospective modified FCC regulations might include changes:
o to the preferred pricing formula for unbundled network elements
provided to us by the traditional local telephone companies;
o to the set of unbundled network elements that are subject to the FCC's
recommended preferred pricing formula; and
o to the set of network elements that are subject to the 1996
Telecommunications Act's unbundling requirements.
Any changes on any of the foregoing issues that are decided in favor of
the traditional local telephone companies would likely increase our costs of
providing service to our customers. When effective, any new regulations may have
a material adverse affect on our business, results
13
of operations, cash flows, financial condition, or prospects.
In one portion of the TRO that was not vacated by the D.C. Circuit Court's
March 2, 2004 decision, the FCC announced that it would exempt from unbundling
obligations certain loop transmission facilities that use fiber or new
technologies for both the business and residential markets. Depending on how the
new prospective rules are written and implemented, the traditional local
telephone companies over time may decide to modify, characterize or replace
their facilities in ways that would qualify them for this exemption and thereby
preclude us from accessing these facilities pursuant to the terms of their
interconnection agreements. Without access to these facilities, we may not be
able to provide all or certain of our services in these areas.
Another portion of the TRO that the D.C. Circuit Court recently upheld
related to an FCC determination with respect to the unbundling of high
frequency, broadband loops and circuits (commonly known as "high capacity
dedicated transport facilities" and "fiber to the home" circuits and loops). As
a result, the traditional local telephone companies need not make these types of
loops and circuits available to competitive local exchange carriers like us for
resale at wholesale or any other discounted rates. We do not significantly rely
on such facilities and accordingly do not currently believe that such a result
will have any material adverse effect on the Company in the foreseeable future;
however, such developments could somewhat limit the number of acquisition
targets that may have been otherwise potentially attractive to the Company.
The FCC will eliminate the traditional local telephone companies'
obligation to provide the high frequency portion of a copper loop to a
competitive DSL provider, known as "line sharing," over the course of the next
three years. Our current business is not directly affected because we do not use
line sharing to provide services to our customers. Line sharing technology
currently does not support the ability to provide the high-capacity symmetric
services most desired by customers in the business market, and therefore has
been primarily used by other competing carriers to provide DSL services in the
residential market.
The FCC's decisions and its rulemaking in response to related judicial
activity will likely be subject to petitions for reconsideration and appeal. We
cannot predict the outcome of these proceedings on our ability to offer services
in the future.
In addition to the TRO proceedings and related judicial activity, the FCC
in February 2002 initiated a new proceeding that will reevaluate the appropriate
degree of regulation of broadband services offered by the traditional local
telephone companies, including whether they should continue to be required to
offer network access to competitors such as us. Any changes to the obligation of
the traditional local telephone companies to provide us with unbundled copper
loops and/or interoffice transport could have significant adverse consequences
for our business. It is currently unclear when a rule or decision regarding this
specific matter will be issued.
There is also the possibility that legislation will be proposed in the
United States Congress that would limit our access to certain unbundled network
elements. In 2002, the House of Representatives passed legislation known as the
Tauzin-Dingell bill, which would have amended the 1996 Telecommunications Act to
prohibit state or federal regulation of high-speed data services. While the
legislation was ultimately not enacted, similar legislation may be proposed in
the future. The effect of such legislation would be that the traditional local
telephone companies would no longer be required to provide unbundled elements at
cost-based rates (if at all) if those elements were to be used to provide
high-speed data services.
14
The traditional local telephone companies have also lobbied numerous state
legislatures to adopt new legislation that would limit, or prohibit, the ability
of their state utility commissions to expand upon certain federal requirements
relating to the obligations of the traditional local telephone companies to
provide access to competitors such as us. Because the existing FCC framework
relies substantially on state implementation, the effect of such state
legislation, if passed, could be to inhibit favorable implementation of the 1996
Telecommunications Act with respect to broadband services, and could negatively
affect our ability to offer services in these states.
Over the past three years, the FCC has granted authority to provide long
distance inter-exchange service to Verizon, SBC, BellSouth and Qwest in many of
the states where we do business, and numerous additional applications are
pending or are expected in the near future. While we do not presently provide a
material amount of long distance inter-exchange service, this ruling and any
future similar rulings could negatively impact the future prospects for our
business. First, the traditional local telephone companies are now able to offer
bundled packages of local, long distance and data services that may be
attractive to some of our existing and potential customers. Second, the prospect
of long distance authority has served as a powerful incentive for the
traditional local telephone companies to comply with their obligations under the
1996 Telecommunications Act given that compliance with the Act's requirements to
provide unbundled network elements and collocation services to competitors such
as us has been and remains a pre-requisite to the FCC's grant of permission to
enter the long distance business. The traditional local telephone companies may
not extend to us the same level of cooperation once they receive approval to
provide long distance inter-exchange service.
Pursuant to the 1996 Telecommunications Act, the FCC requires all
telecommunications carriers providing interstate telecommunications services to
contribute to a universal service fund used to provide subsidies to carriers
that provide service to individuals that live in rural, insular, and high-cost
areas, and to provide telecommunications-related services and facilities for
schools, libraries and certain rural health care providers. The
telecommunications portion of our service is currently subject to this
requirement. For the fourth quarter of 2003, the FCC has established a
contribution rate of 9.2% of our interstate telecommunications revenues. We pass
the cost of our universal service fund contributions along to our customers. The
FCC's implementation of universal service requirements remains subject to
judicial and additional FCC review. In several new proceedings, the FCC will
consider the degree to which companies providing services such as ours should be
obligated to contribute to this fund. We are unable to predict the outcome of
these proceedings and their impact on our business at this time.
DSL.net's subsidiaries are authorized to provide interstate
telecommunications services pursuant to its access tariff filed with the FCC in
April 1999. Although not required for our existing DSL data service offering, on
August 6, 1999 we obtained authority from the FCC to provide international
telecommunications services originating from the United States.
STATE REGULATION
In October 1998, the FCC ruled that DSL and other advanced data services
provided as dedicated access services in connection with interstate services
such as Internet access are interstate services subject to the FCC's
jurisdiction. Accordingly, we could offer DSL services without state regulatory
authority, so long as we do not also provide local or intrastate
telecommunications services via our network. This decision allows us to provide
our DSL services in a manner that potentially reduces state regulatory
obligations. However, the regulatory parameters used to define DSL service are,
directly and indirectly, subject to many
15
pending FCC and judicial proceedings and could change in the future.
Also, some of our services that are not limited to interstate access
potentially may be classified as intrastate services subject to state
regulation. All of the states where we operate require some degree of state
regulatory commission approval to provide certain intrastate services and
maintain ongoing regulatory supervision. In most states, intrastate tariffs are
also required for various intrastate services, although our services are not
subject to price or rate of return regulation. Actions by state public utility
commissions could cause us to incur substantial legal and administrative
expenses and adversely affect our business.
We have obtained authorizations to provide local exchange and
long-distance telecommunications services in all 50 states, the District of
Columbia, and Puerto Rico.
LOCAL GOVERNMENT REGULATION
In certain instances, we may be required to obtain various permits and
authorizations from municipalities, such as for use of rights-of-way, in which
we operate our own local distribution facilities. Whether various actions of
local governments over the activities of telecommunications carriers such as
ours, including requiring payment of franchise fees or other surcharges, pose
barriers to entry for competitive local exchange carriers which violate the 1996
Telecommunications Act or may be preempted by the FCC is the subject of
litigation. While we are not a party to this litigation, we may be affected by
the outcome. If municipal governments impose conditions on granting permits or
other authorizations or if they fail to act in granting such permits or other
authorizations, the cost of providing our services may increase or it may
negatively impact our ability to expand our network on a timely basis and
adversely affect our business.
INTELLECTUAL PROPERTY
We regard our products, services and technology as proprietary and attempt
to protect them with patents, copyrights, trademarks, trade secret laws,
restrictions on disclosure and other methods, as applicable. For example, we own
a federal supplemental registration and claim rights in the name DSL.net. There
can be no assurance these methods will be sufficient to protect our technology
and intellectual property. We also generally enter into confidentiality
agreements with our employees, consultants and business partners; and generally
control access to and distribution of our documentation and other proprietary
information. Despite these precautions, it may be possible for a third party to
copy or otherwise obtain and use our proprietary information without
authorization, or to develop similar information independently. Effective
patent, copyright, trademark and trade secret protection may be unavailable or
limited in certain foreign countries, and the global nature of the Internet
makes it virtually impossible to control the ultimate destination of our
technology or proprietary information. There can be no assurance that the steps
we have taken will prevent misappropriation or infringement of our technology or
proprietary information. In addition, litigation may be necessary in the future
to enforce our intellectual property rights, to protect our trade secrets or to
determine the validity and scope of the proprietary rights of others. Such
litigation could result in substantial costs and diversion of resources and
could have a material adverse effect on our business, operating results and
financial condition. In addition, some of our information, including our
competitive carrier status in individual states and our interconnection
agreements, is a matter of public record and can be readily obtained by our
competitors and potential competitors, possibly to our detriment.
16
EMPLOYEES
As of March 25, 2004, we had approximately 175 employees. We believe that
our future success will depend in part on our continued ability to attract, hire
and retain qualified personnel. Competition for qualified personnel can be
intense, and we may be unable to identify, attract and retain such personnel in
the future. In addition, reductions in our workforce (including those that we
undertook in 2001, 2003 and 2004) may make it difficult to attract, hire and
retain qualified personnel. None of our employees are represented by a labor
union or are the subject of a collective bargaining agreement. We have never
experienced a work stoppage and believe that our employee relations are good.
ITEM 2. PROPERTIES
Our headquarters consists of approximately 31,500 square feet in an office
building in New Haven, Connecticut. We also lease other offices in Santa Cruz,
California; Minneapolis, Minnesota; Wilmington, North Carolina; and Herndon,
Virginia. We vacated and sublet the office in Santa Cruz, California from
December, 2001 through July, 2003; our Santa Cruz office is currently vacant.
See "Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations". In addition, we lease space for network equipment
installations in a number of other locations. With respect to our arrangements
to use space in traditional telephone companies' central offices, please see
Item 1 - Business, "Interconnection Agreements with Traditional Local Telephone
Companies."
ITEM 3. LEGAL PROCEEDINGS
A lawsuit for wrongful termination of employment was filed against us in
the Superior Court in New Haven, Connecticut on July 29, 1999 by a former
officer who was employed by us for less than two months. Plaintiff's claims are
based chiefly on his allegation that we terminated his employment because he
allegedly voiced concerns to senior management about the feasibility of certain
aspects of our business strategy. The plaintiff is principally seeking
compensatory damages for wages and unvested stock options. We deny the
plaintiff's allegations and believe that his claims are without merit. We have
been defending the case vigorously and plan to continue to do so.
A lawsuit was filed against us in Connecticut State Court in the Judicial
District of New Haven on January 15, 2004 by an individual who claims that he
was offered a sales manager position at the Company in December 2003 but was
wrongly deprived of that position at or immediately prior to his initial
employment date. The plaintiff's complaint includes claims for breach of
contract, negligent misrepresentation and intentional infliction of emotional
distress. We deny the plaintiff's allegations and believe that his claims are
without merit. We plan to defend the case vigorously.
We are also a party to legal proceedings related to regulatory approvals.
We are subject to state commission, FCC and court decisions as they relate to
the interpretation and implementation of the 1996 Telecommunications Act and the
interpretation of competitive carrier interconnection agreements in general and
our interconnection agreements in particular. In some cases, we may be deemed to
be bound by the results of ongoing proceedings of these bodies. We therefore may
participate in proceedings before these regulatory agencies or judicial bodies
that affect, and allow us to advance, our business plans.
From time to time, we may be involved in other litigation concerning
claims arising in the
17
ordinary course of our business, including claims brought by current or former
employees and claims related to acquisitions. We do not currently believe that
any of these legal claims or proceedings will result in a material adverse
effect on our business, financial position, results of operations or cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The information required by this Item 4 was included in Item 4 of Part II
of the Quarterly Report on Form 10-Q for the fiscal periods ended September 30,
2003, which has been filed with the Securities and Exchange Commission.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
MARKET INFORMATION
As of March 1, 2004, there were approximately 609 holders of record of our
common stock. Our common stock is listed for quotation on the Nasdaq SmallCap
Market under the symbol "DSLN". Our common stock was listed for quotation on the
Nasdaq National Market under the same symbol until July 22, 2002.
The range of high and low bid prices per share of DSL.net's common stock
as reported on the Nasdaq National Market and the Nasdaq SmallCap Market for the
two most recent fiscal years are shown below. The last trading price of DSL.net
common stock on March 25, 2004 was $ 0.48 per share.
Quarter Ended High Low
------------- ----- -----
March 31, 2002 $1.38 $0.70
June 30, 2002 1.05 0.29
September 30, 2002 0.45 0.24
December 31, 2002 0.89 0.28
March 31, 2003 0.67 0.36
June 30, 2003 0.76 0.35
September 30, 2003 1.07 0.51
December 31, 2003 $0.77 $0.51
On July 22, 2002, The Nasdaq Stock Market, Inc. ("Nasdaq") transferred the
listing of our common stock from the Nasdaq National Market to the Nasdaq
SmallCap Market. We applied for such transfer as a result of our non-compliance
with Nasdaq's Marketplace Rule 4450(a)(5), which required us to maintain a
minimum bid price of $1.00 per share for at least 10 consecutive trading days
during the last ninety day period prior to July 17, 2002 in order to remain
qualified for listing on the Nasdaq National Market. On October 16, 2002, Nasdaq
notified us that, while we had not regained compliance by October 15, 2002 with
the $1.00 minimum bid price per share requirement generally required for
continued listing on the Nasdaq SmallCap Market, we did continue to meet the
initial listing requirements for the Nasdaq
18
SmallCap Market under Rule 4310(c)(2)(A). As a result, we were afforded an
additional 180 calendar days, or until April 14, 2003, to comply with the
minimum bid price of $1.00 per share for 10 consecutive trading days, or such
greater number of trading days as Nasdaq may have determined, in order to remain
listed on the Nasdaq SmallCap Market. On March 11, 2003, Nasdaq amended its
rules to provide that a company that satisfies the initial listing requirements
for the Nasdaq SmallCap Market under Rule 4310(c)(2)(A) would have an additional
90 days (over the 180 days already contemplated by the Nasdaq SmallCap Market
rules) to comply with the minimum bid price of $1.00 per share. On April 15,
2003, Nasdaq notified us that, while we had not regained compliance by April 14,
2003 with the $1.00 minimum bid price per share requirement generally required
for continued listing on the Nasdaq SmallCap Market, we did continue to meet the
initial listing requirements for the Nasdaq SmallCap Market under Rule
4310(c)(2)(A). As a result, we were afforded an additional 90 calendar days, or
until July 14, 2003, to comply with the minimum bid price of $1.00 per share for
10 consecutive trading days, or such greater number of trading days as Nasdaq
may have determined, in order to remain listed on the Nasdaq SmallCap Market. On
July 15, 2003, we received notification from the Nasdaq staff indicating that
our common stock failed to comply with the $1.00 closing bid price per-share
requirement for 10 consecutive trading days as set forth in the Nasdaq's
Marketplace Rule 4310(c)(4) and as such our common stock was subject to
delisting from the Nasdaq SmallCap Market. We appealed this determination to a
Listings Qualifications Panel and were subsequently granted an extension until
November 17, 2003, to comply with the minimum bid price of $1.00 per share for a
minimum of 10 consecutive days. On October 7, 2003, Nasdaq notified us that we
had been granted an additional extension until December 8, 2003 to gain
compliance with the minimum bid price rule pending SEC action on certain Nasdaq
proposed rule changes (discussed below). On December 12, 2003, Nasdaq notified
us that we had been granted an additional extension until January 30, 2004 to
gain compliance with the minimum bid price rule. This extension was granted to
allow for further developments in the pending SEC action on certain Nasdaq rule
changes (discussed below). On December 23, 2003, the SEC approved certain
modifications to Nasdaq's bid price requirements and subsequently notified us on
January 2, 2004 that we had been granted an additional extension until April 19,
2004 to gain compliance with the minimum bid price rule as set forth in Nasdaq's
newly amended Marketplace Rule 4310(c)(8)(D) (discussed below). There can be no
assurance that we will be able to continue to remain listed on the Nasdaq
SmallCap Market.
Nasdaq submitted proposed rule changes to the SEC which proposed, among
other things, to modify the grace periods for companies trying to come into
compliance with the bid price requirements for continued listing. On December
23, 2003, the SEC approved certain modifications to Nasdaq's bid price
requirements. Under the amended Marketplace Rule 4310(c)(8)(d), the Company has
until April 19, 2004 to trade at or above $1.00 per share for a minimum of 10
consecutive trading days, or, if the bid price deficiency is not remedied by
that date, to take steps for implementation of a reverse stock split in order to
continue its Nasdaq SmallCap Market listing. At the annual meeting of
stockholders held on October 14, 2003, our stockholders authorized our Board of
Directors to implement a reverse stock split for this purpose, at their
discretion.
19
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DIVIDEND POLICY
We have never declared or paid any cash dividends on our common stock and
currently intend to retain any future earnings for the future operation and
expansion of our business. In addition, prior to and in preference to any
declaration or payment of any cash dividends on our common stock, the holders of
our Series X and Series Y preferred stock are entitled to receive cumulative
dividends of $120.00 per share per annum when and as declared by the DSL.net
Board of Directors. All such dividends on the Series X and Series Y preferred
stock accrue monthly and are payable in cash, except in the case of the
conversion of the Series X or Series Y preferred stock, as the case may be, into
common stock, in which case dividends may be paid, at the sole option of
DSL.net, in shares of DSL.net common stock. Notwithstanding the foregoing,
accrued but unpaid dividends are payable upon the earliest to occur of:
o the liquidation, dissolution, winding up or change in control of
DSL.net,
o the conversion of the Series X or Series Y preferred stock, as the case
may be, into common stock, and
o the redemption of the Series X or Series Y preferred stock, as the case
may be.
During the second half of 2003 and the first quarter of 2004, all of the issued
and outstanding shares of our Series Y preferred stock and 6,000 of the issued
and outstanding shares of our Series X preferred stock were converted into
shares of our common stock and all accrued dividends on these converted shares
were paid in shares of our common stock. We do not anticipate that any cash
dividends will be declared or paid on our common stock in the foreseeable
future.
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information as of March 22, 2004 with respect
to the shares of the Company's common stock that may be issued under the
Company's existing equity compensation plans:
- -----------------------------------------------------------------------------------------------------
Number of Weighted Average Number of Securities Remaining
Securities to be Exercise Price of Available for Future Issuance
Issued upon Outstanding Options Under Equity Compensation Plans
Exercise of (Excluding Securities Reflected
Outstanding in the first Column)
Plan Category Options
- -------------------------- ------------------ --------------------- ---------------------------------
Equity
Compensation Plans
Approved by
Shareholders 38,194,897 $0.81 12,373,979
- -------------------------- ------------------ --------------------- ---------------------------------
Equity
Compensation Plans
Not Approved by
Shareholders -- -- --
- -------------------------- ------------------ --------------------- ---------------------------------
Total 38,194,897 $0.81 12,373,979
- -------------------------- ------------------ --------------------- ---------------------------------
20
RECENT SALES OF UNREGISTERED SECURITIES
Between July 2003 and March 2004, we issued 37,710,788 shares of our
common stock upon conversion of 15,000 shares of our Series Y preferred stock
(33,890,669 shares upon conversion and 3,820,119 shares issued as dividends) and
we issued 35,650,165 shares of our common stock upon conversion of 6,000 shares
of our Series X preferred stock (33,333,333 shares upon conversion and 2,316,832
shares issued as dividends).
No underwriters were involved in the foregoing sales of securities. Such
sales were made in reliance upon an exemption from the registration requirements
of the Securities Act of 1933, as amended, set forth in Sections 3(a)(9) and
4(2) thereof.
21
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following historical data for the years ended December 31, 2003,
2002, 2001, 2000 and 1999, except for "Other Data," has been derived from our
financial statements audited by PricewaterhouseCoopers LLP, independent
accountants. Our balance sheets at December 31, 2003 and 2002 and the related
statements of operations, changes in stockholders' equity and cash flows for the
years ended December 31, 2003, 2002 and 2001 and notes thereto appear elsewhere
in this annual report on Form 10-K.
Reference is also made to "Item 7 - Management's Discussion and Analysis
of Financial Condition and Results of Operations" and the more complete
financial information included elsewhere in this annual report on Form 10-K.
Year Ended December 31,
--------------------------------------------------------------------------
2003 2002 2001 2000 1999
--------------------------------------------------------------------------
STATEMENT OF OPERATIONS DATA:
Revenue $ 71,333 $ 45,530 $ 41,969 $ 17,789 $ 1,313
Operating expenses:
Network (A) 51,452 33,470 44,451 30,599 1,641
Operations (A) 11,873 7, 949 45,752 32,112 5,974
General and administrative (A) 12,200 11,403 25,229 17,974 4,782
Sales and marketing (A) 8,642 6,969 13,188 25,263 6,848
Stock compensation 438 1,228 1,202 3,192 4,108
Depreciation and amortization 16,359 20,332 28,043 21,133 1,831
--------------------------------------------------------------------------
Total operating expenses 100,964 81,351 157,865 130,273 25,184
Operating loss (29,631) (35,821) (115,896) (112,484) (23,871)
Interest income (expense), net (2,936) (458) 455 6,730 1,889
Other (expense) income, net (2,430) 185 (13) (9) (6)
--------------------------------------------------------------------------
Net loss $ (34,997) $ (36,094) $ (115,454) $ (105,763) $ (21,988)
Exchange of preferred stock -- -- -- -- (11,998)
Dividends on preferred stock (3,698) (3,573) (122) -- --
Accretion of preferred stock (14,327) (10,078) (348) -- --
--------------------------------------------------------------------------
Net loss applicable to common stockholders $ (53,022) $ (49,745) $ (115,924) $ (105,763) $ (33,986)
--------------------------------------------------------------------------
NET LOSS PER COMMON SHARE DATA:
Net Loss per common share, basic and
diluted $ (0.72) $ (0.77) $ (1.81) $ (1.75) $ (2.05)
Shares used in computing net loss per share 74,126 64,858 63,939 60,593 16,550
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Year Ended December 31,
--------------------------------------------------------------------------
2003 2002 2001 2000 1999
--------------------------------------------------------------------------
CASH FLOW DATA:
Used in operating activities $ (13,715) $ (17,706) $ (62,989) $ (74,986) $ (6,343)
Used in investing activities (11,135) (2,368) (2,921) (60,225) (49,264)
Provided by financing activities $ 27,311 $ 12,107 $ 12,871 $ 141,960 $ 121,142
OTHER DATA:
Reconciliation of net loss to adjusted EBITDA:
Net loss $ (34,997) $ (36,094) $ (115,454) $ (105,763) $ (21,988)
Add: Interest and other (income) expense,
net 5,366 273 (442) (6,721) (1,883)
Depreciation and amortization 16,359 20,332 28,043 21,133 1,831
Stock compensation 438 1,228 1,202 3,192 4,108
--------------------------------------------------------------------------
Adjusted EBITDA (B) $ (12,834) $ (14,261) $ (86,651) $ (88,159) $ (17,932)
--------------------------------------------------------------------------
Reconciliation of Adjusted EBITDA to net
cash used in operating activities:
Adjusted EBITDA $ (12,834) $ (14,261) $ (86,651) $ (88,159) $ (17,932)
Interest and other (expense) income, net (450) (444) 611 6,764 1,926
Financing costs (deferrals) expenses (183) -- 49 21 14
Bad debt expense 2,117 2,536 2,996 700 63
Sales discounts 394 1,181 1,498 590 --
Restructuring / impairment charges -- -- 34,083 1,417 --
Write off / sales of equipment 46 555 229 (7) --
Net changes in assets and liabilities (2,805) (7,273) (15,804) 3,687 9,586
--------------------------------------------------------------------------
Net cash used in operating activities $ (13,715) $ (17,706) $ (62,989) $ (74,986) $ (6,343)
==========================================================================
Capital expenditures $ 2,405 $ 1,647 $ 5,345 $ 55,943 $ 33,811
December 31,
--------------------------------------------------------------------------
2003 2002 2001 2000 1999
--------------------------------------------------------------------------
Balance Sheet Data:
Cash, cash equivalents, restricted cash
and marketable securities $ 13,784 $ 11,319 $ 19,631 $ 76,435 $ 79,452
Total assets 59,061 53,496 81,024 194,806 117,632
Long-term obligations (including current
portion) 5,529 4,565 7,463 14,114 3,056
Mandatorily redeemable convertible
preferred stock 17,019 14,122 470 -- --
Stockholders' equity $ 18,300 $ 20,751 $ 50,725 $ 149,417 $ 100,733
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(A) Excluding stock compensation, depreciation and amortization.
(B) Adjusted EBITDA, shown above under "Other Data", consists of net loss
excluding net interest and other income/expense, taxes, depreciation,
amortization of intangibles and non-cash stock compensation expense. Other
companies, however, may calculate Adjusted EBITDA differently from us. We have
provided Adjusted EBITDA because it is a measure of financial performance
commonly used for comparing companies in the telecommunications industry in
terms of operating performance, leverage, and ability to incur and service debt.
Adjusted EBITDA is not a measure determined under generally accepted accounting
principles. Adjusted EBITDA should not be considered in isolation from, and you
should not construe it as a substitute for:
o operating loss as an indicator of our operating performance,
o cash flows from operating activities as a measure of liquidity,
o other consolidated statement of operations or cash flows data presented
in accordance with generally accepted accounting principles, or
o as a measure of profitability or liquidity.
The above financial data includes the operating results of acquisitions
from their acquisition date, which consequently will affect the comparability of
such financial data from year to year.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND
RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH "ITEM 6 - SELECTED
CONSOLIDATED FINANCIAL DATA" AND "ITEM 8 - FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA" THAT APPEAR ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K.
THIS DISCUSSION AND ANALYSIS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE SUCH A
DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE SET FORTH UNDER "RISK FACTORS"
AND ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K. EXISTING AND PROSPECTIVE
INVESTORS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING
STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE HEREOF. WE UNDERTAKE NO OBLIGATION,
AND DISCLAIM ANY OBLIGATION, TO UPDATE OR REVISE THE INFORMATION CONTAINED IN
THIS ANNUAL REPORT ON FORM 10-K, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE
EVENTS OR CIRCUMSTANCES OR OTHERWISE.
OVERVIEW
OUR BUSINESS
We provide high-speed data communications, Internet access, and related
services to small
24
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
and medium sized businesses and branch offices of larger businesses and their
remote office users, throughout the United States, primarily utilizing digital
subscriber line ("DSL") and T-1 technology. In September of 2003, we expanded
our service offerings to business customers in select Mid-Atlantic and Northeast
markets to include integrated voice and data services using VoIP. Our networks
enable data transport over existing copper telephone lines at speeds of up to
1.5 megabits per second. Our product offerings also include Web hosting, domain
name system management, enhanced e-mail, on-line data backup and recovery
services, firewalls, nationwide dial-up services, private frame relay services
and virtual private networks.
We sell directly to businesses, primarily through our own direct sales
force, and to third party resellers whose end users are typically business-class
customers. We deploy our own local communications equipment primarily in select
first and second tier cities. In certain markets where we have not deployed our
own equipment, we utilize the local facilities of other carriers to provide our
service.
OUR GROWTH STRATEGY
In addition to our internal sales and marketing efforts, our strategic
goals have been focused on accelerating our growth and expanding our network and
customer base through select acquisitions of customer lines, assets and/or
businesses. During 2003, we completed the following strategically significant
acquisitions:
o In January 2003, we acquired the majority of Network Access Solutions
Corporation's ("NAS") operations and assets, including operations and
equipment in approximately 300 central offices extending from Virginia
to Massachusetts, and approximately 11,500 subscriber lines (the "NAS
Assets"). This acquisition significantly increased 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. Currently, we operate equipment in
approximately 490 central offices located in approximately 340 cities
in the United States.
o In September 2003, we acquired substantially all of the assets and
subscribers of TalkingNets, Inc., a voice and data communications
provider that offered soft switched-based VoIP and high-speed data
services to businesses. This acquisition gave us the capability to
offer business customers in the business-intensive Mid-Atlantic and
Northeast regions a carrier-class integrated voice and data service
which utilizes VoIP. In December 2003, we introduced in the Washington,
D.C. metropolitan region, an expanded range of VoIP products that
offered integrated voice and data services utilizing DSL-based services
in addition to our T-1 based services. In February 2004, we introduced
our full suite of VoIP and data bundles in the New York City
metropolitan area.
We continuously identify and evaluate acquisition candidates, and in many
cases engage in discussions and negotiations regarding potential acquisitions.
Acquisition candidates include both subscriber lines and whole businesses. Our
discussions and negotiations may not result in an acquisition. Further, if we
make any acquisitions, we may not be able to operate any acquired businesses
profitably or otherwise successfully implement our expansion strategy. We intend
to continue to seek additional opportunities for further acquisitions, which we
believe represents a distinct opportunity to accelerate our growth. We may need
to obtain additional funding to finance additional acquisitions, accordingly, we
continue to engage and pursue discussions with potential investors.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
We also believe there are significant revenue growth opportunities for our
newly introduced VoIP suite of integrated voice and data services. We may also
seek additional funding to expand our voice network in order to accelerate this
growth opportunity.
OUR CASH FINANCINGS AND CONSTRAINTS
Although we have made noticeable progress in reducing the amount of cash
used by our operations, we have not been able to finance our operations from
cash provided by operations. In 2003, 2002 and 2001, net cash used in our
operating activities was approximately $13,715, $17,706 and $62,989,
respectively. The reductions in cash used for operating activities as a percent
of revenues over the three-year period was primarily attributable to increased
revenues and related margins, primarily resulting from acquisitions, combined
with reduced operational expenses (network, operations, selling, general and
administrative expenses), primarily resulting from our restructuring and cost
containment efforts (discussed below).
We also have incurred operating losses and net losses for each month since
our formation in 1998. As of December 31, 2003 and 2002, we had accumulated
deficits of approximately $319,488 and $284,491, respectively.
In addition, our growth strategies have required significant capital and
cash investments. Our operating cash shortfalls and investments have been
financed principally with the proceeds from the sale of stock and from
borrowings, including equipment lease financings. Our most significant recent
financings include:
o In July 2003, we executed a note and warrant purchase agreement for the
sale of $30,000 in senior secured promissory notes and issuance of
warrants to purchase 157,894,737 shares of our common stock at an
exercise price of $0.38 per share for an aggregate purchase price for
the notes and warrants of $30,000. We used approximately $10,200 of the
proceeds from this financing to prepay approximately $14,600 in
pre-existing debt and lease obligations.
o In late 2001 and early 2002, we secured additional private equity
financing from the sale of $35,000 of our Series X and Series Y
preferred stock.
Our independent accountants have noted in their report that our sustained
operating losses raise substantial doubt about our ability to continue as a
going concern. Our business plan includes modest revenue growth for 2004
generated from internal direct marketing sales efforts and additional
operational cost savings to be obtained from streamlining our network and
further reducing discretionary and controllable costs. During the last quarter
of 2003 and the first quarter of 2004, we began implementing some of these cost
reduction measures, including a reduction-in-force of approximately 63 employees
on March 25, 2004. Accordingly, based on our current business plans and
projections as approved by our Board of Directors, we believe that our existing
cash and cash expected to be generated from operations will be sufficient to
fund our operating losses, capital expenditures, lease payments, and working
capital requirements into 2005. 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, cash flows
and financial position, including our ability to continue as a going concern.
We intend to use our cash resources to finance our capital expenditures
and for our working capital and other general corporate purposes. We may also
need additional funding to pursue our strategic objective of accelerating our
growth through acquisition of complementary businesses, subscriber lines and
other assets. The amounts actually expended for these purposes will vary
26
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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 of and prices paid for acquisitions.
Our cash requirements may vary based upon the timing and the success of
implementation of our business plan or if:
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make acquisitions;
o we alter the schedule or targets of our business plan implementation;
or
o we curtail and/or reorganize our operations.
Our financial performance, and whether we achieve profitability or become
cash flow positive, will depend on a number of factors, including:
o development of the high-speed data communications industry and our
ability to compete effectively;
o amount, timing and pricing of customer revenue;
o availability, timing and pricing of acquisition opportunities, and our
ability to capitalize on such opportunities;
o commercial acceptance of our service and attaining expected penetration
within our target markets;
o our ability to recruit and retain qualified personnel;
o up front sales and marketing expenses;
o cost and utilization of our network components which we lease from
other telecommunications providers, including other competitive
carriers;
o our ability to establish and maintain relationships with marketing
partners;
o successful implementation and management of financial, information
management and operations support systems to efficiently and
cost-effectively manage our operational growth; and
o favorable outcome of federal and state regulatory proceedings and
related judicial proceedings, including proceedings relating to the
1996 Telecommunications Act and the Federal Communications Commissions'
Triennial Review Order.
27
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
There can be no assurance that we will be able to achieve our business
plan objectives or that we will achieve or maintain cash flow positive operating
results. If we are unable to generate adequate funds from our operations, we may
not be able to continue to operate our network, respond to competitive pressures
or fund our operations. As a result, we may be required to significantly reduce,
reorganize, discontinue or shut down our operations. Our financial statements do
not include any adjustments that might result from this uncertainty.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RISKS
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.
The following is a brief discussion of the more significant accounting
policies and methods and the judgments and estimates used by us in their
application.
REVENUE RECOGNITION
We recognize revenue in accordance with SEC Staff Accounting Bulletin No.
101 (SAB No. 101), "Revenue Recognition in Financial Statements", which requires
that four basic criteria must be met before revenue can be recognized: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred or
services rendered; (3) the fee is fixed and determinable; and (4) collectibility
is reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which varies based on the speed of the customer's Internet
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of the equipment installed
at the customer's site and the other services we provide, as applicable. Revenue
that is billed in advance of the services provided is deferred until the
services are rendered. Revenue related to installation charges is also deferred
and amortized to revenue over 18 months. Related direct costs incurred (up to
the amount of deferred revenue) are also deferred and amortized to expense over
18 months. Any excess direct costs over installation charges are charged to
expense as incurred. In certain instances, we negotiate credits and allowances
for
28
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
service related matters. We establish a reserve for such credits based on
historical experience. From time to time we offer sales incentives to our
customers in the form of rebates toward select installation services and
customer premise equipment. We record a liability based on historical experience
for such estimated rebate costs, with a corresponding reduction to revenue.
We seek to price our services competitively. The market for high-speed
data communications services and Internet access is rapidly evolving and
intensely competitive. While many of our competitors and potential competitors
enjoy competitive advantages over us, we are pursuing a significant market that,
we believe, is currently under-served. Although pricing is an important part of
our strategy, we believe that direct relationships with our customers and
consistent, high quality service and customer support will be key to generating
customer loyalty. During the past several years, market prices for many
telecommunications services and equipment have been declining, a trend that
might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
We account for our long-lived assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, "ACCOUNTING FOR THE IMPAIRMENT
OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF" ("SFAS No.
144"), 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 No. 142"). This statement requires that the
amortization of goodwill be discontinued and instead an impairment approach be
applied. The impairment tests were performed during the first quarter of 2002
and last quarters of 2002 and 2003, and will be performed annually hereafter (or
more often if adverse events occur) and are based upon a fair value approach
rather than an evaluation of the undiscounted cash flows. If impairment exists,
under SFAS No. 142, the resulting charge is determined by the recalculation of
goodwill through a hypothetical purchase price allocation of the fair value and
reducing the current carrying value to the extent it exceeds the recalculated
goodwill. We did not record any goodwill impairment adjustments resulting from
our impairment reviews during 2002 and 2003.
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result we may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
primarily sell our services directly to end users mainly consisting of small to
medium sized businesses, but we also sell our services to
29
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
certain resellers, such as to Internet service providers ("ISPs"). We believe
that we do not have significant exposure or concentrations of credit risk with
respect to any given customer, as no customer accounted for more than 5% of
annual revenues for the years ended December 31, 2003, 2002 or 2001,
respectively. However, if the country or any region we service, experiences an
economic downturn, the financial condition of our customers could be adversely
affected, which could result in their inability to make payments to us. This
could require additional provisions for allowances. In addition, a negative
impact on revenue related to those customers may occur.
With the acquisition of the NAS Assets on January 10, 2003, we acquired a
number of end users, some of whom we service indirectly through various ISPs. We
sell our services to such ISP's 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 2003.
INVENTORY
Inventories consist of modems and routers (customer premise equipment or
"CPE") which we either sell or lease to customers, and are required to establish
a high speed DSL or T-1 digital connection. Inventories are stated at the lower
of cost or market. Cost of inventory is determined on the "first-in, first-out"
("FIFO") or average cost methods. We establish inventory reserves for excess,
obsolete or slow-moving inventory based on changes in customer demand,
technology developments and other factors.
INCOME TAXES
We use the liability method of accounting for income taxes, as set forth
in Statement of Financial Accounting Standards No. 109, "ACCOUNTING FOR INCOME
TAXES". Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of temporary differences between the
carrying amounts and the tax basis of assets and liabilities and net operating
loss carryforwards, all calculated using presently enacted tax rates.
We have not generated any taxable income to date and, therefore, have not
paid any federal income taxes since inception. Our state and federal net
operating loss carryforwards begin to expire in 2004 and 2019, respectively. Use
of our net operating loss carryforwards may be subject to significant annual
limitations resulting from a change in control due to securities issuances
including 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
current or former employees and claims related to acquisitions. We record
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on an analysis made by legal counsel who consider
information known at the time. We believe we have made reasonable estimates in
the past; however, court decisions could cause liabilities to be incurred in
excess of estimates.
30
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2001, SFAS No. 143, "ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS"
("SFAS No. 143") was issued. SFAS No. 143 addresses financial accounting and
reporting for legal obligations associated with the retirement of tangible
long-lived assets and the associated retirement costs that result from the
acquisition, construction, or development and normal operation of a long-lived
asset. Upon initial recognition of a liability for an asset retirement
obligation, SFAS No.143 requires an increase in the carrying amount of the
related long-lived asset. The asset retirement cost is subsequently allocated to
expense using a systematic and rational method over the assets useful life. SFAS
No. 143 is effective for fiscal years beginning after June 15, 2002. The
adoption of this statement on January 1, 2003, did not have a material affect on
our financial position or results of operations.
In August 2001, SFAS No. 144, "ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL
OF LONG-LIVED ASSETS" was issued. SFAS No. 144 supersedes SFAS No. 121,
"ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS TO BE DISPOSED OF" and
supercedes and amends certain other accounting pronouncements. SFAS No. 144
retains the fundamental provisions of SFAS No. 121 for recognizing and measuring
impairment losses on long-lived assets held for use and long-lived assets to be
disposed of by sale, while resolving significant implementation issues
associated with SFAS No. 121. Among other things, SFAS No. 144 provides guidance
on how long-lived assets used as part of a group should be evaluated for
impairment, establishes criteria for when long-lived assets are held for sale,
and prescribes the accounting for long-lived assets that will be disposed of
other than by sale. SFAS No. 144 is effective for fiscal years beginning after
December 15, 2001. The adoption of SFAS No. 144 did not have an impact on our
financial position and results of operations in 2002 or 2003.
In June 2002, SFAS No. 146, "ACCOUNTING FOR EXIT OR DISPOSAL ACTIVITIES"
("SFAS No. 146"). was issued. SFAS No. 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 SFAS No. 146 did not have a material impact 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 No. 148") was
issued. SFAS No. 148 amends SFAS No. 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 No. 148 amends the
disclosure requirements of SFAS No. 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 No. 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 No. 148 and incorporated those requirements into its
financial statements.
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
31
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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 our financial position, results of operations or cash flows.
In January 2003, the FASB issued FIN No. 46, "CONSOLIDATION OF VARIABLE
INTEREST ENTITIES." FIN No.46 requires that companies that control another
entity through interests other than voting interests should consolidate the
controlled entity. FIN No. 46 is effective for variable interest entities
created after January 31, 2003 and to any variable interest entities in which
the company obtains an interest after that date. FIN No. 46 was originally
effective for the quarter ending September 30, 2003 for variable interest
entities in which the company held a variable interest that it acquired before
February 1, 2003. However, in October 2003, the FASB deferred the effective date
for implementation of FIN No. 46 until December 31, 2003. Accordingly, we
adopted FIN No. 46 effective December 31, 2003 with no material impact on our
financial condition or results of operations.
In April 2003, the FASB issued SFAS No. 149, "AMENDMENT OF STATEMENT 133
ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES." ("SFAS No. 149") SFAS No. 149
amends and clarifies certain derivative instruments embedded in other contracts,
and for hedging activities under SFAS No. 133. SFAS No. 149 was effective for
certain contracts entered into or modified after June 30, 2003. We adopted SFAS
No. 149 effective July 1, 2003 with no material impact on our financial
condition 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 No. 150"). SFAS No. 150 specifies that freestanding financial instruments
within its scope constitute obligations of the issuer and that, therefore, the
issuer must classify them as liabilities. Such freestanding financial
instruments include mandatorily redeemable financial instruments, obligations to
repurchase the issuer's equity shares by transferring assets and certain
obligations to issue a variable number of shares. SFAS No. 150 was effective
immediately for all financial instruments entered into or modified after May 31,
2003. For all other instruments, SFAS No. 150 was effective at the beginning of
the third quarter of 2003. We adopted SFAS No. 150 effective July 1, 2003 with
no material impact on our financial condition or results of operations.
In May 2003, The Emerging Issues Task Force ("EITF") released Issue No.
00-21 "REVENUE ARRANGEMENTS WITH MULTIPLE DELIVERABLES" ("EITF 00-21"). EITF
00-21 requires that: (i) revenue arrangements with multiple deliverables be
divided into separate units of accounting if: the deliverables in the
arrangement have value to the customer on a standalone basis; there is objective
and reliable evidence of the fair value of the undelivered items; and if the
arrangement includes a right of return of a delivered item, delivery or
performance of the undelivered items is considered probable and substantially in
control of the vendor, (ii) arrangement consideration should be allocated among
the separate units of accounting based on their relative fair values, and (iii)
applicable revenue recognition criteria should be considered separately for
separate units of accounting. EITF 00-21 became effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. We
have not yet adopted EITF 00-21, but we have evaluated the impact of adoption,
and determined that it would not have a material effect on our financial
condition or results of operations.
32
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
RESULTS OF OPERATIONS
The following table depicts our results of operations data and the
components of net loss as a percentage of revenue:
Year Ended December 31,
-----------------------
2003 2002 2001
---- ---- ----
Revenue 100.0% 100.0% 100.0%
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Operating expenses:
Network (excluding stock compensation) 72.1% 73.5% 105.9%
Operations
(excluding stock compensation) 16.6% 17.4% 109.0%
General and administrative
(excluding stock compensation) 17.2% 25.0% 60.1%
Sales and marketing
(excluding stock compensation) 12.1% 15.3% 31.4%
Stock compensation 0.6% 2.7% 2.9%
Depreciation and amortization 22.9% 44.7% 66.8%
--------------------------------------
Total operating expenses 141.5% 178.7% 376.1%
Operating loss (41.5)% (78.7)% (276.1)%
Interest (expense) income, net (4.1)% (1.0)% 1.0%
Other (expense) income, net (3.4)% 0.4% 0.0%