Back to GetFilings.com
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------
Form 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Year Ended December 31, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 000-26873
DIGEX, INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 59-3582217
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
14400 Sweitzer Lane
Laurel, MD 20707
(Address of principal executive offices)
(240) 264-2000
Telephone Number
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 $.01 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 reports), 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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment in this Form 10-K. [ ]
Aggregate market value of the voting stock held by non-affiliates (1) of
the registrant on February 28, 2002: $22,791,727.
As of February 28, 2002, there were 24,788,466 and 39,350,000 shares of
the Registrant's Class A and Class B Common Stock outstanding, respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of the Form 10-K will be incorporated by reference from the
Registrant's Proxy Statement for the 2002 Annual Meeting of Stockholders.
(1) As used herein, "voting stock held by non-affiliates" means shares of
Common Stock held by persons other than executive officers, directors and
persons holding in excess of 5% of the registrant's Common Stock. The
determination of market value of the Common Stock is based on the last
reported sale price as reported by the Nasdaq Stock Market on the date
indicated. The determination of the "affiliate" status for purposes of
this report on Form 10-K shall not be deemed a determination as to whether
an individual is an "affiliate" of the registrant for any other purposes.
DIGEX, INCORPORATED
INDEX
Page
----
PART I
Item 1 Business............................................................................. 1
Item 2 Properties........................................................................... 21
Item 3 Legal Proceedings.................................................................... 23
Item 4 Submission of Matters to a Vote of Security Holders.................................. 23
PART II
Item 5 Market for Registrant's Common Equity and Related Stockholder Matters................ 24
Item 6 Selected Financial and Other Operating Data.......................................... 25
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................................
Item 7A Quantitative and Qualitative Disclosures About Market Risk .......................... 44
Item 8 Financial Statements and Supplementary Data.......................................... 45
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure......................................................... 45
PART III
Item 10 Directors and Executive Officers of the Registrant................................... 46
Item 11 Executive Compensation............................................................... 46
Item 12 Security Ownership of Certain Beneficial Owners and Management....................... 46
Item 13 Certain Relationships and Related Transactions....................................... 46
PART IV
Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K...................... 47
Signatures........................................................................... 52
PART I
References in this report to "we," "the Company," or "Digex," mean Digex,
Incorporated except where the context otherwise requires. This report contains
certain "forward-looking statements" concerning Digex's operations, economic
performance and financial condition, which are subject to inherent uncertainties
and risks. Actual results could differ materially from those anticipated in this
report. When used in this report, the words "estimate," "plan," "project,"
"anticipate," "expect," "intend," "believe," and similar expressions are
intended to identify forward-looking statements.
Item 1. Business
Overview
We are a provider of advanced hosting services for companies conducting
business on the Internet. In alliance with WorldCom, Inc., we combine Web
infrastructure and 24x7 technical support with robust, global network resources.
Our services include server management, application support, managed networking
services, and customer care and support services. We also offer value-added IT
services, such as enhanced security, database services, high-availability and
application optimization services, stress testing, and consulting services. As
part of our services, we provide the installation and maintenance of computer
hardware and software, network technology, and systems management to offer our
customers a broad range of managed hosting solutions. From major corporations to
Internet-based businesses, our customers use our services to rapidly deploy
their business solutions including on-line financial services, on-line
procurement, electronic retailing, and customer self-service applications.
At December 31, 2001, we served over 600 customers, including 39 of the
Fortune 500 companies. We also managed 3,588 Windows- and UNIX-based servers in
our data centers, which are positioned on the east and west coasts of the United
States, and in Europe and Asia.
The following are among the factors that we believe will continue to drive
our business:
. the ability to facilitate the implementation and expansion of
customers' Internet-based initiatives;
. an operating platform designed to allow us to scale our
operations to lower marginal unit costs and increased
operating margins;
. substantial working relationships with other technology
companies including BEA Systems Inc., Cisco Systems, Compaq,
Microsoft, Oracle, and Sun Microsystems,;
. an affiliation with WorldCom Inc., with the ability to
leverage WorldCom's customer relationships, sales force, and
global network and facilities infrastructure;
. a network of alliances which provide complementary design,
development and integration services for our customers and
which are intended to represent a source of new customer
referrals for Digex;
. a team of technical experts with certifications from
technology companies such as Cisco Systems, Microsoft, Oracle,
and Sun Microsystems;
. a skilled engineering organization dedicated to identifying
the best available tools, technologies and processes; and
. a geographically distributed sales force.
1
Our History
Our business started in 1996 as the Web hosting unit of Business Internet,
Inc., previously known as DIGEX, Incorporated, a company that was principally an
Internet access and Web hosting services provider. Business Internet went public
in October 1996 under the name DIGEX, Incorporated, and was acquired by
Intermedia Communications Inc. in July 1997. In contemplation of our initial
public offering, we were incorporated as Digex, Incorporated in April 1999, and
Business Internet contributed our assets to the newly formed Digex, Incorporated
in order to effect a recapitalization of our business. On August 4, 1999, we
sold 11,500,000 shares of Class A common stock in our initial public offering.
Subsequent to our initial public offering, Business Internet contributed our
Class B common stock to its wholly-owned subsidiary, Intermedia Financial
Company.
On January 12, 2000, we sold 100,000 shares of our non-voting, redeemable
preferred stock, designated as Series A Convertible Preferred Stock, with
detachable warrants to purchase 1,065,000 shares of our Class A common stock, to
Microsoft Corporation and CPQ Holdings, Inc., a subsidiary of Compaq Computer
Corporation, for an aggregate of $100.0 million, of which $85.0 million was paid
in cash and $15.0 million was in the form of equipment credits from Compaq. See
Note 8 of the notes to our consolidated financial statements. We also entered
into strategic development agreements with both companies to advance our
capabilities to more rapidly install, manage and upgrade Microsoft Windows-based
servers and to streamline the order, delivery and installation of Compaq
hardware and storage devices.
On February 16, 2000, we completed a public offering of 12,650,000 shares
of our Class A common stock. We sold 2,000,000 shares of Class A common stock
and received net proceeds of approximately $171.6 million. Intermedia sold
10,650,000 shares of Class B common stock. The Class B common stock sold by
Intermedia automatically converted into Class A common stock at the closing of
the offering.
Recent Developments
On July 1, 2001, a wholly-owned subsidiary of WorldCom, Inc. merged with
and into Intermedia Communications Inc., with Intermedia continuing as the
surviving corporation as a subsidiary of WorldCom (the "Intermedia - WorldCom
Merger"). As a result of the Intermedia - WorldCom Merger, WorldCom now owns all
of the capital stock of Intermedia, other than its 13-1/2% series B preferred
stock, and approximately 90% of the voting securities of Intermedia. Therefore,
WorldCom has acquired an indirect controlling interest of Digex through
Intermedia as Intermedia continues to own approximately 61.4% of Digex's equity
interests and controls 94.1% of Digex's voting interests, calculated based on
total common stock outstanding, as of December 31, 2001.
Since January 2001, our commercial agreements with WorldCom enable us to
work together to bring managed hosting solutions to the market. These agreements
include the sales channel agreement, facilities agreement, network agreement,
and funding agreement. Under the sales channel agreement, WorldCom can purchase
the Digex portfolio of managed Web hosting products for resale to its customers.
The facilities agreement allow managed Web hosting facilities for Digex to be
built into existing WorldCom data centers in the United States and abroad based
on Digex SmartCenter(SM) specifications. In 2001, through this agreement, we
operationalized our SmartCenters in Ashburn, Virginia; Somerset, New Jersey;
Paris, France; Frankfurt, Germany; and Tokyo, Japan. Through the network
agreement, we are able to connect our Internet data centers to the WorldCom
global IP network. The funding agreement provides for funding of our 2002
business plan. See also "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources."
We have completed our second year of a three-year joint development
project with Compaq and Microsoft. In 2001, we reached several goals. Some of
those included:
2
. the continued development and releases of several features
focused on self service, security, real-time asset and
configuration data in ClientCentral(TM), a management portal
that allows customers to access customer-specific asset data,
billing information, performance statistics, and service
ticket detail;
. the release of Application Notification Services (ANS),
powered by the ArchiteX framework, which is a service that
enables the exchange of back office information between
partners and customers leveraging industry standard
technology, such as the eXtensible Markup Language (XML), to
provide rapid problem resolution and increased system
availability;
. the release of Managed Express Hosting, a new global managed
Web and application hosting portfolio developed to meet the
unique, growing demands of small to medium-sized enterprises
(SMEs), departmental Web requirements of larger-sized
enterprises and emerging international markets;
. the release of Digex Operations Central, which is a core
component of our central management infrastructure, that
allows high levels of efficiency and scale in our operations
environment;
. the development of automated packages around the Microsoft
.Net product suite that provision across various Compaq
servers and storage;
. progress in building next generation Web services that will
allow customers to subscribe to critical operational and
business support data; and
. the filing of a patent for the Digex ArchiteX framework, which
enables next generation Internet applications and services.
The ClientCentral trademark and Digex ArchiteX patent are
currently pending approvals from the U.S. Patent and Trademark
Office.
Industry Background
Introduction
Over the last few years, mainstream businesses have begun to implement Web
sites to complement traditional business models and applications. Among the
various factors which continue to attract these businesses to the Internet is
the transformation of Web sites from being primarily text-based and
informational to becoming interactive, multimedia-enabled, and
transaction-oriented. New technologies and development tools have also led to
the Web-enabling of traditional business functions and applications such as
customer service, procurement, human resource management, and sales force
automation. Forrester Research predicts that by 2006, 18% of global sales will
be conducted on-line, with North America accounting for 58% ($7.5 trillion) in
on-line business and consumer trade. Internet operations and applications are
therefore becoming increasingly mission-critical for many mainstream
enterprises. Ensuring the quality, reliability, and availability of these
Internet operations typically requires substantial investments in developing
Internet expertise and infrastructures. As a result, businesses often seek
collaborative outsourcing arrangements that can increase performance, provide
continuous operation of their Internet solutions, and reduce Internet operating
expenses.
According to IDC, a global provider of technology market forecasts, the
managed/dedicated segment of the U.S. hosting market grew 32% during 2001 to
$2.6 billion, and is expected to grow at a compound annual growth rate of 45%
through 2006. In a 2001 survey conducted by IDC, the decision drivers for the
outsourcing of Web site management are cost savings, lack of in-house skill
sets, security, and support. In the same survey, the primary corporate Web site
initiatives that are targeted for outsourcing in order of usage are marketing
and information purposes, e-business applications, e-commerce initiatives, and
software download management. This migration of business applications to the
Internet will drive growth in the managed hosting market.
3
We continue to position ourselves to take advantage of these market-driven
requirements and are pursuing the $4.2 billion dedicated hosting market
forecasted by IDC for 2002.
Segments of Hosting Services
In order to establish a high quality, reliable Web site or to run a
Web-based application on the Internet, businesses must, among other things,
procure and integrate sophisticated hardware and software, hire and retain an
operations support staff, develop application specific technical skills, and
have access to a secure, fault-tolerant physical location and redundant Internet
connectivity. While it is possible for a business to assemble all of these
elements in-house (i.e. without the help of a specialized provider), many
companies elect to outsource all or a portion of their Internet operations to
companies offering hosting services. Hosting companies, in general, provide
various infrastructure-related services, including secure, monitored data
centers, uninterrupted power supply and high-speed network connectivity. We
categorize the market for outsourced Web hosting services into the following:
. Shared Hosting: Customers share server hardware, software and
bandwidth with other customers. Shared hosting provides a
price competitive entry point for individuals and businesses
desiring a simple Web site.
. Colocation Hosting: Customers own their hardware, software and
network equipment, which is housed at the Web site hosting
company's facilities. The customers retain responsibility for
the installation, management, upgrading and security of their
Web sites. While colocation requires the customer to assume
the majority of the responsibilities for the operation of its
Web site, colocation has been and remains an attractive option
for Web-centric companies with advanced in-house Internet
expertise.
. Managed Hosting: Customers are provided a complete hosting
solution. Unlike colocation, the service provider supplies the
hardware, software, network equipment and support necessary to
run the Web site or application. Managed hosting today
includes dedicated services as well as value-added services,
such as firewall management, stress testing and consulting
services. As Web-enabled IT solutions have become more
complex, even large and technically astute businesses have
found Internet technologies and applications a challenge to
manage. For such companies, including many Fortune 2000
companies, managed hosting has become a preferred alternative.
A variety of companies, such as Internet service providers (ISPs) and
large systems integrators, offer products and services that attempt to address
enterprises' Internet outsourcing needs. However, we believe the solutions
offered by these companies fail to address certain elements required to ensure
that customers' mission-critical Internet operations are reliable, scalable and
responsive. Internet service providers, commonly referred to as ISPs, have
traditionally focused on providing Internet access and many have not developed
the technical expertise and physical resources to support mission-critical Web
sites and applications. In addition, many large systems integrators focus
primarily on large enterprises and traditional information technologies. As a
result, we believe a significant opportunity exists for companies to provide a
combination of complex hosting, outsourced applications management and
professional consulting services that enable businesses to implement reliable,
high-performance and cost effective Internet solutions.
Digex Solution
We focus primarily on providing managed Web and application hosting
services. Our core competency is developing and managing mission-critical Web
solutions for Fortune 2000 companies, application providers, and Web-centric
businesses. We believe we are positioned to assist such businesses in optimizing
the potential of the Internet and their Internet-related applications by
providing our customers with the following advantages:
4
A Suite of Managed Services. We provide a suite of services that enables
companies to conduct business on the Internet. Using a technical staff of
certified engineers, and through the security and reliability of our data
centers, we provide the services and expertise so that our customers have
secure, scalable, high performance operation of mission-critical Web sites and
applications 24-hours a day. These services include:
. managed servers including the support of Windows- and
UNIX-based dedicated servers;
. managed application services such as support for various Web
servers, directory servers, database servers, application
servers and commerce suites;
. managed networking services such as intelligent networking,
private networking, and inter-data center networking;
. customer care and support services such as client services and
access to our self-service portal; and
. value-added IT services such as enhanced security, database
services, high availability and application optimization
services, stress testing, and consulting services.
Internet and Private Network Connectivity. We provide network connectivity
services for our customers' Web sites as well as direct private networking
options for secure "back-end" network connections to private corporate networks
and information systems. Through our network services agreements with WorldCom,
we offer Internet connectivity that provides the following:
. connectivity to a redundant high speed global IP network via
WorldCom;
. use of WorldCom's public and private peering relationships,
permitting direct exchange of traffic with a significantly
large number of carriers and ISPs;
. use of WorldCom's regional direct connections to major ISPs,
dial-up carriers and content service providers; and
. service level agreements guaranteeing high availability and
performance.
Digex also offers an array of intelligent networking services including
products and services from Akamai and Cisco Systems.
Customer Care and Technical Support. We provide customers with 24-hours a
day direct access to our staff of customer care and technical support personnel.
We also use a variety of monitoring services from our network operations center,
which allows us to address problems or rapidly identify and remedy service
interruptions. We believe this level of customer support differentiates Digex in
the marketplace.
At our network operations center, we monitor and report on the health of
servers, software, networks, and security devices managed by us through our
centralized server monitoring platform. The network operations center uses a
variety of technologies and tools, including the Aprisma Spectrum, Micromuse
Netcool, and SiteScope products, to monitor a large volume of server resources
such as processor utilization, system and application processes, log files,
ports and disk space, and security devices, such as firewalls. In addition, the
network operations center monitors specific network devices, such as routers,
switches and load balancing equipment that are critical to the successful
delivery of our hosting services.
Data Centers. Our data centers contain multiple, freestanding computer
rooms to provide containment and isolation. Physical security has been
implemented through controlled security zones requiring card key, personal
5
identification number, and biometric identification. Surveillance cameras record
movement through the data centers and security guards provide real-time roaming
visibility. Cooling and environmental controls for each data center are designed
to monitor and maintain temperature and humidity levels. Finally, all
telecommunications connections enter the data centers through multiple points
from different service arrangements.
Digex Services
We offer a broad range of managed services designed to address the rapidly
evolving requirements of Web-based business initiatives. Our services include
the following:
. core hosting services;
. managed applications;
. managed networking;
. customer care and support services; and
. value-added IT services.
Core Hosting Services
Managed Servers. We offer dedicated Web and application hosting services
designed to enable reliable, scalable, mission-critical Web solutions. We
operate both Windows- and UNIX-based servers using hardware from Compaq and Sun
Microsystems. The Digex Build begins with the operating system (O/S) layer which
has been engineered for security, reliability and scalability. We have
standardized upon Windows NT4 and 2000 for Compaq servers and Sun Solaris 2.6
and 2.8 for Sun Servers. By standardizing around the hardware and operating
systems produced by these vendors, we are able to quickly upgrade, configure and
implement the new servers necessary to accommodate our customers' growing needs
for higher computing speeds and capacity. We are able to offer customers the
option of including the cost of standard equipment in their monthly services
fees or providing it themselves.
Digex SmartServices(SM). We offer a package of core managed hosting
services, under the Digex SmartServices(SM) brand, to provide administration,
monitoring, reporting, security, and backup services for a customer's
mission-critical Internet operations. Our administration services provide
management services for hardware, software and network infrastructure, including
installation, maintenance, and trouble shooting. Our monitoring services are
designed to identify problems that impact the system availability and response
times. Our reporting services provide detailed information about servers,
applications, sites, and network performance. Finally, our backup services
provide data availability and integrity with backup, recovery, and storage
solutions. Digex SmartServices(SM) also include:
. help-desk support available 24-hours a day with access to
certified technical professionals;
. inventory of parts on-site for upgrading and maintenance of
hardware and software;
. industry and vendor security alerts and maintenance; and
. secure remote administration capabilities for remote
management.
6
Managed Express Hosting. Jointly launched in December 2001 with WorldCom,
managed express hosting is a global managed Web and application hosting
portfolio developed to meet the growing demands of small to medium size
enterprises, as well as the departmental Web requirements of larger-sized
enterprises and emerging international markets.
Managed Applications
We provide support for a variety of applications which can be used to
build and conduct business on the Internet. For each platform (Sun Solaris and
Microsoft Windows), we provide equivalent product sets, allowing us to provide
parallel levels of service regardless of the platform our customers wish to run.
Each application is incorporated into an automated Digex Build that has been
prepared for the application. This automated build can be completed over a
scaling number of servers. Applications supported by us include various
operating systems, Web servers, directory servers, database servers, application
servers, and commerce suites.
Web Servers and Directory Servers. On the Windows platform, we support
Microsoft Internet Information Server for NT4 and Windows 2000. For Directory
Services, we support Primary and Backup Domain Controllers for NT4
configurations and Active Directory for Windows 2000 implementations. On the Sun
Solaris platform, we offer iPlanet Web Server and iPlanet Directory Server,
which offer equivalent capabilities to the Microsoft Windows services.
Database Servers. We support database servers on both the Microsoft
Windows and Sun Solaris platforms. For Microsoft Windows, we support Microsoft
SQL database products. In addition to offering SQL for Windows, we added support
for Oracle 8i for Windows in September 2001. We also added Oracle Standard
Edition to our product line, and in October 2001 we extended our support for
Oracle on Sun Solaris by introducing Oracle 9i.
Application Servers and Commerce Suites. Our primary commerce products on
Windows are Microsoft Site Server Commerce Edition for NT4 and Microsoft
Commerce 2000 for Windows 2000. On the Sun Solaris platform, we support iPlanet
Application Server 6.0. Support for BEA Weblogic, ATG Dynamo, and IBM Websphere
applications is also available.
Managed Networking
Intelligent Networking. We offer a variety of intelligent networking
services to our customers. These services include load balancing and
geographical distribution of network traffic using Cisco Systems technology and
high-performance delivery of Internet content using the Akamai network and
technology.
Private Networking. Our private networking services are primarily used to
securely connect a customer's Web site at our site to their private corporate
network or information system. We offer a variety of management options for
private line and virtual private network (VPN) services.
Dynamic Inter-Data Center Networking. We provide high speed
interconnections between data centers to enable virtual local area networks
(VLAN) to span regions. This can be important in designing real-time disaster
avoidance solutions. For example, two databases can be maintained in two
geographically distributed locations in real-time.
Customer Care and Support Services
Client Services. In addition to our core SmartServices(SM), we provide a
defined set of project management and technical consultation deliverables which
are designed to provide customers with the information needed to measure the
performance, satisfaction, and return on a Web solution. Our client service
teams are comprised of project
7
managers, technical account managers, and system engineers. The team provides
consultative deliverables, including case summary and analysis, project
management, upgrades, change management, and inventory and security audits.
Digex ClientCentral(TM) Portal. Digex's customer portal provides access
into some of our back office systems. The portal is XML-enabled, and provides
customers with services such as case management and status queries, personalized
content, asset management, performance reporting, on-line bill presentment,
on-line technical references, and contact and escalation information.
Application Notification Services. Application Notification Services (ANS)
is a solution that allows developers to enable an application to send a
notification based on a specific application event, such as an application
error. The solution utilizes our ArchiteX framework, an automated messaging and
routing system. This solution is managed through our ClientCentral portal.
Value-added IT Services
Security Services. Our security services are designed to maximize the
security of a customer's Web site or application. In July 2001, we introduced
the RSA SecurID product, which provides additional protection to our customer's
data by allowing access to information only upon successfully completing a
two-factor authentication process. Other security service offerings include
security scanning and vulnerability assessment services, managed firewalls,
encryption software, and authentication devices. In November 2001, we introduced
a high speed firewall offering for active business transaction sites. This
firewall, built on the Nokia IP740 security appliance, is configured to run on
our hardened server build. We offer this managed firewall solution to meet the
demand of enterprises who desire up to a gigabit per second of throughput for
their e-commerce Web presence, large data, and Web application backup and
configurations of multi-site VPNs.
Database Services. Our database services provide the installation,
configuration, maintenance, and support of databases on the Windows and Solaris
platforms. In January 2002, we expanded our services for Oracle databases by
including features for administering and maintaining customers' databases, as
well as services for greater monitoring capability. We use advanced technology
to provide database maintenance solutions, including preventive maintenance,
problem diagnosis and resolution, space management, and reorganization and
tuning for Oracle databases.
High-Availability Services. We offer solutions at the network, server and
application layers, with products and Web architectures that are built for speed
and redundancy. Our service offerings address a customer's Web site as a whole,
including content delivery, transaction processing and database processing.
Additionally, we provide high-availability database solutions on both platforms:
SQL 2000 Dynamic Failover for Windows, and Oracle 8i Dynamic Failover for
Solaris. With our Dynamic Failover (DFO) product offerings, we provide a variety
of high-availability database solutions on both the Windows and Sun platforms.
These solutions are designed to automatically switch over to another server in
the event of a failure. Digex also expanded Dynamic Failover options on the Sun
platform by adding support for multiple node solutions in a number of
active/passive or active/active configurations for Oracle Dynamic Failover in
December 2001. In December 2001, we introduced Akamai EdgeSuite(SM) to our
solutions portfolio. EdgeSuite is an integrated set of functionalities designed
to reduce Internet infrastructure complexities and costs by extending
performance, scalability, and reliability benefits of content delivery
throughout an entire Web site.
Application Optimization Services. Our Application Optimation Center (AOC)
was formed in September 2001 to help our customers enhance their application
performance. The AOC provides pre- and post-production deployment and
integration services for client applications. These services include:
. migrating the application to the system configuration;
. testing the application's performance on the designed
configuration;
. reviewing code to identify areas for improvement; and
8
. tuning the application for improved performance and
reliability.
Customers
We have a diverse customer base ranging from Fortune 50 companies to small
and medium size businesses that rely on the Internet. Our customers are
primarily located within the United States. We serve over 600 customers,
covering most major industries. Our customer contracts typically range in
duration from one to three years. Our customers include the following well-known
companies:
Financial Services and Insurance Media and Entertainment Manufacturing Retail and Distribution
- -------------------------------- ----------------------- ------------- -----------------------
American Century Investments BusinessWeek Online Clorox Barnes & Noble
Blue Shield of California Discovery Communications Cummins, Inc. Geiger Brothers
Fannie Mae McGraw Hill Companies Kraft Foods Hammacher Schlemmer & Co., Inc.
Fleet Credit Card Services Reader's Digest Philip Morris J. Crew
Technology and Communications Healthcare Travel & Hospitality
- ----------------------------- ---------- --------------------
Alcatel Canada American Dental Association Amtrak National Railroad
MTI Technology DuPont Pharmaceuticals Passenger Corporation
Microsoft Novartis Norwegian Cruise Lines
SANYO North America Wyeth Thomas Cook
Corporation Trans World Airlines
Sales and Marketing
Our sales strategy is to focus on market segments that we believe have
both a propensity to outsource and to deploy complex, mission-critical Web-based
applications. We sell our services directly through a professional sales force
and receive referrals through a network of business partners. We also work with
WorldCom to sell managed hosting solutions to their existing and prospective
customer base in order to increase our market share. Our sales force is
organized into three units: Direct Sales, Channel Sales, and International.
Supporting each of these units is a team of technical consultants that provides
pre-sales technical support, including requirements gathering, configuration
support, architectural design, and project management.
Direct Sales. During 2001, we redeployed our sales force from a
centralized structure to a field- based organization by opening 11 new regional
offices. We now have a total of 18 field-based teams throughout the United
States and physical sales presence in 24 cities. As of December 31, 2001, our
direct sales force consisted of 134 quota-bearing sales representatives.
Channel Sales. The channel sales organization works with our network of
alliance partners, which includes systems integrators, developers, independent
software vendors, and application service providers. As of December 31, 2001,
the channels sales force organization consisted of 32 individuals.
International. In 2001, our international sales organization included
resources in the United Kingdom, Germany, France, and Japan. We currently have a
sales force and a Web hosting facility in three markets in Europe. We emphasized
the integration of our sales force with WorldCom's sales force in Europe,
targeting their customers with managed hosting needs.
Alliance Programs. Originally launched in 1998, Digex's partner programs
were modified and re-launched in June 2001 to address changes in the marketplace
and our sales channel arrangement with WorldCom. Our alliance program offers our
partners benefits to fit their needs, including referral fees, volume pricing,
pre-production hosting
9
services, and the opportunity to participate in joint marketing initiatives. Our
relationships include: Accenture, Deloitte Consulting, Deloitte & Touche, KPMG,
SAIC, Covansys, ATG, and Compaq Global Services.
Marketing. Our marketing organization is responsible for building our
brand awareness, identifying key target markets and developing programs to
communicate our products and services to the marketplace, and developing our
customer relationships. Another objective of our marketing efforts is to
stimulate the demand for our services through a broad range of marketing
communications and public relations activities. Our primary communication
vehicles include advertising, trade shows, direct response programs, event
sponsorship, our Web sites, and the distribution channels of our technology
vendors such as Microsoft, Compaq, and Sun Microsystems.
Competition
The market served by Digex is highly competitive. There are few
substantial barriers to entry, and we expect to face additional competition from
existing competitors and new market entrants in the future. The principal
competitive factors in this market include:
. quality of service delivery and scalability of infrastructure;
. quality of customer service and support;
. multiple levels of services offered;
. network capacity, reliability, security and adaptability to
new technologies;
. Internet system engineering expertise;
. technical expertise with multiple platforms, protocols and
industry standards;
. relationships with technology partners and vendors;
. number and geographic presence of sales and technical support
personnel;
. price;
. financial resources; and
. brand name.
Our current and potential competitors in the market include:
. large information technology outsourcing firms;
. local, regional, national and international telecommunications
companies;
. pure-play hosting service providers; and
. local, regional, national and international ISPs;
Our competitors may operate in one or more of these areas and include
companies such as International Business Machines Corporation (IBM), Electronic
Data Systems (EDS), Cable & Wireless, Sprint, AT&T, and Qwest Communications
International.
10
We believe our experience and reputation for delivering quality, managed
Web site and application hosting services differentiates us from our key
competitors. We focus on our core competency of Web and application hosting. We
believe we have defined and offer the industry a set of functions required to
configure, engineer, implement and maintain complex, transactional Web
solutions. We believe our technical team, focus, and experience distinguish us
from our competition and enable us to provide quality, managed hosting
solutions.
Intellectual Property Rights
We rely on a combination of copyrights, trademarks, service marks,
patents, trade secrets, and contractual obligations to establish and protect
certain proprietary rights in our data, applications, and services. In addition,
we have applied for a patent for the Digex ArchiteX framework. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to
copy or otherwise obtain and use our data or technology. In addition, the laws
of various foreign countries may not protect our products, services or
intellectual property rights to the same extent as do the laws of the United
States.
We also rely on certain technologies we license from third parties, such
as Microsoft and Netscape. There can be no assurance these third-party
technology licenses will continue to be available to us on commercially
reasonable terms. The loss of such technology could require us to obtain
substitute technology of lower quality or performance standards or at greater
cost, which could harm our business. We continue to pursue the growth of our
intellectual property portfolio.
Government Regulation
In the United States and most countries in which we conduct our major
operations, we are generally not regulated other than pursuant to laws
applicable to businesses in general or to value-added telecommunications
services specifically. In some countries, we are subject to specific laws
regulating the availability of certain material related to, or to the obtaining
or dissemination of, personal information. Adverse developments in the legal or
regulatory environment relating to the Internet industry in the United States,
Europe or elsewhere could have a material adverse effect on our business,
financial condition and operating results.
In October 1998, Congress enacted the Digital Millennium Copyright Act,
which includes a limitation on liability of on-line service providers for
copyright infringement for transmitting, routing, or providing connections,
transient storage, caching or storage at the direction of a user. This
limitation on liability applies if the service provider had no actual knowledge
or awareness that the transmitted or stored material was infringing and if
certain other conditions are met. Since this law is relatively new, it remains
to be seen how the law will be applied to limit liability we may face in the
future for any possible copyright infringement or copyright-related issues. This
law also requires ISPs to follow certain "notice and take-down" procedures in
order to be able to take advantage of the limitation on liability. We have
implemented such procedures. Digex has a formal notification process, whereby we
notify an alleged infringer that we have a complaint, we notify the complainant
about the status, we investigate the matter internally, and if necessary,
suspend the infringer's use of Digex services and products until there is
resolution of the matter. The Digex Acceptable Use Policy Board seeks to respond
quickly to complaints that would fall under the scope of the Digital Millennium
Copyright Act. There is no assurance that our process and acceptable use policy
will shield us from liability but we have made a significant effort to meet the
requirements. Our customers are subject to an acceptable use policy which
prohibits them from posting, transmitting or storing material on or through any
of our services which, in our sole judgment, is (1) in violation of any local,
state, federal or foreign law or regulation, (2) threatening, obscene, indecent
or defamatory or that otherwise could adversely affect any individual, group or
entity or (3) in violation of the intellectual property rights or other rights
of any person.
11
Despite enactment of the Digital Millennium Copyright Act, the law
relating to the liability of on-line services companies and Internet access
providers for information carried on or disseminated through their networks
remains largely unsettled. It is possible claims could be made against on-line
services companies and Internet access providers, including us, under laws
currently existing or adopted in the future in the United States or other
countries for defamation, obscenity, negligence, copyright or trademark
infringement, or other theories based on the nature and content of the materials
disseminated through their networks.
A number of legislative and regulatory proposals from various
international bodies and foreign and domestic governments in the areas of
telecommunications regulation, particularly related to the infrastructures on
which the Internet rests, access charges, encryption standards and related
export controls, content regulation, consumer protection, advertising,
intellectual property, privacy, electronic commerce, and taxation, tariff and
other trade barriers, among others, have been adopted or are now under
consideration. We are unable at this time to predict which, if any, of the
proposals under consideration may be adopted and, with respect to proposals that
have been or will be adopted, whether they will have a beneficial or an adverse
effect on our business, financial condition and operating results.
Moreover, the manner in which existing domestic and foreign laws
(including Directive 95/46/EC of the European Parliament and of the European
Council on the protection of individuals with regard to the processing of
personal data and on the free movement of such data) will or may be applied to
on-line service and Internet access providers is uncertain, as is the effect on
our business given different possible applications. Similarly, we are unable to
predict the effect on us from the potential future application of various
domestic and foreign laws governing content, export restrictions, privacy,
consumer protection, export controls on encryption technology, tariffs and other
trade barriers, intellectual property and taxes. The vast majority of such laws
were adopted prior to the advent of the Internet and related technologies and,
as a result, do not contemplate or address the issues unique to the Internet and
related technologies.
Employees
As of December 31, 2001, we employed approximately 1,393 full and
part-time employees. None of our employees is covered by a collective bargaining
agreement. We believe that our employee relations are good.
Risk Factors
We have a history of negative cash flows and significant losses which may
continue in the foreseeable future.
We have experienced operating losses and negative cash flows from
operations since inception. As of December 31, 2001, our accumulated losses
amounted to approximately $384.3 million. We had net losses of $188.5 million
and net cash used in operating and investing activities of $161.6 million for
the year ended December 31, 2001. We cannot assure you that we will ever become
or remain profitable or that we will generate positive cash flows from
operations.
We currently project continued significant losses and operating cash flow
deficits. Since the Intermedia - WorldCom Merger, we have been dependent on
WorldCom to fund our operating cash flow deficits and capital expenditures.
Pursuant to the terms of the Intermedia - WorldCom Merger and subject to the
limitations under our approved 2002 business plan, which is subject to amendment
and modifications, WorldCom has committed to fund our projected cash flow
deficits and capital expenditures through December 31, 2002. Our 2002 business
plan may require up to $276.0 million, inclusive of amounts for capital
expenditures, the majority of which is expected to be demand driven. This amount
could materially change due to changes in the economy, our target market, our
practice of acquiring equipment on behalf of customers, or our ability to
execute on this business plan, among other factors. The amount of actual
borrowings from WorldCom in 2002 could be more or less than
12
the amounts approved under the business plan. Should we require additional
funding beyond 2002, as currently projected, there can be no assurance that
WorldCom will provide such additional funding. We believe that funding from any
source other than WorldCom on appropriate or commercially acceptable terms is
unlikely to be available.
We depend on WorldCom to fund our operating losses and working capital,
including capital expenditures.
Because we anticipate negative cash flow and a significant need for
working capital for the foreseeable future, we expect we will have to obtain
funds for such purposes from WorldCom or other sources. Because we are a capital
intensive business, funding for these capital expenditures will be required to
expand our business.
WorldCom is our majority stockholder, primary lender, significant channel
partner, and one of our largest vendors. In particular, under the funding
agreement, WorldCom is obligated to provide funding for the approved Digex
business plan through 2002 only. WorldCom will then have an option to continue
funding us beyond 2002, but may not exercise such option. Through 2002, we
expect our working capital needs and capital expenditure requirements to be met
through our note purchase agreement dated July 31, 2001 with WorldCom.
Our ability to succeed is dependent on WorldCom. Our dependence on
WorldCom could, among other things, increase our vulnerability to general
adverse economic and industry conditions, limit our ability to fund future
working capital, operating losses, capital expenditures, acquisitions and other
requirements, and limit our flexibility in reacting to changes in our business
and industry. We strongly urge you to read "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Liquidity and Capital
Resources" elsewhere in this Form 10-K and WorldCom's "Management's Discussion
and Analysis of Financial Condition and Results of Operations - Liquidity and
Capital Resources" in its Form 10-K for the year ended December 31, 2001 as
filed with the Securities and Exchange Commission.
Digex is controlled by a controlling stockholder which could involve multiple
risks for you as a stockholder.
WorldCom controls (through its subsidiary, Intermedia) a majority of our
voting power, and our majority stockholder's interests in us may conflict with
your interests as a stockholder. Intermedia, indirectly through its wholly-owned
subsidiary, Intermedia Financial Company, owns all of the issued and outstanding
shares of our Class B common stock. Intermedia currently owns 39,350,000 shares
of Class B common stock, or approximately 61.4% of the outstanding capital stock
of Digex. Each share of Class B common stock is entitled to 10 votes, as
compared to one vote for each share of Class A common stock. As a result,
WorldCom indirectly controls approximately 94.1% of our voting interests, and
controls the management and affairs of Digex, and all matters submitted to our
stockholders for approval, including the election and removal of directors, and
any merger, consolidation or sale of all or substantially all of our assets. The
price of our Class A common stock may be affected as a result of us having a
controlling stockholder.
We will require additional funds to finance our business, but our ability
to raise funds is significantly limited by agreements that are binding on us.
Intermedia has issued debt securities to the public under seven indentures. As a
subsidiary of Intermedia, we are currently subject to a number of restrictions
under the Intermedia indentures. These restrictions will, among other things,
limit our ability to make certain restricted payments, incur indebtedness and
issue preferred stock, pay dividends or make other distributions, engage in sale
and leaseback transactions, create liens, sell our assets, issue or sell our
equity interests, or enter into certain mergers and consolidations. As a result,
our future financing sources may be significantly limited and our use of any
proceeds of any future financing may be significantly restricted. The note
purchase agreement between WorldCom and Digex also, among other things, limits
our ability to make certain restricted payments, incur indebtedness, sell our
assets, engage in sale and leaseback transactions, and create liens.
Our ability to issue additional capital stock is constrained by WorldCom's
indirect ownership of the Class B common stock, which could make it more
difficult for us to raise capital to expand our business. In the future,
WorldCom may elect to sell additional shares of our Class B common stock to the
public or to distribute these shares
13
to its own stockholders. If as a result of a sale or distribution, Intermedia
would no longer hold more than 50% of the total voting power of our capital
stock, the consent of the majority in principal amount of the noteholders under
the Intermedia indentures would be required for the sale or distribution. In
addition, if we decide in the future to issue and sell additional shares of our
capital stock and, as a result, the voting power represented by the Class B
common stock held by Intermedia would no longer be greater than 50% of the total
voting power of our capital stock, the consent of the majority in principal
amount of the noteholders under the Intermedia indentures would be required for
the sale. We would be free of the restrictions in the Intermedia indentures only
if either Intermedia's voting power was reduced to below 50% as described above
or Intermedia designated us as an "unrestricted subsidiary," which would also
require a consent of a majority in principal amount of the noteholders under the
Intermedia indentures.
We have a limited operating history and our business model is still evolving,
which makes it more difficult for you to evaluate our company and its prospects.
We were established in January 1996 to provide Web site hosting services
for businesses deploying complex, mission-critical Web sites. Today, we provide
hosting solutions for companies conducting business on the Internet, including
on-line financial services, on-line procurement, electronic retailing, and
customer self-service applications. Our range of service offerings has changed
since 1996 and our business model is still evolving. Because some of our
services are new, we cannot be sure that businesses will buy them, and
consequently, the revenue and income potential of our business is unproven. Our
limited operating history makes predicting future results difficult. Our
prospects must be considered in light of the risks, expenses and difficulties
encountered by companies in the rapidly evolving market for hosting services. To
address these risks, among other things, we must:
. provide reliable, technologically current and cost-effective
services;
. continue to upgrade and expand our infrastructure;
. market our brand name and services effectively;
. maintain and develop our business alliances; and
. retain and attract qualified personnel.
We may be unable to achieve our operating and financial objectives if we cannot
manage our growth effectively.
Our business has grown rapidly, and our future success depends in large
part on our ability to manage growth in our business. For us to manage this
growth, we will need to:
. expand and enhance our operating and financial procedures and
controls;
. replace or upgrade our operational and financial management
information systems; and
. attract, train, manage and retain key employees.
These activities are expected to place a significant strain on our
financial and management resources. If we are unable to manage growth
effectively, our business could suffer.
We may experience difficulties developing and maintaining customer relationships
due to their perceptions of our financial position.
Our customers' perceptions of our financial stability may be affected by
current economic conditions and the extent to which we are highly leveraged.
General economic conditions, our outstanding contractual obligations and
contingent commitments may have created a customer perception of relative
illiquidity. Our customers may
14
perceive that there is increased risk in doing business with us due to our
current financial position. To the extent that such perceptions exist, customers
may question our financial stability and viability and thereby increase the
difficulties inherent in securing and maintaining customer relationships
necessary to our business.
We would need to modify our business plans if we lose our largest customers.
Our ten largest customers represented approximately 29% of our monthly
recurring revenue in December 2001. If we lose all of these customers, we would
need to modify our business plan. Any changes to our business plan that increase
the funding amount will require approval from the WorldCom board of directors
before WorldCom would be obligated to fund such an increase. There can be no
assurance that we will be able to receive such funding or be able to secure
funding from other sources at terms acceptable to us to sustain operations.
Given current market conditions, we may have difficulty collecting a portion of
our accounts receivable.
Our allowance for doubtful accounts has increased to approximately 14% of
our trade accounts receivable at December 31, 2001 compared to 10% at December
31, 2000 as a result of management's judgment that our customers may be
financially impaired due to the downturn of the economy and our industry. At
December 31, 2001, accounts receivable from WorldCom was approximately $15.2
million and represented approximately 38% of our total accounts receivable.
Although we believe we are adequately reserved for doubtful accounts, there can
be no assurance that we will be able to collect all of our past due accounts
receivable.
Back office system upgrades and conversions may impact our operations.
As a result of our efforts to efficiently manage our business, we are
currently making, and may be required to make in the future, changes to our back
office system to upgrade to new technologies. These back office system upgrades
and conversions may have a material adverse effect on our financial condition or
consolidated results of operations if such systems do not operate properly or
are not implemented within our expected timeframe.
Our business could be harmed if our management team, which has worked together
for only a brief time, is unable to work together effectively, or if we are
unable to retain and attract key personnel.
We have recently hired key employees and officers, including our Senior
Vice President of Service Delivery and Operations and our Senior Vice President
of Sales in 2001, and are currently searching for a Chief Financial Officer.
These key individuals will be working with other members of our executive
management team, each of whom have been with Digex for an average of two years.
As a result, our management team has worked together for only a brief time. Our
success, in significant part, depends on the continued services of our senior
management personnel, as well as of our key technical and sales personnel.
We believe our short and long-term success also depends largely on our
ability to attract and retain highly skilled technical, managerial and marketing
personnel, particularly additional management personnel in the areas of
application integration and technical support. We may not be able to hire or
retain the necessary personnel to implement our business strategy, or we may
need to pay higher compensation for employees than we currently expect. Our
inability to attract and retain such personnel would limit our growth and harm
our business.
Stock options of Digex Class A common stock have been used as a method to
attract and retain employees, to motivate performance and to align the interests
of management with those of our stockholders. Due to declines in the market
price of our common stock, many stock options held by our employees have an
exercise price that is higher than the current trading price of our common
stock. Without adequate incentives, we may find it more difficult to retain key
employees.
15
Our quarterly and annual results may fluctuate, resulting in fluctuations in the
price of our Class A common stock.
Our results of operations fluctuate on a quarterly and annual basis. We
expect to continue experiencing fluctuations in our future quarterly and annual
results of operations due to a variety of factors, many of which are outside our
control, including:
. demand for and market acceptance of our services;
. introductions of new services by us and our competitors;
. capacity utilization of our data centers and assets;
. timing of customer installations;
. our mix of services sold;
. customer retention;
. the timing and magnitude of our capital expenditures;
. changes in our pricing policies and those of our competitors;
. fluctuations in bandwidth used by customers;
. our retention of key personnel;
. reliable continuity of service and network availability;
. costs related to the acquisition of network capacity and
arrangements for interconnections with third-party networks;
. the provision of customer discounts and credits;
. the introduction by third parties of new Internet and
networking technologies;
. licenses and permits required to construct facilities, deploy
networking infrastructure or operate in the United States and
foreign countries; and
. other general economic factors.
For these and other reasons, in some future quarters, our results of
operations may fall below the expectations of securities analysts or investors,
which could negatively affect the market price of our Class A Common Stock.
We cannot predict the outcome of our joint development effort with Microsoft and
Compaq.
Working closely with Microsoft and Compaq, we expect to invest significant
resources to advance our ability to more rapidly install, manage and upgrade
large numbers of Microsoft Windows-based servers for Web site and application
hosting. While Microsoft and a subsidiary of Compaq have each made a $50.0
million equity investment in our company, neither has an obligation to
contribute additional equity, whether or not the costs associated with this
development project exceed our expectations. See Note 8 and Note 14 of the notes
to our consolidated financial
16
statements. Our alliance agreements also do not prevent Microsoft and/or Compaq
from working with other service providers to develop similar capabilities. In
addition, because this alliance is for a research and development project, we
cannot assure you that any commercially successful products will be developed as
a result of our agreements with Microsoft and Compaq. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Overview and Liquidity and Capital Resources."
Our business, in large part, depends on network services we receive from
WorldCom. Any disruption of these services or our secondary network provider's
inability to maintain its peering relationships could be costly and harmful to
our business.
We currently rely primarily on WorldCom for network services in the U.S.
and U.K. We have relied secondarily on Allegiance Telecom, Inc. for network
services, after it acquired substantially all of the Intermedia Business
Internet assets from WorldCom in December 2001. If either of these providers is
unable to provide our network services or our agreements are terminated, we
would need to rapidly secure an alternative provider of these services. As a
result, we could incur transition costs and our monthly costs of operations
could increase. In addition, such a transition could have a detrimental effect
on our customer service levels.
The Internet is composed of many ISPs that operate their own networks and
interconnect with other ISPs at various peering points. Peering relationships
are arrangements that permit ISPs to exchange traffic with one another without
having to pay for the cost of transit services. Peering relationships are a
competitive factor that allow some hosting companies to provide faster data
transmission than others. We believe the tier-one status and numerous peering
relationships of WorldCom enable them to provide us faster data transmission
than many other ISPs provide. If WorldCom fails to adapt its network
infrastructure to meet industry requirements for peering or loses its peering
relationships for any other reason, then our transmission rates could be
reduced, resulting in a decrease in the service quality we provide to our
customers.
If we are unable to secure sufficient network capacity to meet our future needs
on reasonable terms or at all, we might not be able to provide adequate service
to our customers.
We must continue to expand and adapt our network arrangements to
accommodate an increasing amount of data traffic and changing customers'
requirements. We have entered into network services agreements with WorldCom to
provide us with certain network transit capacity which we believe to be adequate
for our capacity requirements. However, if our future network capacity
requirements exceed the capacity WorldCom has committed to provide to us, we may
have to pay higher prices for such additional network capacity or such capacity
might not be available at all. Our failure to achieve or maintain high-capacity
data transmission could negatively impact service levels to our existing
customers and limit our ability to attract new customers.
We operate in an evolving market with uncertain prospects for growth.
The market for Web and application hosting and related services is
evolving rapidly. Our future growth, if any, will depend on the continued trend
of businesses outsourcing their hosting and our ability to market and sell our
services effectively. There can be no assurance that the market for our services
will grow, that our services will be adopted, or that businesses will use these
Internet-based services to the degree or in the manner that we expect. It is
possible that at some point businesses may find it cheaper, more secure or
otherwise preferable to host their Web sites and applications internally and
decide not to outsource the management of their Web sites and applications. If
we are unable to react quickly to changes in the market, if the market fails to
develop, or develops more slowly than expected, or if our services do not
achieve market acceptance, then we are unlikely to become or remain profitable.
We are subject to the risks associated with rapid industry changes.
The Internet services industry in which we operate is characterized by
rapidly changing technology, evolving industry standards, emerging competition
and frequent new service, software and other product innovations. We
17
cannot guarantee that we will be able to identify new service opportunities
successfully and develop and bring new services to market in a timely and
cost-effective manner, or that products, software and services or technologies
developed by others will not render our services non-competitive or obsolete. In
addition, we cannot provide any assurance that our service developments or
enhancements will achieve or sustain market acceptance or be able to address
effectively the compatibility issues raised by technological changes or new
industry standards.
We may be unable to achieve our operating and financial objectives due to
significant competition in the managed hosting industry.
The market for hosting Web sites and applications is highly competitive.
There are few substantial barriers to entry and many of our current competitors
have substantially greater financial, technical and marketing resources, larger
customer bases, more data centers, longer operating histories, greater name
recognition and more established relationships in the industry than we possess.
See also "Business-- Competition." Our current and potential competitors in the
market include large information technology outsourcing firms,
telecommunications companies, Web hosting service providers, and Internet
service providers. Our competitors may operate in one or more of these areas and
include companies such as IBM, EDS, Cable & Wireless, Sprint, AT&T, and Qwest
Communications International. A number of our other competitors have recently
filed for protection under the federal bankruptcy laws.
Our competitors may be able to expand their network infrastructures and
service offerings more quickly. They may also bundle other services with their
managed hosting services, which could allow them to reduce the relative prices
of their Web site hosting and/or application hosting services beyond levels that
we could compete with, and generally adopt more aggressive pricing policies. In
addition, some competitors have entered and will likely continue to enter into
joint ventures or alliances to provide additional services which may be
competitive with our services. We also believe the Web hosting and application
hosting markets are likely to experience consolidation in the near future, which
could result in increased price and other competition that would make it more
difficult for us to compete.
Our business will not grow unless Internet usage grows and Internet performance
remains adequate.
Our success will depend on the continued growth in the use of the Internet
as a commercial marketplace. In addition, our business plan anticipates
extensive growth in the Web and application hosting markets. The growth of the
Internet, including the Web hosting and application hosting markets, is subject
to a high level of uncertainty and depends on a number of factors, including the
growth in consumer and business use of new interactive technologies, the
development of technologies that facilitate interactive communications, security
concerns, increases in data transport capacity and general economic conditions.
If the Internet as a commercial medium fails to grow or develops more slowly
than expected, then our business is unlikely to grow.
The growth in the use of the Internet in general has caused frequent
periods of performance degradation, requiring the upgrade of routers and
switches, telecommunications links and other components forming the
infrastructure of the Internet by ISPs and other organizations with links to the
Internet. Any perceived degradation in the performance of the Internet as a
whole could undermine the benefits of our services. The performance of our Web
site and application hosting services is ultimately limited by and relies on the
speed and reliability of the networks operated by third parties. Consequently,
the growth of the market for our services depends on improvements being made to
the entire Internet infrastructure to alleviate overloading and congestion.
Our success also depends on rapid growth in sales of our particular
Internet service offerings. This growth depends, in part, on customers trusting
us to deliver the services in a timely and efficient manner, and that we will
continue to operate for at least as long as the life of any contract between us
and our customers. This trust may be difficult to establish because there has
been substantial downturn in the telecommunications and technology industry,
leading to many bankruptcies and closures of competing Internet service
providers. Some of these closures required the customers of the closing Internet
service provider to find alternative providers on very short notice. We
18
cannot assure you that our success will not be adversely impacted as a result of
a downturn in the Internet services industry.
Our data centers and the networks we rely on are sensitive to harm from human
actions and natural disasters. Any resulting disruption could significantly
damage our business and reputation.
Our reputation for providing reliable service largely depends on the
performance and security of our data centers and equipment, and of the network
infrastructure of our connectivity providers. In addition, our customers often
maintain confidential information on our servers. However, our data centers and
equipment, the networks we use, and our customers' information are subject to
damage and unauthorized access from human error and tampering, breaches of
security, natural disasters, terrorist attacks, power loss, capacity
limitations, software defects, telecommunications failures, intentional acts of
vandalism, including computer viruses, and other factors that have caused, and
will continue to cause, interruptions in service or reduced capacity for our
customers, and could potentially jeopardize the security of our customers'
confidential information such as credit card and bank account numbers. Despite
precautions we have taken and plan to take, the occurrence of a security breach,
a natural disaster, interruption in service or other unanticipated problems
could seriously damage our business and reputation and cause us to lose
customers. Additionally, the time and expense required to eliminate computer
viruses and alleviate other security problems could be significant and could
impair our service quality. We also often provide our customers with service
level agreements. If we do not meet the required service levels, we may have to
provide credits to our customers, which could significantly reduce our revenues.
Additionally, in the event of any resulting harm to customers, our customers
might seek to hold us liable for damages. Awards for such damages might exceed
our liability insurance by an unknown but significant amount and could seriously
harm our business.
Providing services to customers with mission-critical Web sites and Web-based
applications could potentially expose us to lawsuits for customers' lost profits
or other damages.
Because our Web and application hosting services are critical to many of
our customers' businesses, any significant interruption in our services could
result in lost profits or other indirect or consequential damages to our
customers. Our customers are required to sign server order forms which
incorporate our standard terms and conditions. Although these terms disclaim our
liability for any such damages, a customer could still bring a lawsuit against
us claiming lost profits or other consequential damages as the result of a
service interruption or other Web site or application problems that the customer
may ascribe to us. There can be no assurance that a court would enforce any
limitations on our liability, and the outcome of any lawsuit would depend on the
specific facts of the case and legal and policy considerations. We also believe
we would have meritorious defenses to any such claims, but there can be no
assurance that we would prevail. In such cases, we could be liable for
substantial damage awards. Such damage awards might exceed our liability
insurance by unknown but significant amounts, which would seriously harm our
business.
There is uncertainty concerning our continued use of Arthur Andersen LLP as our
outside auditors.
On March 14, 2002, the United States Department of Justice obtained an
indictment against Arthur Andersen LLP, our independent public accountants since
October 2001, on a single count of obstruction of justice in connection with a
matter unrelated to us or our consolidated financial statements. The
consequences of this indictment are unknown at this time.
Arthur Andersen LLP has provided the Securities and Exchange Commission
(the "SEC") with assurances that it will continue to audit financial statements
in accordance with generally accepted auditing standards and applicable
professional and firm auditing standards, including quality control standards.
Arthur Andersen LLP has also committed to the SEC to advise the SEC immediately
if it becomes unable to continue to provide those assurances. We have received
from Arthur Andersen LLP a letter to the effect that Arthur Andersen LLP has
represented that the audit was subject to its quality control system for the
U.S. accounting and auditing practice to provide reasonable assurance that the
engagement was conducted in compliance with the professional standards and that
19
there was appropriate continuity of personnel working on our audit, and
availability of national office consultation.
The result of the indictment or other lawsuits against Arthur Andersen LLP
may cause us to re-select independent public accountants. The Audit Committee of
the board of directors reviews the selection of our independent public
accountants each year and expects to conduct such a review in due course.
Regulatory and legal uncertainties could have significant costs or otherwise
harm our business.
Laws and regulations directly applicable to communications and commerce
over the Internet are becoming more prevalent. The United States Congress has
recently considered enacting Internet laws regarding children's privacy,
copyrights, taxation and the transmission of sexually explicit material. The
European Union also enacted its own privacy regulations. The law of the
Internet, however, remains largely unsettled, even in areas where there has been
some legislative action. It may take years to determine whether and how existing
laws such as those governing intellectual property, privacy, libel and taxation
apply to the Internet. In addition, the growth and development of the market for
on-line commerce may prompt calls for more stringent consumer protection laws,
both in the United States and abroad, that may impose additional burdens on
companies conducting business on-line. The application of existing laws or
promulgation of new laws could require us to expend substantial resources to
comply with such laws or discontinue certain service offerings. Increased
attention to liability issues could also divert management attention, result in
unanticipated expenses and harm our business. Regulation of the Internet may
also harm our customers' businesses, which could lead to reduced demand for our
services. We are not currently subject to direct regulation by the Federal
Communications Commission ("FCC") or any other government agency, other than as
to regulations applicable to business in general. However, in the future we may
become subject to regulation by the FCC or other federal or state agencies,
which could increase our costs and harm our business. See "Business--Government
Regulation."
We provide services over the Internet in many states in the United States
and in many foreign countries, and we facilitate the activities of our customers
in these jurisdictions. As a result we may be required to qualify to do
business, or be subject to taxation, or be subject to other laws and
regulations, in these jurisdictions even if we do not have a physical presence
or employees or property in these jurisdictions. The application of these
multiple sets of laws and regulations is uncertain, but we could find that we
are subject to regulation, taxation, enforcement or other liability in
unexpected ways, which could materially and adversely affect our business.
Further, the imposition upon us and other Internet network providers of
potential liability for information carried on or disseminated through systems
could require us to implement measures to reduce exposure to liability, which
may require the expenditure of substantial resources, or to discontinue various
service or product offerings. In addition, the costs of defending against any
claims and potential adverse outcomes of these claims could have a material
adverse effect on our business. While we carry professional liability insurance,
it may not be adequate to compensate or may not cover us in the event we become
liable for information carried on or disseminated through our networks.
Difficulties presented by international economic, political, legal, accounting
and business factors could harm our business in international markets.
We opened our first non-U.S. data center in the London metropolitan area
in July 2000 and additional international data centers located in Frankfurt,
Paris, and Tokyo in the second quarter of 2001. We may also enter into joint
ventures or outsourcing agreements with third parties, acquire rights to
high-bandwidth transmission capability, acquire complementary businesses or
operations, or establish and maintain new operations outside of the United
States. Thus, we may depend on third parties to be successful in our
international operations. In addition, the rate of development and adoption of
the Internet has been slower outside of the United States, and the cost of
bandwidth has been higher, which may adversely affect our ability to expand
operations and may increase our cost of operations internationally. The risks
inherent in conducting business internationally include:
20
. unexpected changes in regulatory, tax and political
environments;
. longer payment cycles and problems in collecting accounts
receivable;
. fluctuations in currency exchange rates and imposition of
currency exchange controls;
. ability to secure and maintain the necessary physical and
telecommunications infrastructure;
. challenges in staffing and managing foreign operations; and
. employment laws and practices in foreign countries.
Any of these could adversely affect our international operations.
Furthermore, some foreign governments have enforced laws and regulations on
content distributed over the Internet that are more restrictive than those
currently in place in the United States. Any one or more of these factors could
adversely affect our contemplated future international operations and
consequently, our business.
This report includes forward-looking statements, which could differ from actual
results.
Some of the statements in this Form 10-K that are not historical facts are
"forward-looking statements" (as such term is defined in the Private Securities
Litigation Reform Act of 1995). Forward-looking statements can be identified by
the use of words such as "estimates," "projects," "anticipates," "expects,"
"intends," "believes" or comparable terminology, the negative thereof or other
variations thereon or by discussions of strategy that involve risks and
uncertainties. Examples of forward-looking statements include discussions
relating to:
. plans to expand our existing managed hosting services;
. introductions of new products and services;
. proposals to build new data centers in various geographic
areas;
. estimates of market sizes and addressable markets for our
services and products;
. estimates of future revenues; and
. statements regarding the future course of our relationship
with Intermedia and WorldCom.
We wish to caution you that all the forward-looking statements contained
in this document are only estimates and predictions. Our actual results could
differ materially from those anticipated in the forward-looking statements due
to risks, uncertainties or actual events differing from the assumptions
underlying these statements. Such risks, uncertainties and assumptions include,
but are not limited to, those discussed in this Form 10-K.
Item 2. Properties
We currently lease office space for our corporate headquarters in Laurel,
Maryland and administrative offices in Beltsville, Maryland and San Jose,
California. Our international administrative offices in the United Kingdom
support our international operations. Our regional sales offices are located in
major cities and metropolitan areas within the United States, Europe, and Asia.
As of December 31, 2001, we leased or colocated an aggregate of 19 facilities
for our sales offices in the following locations:
21
U.S. locations International locations
- ---------------------------------------------------- -------------------------
Atlanta, GA Detroit, MI New York, NY Frankfurt, Germany
Boston, MA East Rutherford, NJ Philadelphia, PA London, United Kingdom
Chicago, IL Irvine, CA San Francisco, CA Paris, France
Dallas, TX Los Angeles, CA San Jose, CA Tokyo, Japan
Denver, CO Miami, FL Washington, DC
In the fourth quarter of 1999, we opened our data centers on the east and
west coasts of the United States. Our first international data center, located
in London and became operational in July 2000, gives Digex customers in Europe
the technology, security, and support services in Europe they have come to rely
on in the United States. Our U.S. data centers, except for those built into
WorldCom facilities, are leased with terms expiring in 2009. We currently lease
space and equipment for our U.K. data center from MCI WorldCom, a subsidiary of
WorldCom, after it had purchased certain assets from Telia UK Limited, our
previous supplier.
Through our facilities agreement with WorldCom, we have built several
managed Web hosting facilities into existing WorldCom data centers in the United
States and abroad patterned on Digex SmartCenter(SM) specifications. Our first
data center completed through this agreement is located in Ashburn, Virginia and
became operational in the first quarter of 2001. In the second quarter of 2001,
we operationalized data centers built into WorldCom facilities in Somerset, New
Jersey; Paris, France; Frankfurt, Germany; and Tokyo, Japan. We have leased and
intend to continue to lease space in these WorldCom data centers based on
customer demand. The initial term of the agreement expires on December 31, 2003
and may be extended for an additional year, upon the election of Digex or
WorldCom by written notice.
As of December 31, 2001, our total property and equipment in service
consisted of buildings (5.5%), electronic and computer equipment (58.7%),
computer software (14.2%), furniture, office equipment, and vehicles (2.0%), and
leasehold improvements (19.6%). Such properties do not lend themselves to
description by character and location of principal units. Substantially all of
our equipment is housed in multiple leased facilities on the east and west
coasts of the United States. We believe that our properties are adequate and
suitable for their intended purposes.
Data Center Infrastructure
We presently operate secure data centers specifically designed for the
non-stop 24-hours a day hosting of Web sites and Web-based applications. Our
data centers combine the predictability and control of traditional
mainframe-based data centers with the network access and capacity required for
today's Internet-based computing. Our data centers are designed to provide high
service levels while permitting customers to rapidly deploy new and strategic
applications without increasing cost or incurring risk.
The physical infrastructure and security controls of our data centers have
been designed to support rigorous requirements for secure data storage and
processing. Physical benefits of our data centers include: physical security;
multi-redundant mechanics, utilities and environmental controls; network
connectivity; and fully-integrated customer work areas.
Specifically, our data centers include multiple separate computer rooms
offering customers containment and isolation from accidents or disasters
occurring within or outside of each data center. Physical security has been
implemented through controlled security zones requiring access card, personal
identification number keypad entry, and biometric identification. Each data
center has five security zones that require separate access levels to gain
entry. Our highest security zones include computer rooms physically constructed
as a building-within-a-building, with fire suppression and other controls
separate from the remainder of the data center. Fencing above the ceiling and
below the raised floor isolate each security zone. Surveillance cameras record
movement through the data centers and security guards provide real-time roaming
visibility. Our cooling towers are surrounded by security fences and monitored
by cameras. Cooling and environmental controls for each data center are designed
to monitor and maintain temperature and humidity levels. Our data centers also
provide reliable networking connectivity to national
22
Internet backbone carriers for our customers. Telecommunications circuits enter
the data centers through multiple paths from different service arrangements.
Multiple points of presence allow continued operation of service without
degradation. Finally, our data centers include separate, private customer work
areas. These work areas are isolated from the security zones that house our
servers, permitting customers to work on-site as necessary.
Item 3. Legal Proceedings
Digex does not believe that there are any pending or threatened legal
proceedings that, if adversely determined, would have a material adverse effect
on Digex's consolidated results of operations, cash flows, or financial
position.
Item 4. Submission of Matters to a Vote of Security Holders
Matters submitted to a vote at the Annual Meeting of Stockholders held on
December 12, 2001 and the results of such meeting are as follows:
Votes Votes Votes Votes
For Against Withheld Abstained
--- ------- -------- ---------
1. Election of directors to serve until the 2002 Annual
Meeting of Stockholders.
Ronald R. Beaumont ..................................................... 414,014,133 -- 61,521 --
Gregory J. Clark ....................................................... 414,017,388 -- 58,266 --
Bernard J. Ebbers ...................................................... 414,014,551 -- 61,103 --
K. William Grothe, Jr. ................................................. 414,018,251 -- 57,403 --
Edith E. Holiday ....................................................... 414,014,406 -- 61,248 --
Bert C. Roberts, Jr. ................................................... 414,014,351 -- 61,303 --
Mark K. Shull .......................................................... 414,014,541 -- 61,113 --
Scott D. Sullivan ...................................................... 414,014,351 -- 61,303 --
Lawrence C. Tucker ..................................................... 414,017,706 -- 57,948 --
2. Approval of the amendment to the certificate of incorporation of
Digex to prohibit Digex from entering into certain transactions with
WorldCom without there being at least two independent directors and
without the transaction being approved by either a majority of the
independent directors or two-thirds of the entire board of directors
(other than the independent directors) ................................. 414,637,237 15,102 -- 2,033
3. Approval of Arthur Andersen LLP as independent
auditors of Digex for the year ended December 31,
2001 ................................................................... 414,055,777 19,624 -- 253
A majority of the votes present, in person or by proxy, and entitled to
vote at the meeting, were cast in favor of the three proposals.
23
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Our Class A common stock trades on the Nasdaq Stock Market under the
symbol "DIGX." As of March 8, 2002, there were 62 holders of record of our Class
A common stock and, based on an estimate of the number of individual
participants represented by security position listings, there are approximately
13,400 beneficial holders of our Class A common stock. All of our outstanding
Class B common stock is held of record by Intermedia Financial Company. The
approximate high and low closing prices for our Class A common stock, as
reported by the Nasdaq Stock Market, were:
2001 2000
------------------- -------------------
High Low High Low
------- ------- ------- -------
First quarter .................. $ 31.38 $ 12.69 $171.50 $ 56.06
Second quarter ................. 19.50 8.38 111.00 35.25
Third quarter .................. 11.21 3.34 94.00 46.88
Fourth quarter ................. 3.35 1.40 58.44 21.19
Dividend Policy
We do not anticipate paying any dividends on any of our common stock in
the foreseeable future. Moreover, we are subject to restrictions under the
Intermedia indentures, which restrict any subsidiary of Intermedia from paying
dividends unless Intermedia meets certain financial tests. Intermedia does not
currently meet and is not expected to meet these financial tests in the
foreseeable future. Therefore, we are effectively prohibited from paying
dividends. We may also incur indebtedness in the future, which may prohibit or
effectively restrict the payment of dividends.
Pursuant to a final settlement of the consolidated derivative and class
action suits approved by the Delaware Court of Chancery in Wilmington, Delaware,
WorldCom made a payment of WorldCom common stock having a total value of $165.0
million for distribution to Digex common stock holders following the closing of
the Intermedia - WorldCom Merger in July 2001. One half of the settlement fund
net of plaintiffs' attorneys fees was distributed to record holders of Digex
common stock as of September 1, 2000. The balance of the settlement fund net of
attorneys' fees was paid to record holders of Digex stock as of June 29, 2001.
Neither Intermedia nor its affiliates was entitled to any distribution from the
settlement fund. The merger agreement between Intermedia and WorldCom was
amended, among other things, to change the consideration to be paid to
Intermedia shareholders in connection with the merger. The fees and expenses of
all plaintiffs and all counsel representing all plaintiffs in the action were
paid out of the settlement fund. In connection with the settlement, WorldCom has
agreed to reimburse Digex for certain fees and expenses incurred by Digex
associated with the merger and the consolidated lawsuit in an amount not to
exceed $15.0 million. A further provision of the settlement makes Section 203 of
the Delaware General Corporation Law inapplicable to future transactions between
WorldCom and Digex.
For each share of WorldCom Group common stock paid into the settlement
fund, 1/25th of a share of MCI Group common stock was also paid into such fund.
The value of the WorldCom Group common stock and the MCI Group common stock was
based upon the average trading price of 10 trading days randomly selected from a
20-day trading period from May 31, 2001 through June 27, 2001. Based on a
randomly selected average trading price of $16.672 per share, WorldCom deposited
9,896,833 shares of WorldCom Group common stock and 395,873 shares of MCI Group
common stock into the settlement fund on July 2, 2001.
24
Approximately 7.5% of the shares deposited into the settlement fund was
distributed to the legal counsel for the plaintiffs in the litigation,
approximately 46.25% of the settlement fund was distributed to the holders of
record of Digex Class A common stock as of September 1, 2000 (based on an
exchange rate of 0.18838 shares of WorldCom Group common stock and 0.00754
shares of MCI Group common stock for each share of Digex Class A common stock),
and the remaining 46.25% was distributed to holders of record of Digex Class A
common stock as of June 29, 2001 (based on an exchange rate of 0.18465 shares of
WorldCom Group common stock and 0.00739 shares of MCI Group common stock for
each share of Digex Class A common stock).
Recent Sales of Unregistered Securities.
None.
Use of Proceeds from a Sale of Registered Securities
None.
Item 6. Selected Financial and Other Operating Data
The following table sets forth selected historical financial data of Digex
for the period from July 7, 1997, the date of acquisition by Intermedia of the
Web site hosting unit (the "Predecessor") of Business Internet, Inc., to
December 31, 1997, the years ended December 31, 1998, 1999, 2000, and 2001, and
of the Predecessor for the period from January 1, 1997 to July 6, 1997. The
selected historical financial data has been derived from Digex's and the
Predecessor's audited financial statements.
The following table also sets forth pro forma financial information of
Digex for the year ended December 31, 1997. The pro forma financial information
gives effect to the purchase by Intermedia of the Predecessor as if such
acquisition had occurred on January 1, 1997. The presentation of pro forma
financial information was made to permit useful comparison of results of
operations between periods presented. This pro forma financial information is
not necessarily indicative of the operating results Digex would have achieved if
the Predecessor had been acquired on January 1, 1997. The relationship between
Business Internet and the Predecessor is more fully described in Note 1 to the
consolidated financial statements.
In the following table, basic and diluted net loss per share have been
calculated assuming that the common shares issued in connection with our
recapitalization in April 1999 were outstanding for all periods of Digex
presented, and giving effect to the 50,000-for-one stock split of our Class B
common stock effected in July 1999 prior to the closing of our initial public
offering.
25
The following financial information should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business" and our consolidated financial statements and related
notes, included elsewhere in this report.
Predecessor Digex
----------- -----------------------------------------------------------------------------------
Historical Historical Pro Forma (1) Historical
----------- --------------- ------------- --------------------------------------------
Period from
Period from July 7, 1997
January 1, (date of Year Ended
1997 acquisition) to Year Ended December 31,
to July 6, December 31, December 31, --------------------------------------------
1997 1997 1997 1998 1999 2000 2001
----------- --------------- ------------ -------- -------- --------- ---------
(unaudited)
(In thousands, except share and per share data)
Statement of Operations
Data:
Revenue:
Revenue ................... $ 4,420 $ 7,192 $ 11,612 $ 22,635 $ 59,786 $ 162,085 $ 185,025
Revenue from
WorldCom .............. -- -- -- -- -- 6,000 29,328
-------- ------------ ------------ -------- -------- --------- ---------
Total revenue ............... 4,420 7,192 11,612 22,635 59,786 168,085 214,353
Costs and expenses:
Cost of operations ....... 4,149 1,739 2,808 6,710 9,656 21,244 16,138
Cost of services ......... 1,817 1,611 3,428 7,044 21,750 69,658 103,962
Selling, general and
administrative ......... 6,649 5,589 12,238 16,021 65,948 134,227 125,140
Provision for doubtful
accounts ............... 352 498 850 1,491 4,265 10,649 15,374
Deferred
compensation ........... -- -- -- -- 1,299 4,101 3,192
Depreciation and
amortization ........... 519 2,753 4,850 8,109 29,070 78,819 136,396
Charge off of purchased
in-process research and
development ............. -- 15,000(2) 15,000(2) -- -- -- --
-------- ------------ ------------ -------- -------- --------- ---------
Total costs and expenses ..... 13,486 27,190 39,174 39,375 131,988 318,698 400,202
-------- ------------ ------------ -------- -------- --------- ---------
Loss from operations ......... (9,066) (19,998) (27,562) (16,740) (72,202) (150,613) (185,849)
Other income (expense):
Interest expense ........ -- -- -- -- (1,094) (2,008) (4,768)
Interest income and
other ............... -- -- -- -- 3,458 9,686 2,158
-------- ------------ ------------ -------- -------- --------- ---------
Loss before income tax
benefit ................... (9,066) (19,998) (27,562) (16,740) (69,838) (142,935) (188,459)
Income tax benefit ........... -- 1,440 4,710 159 4,839 -- --
-------- ------------ ------------ -------- -------- --------- ---------
Loss before cumulative effect
of change in accounting
principle ................. (9,066) (18,558) (22,852) (16,581) (64,999) (142,935) (188,459)
Cumulative effect of
change in accounting
principle ................. -- -- -- -- -- (166) --
-------- ------------ ------------ -------- -------- --------- ---------
Net loss ..................... (9,066) (18,558) (22,852) (16,581) (64,999) (143,101) (188,459)
Accretion of preferred
stock
discount .................. -- -- -- -- -- -- (4,025)
-------- ------------ ------------ -------- -------- --------- ---------
Net loss available to
common stockholders ....... $ (9,066) $ (18,558) $ (22,852) $(16,581) $(64,999) $(143,101) $(192,484)
======== ============ ============ ======== ======== ========= =========
Net loss per common share
basic and diluted ......... -- $ (0.37) $ (0.46) $ (0.33) $ (1.19) $ (2.26) $ (3.00)
======== ============ ============ ======== ======== ========= =========
Proforma amounts,
assuming the accounting
change is applied
retroactively:
Net loss ..................... $ (9,066) $ (18,558) $ (22,852) $(16,618) $(65,115) $(142,935) $(192,484)
======== ============ ============ ======== ======== ========= =========
26
Net loss per common share:
basic and diluted ..... -- $ (0.37) $ (0.46) $ (0.33) $ (1.19) $ (2.25) $ (3.00)
======== ============ ============ ============ ============ ============ ============
Shares used in computing
basic and diluted and
proforma net loss per
share ................. -- 50,000,000 50,000,000 50,000,000 54,726,027 63,404,839 64,076,647
======== ============ ============ ============ ============ ============ ============
Other Data:
EBITDA before certain
charges (3) ............. $ (8,547) $ (2,245) $ (7,712) $ (8,631) $ (41,833) $ (67,693) $ (46,261)
Net cash used in
operating activities .. (7,172) (6,079) (13,251) (10,930) (20,515) (62,520) (62,705)
Net cash used in
investing activities .. (1,004) (55,237) (56,241) (30,969) (170,193) (204,604) (98,882)
Net cash provided by
financing activities .. 8,176 61,316 69,492 41,899 279,486 261,818 90,453
Capital expenditures ..... 1,004 8,016 9,020 30,969 170,396 202,604 98,201
Digex
------------------------------------------------------------
December 31,
1997 1998 1999 2000 2001
-------- ------- -------- -------- --------
(In thousands)
Balance Sheet Data:
Cash and cash equivalents (4) .............................. $ -- $ -- $ 88,778 $ 83,434 $ 12,096
Restricted investment ...................................... -- -- -- 2,000 3,197
Working capital (deficit) .................................. (351) 1,231 74,778 71,922 9,243
Property and equipment, net ................................ 12,930 39,059 205,903 348,975 327,701
Total assets ............................................... 49,693 77,739 344,309 521,051 427,358
Long-term notes payable, including current portion ......... -- -- 3,712 4,207 93,264
Capital lease obligations, including current portion ....... 1,980 2,089 16,567 29,002 35,152
Redeemable preferred stock ................................. -- -- -- 71,572 81,503
Total stockholders'/owner's equity ......................... 45,527 70,845 290,189 345,056 157,644
- ----------
(1) The pro forma statement of operations data for the year ended December 31,
1997, represents the combining of the historical Predecessor statement of
operations data for the period from January 1, 1997 to July 6, 1997 and
the historical Digex statement of operations data for the period from July
7, 1997 to December 31, 1997, as adjusted for the following items:
. A decrease in cost of operations of $3,080 which represents
reduced network expenses.
. An increase in depreciation and amortization of $1,578 which
represents amortization of intangible assets arising from the
acquisition.
. An increase in income tax benefit of $3,270 which represents
the income tax effect of purchase accounting adjustments.
(2) This amount represents a one-time charge to operations for charge off of
purchased in-process research and development related to the Predecessor
in connection with Intermedia's purchase of Business Internet on July 7,
1997.
(3) EBITDA before certain charges consists of (earnings) loss before interest
expense, interest income and other, merger-related expenses, foreign
exchange gains (losses), income tax benefit, deferred compensation,
charge-off of purchased in-process research and development, and
depreciation and
27
amortization. EBITDA before certain charges does not represent funds
available for management's discretionary use and is not intended to
represent cash flow from operations. EBITDA before certain charges should
also not be construed as a substitute for operating income or a better
measure of liquidity than cash flow from operating activities, which are
determined in accordance with generally accepted accounting principles.
This caption excludes components that are significant in understanding and
assessing our results of operations and cash flows. In addition, EBITDA
before certain charges is not a term defined by generally accepted
accounting principles and as a result our measure of EBITDA before certain
charges might not be comparable to similarly titled measures used by other
companies. However, we believe that EBITDA before certain charges is
relevant and useful information which is often reported and widely used by
analysts, investors and other interested parties in the Web and
application hosting industry. Accordingly, we are disclosing this
information to permit a more comprehensive analysis of our operating
performance, as an additional meaningful measure of performance and
liquidity, and to provide additional information with respect to our
ability to meet future debt service, capital expenditure and working
capital requirements.
(4) Prior to our initial public offering in July 1999, we participated in
Intermedia's and the Predecessor's centralized cash management system,
and, as a result, did not carry cash balances on our financial statements
for any period prior to the initial public offering. Since that date, we
have maintained and reported cash balances on our financial statements.
28
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
We are a provider of advanced hosting services for companies conducting
business on the Internet. Our services include server management, application
support, managed networking services, and customer care and support services. We
also offer value-added IT services, such as enhanced security, database
services, high- availability and application optimization services, stress
testing, and consulting services. As part of our services, we provide the
installation and maintenance of computer hardware and software, network
technology, and systems management to offer our customers a broad range of
managed hosting solutions. From major corporations to Internet-based businesses,
our customers use our services to rapidly deploy their business solutions
including on-line financial services, on-line procurement, electronic retailing,
and customer self-service applications.
WorldCom is our majority stockholder, primary lender, significant channel
partner, and one of our largest vendors. In particular, under the funding
agreement, WorldCom is obligated to provide funding for the approved Digex
business plan through 2002 only. WorldCom will then have an option to continue
funding us beyond 2002, but may not exercise such option. Through 2002, we
expect our working capital needs and capital expenditure requirements to be met
through our note purchase agreement dated July 31, 2001 with WorldCom.
At December 31, 2001, we served over 600 customers, of which approximately
171 customers are WorldCom channel customers. We also managed 3,588 Windows- and
UNIX-based servers in our data centers, which are positioned on the east and
west coasts of the United States, and in Europe and Asia. Approximately 660 of
our total managed servers were sold through the WorldCom sales channel
agreement.
We currently project continued significant losses and operating cash flow
deficits. Since the Intermedia - WorldCom Merger, we have been dependent on
WorldCom to fund our operating cash flow deficits and capital expenditures.
Pursuant to the terms of the Intermedia - WorldCom Merger and subject to the
limitations under our approved 2002 business plan, which is subject to amendment
and modifications, WorldCom has committed to fund our projected cash flow
deficits and capital expenditures through December 31, 2002. Our 2002 business
plan may require up to $276.0 million, inclusive of amounts for capital
expenditures, the majority of which is expected to be demand driven. This amount
could materially change due to changes in the economy, our target market, our
practice of acquiring equipment on behalf of customers, or our ability to
execute on this business plan, among other factors. The amount of actual
borrowings from WorldCom in 2002 could be more or less than the amounts approved
under the business plan. Should we require additional funding beyond 2002, as
currently projected, there can be no assurance that WorldCom will provide such
additional funding. We believe that funding from any source other than WorldCom
on appropriate or commercially acceptable terms is unlikely to be available.
In October 2000, we entered into a Prime/Subcontractor Agreement with
WorldCom whereby we agreed to provide, for certain service fees, managed hosting
services to WorldCom customers in the United States and in all international
locations we presently serve or will serve in the future. Under the terms of the
agreement, we provide the computer hardware, software, network technology,
Internet connectivity and systems management necessary to offer WorldCom's
customers comprehensive outsourced managed hosting solutions. In November 2000,
WorldCom announced the immediate U.S. availability of an expanded global Web
hosting product suite to include high-end managed hosting services through
arrangements with us. We recognized $6.0 million of revenue under the agreement
in the fourth quarter of 2000.
Through the sales channel agreement, WorldCom has commenced reselling our
portfolio of managed hosting products. We also have access to WorldCom's sales
force to enhance our global presence. If we satisfy certain service level and
data center capacity commitments, WorldCom has agreed to purchase up to a total
of $500.0 million during the period from 2001 through 2003. WorldCom has agreed
to purchase $50.0 million and $192.0 million of managed hosting services in 2001
and 2002, respectively. WorldCom has agreed to
29
purchase, in 2003, a minimum amount of managed hosting services equal to the
lesser of $260.0 million or an amount equal to four times the actual services
purchased by WorldCom for resale in the fourth quarter of 2002 ("the Minimum
Annual Commitment"). WorldCom agreed to compensate us, on a quarterly basis, for
the full amount of operating losses before depreciation and amortization
incurred in servicing WorldCom customers under the sales channel agreement,
during 2001. However, in 2001 and thereafter, to the extent that we generate
operating income before depreciation and amortization in servicing WorldCom
under the sales channel agreement, we have agreed to share such operating income
with WorldCom. WorldCom's participation in operating results is recognized as
adjustments to revenue recognized under the sales channel agreement.
Total revenues from WorldCom under the sales channel agreement include (1)
actual managed hosting services purchased for resale by WorldCom and (2) the
difference, if any, between actual managed hosting services purchased by
WorldCom and WorldCom's Minimum Annual Commitment. These amounts are further
adjusted for compensation due to or due from WorldCom as discussed above based
upon the net results of activity under the agreement.
In 2001, we recognized revenue of $29.3 million, of which total revenues
of $29.1 million were recorded under the sales channel agreement. Total revenues
from actual managed hosting services were $14.8 million. Total revenues for the
difference between actual managed hosting services sold and the Minimum Annual
Commitment were $32.3 million. These amounts were reduced by $18.0 million,
representing WorldCom's share in the net earnings related to activity under the
sales channel agreement.
Through our facilities agreement with WorldCom, we have built managed
hosting facilities in several existing WorldCom data centers in the United
States and around the world. We have leased and intend to continue to lease
space from WorldCom at these data centers based on customer demand. These
hosting facilities were patterned after our SmartCenter(SM) facilities in the
U.S. Our first data center completed through this agreement is located in
Ashburn, Virginia and became operational in the first quarter of 2001. In the
second quarter of 2001, we operationalized data centers built in WorldCom
facilities in New Jersey, France, Germany, and Japan. We may continue to build
additional hosting facilities in other WorldCom data centers in the future. The
payments for the data center space and connections from the space to a WorldCom
Internet Protocol network hub amounted to $1.7 million for the year ended
December 31, 2001.
Our network agreement with WorldCom provides us with terms to purchase
bandwidth and connectivity from WorldCom in the United States to support our
managed hosting activities. Through this arrangement, we were able to connect
our Internet data centers to the WorldCom global IP network that runs through
North America, South America, Europe, Asia, and Australia with over 2,500 points
of presence. In the second quarter of 2001, we fully transitioned to the
WorldCom global IP network as our primary network. The payments for the
dedicated Internet connections and WorldCom network services amounted to
approximately $6.0 million for the year ended December 31, 2001.
Through our network services agreements, WorldCom, Intermedia, and Telia
UK Limited provided us with bandwidth and network connectivity in 2001. During
2001, our U.K. data center received primary and redundant network services from
WorldCom and Telia, respectively. Telia provided for our data center space and
infrastructure equipment in our U.K. data center, until the assets were
purchased by WorldCom in December 2001. Effective March 2002, WorldCom serves as
our primary bandwidth provider for the U.K.
Critical Accounting Policies and Estimates
The following discussion and analysis of financial condition and results
of operations should be read in conjunction with the consolidated financial
statements and related notes herein, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets,
30
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. We evaluate our estimates on a continual basis, including those
related to revenue recognition, allowance for doubtful accounts, property and
equipment, intangible assets, and redeemable preferred stock. 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 from
these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of its consolidated
financial statements:
Revenue Recognition. We generate most of our revenues from fixed monthly
fees charged to customers under contracts having terms that typically range from
one to three years. We also charge installation fees for new and existing
customers upgrading service. In accordance with Staff Accounting Bulletin No.
101 ("SAB 101"), we recognize installation revenue and related direct
incremental costs of performing the installation over a period that we estimate
to be the longer of the estimated life of the customer relationship or the
average life of all customer contracts. We continually analyze the average life
of our customer relationships and contracts and have determined that a 24-month
period is a reasonable estimate. Any revisions in the estimated contract period
will be charged to income in the period in which the facts that give rise to the
revision become known. The difference between the actual amount invoiced to
WorldCom through the sales channel agreement and the minimum annual revenue
commitment is recognized as revenue at the end of the measurement period, net of
our share of operating income before depreciation and amortization in servicing
WorldCom.
Allowance for Doubtful Accounts. We regularly assess the credit standing
of our customers and the collectibility of receivables. We cease revenue
recognition when collectibility is not probable. Allowances for doubtful
accounts are maintained for estimated losses resulting from the inability of our
customers to make required payments. If the financial condition of our customers
becomes uncertain or deteriorates, impairing their ability to make payments,
additional allowances may be required.
Impairment of Long-lived Assets. We review our long-lived assets for
impairment when events or changes in circumstances indicate the carrying value
of such assets may not be recoverable. We also evaluate the useful life of
assets periodically. The review consists of a comparison of the carrying value
of the assets with the assets' expected future undiscounted cash flows without
interest costs. Estimates of expected future cash flows represent management's
best estimate based on reasonable and supportable assumptions and projections.
If actual market conditions are less favorable than those projected by
management, asset write-downs may be required. Management will continue to
evaluate overall industry and company specific circumstances and conditions as
necessary.
Redeemable Preferred Stock We are accreting the preferred stock discount
of $16.1 million to the mandatory conversion date in January 2005. To date,
management believes that a redemption event is not probable due to the covenants
contained in Intermedia's indentures, which restrict redemption, and the
requirement of legal availability of funds. These conditions currently prohibit
the redemption of the securities. The current market conditions and the value of
our common stock decrease the likelihood that the preferred stock will be
converted earlier than the mandatory conversion date. If these conditions
change, our estimate of when the preferred stock becomes redeemable or will be
converted may require an adjustment to the accretion amount. Management will
continue to evaluate the conditions as necessary.
Refer to "Business - Risk Factors" for known trends or uncertainties that
are reasonably likely to affect our financial condition or results of
operations.
Refer to Note 1 to the consolidated financial statements for further
discussion of our significant accounting policies.
31
General
Revenues. Our revenues principally consist of monthly service fees charged
to customers under contracts having terms that typically range from one to three
years. Monthly services fees are recognized in the month the service is
rendered. We also charge installation fees for new and existing customers
upgrading service. Installation revenue and related direct incremental costs of
performing the installation are recognized over the estimated contract period.
We continually analyze the average life of our customer relationships and
contracts and have determined that a 24-month period is a reasonable estimate.
Certain customer payments for managed Web hosting services received in advance
of service delivery are deferred until the service is performed. Additional
services are recognized in the month the services are performed. Revenue earned
from the sale of third party equipment is also included.
Costs and Expenses. Costs and expenses include:
. cost of operations;
. cost of services;
. selling, general and administrative expenses;
. provision for doubtful accounts;
. deferred compensation; and
. depreciation and amortization expense.
Cost of operations consist primarily of the costs for our network
connectivity and firewall services. We expect our network connectivity
requirements to grow in conjunction with the growth of our overall business,
including the expansion of our business abroad through our wholly-owned
subsidiaries, and accordingly expect these costs to increase in the future.
Expenses directly attributed to the sale of third party equipment is also
included.
Cost of services consist primarily of facilities administration expenses
including rent, maintenance and utilities to support our data centers and
salaries and related benefits for our technical operations. We expect our cost
of services to increase in dollar amount as our business grows but to decline as
a percentage of revenue due to economies of scale and expected improvements in
technology and productivity.
Selling, general and administrative expenses consist primarily of salaries
and benefits for our marketing, sales and support personnel, advertising costs,
consultants' fees, and other miscellaneous expenses. We expect selling, general
and administrative expenses to increase in dollar amount and to decline as a
percentage of revenue over time.
Provision for doubtful accounts is maintained to reserve against trade
account receivables that have been estimated to be uncollectible due to the
inability of our customers to make the required payment.
Deferred compensation expense relates to stock options that were granted
by Digex to certain employees at exercise prices below market value.
Depreciation and amortization expense consists primarily of depreciation
of our data centers, servers and related equipment and amortization of our
intangible assets. We expect these expenses to increase due to our
32
plans to invest significant capital to continue to expand our data center
capacity.
Results of Operations
The following table presents amounts as reported in our audited financial
statements and certain information derived from these statements as a percentage
of revenue for the years ended December 31, 2001, 2000, and 1999.
Year Ended December 31,
--------------------------------------------------------------------------
2001 2000 1999
-------------------- -------------------- --------------------
Revenue:
Revenue .................................. $ 185,025 86.3% $ 162,085 96.4% $ 59,786 100.0%
Revenue from WorldCom .................... 29,328 13.7 6,000 3.6 -- --
--------- ----- --------- ----- --------- -----
Total revenue ....................... 214,353 100.0 168,085 100.0 59,786 100.0
Costs and expenses:
Cost of operations ....................... 16,138 7.5 21,244 12.6 9,656 16.2
Cost of services ......................... 103,962 48.5 69,658 41.4 21,750 36.4
Selling, general and administrative ...... 125,140 58.4 134,227 80.0 65,948 110.3
Provision for doubtful
accounts .............................. 15,374 7.2 10,649 6.3 4,265 7.1
Deferred compensation .................... 3,192 1.5 4,101 2.4 1,299 2.2
Depreciation and
amortization .......................... 136,396 63.6 78,819 46.9 29,070 48.6
--------- ----- --------- ----- --------- -----
Total costs and expenses ............ 400,202 186.7 318,698 189.6 131,988 220.8
--------- ----- --------- ----- --------- -----
Loss from operations ........................ (185,849) (86.7) (150,613) (89.6) (72,202) (120.8)
Other income (expense):
Interest expense ........................ (4,768) (2.2) (2,008) (1.2) (1,094) (1.8)
Interest income and other ............... 2,158 1.0 9,686 5.8 3,458 5.8
--------- ----- --------- ----- --------- -----
Loss before income tax benefit .............. (188,459) (87.9) (142,935) (85.0) (69,838) (116.8)
Income tax benefit .......................... -- -- -- -- 4,839 8.1
--------- ----- --------- ----- --------- -----
Net loss .................................... $(188,459) (87.9)% $(142,935) (85.0)% $ (64,999) (108.7)%
========= ===== ========= ===== ========= =====
Year Ended December 31, 2001 Compared to the Year Ended December 31, 2000
Revenue
Total revenue increased 27.5% to $214.4 million in 2001 compared to $168.1
million in 2000. The increase in revenue was due to sales to new customers,
additional services to existing customers, and revenue recognized through our
sales channel agreement with WorldCom, net of customers' modifications to site
configurations. Our installed base of servers decreased 15.0% to 3,588 at
December 31, 2001 from 4,216 at December 31, 2000. However, the average revenue
per server increased 4% to $4,414 in 2001 from $4,259 in 2000. In 2001, we
recognized revenue of $29.3 million from WorldCom, of which total revenues of
$29.1 million were recorded under the sales channel agreement, compared to $6.0
million recorded under the Prime/Subcontractor agreement with WorldCom in 2000.
Additionally, in 2001, total revenues from actual managed hosting services were
$14.8 million. Total revenues for the difference between actual managed hosting
services sold and the minimum annual commitment were $32.3 million. These
amounts were reduced by $18.0 million, representing WorldCom's share in the net
earnings related to activity under the sales channel agreement. Revenue in 2000
included $5.0 million from a one-time sale of third party equipment, with no
similar one-time sale in 2001.
33
Cost of Operations
Cost of operations decreased 24.0% to $16.1 million in 2001 compared to
$21.2 million in 2000. The decrease was primarily due to a one-time cost
associated with the one-time sale of third party equipment of approximately $4.3
million in 2000, along with improved operating efficiencies and lower costs
attributed to our amended network agreement with Intermedia in the second
quarter of 2001 and our network agreement with WorldCom effective January 1,
2001. As a percentage of revenue, cost of operations decreased to 7.5% in 2001
compared to 10.7% in 2000 (excluding third party equipment sales and costs in
the second quarter of 2000) as a result of improved network utilization.
Cost of Services
Cost of services increased 49.2% to $104.0 million in 2001 compared to
$69.7 million in 2000. The increase was primarily related to the increased level
of operations, charges under our facilities agreement with WorldCom, the
expansion of our new data centers (including costs related to the hiring of
additional personnel in customer service, engineering, and facilities
administration), accruals for changes in employee benefits, and additional
maintenance contracts to service our computer hardware and software. As a
percentage of revenue, total cost of services increased to 48.5% in 2001
compared to 41.4% in 2000.
Selling, General and Administrative
Selling, general and administrative expenses decreased 6.8% to $125.1
million in 2001 compared to $134.2 million in 2000. The decrease was primarily
attributable to a large decrease in marketing and advertising expenses, and the
expiration of our general and administrative agreement with Intermedia.
Marketing and advertising expenses were approximately $17.8 million in 2001
compared with $21.9 million in 2000. The general and administrative agreement
with Intermedia was less than $0.1 million in 2001 compared with $15.0 million
in 2000. Additional factors contributing to the decline in selling, general and
administrative expense include a reduction in property taxes, and reduction in
recruitment and outside consultants' fees, partly offset by increased costs
associated with a larger employee base, accruals for changes in employee
benefits, regional deployment and relocation of the sales force, and expense
recognition of deferred costs related to our adoption of SAB 101. As a
percentage of revenue, total selling, general and administrative expenses
decreased to 58.4% in 2001 compared to 80.0% in 2000, primarily because our
revenue grew while a portion of the selling, general and administrative cost
remained fixed.
Provision for Doubtful Accounts
Provision for doubtful accounts increased 44.4% to $15.4 million in 2001
compared to $10.6 million in 2000 as many of our customers, particularly
Internet-based businesses, ceased operations or reduced or eliminated our Web
hosting services. The continued decline in stock prices for many companies in
the telecommunications and technology industry and the overall tightening of the
capital markets, which limited the access of many our customers to the necessary
capital to continue operations, led to our specific write-off of such accounts.
Deferred Compensation
Deferred compensation expense decreased 22.2% to $3.2 million in 2001
compared to $4.1 million in 2000. The decrease was due to forfeitures in stock
options held by executive officers and key employees terminated since December
31, 2000. Approximately $4.4 million of unearned compensation was forfeited in
34
2001. Since December 31, 2000, we recorded approximately $0.9 million of
deferred compensation, a separate component of stockholders' equity, to be
expensed over the four-year vesting period of the options.
Depreciation and Amortization
Depreciation and amortization expenses increased 73.0% to $136.4 million
in 2001 compared to $78.8 million in 2000. The increase was principally due to
additional servers and other facilities and equipment placed in service during
and subsequent to fiscal year 2000. We entered into a capital lease for our
corporate headquarters facility in the third quarter of 2000 and capital leases
for equipment in the second and third quarters of 2001, which have also
contributed to the increase in expense. Also included in depreciation and
amortization expense is a $4.3 million loss related to the disposal of certain
equipment in 2001. We have electronics, computer hardware, and computer software
with useful lives ranging from three to five years. We expect increases in
depreciation charges through 2002 due to an expected increase in customer
equipment installations based on market demand.
Interest Expense
Interest expense increased 137.5% to $4.8 million in 2001 compared to $2.0
million in 2000. The increase resulted from a capital lease effective beginning
September 2000 for our corporate headquarters facility, $11.1 million of capital
leases for equipment and vehicles, and from issuances of $93.3 million of notes
payable primarily to Intermedia since December 31, 2000.
Interest Income and Other
Interest income and other decreased 77.7% to $2.2 million in 2001 compared
to $9.7 million in 2000. The decrease resulted principally from declining cash
balances and falling interest rates during the period. In addition, we also
incurred merger-related expenses of $2.9 million for legal fees, investment
advisory fees, and certain travel expenses associated with due diligence
activities relating to the merger and the possible sale of Digex in 2000. Upon
the final settlement of our shareholder litigation, we received $12.5 million
from WorldCom for the reimbursement of merger-related costs incurred by us. As
such, we recognized no merger-related expenses in 2001.
EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, decreased 31.7% to
$(46.3) million in 2001 compared to $(67.7) million in 2000. The change is
primarily attributable to increased revenue and a slower growth rate in costs
due to operational efficiencies. Costs associated with the administration and
maintenance of our expanded data centers and increased selling, general and
administrative costs will continue to represent a large portion of expenses.
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest income and other, merger-related expenses, foreign exchange
gains (losses), income tax benefit, deferred compensation, and depreciation and
amortization. EBITDA before certain charges does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations. EBITDA before certain charges should also not be construed as a
substitute for operating income or a better measure of liquidity than cash flow
from operating activities, which are determined in accordance with generally
accepted accounting principles. This caption excludes components that are
significant in understanding and assessing our results of operations and cash
flows. In addition, EBITDA before certain charges is not a term defined by
generally accepted accounting principles and as a result our measure of EBITDA
before certain charges might
35
not be comparable to similarly titled measures used by other companies. However,
we believe that EBITDA before certain charges is relevant and useful information
which is often reported and widely used by analysts, investors and other
interested parties in the Web and application hosting industry. Accordingly, we
are disclosing this information to permit a more comprehensive analysis of our
operating performance, as an additional meaningful measure of performance and
liquidity, and to provide additional information with respect to our ability to
meet future debt service, capital expenditure and working capital requirements.
See the consolidated financial statements and notes thereto contained elsewhere
in this report for more detailed information.
Year Ended December 31, 2000 Compared to the Year Ended December 31, 1999
Revenue
Total revenue increased 181.1% to $168.1 million in 2000 compared to $59.8
million in 1999. The increase in revenue was due to sales to new customers, a
significant increase in the number of managed servers per customer, and a rise
of average monthly revenue per server in the fourth quarter of $4,259 in 2000
compared to $3,354 for the same period in 1999. Our installed base of servers
increased 82% to 4,216 at December 31, 2000 from 2,311 at December 31, 1999. Of
total revenue, $6.0 million was attributable to the prime/subcontractor
agreement with WorldCom in 2000. In addition to revenue from managed Web and
application hosting services, Digex recognized $5.0 million from a one-time sale
of third party equipment in the second quarter of 2000.
Cost of Operations
Cost of operations increased 120.0% to $21.2 million in 2000 compared to
$9.7 million in 1999. The increase was due to additional network costs resulting
from our expanded customer base and increases in service offerings. As a
percentage of revenue (excluding third party equipment sales in the second
quarter of 2000), cost of operations (excluding the cost of sales) decreased to
10.7% in 2000 compared to 16.2% in 1999 due to the net effect of improved
network utilization.
Cost of Services
Cost of services increased 220.3% to $69.7 million in 2000 compared to
$21.8 million in 1999. The increase was primarily related to the increased level
of operations and the expansion of our new data centers including costs related
to the hiring of additional personnel and consultants in customer service,
engineering, and facilities administration supporting server growth. As a
percentage of revenue, total cost of services increased to 41.4% in 2000
compared to 36.4% in 1999. Costs did not increase proportionally with revenue
due primarily to additional costs incurred in 2000 related to the asset
migration agreement.
Selling, General and Administrative
Selling, general and administrative expenses increased 103.5% to $134.2
million in 2000 compared to $65.9 million in 1999. Through 2000, as part of our
growth strategy, we continued to build our infrastructure and administrative
requirements to operate as a separate public company. Increases in selling,
general and administrative expenses for 2000 included the costs associated with
an increased employee base, advertising campaigns, back office support
(including our general and administrative agreement with Intermedia), rent for
additional office space, consultants' professional fees, and the addition of key
executive management to support the growth of the business. As a percentage of
revenue, total selling, general and administrative expenses decreased to 80.0%
in 2000 compared to 110.3% in 1999, primarily because our revenue grew while
36
a portion of the selling, general and administrative cost is fixed.
Provision for Doubtful Accounts
Provision for doubtful accounts increased 149.7% to $10.6 million in 2000
compared to $4.3 million in 1999 due to the growth of our business during 2000
and the addition of new customers. As a percentage of revenue, provision for
doubtful accounts decreased to 6.3% in 2000 compared to 7.1% in 1999.
Deferred Compensation
Deferred compensation expense increased 215.7% to $4.1 million in 2000
compared to $1.3 million in 1999. The increase was primarily due to increases in
stock options granted to certain employees at exercise prices below market value
since July 29, 1999. We recorded approximately $13.5 million of deferred
compensation in 1999 and $2.1 million (net of forfeitures) in 2000, a separate
component of stockholders' equity, to be expensed over the four-year vesting
period of the options.
Depreciation and Amortization
Depreciation and amortization expenses increased 171.1% to $78.8 million
in 2000 compared to $29.0 million in 1999. The increase was principally due to
additional servers and other facilities and equipment placed in service since
December 31, 1999. We entered into a capital lease for our corporate
headquarters facility in the third quarter of 2000, which also contributed to
the increase in expense. We have electronics, computer hardware, and computer
software with useful lives ranging from three to five years.
Interest Expense
Interest expense increased 83.5% to $2.0 million in 2000 compared to $1.1
million in 1999. The increase resulted from the capital leases assigned to us by
Intermedia during the second quarter of 1999 and the capital lease for our new
corporate headquarters facility in the third quarter of 2000. Additionally, a
note payable was issued by us to a third party during the third quarter of 1999.
Interest Income and Other
Interest and other income increased 180.1% to $9.7 million in 2000
compared to $3.5 million in 1999. The increase resulted principally from
interest earned on the cash proceeds from the investment in Digex by Microsoft
and a subsidiary of Compaq, an initial and subsequent public equity offering,
and exercised stock options.
EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, increased 61.8% to
$(67.7) million in 2000 compared to $(41.8) million in 1999. The change is
primarily attributable to costs associated with our growth strategy. Costs
associated with the administration and maintenance of our expanded data centers
and increased selling, general and administrative costs will continue to
represent a large portion of expenses during our planned expansion. In addition,
we expect to continue to experience growth in marketing and selling expenses as
new customers are acquired.
37
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest income and other, merger-related expenses, foreign exchange
gains (losses), income tax benefit, deferred compensation, and depreciation and
amortization. EBITDA before certain charges does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations. EBITDA before certain charges should also not be construed as a
substitute for operating income or a better measure of liquidity than cash flow
from operating activities, which are determined in accordance with generally
accepted accounting principles. This caption excludes components that are
significant in understanding and assessing our results of operations and cash
flows. In addition, EBITDA before certain charges is not a term defined by
generally accepted accounting principles and as a result our measure of EBITDA
before certain charges might not be comparable to similarly titled measures used
by other companies. However, we believe that EBITDA before certain charges is
relevant and useful information which is often reported and widely used by
analysts, investors and other interested parties in the Web and application
hosting industry. Accordingly, we are disclosing this information to permit a
more comprehensive analysis of our operating performance, as an additional
meaningful measure of performance and liquidity, and to provide additional
information with respect to our ability to meet future debt service, capital
expenditure and working capital requirements. See the consolidated financial
statements and notes thereto contained elsewhere in this report for more
detailed information.
Liquidity and Capital Resources
Cash Flows
WorldCom is our majority stockholder, primary lender, significant channel
partner, and one of our largest vendors. In particular, under the funding
agreement, WorldCom is obligated to provide funding for the approved Digex
business plan through 2002 only. WorldCom will then have an option to continue
funding us beyond 2002, but may not exercise such option. Through 2002, we
expect our working capital needs and capital expenditure requirements to be met
through our note purchase agreement dated July 31, 2001 with WorldCom.
We currently project continued significant losses and operating cash flow
deficits. Since the Intermedia - WorldCom Merger, we have been dependent on
WorldCom to fund our operating cash flow deficits and capital expenditures.
Pursuant to the terms of the Intermedia - WorldCom Merger and subject to the
limitations under our approved 2002 business plan, which is subject to amendment
and modifications, WorldCom has committed to fund our projected cash flow
deficits and capital expenditures through December 31, 2002. Our 2002 business
plan may require up to $276.0 million, inclusive of amounts for capital
expenditures, the majority of which is expected to be demand driven. This amount
could materially change due to changes in the economy, our target market, our
practice of acquiring equipment on behalf of customers, or our ability to
execute on this business plan, among other factors. The amount of actual
borrowings from WorldCom in 2002 could be more or less than the amounts approved
under the business plan. Should we require additional funding beyond 2002, as
currently projected, there can be no assurance that WorldCom will provide such
additional funding. We believe that funding from any source other than WorldCom
on appropriate or commercially acceptable terms is unlikely to be available.
We have used cash in our operating and investing activities during all
periods since inception. These cash usages have been funded by permanent
contributions to capital from Intermedia totaling $148.3 million, proceeds from
our equity offerings, and borrowings primarily from Intermedia and WorldCom.
Since the date of our initial public offering, there have been no permanent
capital contributions made by Intermedia.
Net cash used in operating activities was $62.7 million in 2001, $62.5
million in 2000, and $20.5 million in 1999. Net cash used for operating
activities in each of these periods was primarily the result of operating losses
and changes in working capital. In 2001, we issued $6.8 million of promissory
notes to certain officers and employees of Digex. The notes are payable to Digex
on the earlier of (1) November 1, 2003 or (2) the termination of the employee's
employment with us for any reason.
38
Net cash used for investing activities was $98.9 million in 2001, $204.6
million in 2000, and $170.2 million in 1999. Net cash used for investing
activities in each of these periods was primarily the result of capital
expenditures for data center infrastructure, which includes servers purchased
for customer use, as well as leasehold improvements, furniture and fixtures, and
computers and other equipment, including a $2.0 million letter of credit
pursuant to a ten-year lease entered into by us on June 29, 2000 for our
corporate headquarters facility in Laurel, Maryland. In 2001, we obtained
additional letters of credit pursuant to certain operating leases for office
space which require 120% of the value of the letter of credit to be restricted.
We have reduced our capital expenditures in 2001 in accordance with our business
needs and as a result of the economic downturn. Although we have plans to invest
in property and equipment, we have no material commitments for such items at
this time.
Net cash provided by financing activities was $90.5 million in 2001,
$261.8 million in 2000, and $279.5 million in 1999. Net cash provided by
financing activities was primarily due to the proceeds from our issuances of
common stock, preferred stock, and notes payable, and proceeds from exercises of
employee stock options, offset by payments on long-term note payable and capital
lease obligations.
Stock Offerings
Prior to the date of our initial public offering, our capital expenditures
and operating expenses were principally funded by Intermedia. On August 4, 1999,
we sold 11,500,000 shares of Class A common stock in our initial public
offering. The net proceeds from the offering were approximately $178.9 million.
On January 12, 2000, we sold 100,000 shares of our non-voting, redeemable
preferred stock, designated as Series A convertible preferred stock, with
detachable warrants to purchase 1,065,000 shares of our Class A common stock, to
Microsoft Corporation and CPQ Holdings, Inc., a subsidiary of Compaq Computer
Corporation, for an aggregate of $100.0 million, of which $85.0 million was in
cash, and $15.0 million was in the form of equipment purchase credits. Of the
$15.0 million of equipment purchase credits, approximately $5.9 million and $2.7
million was used for equipment purchases in 2001 and 2000, respectively. The
warrants can be exercised at any time on or before January 12, 2003 at an
initial price of $57.00 per share, subject to certain adjustments. The proceeds
from the offering were allocated between the preferred stock and the warrants
based upon their relative fair values.
Subject to the legal availability of funds, the preferred stock is
redeemable in cash at the option of the holders after January 12, 2004 or upon
our change of control at a price of $1,000 per share if the redemption is then
permitted under those indentures of Intermedia which existed on January 10,
2000. If the restrictions under these agreements terminate at an earlier date,
the holders may require us to redeem the preferred stock before entering into an
agreement which would restrict the ability to redeem the preferred stock. We are
not required to make sinking fund payments with respect to the preferred stock.
See Note 8 of the notes to our consolidated financial statements for a
description of the preferred stock.
To the extent necessary to perform our obligations under our agreement
with Compaq, the proceeds from the investment by a subsidiary of Compaq will be
used toward the development of a platform for the delivery of application
hosting services, which will include capital expenditures and research and
development expenditures. Therefore, we do not expect the proceeds of the
investment by a subsidiary of Compaq to be available for general corporate
purposes. We also intend to use the proceeds of the investment by Microsoft to
fund this development project.
On February 16, 2000, we completed a public offering of 12,650,000 shares
of our Class A common stock. We sold 2,000,000 shares of Class A common stock
and received net proceeds of approximately $171.6 million.
39
Intermedia sold 10,650,000 shares of Class B common stock. The Class B common
stock sold by Intermedia automatically converted into Class A common stock at
the closing of the offering.
The net proceeds of our public offerings and the cash proceeds of the
investments by Microsoft and Compaq were used to purchase telecommunications
related assets due to restrictions in Intermedia's debt instruments. Therefore,
to provide for the funding of our operating expenses, we made arrangements to
sell to Intermedia certain telecommunications related assets that were purchased
by Digex with the net proceeds of these offerings. The assets were sold to
Intermedia for cash at our cost. We received approximately $33.7 million in 2000
and $25.3 million in 1999 from Intermedia related to the sale of
telecommunications related assets. These proceeds were unrestricted and were
used to fund our operating expenses.
In accordance with the Digex Long-Term Incentive Plan, stock options
granted to certain employees of Digex and Intermedia became vested and
exercisable beginning in the third quarter of 2000. Cash proceeds from issuances
of Digex's common stock of $2.1 million in 2001 and $6.1 million in 2000 were
received as a result of exercised stock options. With the present economic
downturn, market price of our stock, and exercise prices of the option grants,
we do not expect a significant amount of stock option exercises in the
foreseeable future.
Funding from Affiliates
On July 1, 2001, pursuant to the terms of the merger agreement, dated
September 1, 2000, and the amendments thereto, a wholly-owned subsidiary of
WorldCom was merged with and into Intermedia with Intermedia continuing as the
surviving corporation and as a subsidiary of WorldCom. As a result of the
merger, WorldCom beneficially owns a majority of our capital stock and has
voting control of us.
On July 31, 2001, we entered into a note purchase agreement with WorldCom
whereby WorldCom has agreed to provide funding for the Digex business plans for
2001 and 2002 as approved by the Digex and WorldCom boards of directors. The
Digex and WorldCom boards of directors have approved the Digex business plan for
2002. Subject to the terms and conditions of the agreement, we will issue and
WorldCom will purchase (or cause an affiliate to purchase) a series of senior
notes up to an aggregate principal amount sufficient to satisfy our net cash
requirements under the approved business plan. Interest on the unpaid principal
balance is payable monthly at a rate equal to LIBOR plus 300 basis points.
Repayment of principal is due on December 31, 2002 and may be extended to
December 31, 2006 upon our election by written notice. We expect to make this
election by December 2002, at which time amounts then outstanding will be repaid
in equal monthly straight-line amortization payments of principal and interest
through December 31, 2006. As a result, this debt has been classified as
long-term. Any changes to our business plan that require increased funding would
require the WorldCom board of directors' approval before WorldCom would be
obligated to fund any such increase.
In the third and fourth quarters of 2001, Digex issued and WorldCom caused
Intermedia to purchase a series of senior notes totaling $65.0 million to
satisfy our net cash requirements under our approved 2001 business plan. The
principal remains outstanding at December 31, 2001. Through December 31, 2001,
variable interest on the unpaid principal balance was paid monthly at an
interest rate of 300 basis points over LIBOR rate (weighted average interest
rate of 5.40%).
We issued a promissory note, governed by the terms of the revolving credit
facility agreement dated December 22, 1999, as amended to date, to Intermedia
for the $12.0 million borrowing in the second quarter of 2001. Repayment was due
on demand at the earlier of: (1) the consummation of the Intermedia - WorldCom
Merger; (2) July 3, 2001; (3) the cancellation or termination of the credit
facility; and (4) following default which would accelerate the amounts due.
Following the completion of the Intermedia - WorldCom Merger in July 2001,
WorldCom repaid the total amount outstanding under the credit facility and
terminated Intermedia's revolving credit facility as of August 1, 2001. Through
July 31, 2001, variable interest on the unpaid principal balance of both loans
accrued monthly at an average LIBOR rate of approximately 4.50% per annum.
40
On June 26, 2001, we borrowed $6.0 from Intermedia as an intercompany loan
at an interest rate of 14.12%. The intercompany loan balance was increased to
$13.0 million on November 13, 2001 with the borrowing of an additional $7.0
million. Through December 31, 2001, the weighted average interest rate of the
intercompany loans, promissory notes and subsequent refinancing was 5.67%.
On January 14, 2002, we entered into a note purchase agreement, dated July
31, 2001, with Intermedia to refinance the $13.0 million intercompany loan and
$12.0 million promissory note to Intermedia under a series of senior notes
totaling $25.0 million. The terms of the agreement are substantially the same as
the original note purchase agreement, dated July 31, 2001 between Digex and
WorldCom, with the repayment of principal due on December 31, 2003. There is no
option to extend the maturity date of the notes. Interest is payable monthly at
an interest rate of 300 basis points over LIBOR.
Other Indebtedness
In January 2001, we received proceeds from a $3.0 million loan from the
State of Maryland Department of Business and Economic Development under the
Sunny Day Fund initiative. The loan is subject to multiple maturity dates, and
is guaranteed by Intermedia. Interest on the unpaid principal balances accrues
at 5% per annum. The principal amounts and any accrued interest will be deferred
each year through December 31, 2008 if we meet certain annual conditions
regarding the hiring of permanent, full time employees and the expenditures for
the development of a Web hosting facility in Prince George's County, Maryland.
At December 31, 2008, the principal amounts and any accrued interest outstanding
may convert to a grant upon the achievement of certain requirements by us. Digex
was in compliance for deferring full repayment of the loan at December 31, 2001
and expects to satisfy the requirements for full conversion at December 31,
2008. However, if certain minimum employment requirements are not met at
December 31, 2004, partial or full repayment of the outstanding balance is due
on April 1, 2005.
In April 2001, we received proceeds from a $300,000 loan from Prince
George's County Economic Development Corporation. The loan matures on April 6,
2006, and is guaranteed by Intermedia. Interest on the unpaid principal balances
accrues at 5% per annum. Interest and principal are payable monthly, beginning
May 6, 2001.
We will use the proceeds from these loans to finance a portion of the cost
of acquiring equipment and construction at our headquarter facilities in Laurel,
Maryland. Subject to the terms of the loan agreements and the approval by the
State of Maryland and/or Prince George's County, on or after January 1, 2005, we
may be eligible for an additional loan of $1.0 million under the Sunny Day Fund
initiative from the State of Maryland and/or $100,000 from Prince George's
County to finance a portion of the cost of acquiring equipment and constructing
facilities within Prince George's County, Maryland.
Financing activities also included the principal payments on our loan from
Prince George's County Economic Development Corporation and on our capital lease
obligations for our three data center facilities.
In the first and second quarters of 2001, we entered into master lease and
financing agreements with two vendors for lines of credit to facilitate the
leasing of computer hardware and software. The terms of the associated schedules
range from 12 months for financing a maintenance contract to 36 months for
leasing computer equipment. We will have an option to purchase the equipment at
the end of the initial lease term. Interest and principal are payable monthly
with interest rates ranging from 7.2% to 12.3% per annum. As of December 31,
2001, we acquired $11.0 million of computer equipment and maintenance services
under these leasing and financing arrangements.
41
Contractual Obligations and Contingent Commitments
Our contractual obligations and contingent commitments as of December 31,
2001 are aggregated below (in thousands):
Amounts due by period
-------------------------------------------------
Less than
Total 1 year 1 - 3 years 4 - 5 years Thereafter
-------- --------- ----------- ----------- ----------
Contractual obligations:
Notes payable to Intermedia ..... $ 90,000 $ -- $57,500 $ 32,500 $ --
Notes payable to third parties .. 3,264 56 121 3,087 --
Capital lease obligations ....... 47,483 8,609 14,179 9,682 15,013
Operating leases ................ 15,886 3,415 5,817 4,093 2,561
Contingent Commitments:
Redeemable preferred stock ...... 100,000 -- -- 100,000 --
Employee retention bonuses ...... 11,784 -- 11,784 -- --
-------- ------- ------- -------- -------
Total .............................. $268,417 $12,080 $89,401 $149,362 $17,574
======== ======= ======= ======== =======
We lease certain property and equipment under various operating and
capital lease arrangements that expire over the next 11 years. Refer to Note 7
of the notes to our consolidated financial statements for discussion of our
capital and operating leases.
We entered into retention bonus agreements with certain of our executive
officers and key employees. Under the agreements, each such officer or employee
(or his or her estate) is entitled to receive the amounts (1) if he or she is
actively employed with us through and including November 1, 2003 or (2) if prior
to that time we terminate his or her employment without cause or his or her
employment is terminated as a result of death or permanent disability. No
officer or employee is entitled to the retention bonus under this agreement, or
any pro rata portion thereof, if his or her employment terminates prior to
November 1, 2003 by reason of termination for cause, resignation for any reason
or termination resulting from constructive discharge by us. As of December 31,
2001, the potential retention bonus pool payable in 2003 under these agreements
totaled $11.8 million.
Increases in interest rates on variable rate debt would have an adverse
effect upon our reported net loss and cash flow. We believe that we will have
adequate cash flow to service our debt and capital requirements in 2002 under
our funding agreement with WorldCom. However, economic downturns, increased
interest rates and other adverse developments, including factors beyond our
control, could impair our ability to service our indebtedness. In addition, the
cash flow required to service our debt may reduce our ability to fund internal
growth, additional acquisitions and capital improvements.
We have incurred significant net losses and operating cash flow deficits
since inception. We expect to continue experiencing negative cash flow from
operating and investing activities. Since the Intermedia - WorldCom Merger, we
have been dependent on WorldCom to fund our operating cash flow deficits and
continued capital investments. We anticipate that we will have significant cash
requirements for several years as we fill our existing data center capacity,
expand into WorldCom data centers, increase servers under management, acquire
additional office space to support our expanding operations and invest in our
marketing organization. In addition, we expect to invest in the purchase of
property and equipment and for research and development, including funding the
expenses associated with our research and development alliance with Microsoft
and a subsidiary of Compaq. We expect our capital expenditures to increase due
to the growth of servers under management and our continuing data center
expansion in the United States and abroad. If
42
necessary, we intend to pursue additional equipment lease financing from our
vendors or third parties to facilitate the acquisition of computer hardware and
related software in the future.
Pursuant to the terms of the Intermedia - WorldCom Merger and subject to
the limitations under our approved 2002 business plan, which is subject to
amendment and modifications, WorldCom has committed to fund our projected cash
flow deficits and capital expenditures through December 31, 2002. Our 2002
business plan may require up to $276.0 million, inclusive of amounts for capital
expenditures, the majority of which is expected to be demand driven. This amount
could materially change due to changes in the economy, our target market, our
practice of acquiring equipment on behalf of customers, or our ability to
execute on this business plan, among other factors. The amount of actual
borrowings from WorldCom in 2002 could be more or less than the amounts approved
under the business plan. Should we require additional funding beyond 2002, as
currently projected, there can be no assurance that WorldCom will provide such
additional funding. We believe that funding from any source other than WorldCom
on appropriate or commercially acceptable terms is unlikely to be available.
With our existing cash resources and financing available from WorldCom, we
believe we have sufficient capital to sustain our current operations and capital
expenditure plans into 2003. Because the note purchase agreement provides us
with access to readily available cash, we plan to maintain minimal cash balances
and borrow only when required to sustain our operations. It is our understanding
that WorldCom currently intends to fund our operations and cash flow
requirements through March 31, 2003. However, there can be no assurance that
WorldCom will provide such funding. We intend to work out a binding agreement
with WorldCom to this respect.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 142, Goodwill and Other Intangible Assets, which is effective for fiscal
years beginning after December 15, 2001. Under the new rules, goodwill and
intangible assets deemed to have indefinite lives will no longer be amortized
but will be subject to annual impairment tests. In addition, the statement
includes provisions for the reclassification of certain existing recognized
intangibles as goodwill, reassessment of the useful lives of existing recognized
intangibles, reclassification of certain intangibles out of previously reported
goodwill and the identification of reporting units for purposes of assessing
potential future impairments of goodwill. Goodwill and other intangibles,
acquired prior to July 1, 2001, may be amortized until the adoption of the
statement.
We will adopt the provisions of SFAS No. 142 beginning in 2002. At that
time, we will cease amortization of amounts assigned to goodwill and acquired
workforce. Amortization of goodwill and acquired workforce was approximately
$2.2 million for the year ended December 31, 2001. The net book value of
goodwill and acquired workforce at December 31, 2001 was approximately $11.9
million. We continue to evaluate the potential impact of adopting SFAS No. 142
on the carrying value of the goodwill on our consolidated balance sheet. If,
within six months of adopting SFAS No. 142, we determine that impairment of
goodwill exists, we will record the charge to reduce the carrying value of the
goodwill to fair value as a cumulative effect of a change in accounting
principle in the first quarter of 2002. Although we continue to evaluate the
impact, our ultimate determination could result in the impairment of some or all
of the approximately $11.9 million in carrying value of the goodwill on our
consolidated balance sheet.
In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which supercedes both SFAS No. 121, Impairment of Long-Lived
Assets for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions for the disposal of a segment of a business contained in APB Opinion
No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions, effective for fiscal years beginning after
December 15, 2001. Under the new rules, a single accounting model for long-lived
assets to be disposed of by sale will be used to broaden the presentation of
discontinued operations. We do not expect the
43
implementation of SFAS No. 144 to have a material impact on our consolidated
results of operations or financial position.
Information Regarding Forward-Looking Statements
The information set forth above in "Management's Discussion and Analysis
of Financial Conditions and Results of Operations" includes forward-looking
statements that involve numerous risks and uncertainties within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Forward-looking statements can be
identified by the use of forward-looking terminology such as "estimates,"
"projects," "anticipates," "expects," "intends," "believes," or the negative
thereof or other variations thereon or comparable terminology or by discussions
of strategy that involve risks and uncertainties. Readers are cautioned not to
place undue reliance on these forward-looking statements, which reflect
management's analysis, judgment, belief or expectation only as of the filing
date of this Annual Report on Form 10-K, and we undertake no duty to update this
information to reflect events or circumstances that arise after the date hereof.
See "Risk Factors--This report includes forward-looking statements which could
differ from actual results."
Income Taxes
We account for income taxes under SFAS No. 109, Accounting for Income
Taxes. At December 31, 2001, a full valuation allowance was provided on net
deferred tax assets of $141.3 million based upon our deficit in earnings and the
uncertainty surrounding our ability to recognize such assets. The valuation
allowance relates primarily to a net operating loss carryforward. Income tax
accounting information is disclosed in Note 12 of the notes to our consolidated
financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss arising from adverse changes in market
rates and prices, such as interest rates, foreign currency exchange rates, and
other relevant market rate or price changes. Market risk is directly influenced
by the volatility and liquidity in the markets in which the related underlying
assets are traded.
Interest Rate Risks
Changes in interest rates affect interest income earned on our cash
equivalents and restricted investments, and interest expense on variable
interest rate borrowings. Although we have long-term notes payable which bear an
effective fixed interest rate, the fair market value of our fixed rate long-term
notes payable is sensitive to changes in interest rates. We run the risk that
market rates will decline, and the required payments will exceed those based on
current market rates. Under our current risk management policies, we do not use
interest rate derivative instruments to manage our exposure to interest rate
changes.
We performed a sensitivity analysis on our variable rate long-term notes
payable to assess the risk of interest rate changes on our potential loss in
future earnings and cash flows. A sensitivity analysis is defined as the
measurement of potential loss in future earnings, fair values or cash flows of
market sensitive instruments resulting from one or more selected hypothetical
changes in interest rates and other market rates or prices over a selected time.
In the sensitivity analysis model, a hypothetical change in market rates is
selected that is expected to reflect reasonably possible near-term changes in
those rates. The term "near-term" means a period of time up to one year after
the date of the financial statements. Information provided by the sensitivity
analysis does not necessarily represent the actual changes in fair value, future
earnings, or cash flows that we would incur under normal market conditions
because, due to practical limitations, all variables other than the specific
market risk
44
factor are held constant. Our sensitivity analysis excluded fixed rate long-term
notes payable because there is no foreseeable market for these debt obligations.
Interest rate changes on our variable interest rate borrowings will affect
our future earnings and cash flows as the borrowings are based on LIBOR plus a
stated percentage which subjects us to variability in net loss and cash flows
for the effect of changes in LIBOR. These notes have original maturities ranging
from 1.5 years to 2.5 years. We currently expect to extend the maturity of one
of the borrowings as discussed in "Management's Discussion and Analysis of
Financial Condition and Results of Operation - Liquidity & Capital Resources"
above. As a result, we have prepared the sensitivity analysis through the
extended maturity date in December 2006. The model to determine sensitivity
assumes a hypothetical 10% parallel shift based on the market interest rate in
effect at December 31, 2001. At December 31, 2001, a hypothetical 10% increase
in interest rates, with all other variables held constant, would increase
potential loss in future earnings and cash outflows through maturity by
approximately $1.3 million. We may choose to take certain actions in the future
to mitigate such hypothetical losses.
Foreign Currency Risks
We expect to continue recognizing revenue from international sales
denominated in foreign currency. As a global concern, we could face exposure to
adverse movements in foreign currency exchange rates on the financial results of
foreign subsidiaries that are translated into U.S. dollars upon consolidation.
These exposures may change over time as business practices evolve and could
affect our financial results. Currently, we do not hedge against any foreign
currency risk and, as a result, could incur gains or losses. Based on our
foreign currency transactions in 2001, we believe that any potential loss in
future earnings that would result from a hypothetical 10% adverse change in
foreign currency exchange rates would not be material to our consolidated
results of operations.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements listed in Item 14 are included in
this report beginning on page F-1.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
The Audit Committee of the Digex Board of Directors recommended to the
Board that Arthur Andersen LLP be engaged as the independent auditors of Digex.
Arthur Andersen LLP is the certifying accountant of WorldCom, Inc., our majority
stockholder. Pursuant to resolutions of the Board of Directors, Ernst & Young
LLP was dismissed as of October 1, 2001. On October 1, 2001, Arthur Andersen LLP
was engaged as the independent auditors to audit the consolidated financial
statements of Digex for the year ending December 31, 2001.
Ernst & Young LLP has audited our financial statements since 1999. The
reports of Ernst & Young LLP on the financial statements of Digex for the years
ended December 31, 2000 and 1999 did not contain an adverse opinion, a
disclaimer of opinion, and were not qualified or modified as to uncertainty,
audit scope, or accounting principles. To the knowledge of management, during
the fiscal years ended December 31, 2000 and 1999, and in the subsequent period
through the date of dismissal, there were no disagreements with Ernst & Young
LLP on any matters of accounting principles or practices, financial statement
disclosure, or auditing scope and procedures which, if not resolved to the
satisfaction of Ernst & Young LLP, would have caused Ernst & Young LLP to make
reference to the matter in their report. We have requested Ernst & Young LLP to
furnish a letter addressed to the SEC stating whether it agrees with the above
statements. A copy of that letter, dated October 1, 2001, has been filed with
the SEC and incorporated by reference as Exhibit 16.1 to this Form 10-K.
45
PART III
Item 10. Directors and Executive Officers of the Registrant
The information required by this Item 10 is incorporated by reference to
the information captioned "Proposal One: Election of Directors" and "Executive
Officers" to be included in Digex's proxy statement for its 2002 Annual Meeting
of Stockholders.
Item 11. Executive Compensation
The information required by this Item 11 is incorporated by reference to
the information captioned "Executive Compensation" and "Compensation Committee
Interlocks and Insider Participation" to be included in the proxy statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item 12 is incorporated by reference to
the information captioned "Beneficial Ownership" to be included in the proxy
statement.
Item 13. Certain Relationships and Related Transactions
The information required by the Item 13 is incorporated by reference to
the information captioned "Certain Relationships and Related Transactions" to be
included in the proxy statement.
46
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) Financial Statement and Financial Statement Schedules
The following consolidated financial statements of Digex and the notes
thereto, the related reports thereon of the independent auditors, and financial
statement schedules, are filed pursuant to Item 8 of this Report:
Index to Financial Statements
Page
----
Report of Independent Public Accountants - Digex, Incorporated .................................. F-1
Report of Independent Auditors - Digex, Incorporated ............................................ F-2
Report of Independent Auditors - Digex (UK) Limited ............................................. F-3
Report of Independent Auditors - Digex Sweden AB ................................................ F-4
Consolidated Balance Sheets as of December 31, 2001 and 2000 .................................... F-5
Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000, and 1999...... F-6
Consolidated Statements of Redeemable Preferred Stock, Stockholders' Equity, and
Comprehensive Loss for the Years Ended December 31, 2001, 2000, and 1999................... F-7
Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000, and 1999 ..... F-9
Notes to Consolidated Financial Statements....................................................... F-11
Financial Statement Schedules
Schedule II--Valuation and Qualifying Accounts .................................................. F-39
All other financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission (the
"SEC") are not required pursuant to the instructions to Item 8 or are
inapplicable and therefore have been omitted.
47
EXHIBIT INDEX
All Exhibits listed below are filed with this Annual Report on Form 10-K, unless
specifically stated to be incorporated by reference to other documents
previously filed with the SEC.
Exhibit
Numbers Description
2.1 -- Contribution Agreement by and between Digex and Business
Internet, Inc., dated as of April 30, 1999.*
2.2 -- Assignment and Assumption Agreement by and between Digex and
Business Internet, Inc., dated as of April 30, 1999.*
2.3 -- Trademark Assignment by and between Digex and Business Internet,
Inc., dated as of April 30, 1999.*
2.4 -- Bill of Sale to the Contribution Agreement, dated as of April 30,
1999.*
2.5 -- Agreement and Plan of Merger among WorldCom, Inc., Wildcat
Acquisition Corp. and Intermedia Communications Inc., dated as of
September 1, 2000. Incorporated herein by reference to Digex's Form
8-K (File No. 000-26873) filed with the SEC on September 7, 2000.
3.1 -- Certificate of Incorporation of Digex and amendments thereto,
including the Certificate of Designation for the Series A Preferred
Stock.
3.2 -- Bylaws of Digex, as amended. Incorporated herein by reference to
Digex's Form 10-Q (File No. 000-26873) filed with the SEC on May 12,
2000.
4.1 -- Warrant Agreement, dated as of January 12, 2000, among Digex,
Microsoft Corporation and CPQ Holdings, Inc.**
4.2 -- Registration Rights Agreement, dated as of January 12, 2000,
among Digex, Microsoft Corporation and CPQ Holdings, Inc.**
10.1 -- Lease by and between Intermedia and Intel Corporation, dated as
of November 10, 1998.*
10.2 -- Lease by and between Intermedia and Ammendale Commerce Center
Limited Partnership, dated as of April 15, 1998.*
10.3 -- Lease by and between Intermedia and 1111 19th Street Associates,
dated as of July 23, 1998.*
10.4 -- Software License and Services Agreement by and between Digex and
Oracle Corporation, dated as of May 27, 1999.*
10.5 -- License Agreement by and between Digex and Microsoft
Corporation.*
10.6 -- Internet Transit Services Agreement (East Coast) between Digex
and Business Internet,
48
Inc., dated as of April 30, 1999. (2)*
10.7 -- Internet Transit Services Agreement (West Coast) between Digex
and Business Internet, Inc., dated as of April 30, 1999. (2)*
10.8 -- Managed Firewall Services Agreement between Digex and Business
Internet, Inc., dated as of April 30, 1999. (2)*
10.9 -- Employment Letter dated June 29, 1999 between Digex and Mark K.
Shull, and amendments thereto. (1)**
10.10 -- Employment Letter dated July 9, 1999 between Digex and Rebecca
Ward, and amendments thereto. (1)**
10.11 -- Employment Letter dated December 15, 1999 between Digex and
Timothy M. Adams, and amendments thereto. (1)**
10.12 -- Employment Letter dated September 11, 1996 between Digex and
Robert B. Patrick, and amendments thereto. (1)**
10.13 -- Digex Long-Term Incentive Plan. (1)**
10.14 -- Intermedia 1996 Long-Term Incentive Plan. (1)**
10.15 -- General and Administrative Services Agreement between Digex and
Intermedia, dated as of April 30, 1999. *
10.16 -- Amendment No. 1, dated as of January 17, 2000, to General and
Administrative Services Agreement between Digex and Intermedia.**
10.17 -- Use of Proceeds Agreement between Digex and Intermedia, dated as
of June 2, 1999.**
10.18 -- Use of Proceeds Agreement between Digex and Intermedia, dated as
of January 11, 2000.**
10.19 -- Use of Proceeds Agreement between Digex and Intermedia, dated as
of January 24, 2000.**
10.20 -- Expense Summary and Indemnity Arrangement Agreement between Digex
and Intermedia, dated as of January 24, 2000.**
10.21 -- Employment Letter dated July 6, 2000 between Digex and Bruce F.
Metge. (1)***
10.22 -- Lease by and between Digex and Riggs & Company, dated as of June
29, 2000. (3)***
10.23 -- Amendment No. 2, dated as of June 29, 2000, to the General and
Administrative Services Agreement between Digex and Intermedia. ***
10.24 -- Asset Migration Agreement, dated as of June 1, 2000, between
Digex and Intermedia.***
10.25 -- Amended and Restated Guaranty Agreement, dated as of October 31,
2000, by Digex, as Guarantor, on behalf of Bank of America, N.A., as
Administrative Agent for Lenders, amending and restating the
Guaranty Agreement, dated as of December 22, 1999, by
49
Digex, as Guarantor, on behalf of Bank of America N.A., as
Administrative Agent for Lenders. ****
10.26 -- Amended and Restated Security Agreement, dated as of October 31,
2000, between Digex, as Debtor, and Bank of America, N.A., as the
Secured Party on behalf of Lenders, amending and restating the
Security Agreement, dated as of December 22, 1999, between Digex, as
Debtor, and Bank of America, N.A., as the Secured Party on behalf of
Lenders.****
10.27 -- Amendment, dated as of October 24, 2000, to the Use of Proceeds
Agreement between Digex and Intermedia, dated as of January 24,
2000. ****
10.28 -- Employment Letter dated October 26, 2000 between Digex and Howard
Weizmann. Incorporated herein by reference to Digex's Form 10-K
(File No. 000-26873) filed with the SEC on April 2, 2001. (1)
10.29 -- Master Channel Agreement between Digex and MCI WorldCom Network
Services, Inc., dated as of January 1, 2001. Incorporated herein by
reference to Digex's Form 8-K (File No. 000-26873) filed with the
SEC on March 5, 2001.
10.30 -- Master Facilities Agreement between Digex and MCI WorldCom
Network Services, Inc., dated as of January 1, 2001. Incorporated
herein by reference to Digex's Form 8-K (File No. 000-26873) filed
with the SEC on March 5, 2001.
10.31 -- Stipulation of Settlement between all parties to the consolidated
action entitled In Re: Digex, Inc. Shareholders Litigation,
Consolidated Civil Action No. 18336 NC pending in the Court of
Chancery of the State of Delaware, Richard A. Jalkut, Jack E. Reich,
and Mark K. Shull, dated as of March 2, 2001. Incorporated herein by
reference to Digex's Form 8-K (File No. 000-26873) filed with the
SEC on March 5, 2001.
10.32 -- Promissory Note, dated May 29, 2001, between Digex and
Intermedia. Incorporated herein by reference from Digex's Form 10-Q
(File No. 000-26873) filed with the SEC on May 12, 2000.
10.33 -- Note Purchase Agreement, dated July 31, 2001, between Digex and
WorldCom. Incorporated herein by reference from Digex's Form 10-Q
(File No. 000-26873) filed with the SEC on November 14, 2001.
10.34 -- Employment Letter dated April 10, 2001, between Digex and George
L. Kerns. Incorporated herein by reference from Digex's Form 10-Q
(File No. 000-26873) filed with the SEC on November 14, 2001. (1)
10.35 -- Form of Retention Bonus Agreement between Digex and certain
executive officers. (1)
10.36 -- Form of Promissory Note payable to Digex by certain executive
officers.
10.37 -- Note Purchase Agreement, dated July 31, 2001, between Digex and
Intermedia.
10.38 -- Letter regarding a change in certifying accountant. Incorporated
herein by reference from Digex's Form 8-K (File No. 000-26873) filed
with the SEC on October 3, 2001.
23.1 -- Consent of Arthur Andersen LLP.
50
23.2 -- Consent of Ernst & Young LLP.
23.3 -- Consent of Ernst & Young LLP.
23.4 -- Consent of Ernst & Young AB.
99.1 -- Letter regarding a confirmation of receipt of assurances from
Arthur Andersen LLP.
- ----------
(1) Management contract or compensatory plan or arrangement.
(2) Confidential treatment of certain provisions of this exhibit was requested
and granted by the SEC in connection with the filing of Digex's
registration statement on Form S-1 (File No. 333-77105).
(3) Confidential treatment of certain provisions of this exhibit was requested
and granted by the SEC in connection with the filing of Digex's Form 10-Q
for the quarter ended June 30, 2000 (File No.000-26873) filed with the SEC
on August 14, 2000.
* Incorporated herein by reference to Digex's registration statement on Form
S-1 (File No. 333-77105) filed with the SEC.
** Incorporated herein by reference to Digex's registration statement on Form
S-1 (File No. 333-94879) filed with the SEC.
*** Incorporated herein by reference to Digex's Form 10-Q for the quarter
ended June 30, 2000 (File No. 000-26873) filed with the SEC on August 14,
2000.
**** Incorporated herein by reference to Digex's Form 10-Q for the quarter
ended September 30, 2000 (File No. 000-26873) filed with the SEC on
November 14, 2000.
(b) Reports on Form 8-K
The following Current Reports on Form 8-K were filed during the fourth
quarter of 2001:
Digex filed a Current Report on Form 8-K, dated October 1, 2001, reporting
under Item 4 regarding a change in certifying accountant. Digex also reported
under Item 7 the filing of a letter addressed to the SEC stating whether Ernst &
Young LLP agrees with certain statements made in the Form 8-K as an exhibit.
Digex filed a Current Report on Form 8-K, dated October 24, 2001,
reporting under Item 5 the issuance of a press release discussing Digex's third
quarter results. Digex also reported under Item 7 the filing of the press
release as an exhibit to the Form 8-K.
Digex filed a Current Report on Form 8-K, dated November 15, 2001,
reporting under Item 5 the replacement of two existing members and the
appointment of three additional members to the board of directors.
51
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: April 1, 2002
DIGEX, INCORPORATED
(Registrant)
By: /s/ MARK K. SHULL
-------------------------------------
Mark K. Shull
President and Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
Principal Executive Officer:
/s/ MARK K. SHULL Director, President and April 1, 2002
- ------------------------------------- Chief Executive Officer
Mark K. Shull
Principal Financial and Accounting Officer:
/s/ T. SCOTT ZIMMERMAN Interim Chief Financial Officer, April 1, 2002
- ------------------------------------- Vice President and Controller
T. Scott Zimmerman
Directors:
/s/ BERNARD J. EBBERS Chairman of the Board April 1, 2002
- -------------------------------------
Bernard J. Ebbers
/s/ RONALD R. BEAUMONT Director April 1, 2002
- -------------------------------------
Ronald R. Beaumont
/s/ GREGORY J. CLARK Director April 1, 2002
- -------------------------------------
Gregory J. Clark
/s/ K. WILLIAM GROTHE, JR. Director April 1, 2002
- -------------------------------------
K. William Grothe, Jr.
/s/ EDITH E. HOLIDAY Director April 1, 2002
- -------------------------------------
Edith E. Holiday
/s/ BERT C. ROBERTS, JR. Director April 1, 2002
- -------------------------------------
Bert C. Roberts, Jr.
/s/ SCOTT D. SULLIVAN Director April 1, 2002
- -------------------------------------
Scott D. Sullivan
/s/ LAWRENCE C. TUCKER Director April 1, 2002
- -------------------------------------
Lawrence C. Tucker
52
Report of Independent Public Accountants
The Board of Directors and Stockholders of
Digex, Incorporated:
We have audited the accompanying consolidated balance sheet of Digex,
Incorporated (the "Company") as of December 31, 2001, and the related
consolidated statements of operations, redeemable preferred stock, stockholders'
equity and comprehensive loss, and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit. We did not audit the financial statements of Digex (UK) Limited and
Digex Sweden A.B., subsidiaries of Digex, Incorporated, as of and for the year
ended December 31, 2001. Such statements are included in the consolidated
financial statements of Digex, Incorporated and reflect total assets and total
revenues of less than 2 percent of the related consolidated totals in 2001.
Those statements were audited by other auditors whose reports have been
furnished to us, and our opinion, insofar as it relates to amounts included for
those subsidiaries, is based solely on the reports of other auditors.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit and the reports of other
auditors provide a reasonable basis for our opinion.
In our opinion, based on our audit and the reports of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Digex, Incorporated as
of December 31, 2001, and the consolidated results of its operations and its
cash flows for the year then ended, in conformity with accounting principles
generally accepted in the United States.
Our audit was made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The schedule listed in the
index at Item 14(a) to the financial statements is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not part of
the basic consolidated financial statements. The schedule has been subjected to
the auditing procedures applied in the audit of the basic consolidated financial
statements and, in our opinion, based on our audit and the reports of other
auditors, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic consolidated financial statements
taken as a whole.
/s/ ARTHUR ANDERSEN LLP
Vienna, Virginia
February 6, 2002; except with respect
to the matters discussed in Note 1 and
Note 6, as to which the date is February 25, 2002
F-1
Report of Independent Auditors
The Board of Directors and Stockholders of
Digex, Incorporated:
We have audited the accompanying consolidated balance sheet of Digex,
Incorporated as of December 31, 2000, and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the two years in the
period ended December 31, 2000. Our audits also included the financial statement
schedule as of and for the years ended December 31, 2000 and 1999, listed in the
Index at Item 14(a). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Digex, Incorporated at December 31, 2000, and the consolidated results of its
operations and its cash flows for each of the two years in the period ended
December 31, 2000, in conformity with accounting principles generally accepted
in the United States. Also, in our opinion, the related financial statement
schedule as of and for the years ended December 31, 2000 and 1999, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in 2000
the Company changed its method of accounting for revenue recognition.
/s/ ERNST & YOUNG LLP
McLean, Virginia
January 30, 2001
Except for the second, fifth, sixth, and seventh paragraphs of Note 14
and the first paragraph of Note 15, as to which the date is
March 2, 2001
F-2
Report of Independent Auditors
To the Board of Directors and Stockholders of
Digex (UK) Limited:
We have audited the balance sheets of Digex (UK) Limited as of December
31, 2001 and 2000 and the related profit and loss accounts for the year ended
December 31, 2001 and the period from February 28, 2000 (inception) to December
31, 2000 (not presented separately herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audits to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digex (UK) Limited at
December 31, 2001 and 2000, and the results of its operations for the year ended
December 31, 2001 and the period from February 28, 2000 (inception) to December
31, 2000, in conformity with accounting principles generally accepted in the
United Kingdom.
/s/ ERNST & YOUNG LLP
London, England
March 28, 2002
F-3
Report of Independent Auditors
To the Board of Directors and Stockholders of
Digex Sweden AB:
We have audited the balance sheets of Digex Sweden AB as of December 31,
2001 and 2000, and the related statements of income for the years then ended
(not separately presented herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digex Sweden AB at December
31, 2001 and 2000, and the results of its operations for the years then ended
(not separately presented herein) in conformity with accounting principles
generally accepted in Sweden.
Stockholm, Sweden
March 15, 2002
Ernst & Young AB
/s/ BJORN FERNSTROM
F-4
DIGEX, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share information)
December 31,
-------------------------
2001 2000
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents ..................................................... $ 12,096 $ 83,434
Restricted investments ........................................................ 3,197 2,000
Accounts receivable, net of allowance of $4,806 in 2001 and $4,741 in 2000 .... 25,159 36,241
Due from WorldCom ............................................................. 15,179 6,000
Deferred costs ................................................................ 7,302 8,627
Prepaid expenses and other current assets ..................................... 7,579 7,452
--------- ---------
Total current assets .................................................. 70,512 143,754
Property and equipment, net ......................................................... 327,701 348,975
Goodwill and intangible assets, net ................................................. 19,231 23,222
Notes receivable from employees ..................................................... 6,825 --
Other assets ........................................................................ 3,089 5,100
--------- ---------
Total assets .......................................................... $ 427,358 $ 521,051
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses ......................................... $ 47,966 $ 59,455
Current portion of deferred liabilities ....................................... 7,572 7,734
Current portion of note payable ............................................... 56 2,772
Current portion of capital lease obligations .................................. 5,675 1,871
--------- ---------
Total current liabilities ............................................. 61,269 71,832
Deferred liabilities ................................................................ 4,257 4,025
Notes payable ....................................................................... 3,208 1,435
Notes payable to Intermedia ......................................................... 90,000 --
Capital lease obligations ........................................................... 29,477 27,131
--------- ---------
Total liabilities ..................................................... 188,211 104,423
--------- ---------
Commitments and contingencies
Redeemable preferred stock, $.01 par value; 5,000,000 shares authorized; 100,000
shares designated as Series A Convertible; 100,000 Series A Convertible
shares issued and outstanding in 2001 and 2000 (aggregate liquidation
preference of
$100,000) ...................................................................... 81,503 71,572
Stockholders' equity:
Class A common stock, $.01 par value; 100,000,000 shares authorized;
24,788,446 and 24,546,543 shares issued and outstanding in 2001 and
2000, respectively ........................................................ 248 245
Class B common stock, $.01 par value; 50,000,000 shares authorized;
39,350,000 issued and outstanding in 2001 and 2000 ........................ 394 394
Additional capital ............................................................ 545,020 550,465
Accumulated deficit ........................................................... (384,328) (195,869)
Deferred compensation ......................................................... (3,448) (10,141)
Accumulated other comprehensive loss .......................................... (242) (38)
--------- ---------
Total stockholders' equity ............................................ 157,644 345,056
--------- ---------
Total liabilities and stockholders' equity ............................ $ 427,358 $ 521,051
========= =========
See accompanying notes to consolidated financial statements.
F-5
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share data)
Year Ended December 31,
--------------------------------------------------
2001 2000 1999
------------ ------------ ------------
Revenue:
Revenue ............................................. $ 185,025 $ 162,085 $ 59,786
Revenue from WorldCom ............................... 29,328 6,000 --
------------ ------------ ------------
Total revenue ............................................. 214,353 168,085 59,786
Costs and expenses:
Cost of operations .................................. 16,138 21,244 9,656
Cost of services .................................... 103,962 69,658 21,750
Selling, general and administrative ................. 125,140 134,227 65,948
Provision for doubtful accounts ..................... 15,374 10,649 4,265
Deferred compensation ............................... 3,192 4,101 1,299
Depreciation and amortization ....................... 136,396 78,819 29,070
------------ ------------ ------------
Total costs and expenses .................................. 400,202 318,698 131,988
------------ ------------ ------------
Loss from operations ...................................... (185,849) (150,613) (72,202)
Other income (expense):
Interest expense .................................... (4,768) (2,008) (1,094)
Interest income and other ........................... 2,158 9,686 3,458
------------ ------------ ------------
Loss before income tax benefit ............................ (188,459) (142,935) (69,838)
Income tax benefit ........................................ -- -- 4,839
------------ ------------ ------------
Loss before cumulative effect of change in accounting
principle ........................................... (188,459) (142,935) (64,999)
Cumulative effect of change in accounting principle ....... -- (166) --
------------ ------------ ------------
Net loss .................................................. (188,459) (143,101) (64,999)
Accretion of preferred stock discount ..................... (4,025) -- --
------------ ------------ ------------
Net loss available to common stockholders ................. $ (192,484) $ (143,101) $ (64,999)
============ ============ ============
Loss per common share- basic and diluted:
Loss before cumulative effect of change in accounting
principle ........................................... $ (3.00) $ (2.25) $ (1.19)
Cumulative effect of change in accounting principle ....... -- (0.01) --
------------ ------------ ------------
Net loss per common share ................................. $ (3.00) $ (2.26) $ (1.19)
============ ============ ============
Pro forma net loss and loss per common share, assuming
the accounting change is applied retroactively:
Net loss available to common stockholders ................. $ (192,484) $ (142,935) $ (65,115)
============ ============ ============
Net loss per common share ................................. $ (3.00) $ (2.25) $ (1.19)
============ ============ ============
Shares used in computing basic and diluted net loss and
proforma net loss per share ......................... 64,076,647 63,404,839 54,726,027
============ ============ ============
See accompanying notes to consolidated financial statements.
F-6
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK,
STOCKHOLDERS' EQUITY, AND COMPREHENSIVE LOSS
(Amounts in thousands)
REDEEMABLE
PREFERRED
STOCK STOCKHOLDERS' EQUITY
----------------- --------------------------------------------------
Common Stock
------------
Series A Class A Class B
----------------- --------------- ----------------- Additional
Shares Amount Shares Amount Shares Amount Capital
------ ------ ------ ------ ------ ------ -------
Balance at December 31, 1998 .................... -- $ -- -- $ -- -- $ -- $ --
Total allocated costs ........................... -- -- -- -- -- -- --
Funding for working capital ..................... -- -- -- -- -- -- --
Funding for purchases of property, plant
and equipment ................................ -- -- -- -- -- -- --
Recapitalization by Intermedia .................. -- -- -- -- 50,000 500 114,566
Contributions from Intermedia following
recapitalization ............................. -- -- -- -- -- -- 47,689
Initial public offering of common stock, net of
issuance cost ................................ -- -- 11,500 115 -- -- 178,788
Issuance of stock options under long-term
compensation plan ............................ -- -- -- -- -- -- 13,510
Amortization of deferred compensation ........... -- -- -- -- -- -- --
Net loss ........................................ -- -- -- -- -- -- --
----------------- --------------------------------------------------
Balance at December 31, 1999 .................... -- -- 11,500 115 50,000 500 354,553
Issuance of Series A Convertible preferred
stock and warrants, net of available
equipment credits ............................ 100 68,900 -- -- -- -- 16,100
Purchase of equipment with equipment credits
granted in connection with the issuance of
preferred stock .............................. -- 2,672 -- -- -- -- --
Subsequent public offering of common stock, net
of issuance cost ............................. -- -- 12,650 126 (10,650) (106) 171,623
Issuance of stock options under long-term
compensation plan, net of forfeitures ........ -- -- -- -- -- -- 2,067
Exercise of common stock options ................ -- -- 397 4 -- -- 6,122
Amortization of deferred compensation ........... -- -- -- -- -- -- --
STOCKHOLDERS' EQUITY
-------------------------------------------------------------------
Accumulated Owner's
Other Net
Accumulated Deferred Comprehensive Investment
Deficit Compensation Loss (Deficit) Total
------- ------------ ---- --------- -----
Balance at December 31, 1998 .................... $ -- $ -- $ -- $ 70,845 $ 70,845
Total allocated costs ........................... -- -- -- 3,541 3,541
Funding for working capital ..................... -- -- -- 11,443 11,443
Funding for purchases of property, plant
and equipment ................................ -- -- -- 89,574 89,574
Recapitalization by Intermedia .................. -- -- -- (115,066) --
Contributions from Intermedia following
recapitalization ............................. -- -- -- (48,106) (417)
Initial public offering of common stock, net of
issuance cost ................................ -- -- -- -- 178,903
Issuance of stock options under long-term
compensation plan ............................ -- (13,510) -- -- --
Amortization of deferred compensation ........... -- 1,299 -- -- 1,299
Net loss ........................................ (52,768) -- -- (12,231) (64,999)
-------------------------------------------------------------------
Balance at December 31, 1999 .................... (52,768) (12,211) -- -- 290,189
Issuance of Series A Convertible preferred
stock and warrants, net of available
equipment credits ............................ -- -- -- -- 16,100
Purchase of equipment with equipment credits
granted in connection with the issuance of
preferred stock .............................. -- -- -- -- --
Subsequent public offering of common stock, net
of issuance cost ............................. -- -- -- -- 171,643
Issuance of stock options under long-term
compensation plan, net of forfeitures ........ -- (2,067) -- -- --
Exercise of common stock options ................ -- -- -- -- 6,126
Amortization of deferred compensation ........... -- 4,137 -- -- 4,137
F-7
Comprehensive loss:
Net loss ..................................... -- -- -- -- -- -- --
Foreign currency translation adjustment ...... -- -- -- -- -- -- --
Total comprehensive loss .....................
----------------- --------------------------------------------------
Balance at December 31, 2000 .................... 100 71,572 24,547 245 39,350 394 550,465
Purchase of equipment with equipment credits
granted in connection with the issuance of
preferred stock .............................. -- 5,906 -- -- -- -- --
Issuance of stock options under long-term
compensation plan, net of forfeitures ........ -- -- -- -- -- -- (3,501)
Exercise of common stock options ................ -- -- 241 3 -- -- 2,081
Amortization of deferred compensation ........... -- -- -- -- -- -- --
Comprehensive loss:
Net loss ..................................... -- -- -- -- -- -- --
Accretion of preferred stock discount ........ -- 4,025 -- -- -- -- (4,025)
Foreign currency translation adjustment ...... -- -- -- -- -- -- --
Total comprehensive loss .....................
----------------- --------------------------------------------------
Balance at December 31, 2001 .................... 100 $81,503 24,788 $248 39,350 $ 394 $ 545,020
================= ==================================================
Comprehensive loss:
Net loss ..................................... (143,101) -- -- -- (143,101)
Foreign currency translation adjustment ...... -- -- (38) -- (38)
---------
Total comprehensive loss ..................... (143,139)
------------------------------------------------------------------
Balance at December 31, 2000 .................... (195,869) (10,141) (38) -- 345,056
Purchase of equipment with equipment credits
granted in connection with the issuance of
preferred stock .............................. -- -- -- -- --
Issuance of stock options under long-term
compensation plan, net of forfeitures ........ -- 3,501 -- -- --
Exercise of common stock options ................ -- -- -- -- 2,084
Amortization of deferred compensation ........... -- 3,192 -- -- 3,192
Comprehensive loss:
Net loss ..................................... (188,459) -- -- -- (188,459)
Accretion of preferred stock discount ........ -- -- -- -- (4,025)
Foreign currency translation adjustment ...... -- -- (204) -- (204)
---------
Total comprehensive loss ..................... (192,688)
------------------------------------------------------------------
Balance at December 31, 2001 .................... $(384,328) $ (3,448) $(242) $ -- $ 157,644
==================================================================
See accompanying notes to consolidated financial statements.
F-8
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
Year Ended December 31,
-------------------------------------
2001 2000 1999
--------- --------- ---------
Operating activities:
Net loss .......................................................... $(188,459) $(143,101) $ (64,999)
Cumulative effect of change in accounting principle ............... -- 166 --
--------- --------- ---------
Loss before cumulative effect of change in accounting principle ... (188,459) (142,935) (64,999)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization .................................. 136,396 78,819 29,070
Provision for doubtful accounts ................................ 15,374 10,649 4,265
Amortization of deferred compensation .......................... 3,192 4,137 1,299
Loss on sale/disposal of telecommunications equipment .......... -- 655 52
Deferred income taxes .......................................... -- -- (4,839)
Accretion of interest on note payable and capital lease
obligations .................................................. 112 467 --
Changes in operating assets and liabilities:
Accounts receivable ............................................ (4,292) (26,535) (18,519)
Due from WorldCom .............................................. (9,179) (6,000) --
Deferred costs ................................................. 1,325 (8,627) --
Prepaid expenses and other current assets ...................... (127) (5,956) (606)
Notes receivable from employees ................................ (6,825) -- --
Other assets ................................................... 2,011 (4,562) (79)
Accounts payable and accrued expenses .......................... (12,303) 25,997 33,619
Deferred liabilities .......................................... 70 11,371 222
--------- --------- ---------
Net cash used in operating activities ............................. (62,705) (62,520) (20,515)
Investing activities:
Purchases of property and equipment ............................... (98,201) (202,604) (170,396)
Purchase of restricted investments ................................ (1,197) (2,000) --
Proceeds from sale of property and equipment ...................... 516 -- 203
--------- --------- ---------
Net cash used in investing activities ............................. (98,882) (204,604) (170,193)
Financing activities:
Proceeds from subsequent public offering, net of costs ............ -- 171,645 --
Proceeds from issuance of preferred stock ......................... -- 85,000 --
Proceeds from issuances of notes payable .......................... 93,300 -- --
Proceeds from exercises of common stock options ................... 2,084 6,126 --
Principal payments on long-term note payable and capital lease
obligations ..................................................... (4,931) (953) (1,424)
Proceeds from initial public offering, net of costs ............... -- -- 178,903
Net contributions from Intermedia ................................. -- -- 102,007
--------- --------- ---------
Net cash provided by financing activities ......................... 90,453 261,818 279,486
Effect of exchange rate on cash and cash equivalents ................. (204) (38) --
Net (decrease) increase in cash and cash equivalents ................. (71,338) (5,344) 88,778
Cash and cash equivalents at beginning of the year ................... 83,434 88,778 --
--------- --------- ---------
Cash and cash equivalents at end of the year ......................... $ 12,096 $ 83,434 $ 88,778
========= ========= =========
Supplemental disclosures of cash flow information:
Assets acquired through capital leases ............................ $ 11,084 $ 13,249 $ 17,111
F-9
Assets purchased with equipment credits granted in connection
with the issuance of preferred stock ........................... 5,906 2,672 --
Asset purchase financed by note payable ........................... -- -- 4,672
Interest paid ..................................................... 3,622 1,696 1,010
See accompanying notes to consolidated financial statements.
F-10
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization, Basis of Presentation and Significant Accounting Policies
Organization
Digex, Incorporated ("Digex") was incorporated on April 26, 1999, under
the laws of the State of Delaware. Digex's business was operated as the Web site
hosting unit of Intermedia Communications Inc. ("Intermedia") since its
acquisition by Intermedia on July 7, 1997. On that date, Intermedia acquired
Business Internet, Inc. (previously known as DIGEX, Incorporated), including the
Web site hosting unit, in a business combination accounted for as a purchase.
The Web site hosting unit presented in the accompanying consolidated financial
statements had no legal status or existence prior to the incorporation of Digex
on April 26, 1999. Prior to April 30, 1999, Digex had no assets or liabilities.
Digex's predecessor operations began in January 1996 to provide managed
Web hosting services, principally to Fortune 2000 companies. Digex's services
include implementing and maintaining secure, scalable, high-performance Web
sites on the Internet 24-hours a day. In addition, Digex provides a suite of Web
management services, including business process solutions and value-added
testing services directed toward improving its customers' overall Internet
performance.
On July 1, 2001, pursuant to the terms of the agreement and plan of
merger, dated September 1, 2000, and the amendments thereto, a wholly-owned
subsidiary of WorldCom, Inc. was merged with and into Intermedia Communications
Inc. with Intermedia continuing as the surviving corporation and as a subsidiary
of WorldCom (the "Intermedia - WorldCom Merger"). As a result of the Intermedia
- - WorldCom Merger, WorldCom now owns all of the capital stock of Intermedia,
other than the 13-1/2% series B preferred stock, and approximately 90% of the
voting securities of Intermedia. Therefore, WorldCom has acquired an indirect
controlling interest of Digex through Intermedia as Intermedia continues to own
approximately 61.4% of Digex's equity interests and controls 94.1% of Digex's
voting interests, calculated based on total common stock outstanding, as of
December 31, 2001.
As part of the Intermedia - WorldCom Merger, WorldCom and Digex have
entered into a series of operating and funding agreements under which Digex
sells hosting services to WorldCom, may borrow to satisfy cash requirements, and
purchases certain telecommunication services from WorldCom. These agreements are
discussed in more detail in Note 6 and Note 14 to the consolidated financial
statements.
Digex currently projects continued significant losses and operating cash
flow deficits. Since the Intermedia - WorldCom Merger, Digex has been dependent
on WorldCom to fund its operating cash flow deficits and capital expenditures.
Pursuant to the terms of the Intermedia - WorldCom Merger and subject to the
limitations under the approved 2002 business plan, which is subject to amendment
and modifications, WorldCom has committed to fund Digex's projected cash flow
deficits and capital expenditures through December 31, 2002. The 2002 business
plan may require up to $276.0 million, inclusive of amounts for capital
expenditures, the majority of which is expected to be demand driven. This amount
could materially change due to changes in the economy, Digex's target market,
its practice of acquiring equipment on behalf of customers, or its ability to
execute on this business plan, among other factors. The amount of actual
borrowings from WorldCom in 2002 could be more or less than the amounts approved
under the business plan. Should Digex require additional funding beyond 2002, as
currently projected, there can be no assurance that WorldCom will provide such
additional funding. Digex
F-11
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
believes that funding from any source other than WorldCom on appropriate or
commercially acceptable terms is speculative.
Digex's operations are subject to other certain risks and uncertainties,
including among others, uncertainties relating to product and service offering
development, rapidly changing technology, current and potential competitors with
greater financial, technological, and marketing resources, and dependence on key
management personnel.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of
Digex and its wholly-owned subsidiaries. All significant intercompany accounts
and transactions have been eliminated in consolidation. Certain prior period
amounts have been reclassified to conform to the current period presentation.
The financial statements for periods prior to April 30, 1999 represent the
carved-out operations of the managed Web and application hosting unit of
Intermedia. Digex's accumulated deficit of $384.3 million arose after April 30,
1999. Accumulated losses and capital contributions from Intermedia were included
in owner's net investment prior to April 30, 1999 and were transferred to
additional capital upon the capitalization of Digex. Intermedia contributed
approximately $115.1 million in assets and certain liabilities on April 30,
1999. Intermedia also contributed additional capital of $48.1 million to Digex
beginning May 1 through August 4, 1999, principally by way of contributions of
telecommunications assets. These contributions were accounted for at
Intermedia's underlying book values on the date of contribution. As more fully
discussed in Note 2 to the consolidated financial statements, "Related Party
Corporate Allocations," the financial statements for 1999 include allocations of
network costs and corporate expenses. In addition, for financial reporting
purposes, the equity activity of Digex prior to its incorporation has been
accumulated into a single disclosure caption entitled "Owner's Net Investment."
There have been no adjustments to the consolidated financial statements of
Digex from the Intermedia - WorldCom Merger.
Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions. Such estimates and assumptions affect the reported
amounts of assets and liabilities, as well as the disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates. Estimates that are subject to change include
estimates of the collectibility of accounts receivable and the useful lives and
ultimate realizability of property, equipment, goodwill, and intangible assets.
F-12
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cash Equivalents and Restricted Investments
Digex considers all highly liquid investments with an original maturity of
three months or less when purchased to be cash equivalents.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the property and
equipment, ranging from three years for electronics to five years for furniture
and office equipment. Buildings, leasehold improvements, and equipment under
capital leases are depreciated using the straight-line method over the lesser of
the lease term or the estimated useful life of the asset. Acquired and
internally developed software is amortized using the straight-line method over
periods ranging from three to five years.
Goodwill and Intangible Assets
Goodwill and intangible assets include assets that arose in connection
with the purchase of Business Internet, Inc. by Intermedia. Identifiable
intangible assets arising from the purchase are stated at cost and consist of
trade name, customer lists, acquired workforce, developed technology and
goodwill. Amortization of these assets is computed using the straight-line
method over the estimated periods of benefit, generally five years for developed
technologies and ten years for all other intangible assets and goodwill. Refer
to "Recent Accounting Pronouncements" in Note 1 to the consolidated financial
statements for changes to the accounting policy effective January 1, 2002.
Impairment of Long-Lived Assets
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of, Digex reviews its long-lived assets, including
intangible assets, for impairment when events or changes in circumstances
indicate the carrying value of such assets may not be recoverable. The review
consists of a comparison of the carrying value of the assets with the assets'
expected future undiscounted cash flows without interest costs. Estimates of
expected future cash flows represent management's best estimate based on
reasonable and supportable assumptions and projections. If the expected future
undiscounted cash flow exceeds the carrying value of the asset, no impairment
indicator is considered present. If the carrying value exceeds the future
undiscounted cash flow, an impairment indicator is considered present. Such
impairment would be measured and recognized using a discounted cash flow method.
Refer to "Recent Accounting Pronouncements" in Note 1 to the consolidated
financial statements for changes to the accounting policy effective January 1,
2002.
Digex has performed an undiscounted cash flow analysis related to its
long-lived assets. The result of that analysis indicates that no impairment to
the carrying value of its fixed assets nor intangible assets has
F-13
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
occurred as of December 31, 2001. In 2001, losses on disposed equipment of
approximately $4.3 million have been included in depreciation and amortization
expense.
Fair Value of Financial Instruments
The carrying values of Digex's financial instruments, including cash and
cash equivalents, restricted investments, accounts receivable, notes receivable,
accounts payable, notes payable and capital lease obligations approximate their
fair market values.
Revenue Recognition
Revenues principally consist of monthly service fees charged to customers
under contracts having terms that typically range from one to three years.
Monthly services fees are recognized in the month the service is rendered. Digex
also charges installation fees for new and existing customers upgrading service.
Installation revenue and related direct incremental costs of performing the
installation are recognized over the estimated contract period. Certain customer
payments for managed Web hosting services received in advance of service
delivery are deferred until the service is performed. Additional services are
recognized in the month the services are performed. Refer to "Change in
Accounting Principle" in Note 1 to the consolidated financial statements for
further discussion.
Advertising Costs
Digex expenses advertising costs as incurred. Advertising expense amounted
to $17.8 million in 2001, $21.9 million in 2000, and $6.8 million in 1999 and is
included in the consolidated statements of operations as selling, general and
administrative expense.
Research and Development Costs
Digex expenses research and development costs ("R&D costs") as incurred,
except for equipment that has alternative future uses, in accordance with SFAS
No. 2, Accounting for Research and Development Costs. Indirect costs and general
administrative expenses directly related to a joint development project and
normal business development activities are expensed as incurred. R&D costs
amounted to $2.8 million in 2001, $9.5 million in 2000, and $0.6 million in 1999
and are included in the consolidated statements of operations as selling,
general and administrative expense.
Product development costs incurred for internal use software and software
supporting managed hosting services are expensed as incurred until the
application development state, after which costs are capitalized in accordance
with Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. Digex has capitalized $16.2 million and
$4.8 million of software development costs in 2001 and 2000, respectively.
F-14
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock-Based Compensation
Digex accounts for employee stock-based compensation in accordance with
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations. Accordingly, in cases where exercise
prices at the date of the grant equal or exceed fair market value of the
underlying common stock, Digex recognizes no compensation expense. In cases
where exercise prices at the date of the grant are less than the fair value,
compensation is recognized over the period of performance or vesting period.
Income Taxes
Digex accounts for income taxes under the provisions of SFAS No. 109,
Accounting for Income Taxes. SFAS No. 109 requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. Under this
method, deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS
No. 130, Reporting Comprehensive Income. This standard requires that total
comprehensive income (loss) be disclosed with equal prominence as net income.
Comprehensive income is defined as changes in stockholders' equity exclusive of
transactions with owners, such as capital contributions and dividends. Digex
adopted this standard in 1998 and implemented the standard for all years
presented herein. Digex's only component of accumulated other comprehensive loss
for 2001 and 2000 resulted from foreign currency translation. Comprehensive
losses were equal to net losses for 1999.
Foreign Currency Translation
The financial statements of foreign subsidiaries have been translated into
U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation. All
balance sheet accounts have been translated using the exchange rates in effect
at the balance sheet date. Income statement amounts have been translated using
the average exchange rate for the period. Foreign currency translation
adjustments are reported as a component of accumulated other comprehensive
loss within stockholders' equity. The gains and losses of $0.003 million in
2001 and $0.07 million in 2000 resulting from foreign currency transactions are
reported as interest income and other in the consolidated results of operations.
There was no gain or loss resulting from foreign currency transactions in 1999.
F-15
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Concentrations of Credit Risk
Financial instruments that potentially expose Digex to credit risk consist
primarily of cash and cash equivalents, restricted investments, accounts
receivable, loans receivable, and notes payable. Digex's cash and cash
equivalents are primarily invested in overnight repurchase agreements at a
high-quality institution.
Accounts receivable are due from commercial entities to whom credit is
extended based on evaluation of the customer's financial condition, and in
certain cases collateral is required. Anticipated credit losses are provided for
in the consolidated financial statements and have been within management's
expectations for all periods presented. As of December 31, 2001, Digex does not
have any significant concentrations of business transacted with a particular
customer or supplier, other than WorldCom, that could, if suddenly eliminated,
adversely impact its operations. Refer to Note 14 "Related Party Agreements" for
a discussion of commercial agreements between Digex and WorldCom.
Substantially all of its borrowings are through Intermedia from WorldCom.
If funding is not made available by WorldCom, Digex may have difficulty in
obtaining funding from other sources on terms acceptable to Digex. Refer to Note
6 "Long-term Notes Payable" for a discussion of the funding agreement between
Digex and WorldCom.
Change in Accounting Principle
Effective January 1, 2000, Digex changed its method of accounting for
revenue recognition in accordance with Staff Accounting Bulletin No. 101 ("SAB
101"), Revenue Recognition in Financial Statements. Prior to January 1, 2000,
Digex had recognized installation revenue, in accordance with industry practice,
upon completion of the managed Web hosting solution installation. The direct
costs associated with the installation were expensed as incurred. Under the new
accounting method adopted retroactive to January 1, 2000, Digex now recognizes
installation revenue and related direct incremental costs of performing the
installation over the contract term. Digex continually analyzes the average life
of its customer relationships and contracts and has determined that a 24 month
contract term is a reasonable estimate.
The cumulative effect of the change on years prior to 2000 resulted in a
net charge of $0.2 million ($5.3 million revenue less related direct incremental
costs), which is included in the consolidated statement of operations for the
year ended December 31, 2000. The effect of the change on the year ended
December 31, 2000 was to increase net loss before the cumulative effect of the
change in accounting principle by $0.2 million (less than $0.01 per share). For
the year ended December 31, 2000, Digex recognized revenue of $4.6 million and
direct incremental costs of $4.4 million that was included in the cumulative
effect adjustment as of January 1, 2000. Digex recognized revenue of $8.2
million in 2001 that had been deferred as of December 31, 2000. With the
adoption of SAB 101, there was no impact to Digex's business operations or cash
flows. There was also no material impact to Digex's consolidated financial
statements. The pro forma amounts presented in the consolidated statements of
operations were calculated assuming the accounting change was made retroactively
to prior periods.
F-16
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Recent Accounting Pronouncements
In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which is effective for fiscal years beginning after December 15, 2001.
Under the new rules, goodwill and intangible assets deemed to have indefinite
lives will no longer be amortized but will be subject to annual impairment tests
based upon estimated fair value. In addition, the statement includes provisions
for the reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. Goodwill and other intangibles, acquired prior to July
1, 2001, may be amortized until the adoption of the statement.
Digex will adopt the provisions of SFAS No. 142 beginning in 2002. At that
time, Digex will cease amortization of amounts assigned to goodwill and acquired
workforce. Amortization of goodwill and acquired workforce was approximately
$2.2 million for the year ended December 31, 2001. The net book value of
goodwill and acquired workforce at December 31, 2001 was approximately $11.9
million. Management is continuing to evaluate the potential impact of adopting
SFAS No. 142 on the carrying value of the goodwill on its consolidated balance
sheet. If, within six months of adopting SFAS No. 142, management determines
that impairment of goodwill exists, Digex will record the charge to reduce the
carrying value of its goodwill to fair value as a cumulative effect of a change
in accounting principle in the first quarter of 2002. Although Digex continues
to evaluate the impact, management's ultimate determination could result in the
impairment of some or all of the approximately $11.9 million in carrying value
of the goodwill on its consolidated balance sheet.
In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which supercedes both SFAS No. 121, Impairment of Long-Lived
Assets for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions for the disposal of a segment of a business contained in APB Opinion
No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions, effective for fiscal years beginning after
December 15, 2001. Under the new rules, a single accounting model for long-lived
assets to be disposed of by sale will be used to broaden the presentation of
discontinued operations. Digex does not expect the implementation of SFAS No.
144 to have a material impact on its consolidated results of operations or
financial position.
2. Related Party Corporate Allocations
Prior to August 4, 1999, Digex utilized the central cash management
systems of Business Internet and Intermedia. Cash requirements during these
periods were satisfied by cash transactions and transfers that were accounted
for through an intercompany account. In addition, Intermedia charged Digex for
identifiable corporate and operating expenses, such as network cost and
corporate overhead cost. Intercompany account balances for periods prior to July
29, 1999 have been treated as permanent contributions and have been reflected as
a component of owner's net investment in the accompanying consolidated financial
statements.
F-17
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes corporate charges and allocations included
in the accompanying consolidated financial statements (in thousands):
Statement of Operations Caption 1999
------------------------------- -------
Cost of operations .......................................... $ 9,190
Cost of services ............................................ 494
Selling, general and administrative ......................... 18,123
-------
$27,807
=======
Amounts include expenses recorded as a result of certain related party
agreements with Intermedia. Management believes that the allocation methodology
applied is reasonable. However, it was not practicable to determine whether the
allocated amounts represent amounts that would have been incurred on a
standalone basis. Explanations of the composition and the method of allocation
for the above captions are as follows:
Cost of Operations
Allocated costs within this caption were the costs of telecommunications
backbone circuits. These costs were allocated to Digex based upon circuit usage
and rate information.
Cost of Services
Allocated costs within this caption were the costs associated with two
data centers (maintenance, utilities and support and employment costs for
network engineering and support, and certain other overhead). These costs were
allocated based upon the employee base.
Selling, General and Administrative
Allocated costs within this caption were the costs of human resources,
information systems services, accounting and back office support, executive
salaries and other general and administrative costs, including rent. All costs
except accounting and back office support were allocated based upon the employee
base. Accounting and back office support were allocated based upon the relative
percentage of monthly recurring revenues.
Refer to Note 14 to the consolidated financial statements for additional
related party transactions and agreements.
F-18
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3. Property and Equipment
Property and equipment consisted of the following (in thousands):
December 31,
------------------------
2001 2000
--------- ---------
Buildings ........................................ $ 30,178 $ 30,178
Electronics and computer equipment ............... 324,667 276,587
Computer software ................................ 78,594 54,845
Furniture, office equipment, and vehicles ........ 11,300 8,532
Leasehold improvements ........................... 108,428 84,485
--------- ---------
553,167 454,627
Less accumulated depreciation and amortization ... (225,466) (105,652)
--------- ---------
$ 327,701 $ 348,975
========= =========
Depreciation and amortization expense relating to property and equipment
was $128.1 million in 2001, $74.8 million 2000, and $25.1 million in 1999.
Property and equipment capitalized under capital leases consisted of the
following (in thousands):
December 31,
-----------------------
2001 2000
-------- --------
Buildings ........................................ $ 30,178 $ 30,178
Electronics and computer equipment ............... 10,954 --
Furniture, office equipment, and vehicles ........ 490 339
-------- --------
41,622 30,517
Less accumulated amortization .................... (9,572) (3,440)
-------- --------
$ 32,050 $ 27,077
======== ========
Property and equipment include the present value of the capital lease
which is amortized over the lesser of the asset life or lease term. Amortization
of these assets is included in depreciation and amortization expense.
F-19
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
4. Intangible Assets
Intangible assets consisted of the following (in thousands):
December 31,
--------------------------
2001 2000
-------- --------
Goodwill ................................... $ 19,099 $ 19,099
Trade name ................................. 9,750 9,750
Customer list .............................. 3,120 3,120
Developed technologies ..................... 2,720 2,720
Acquired workforce ......................... 1,253 1,253
-------- --------
35,942 35,942
Less accumulated amortization .............. (16,711) (12,720)
-------- --------
$ 19,231 $ 23,222
======== ========
Amortization expense amounted to approximately $4.0 million in each of
2001, 2000, and 1999.
5. Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consisted of the following (in
thousands):
December 31,
-----------------------
2001 2000
------- -------
Accounts payable ............................... $15,122 $31,996
Accrued payroll and related taxes .............. 11,635 9,932
Accrued fixed asset purchases .................. 4,663 4,419
Other accrued expenses ......................... 16,546 13,108
------- -------
$47,966 $59,455
======= =======
F-20
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6. Long-term Notes Payable
Long-term notes payable consisted of the following (in thousands):
December 31,
---------------------
2001 2000
------- ------
Notes payable to Intermedia ....................... $90,000 $ --
Note payable to State of Maryland ................. 3,000 --
Note payable to Prince George's County ............ 264 --
Note payable to vendor ............................ -- 4,207
------- ------
Total long-term notes payable, including
current portion .............................. $93,264 $4,207
======= ======
In January 2001, Digex received proceeds from a $3.0 million loan from the
State of Maryland Department of Business and Economic Development under the
Sunny Day Fund initiative. The loan is subject to multiple maturity dates, and
is guaranteed by Intermedia. Interest on the unpaid principal balance accrues at
5% per annum. Repayment of principal and any accrued interest will be deferred
each year through December 31, 2008 if Digex meets certain annual conditions
regarding the hiring of permanent, full time employees and the expenditures for
the development of a Web hosting facility in Prince George's County, Maryland.
At December 31, 2008, the principal amounts and any accrued interest outstanding
may convert to a grant upon the achievement of certain requirements by Digex.
Digex was in compliance for deferring full repayment of the loan at December 31,
2001 and expects to satisfy the requirements for full conversion at December 31,
2008. However, certain minimum employment requirements to be eligible for
partial or full repayment will increase in 2004. If the minimum employment
requirements are not met at December 31, 2004, partial or full repayment of the
outstanding balance is due on April 1, 2005.
In April 2001, Digex received proceeds from a $300,000 loan from Prince
George's County Economic Development Corporation. The loan matures on April 6,
2006 and is guaranteed by Intermedia. Interest on the unpaid principal balances
accrues at 5% per annum. Interest and principal are payable monthly, beginning
May 6, 2001.
A note payable of $4.7 million was issued in 1999 in connection with the
purchase of software. The note accrued interest at an effective rate of 7.00%
per annum and was expected to mature in January 2002. Principal repayments were
not made in 2001 as the outstanding balance has been in dispute since 2000.
Additionally, there have been no demands for payment. As of December 31, 2001,
we retired the software and accordingly extinguished the note.
F-21
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Borrowings from Related Parties
On July 31, 2001, Digex entered into a note purchase agreement with
WorldCom whereby WorldCom has agreed to provide funding for the Digex business
plans for 2001 and 2002 as approved by the Digex and WorldCom boards of
directors. The Digex and WorldCom boards of directors have approved the Digex
business plans for 2001 and 2002. Subject to the terms and conditions of the
agreement, Digex will issue and WorldCom will purchase (or cause an affiliate to
purchase) a series of senior notes up to an aggregate principal amount
sufficient to satisfy Digex's net cash requirements under the approved business
plan. Interest on the unpaid principal balance is payable monthly at a rate
equal to LIBOR plus 300 basis points. Repayment of principal is due on December
31, 2002, but may be extended to December 31, 2006 upon the election of Digex by
written notice. Management intends to make this election by December 2002, at
which time amounts then outstanding will be repaid in equal monthly
straight-line amortization payments of principal and interest through December
31, 2006. As a result, this debt has been classified as long-term. Any changes
to its business plan that require increased funding would require the WorldCom
board of directors' approval before WorldCom would be obligated to fund any such
increase.
Digex issued and WorldCom caused Intermedia to purchase a series of senior
notes totaling $65.0 million to satisfy Digex's net cash requirements under its
approved 2001 business plan. Through December 31, 2001, variable interest on the
unpaid principal balance was paid monthly at an interest rate of 300 basis
points over LIBOR rate (weighted average interest rate of 5.40%). Interest cost
incurred and charged to expense related to the funding agreement with WorldCom
was $0.9 million in 2001.
In the second quarter of 2001, Digex borrowed $12.0 million from
Intermedia. Through July 31, 2001, variable interest on the unpaid principal
balance was paid monthly at an average LIBOR rate of approximately 4.50% per
annum. Digex borrowed an additional $6.0 million on June 26, 2001 and $7.0
million on November 13, 2001 from Intermedia as an intercompany loan. The
variable interest on the unpaid principal balance of the $13.0 million
intercompany loan and $12.0 million promissory note was paid monthly at an
interest rate of 300 basis points over LIBOR rate (weighted average interest
rate of 5.67%) through December 31, 2001.
On January 14, 2002, Digex entered into a note purchase agreement, dated
July 31, 2001, with Intermedia to refinance the $13.0 million intercompany loan
and $12.0 million promissory note to Intermedia under a series of senior notes
totaling $25.0 million. The terms of the agreement are substantially the same as
the original note purchase agreement, dated July 31, 2001 between Digex and
WorldCom, with the repayment of principal due on December 31, 2003. There is no
option to extend the maturity date of the notes. Interest is payable monthly at
an interest rate of 300 basis points over LIBOR. Accordingly, both loans are
classified as long-term debt as of December 31, 2001.
Principal repayments on notes payable are as follows (in thousands):
Year ending December 31:
2002 ................................................. $ 56
2003 ................................................. 41,309
2004 ................................................. 16,312
2005 ................................................. 19,315
F-22
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2006 ................................................. 16,272
Thereafter ........................................... --
--------
93,264
Less: Current portion of note payable ...................... (56)
--------
Total long-term notes payable .............................. $ 93,208
========
Interest cost incurred and charged to expense related to notes payable was
$1.8 million in 2001, $0.3 million in 2000 and $0.2 million in 1999. Of total
interest expense in 2001, interest cost incurred and charged to expense related
to notes payable to related parties was $1.5 million.
7. Lease Commitments
Digex leases certain property and equipment under various operating and
capital lease arrangements that expire over the next 11 years.
On June 29, 2000, Digex entered into a ten-year lease commencing in
September 2000 for its corporate headquarters facility in Laurel, Maryland. The
lease agreement requires an initial security deposit of $2.0 million in the form
of a letter of credit. This letter of credit may be reduced at the commencement
of the seventh lease year to an amount equal to the then current one month's
base rent if certain conditions are met annually prior the seventh year of the
lease.
Digex had collateralized letters of credit under office space lease
arrangements aggregating $3.2 million and $2.0 million as of December 31, 2001
and 2000, respectively, and are presented as restricted investments on the
consolidated balance sheets.
In the first and second quarters of 2001, Digex entered into master lease
and financing agreements with two vendors for lines of credit to facilitate the
leasing of computer hardware and software. The terms of the associated schedules
range from 12 months for financing a maintenance contract to 36 months for
leasing computer equipment. Digex will have an option to purchase the equipment
at the end of the initial lease term. Interest and principal are payable monthly
with interest rates ranging from 7.2% to 12.3% per annum. As of December 31,
2001, Digex had acquired $11.0 million of computer equipment and maintenance
services under these leasing and financing arrangements.
Future noncancelable lease payments under Digex's lease commitments at
December 31, 2001 are as follows (in thousands):
Capital Operating
Leases Leases
-------- ---------
Future minimum lease payments:
Year ending December 31:
2002 ............................................. $ 8,609 $ 3,415
2003 ............................................. 8,220 2,918
2004 ............................................. 5,959 2,899
F-23
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2005 ............................................. 4,774 2,551
2006 ............................................. 4,908 1,542
Thereafter ............................................. 15,013 2,561
-------- -------
47,483 $15,886
=======
Less amount representing interest ...................... (12,331)
--------
Present value of lease payments ........................ 35,152
Current portion of capital lease obligations ........... (5,675)
--------
Long-term portion of capital lease obligations ......... $ 29,477
========
In January 2002, Digex renewed one of its office space leases for an
additional seven year term, expiring on or around January 31, 2009 based on the
rent commencement date. Future minimum liability associated with the lease
renewal is $6.4 million.
Rent expense amounted to $7.3 million (which included $1.7 million of
rental expenses recognized under the facilities agreement with WorldCom), $3.9
million, and $2.0 million for the years ended December 31, 2001, 2000, and 1999,
respectively. Refer to Note 14 to the consolidated financial statements for a
description of the facilities agreement.
8. Series A Convertible Preferred Stock
In January 2000, Digex sold 100,000 shares of its non-voting preferred
stock, designated as Series A Convertible Preferred Stock, with detachable
warrants to purchase 1,065,000 shares of its Class A common stock, for an
aggregate of $100.0 million, of which $15.0 million was in the form of equipment
purchase credits. Of the $15.0 million of equipment purchase credits,
approximately $5.9 million and $2.7 million was used for equipment purchases
during the year ended December 31, 2001 and 2000, respectively. The warrants can
be exercised at any time on or before January 12, 2003 at an initial price of
$57.00 per share, subject to certain adjustments. The proceeds from the offering
were allocated between the preferred stock and the warrants based upon their
relative fair values.
In the event of liquidation, each share of preferred stock is entitled to
a liquidation preference of $1,000 per share before any amount may be paid to
common stockholders. The holders of the preferred stock are not entitled to
receive dividends. Digex may not issue any stock with the same or senior
preferences or priorities to this series without the consent of the majority of
its preferred stockholders.
Each share of preferred stock is convertible into shares of Class A common
stock at a conversion price of $68.40 per share, subject to certain adjustments,
for a total of approximately 1,462,000 shares of Class A common stock. Unless
earlier converted, on January 12, 2005, each share of preferred stock will
automatically convert into the number of shares of Class A common stock equal to
$1,000 divided by the average of the closing prices of the Class A common stock
for the twenty consecutive trading days prior to January 12, 2005.
F-24
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Subject to the legal availability of funds, the preferred stock is
redeemable in cash at the option of the holders after January 12, 2004 or upon a
change of control of Digex at a price of $1,000 per share if the redemption is
then permitted under those indentures of Digex and Intermedia which existed on
January 10, 2000. If the restrictions under these agreements terminate at an
earlier date, the holders may require Digex to redeem the preferred stock before
entering into an agreement which would restrict the ability to redeem the
preferred stock. Digex is not required to make sinking fund payments with
respect to the preferred stock.
Digex is accreting the preferred stock discount of $16.1 million to the
mandatory conversion date in January 2005. The effect of the accretion is to
increase net loss available to common stockholders by approximately $4.0 million
(or $0.06 per share) for the year ended December 31, 2001. To date, Digex
believes that a redemption event is not probable due to the covenants contained
in the indentures of Digex and Intermedia restricting redemption and the
requirement of legal availability of funds, which would prohibit redemption of
the securities.
9. Stockholders' Equity
Digex is authorized to issue up to 150,000,000 shares of common stock
(including 100,000,000 Class A shares and 50,000,000 Class B shares) and up to
5,000,000 shares of preferred stock. The Class A and Class B common stock are
identical in all respects except that the Class A is entitled to one vote for
each share and the Class B is entitled to ten votes for each share.
On August 4, 1999, Digex sold 11,500,000 shares of its Class A common
stock in an initial public offering. The shares sold represented approximately
18.7% of the aggregate number of shares of Class A and Class B common stock then
outstanding. After the offering, Intermedia retained a 97.8% voting interest in
Digex. The net proceeds from the offering were approximately $178.9 million and
could be used only to purchase telecommunications related assets due to
restrictions in Intermedia's debt instruments.
On February 16, 2000, Digex completed a public offering of 12,650,000
shares of Class A common stock. Digex sold 2,000,000 shares of Class A common
stock and received net proceeds of approximately $171.6 million. Intermedia sold
10,650,000 shares of Class B common stock. The Class B common stock sold by
Intermedia automatically converted into Class A common stock at the closing of
the offering.
10. Deferred Compensation
Since July 29, 1999, Digex granted options to purchase 852,500 shares (net
of 620,000 forfeited options) of Class A common stock under the Digex Long Term
Incentive Plan to certain employees of Digex at exercise prices below market
value. Digex recorded deferred compensation of $0.9 million in 2001, $4.2
million in 2000, and $13.5 million in 1999, a separate component of
stockholders' equity, to be expensed over the four-year vesting period of the
options. Deferred compensation was reduced by $4.4 million in 2001 and $2.1
million in 2000 for forfeited stock options in connection with terminations of
F-25
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
employment. Deferred compensation expense of $3.2 million, $4.1 million, and
$1.3 million was recorded during the years ended December 31, 2001, 2000, and
1999, respectively.
11. Employee Benefit Plans
Stock-based Compensation Plan
Under the provisions of the Intermedia 1996 Long-Term Incentive Plan (1996
Plan), certain employees and directors of Digex were granted options to buy
shares of Intermedia common stock, generally at market value with terms of five
to ten years. Upon the completion of the Intermedia - WorldCom Merger, each
unexercised stock option exercisable for shares of Intermedia common stock was
converted into options exercisable for shares of WorldCom Group common stock.
The exercise price and the number of shares issuable upon exercise were divided
and multiplied, respectively, by 1.0319. Vesting and exercisability of
individual options and other terms and conditions were governed by the 1996
Plan. Since the Intermedia - WorldCom Merger, there will be no additional stock
option grants under this Plan.
The Digex Long-Term Incentive Plan adopted on July 23, 1999 (1999 Plan)
and administered by the compensation committee of the Board of Directors permits
awards of stock, stock options, stock appreciation rights, restricted stock and
other stock-based awards as incentives to current and prospective employees,
officers, directors, and those of Digex's subsidiaries or of any person that
owns over 50% of the voting power of our authorized and outstanding voting
shares. Stock options are generally vested over a four-year period for officers
and employees. Exercisable options expire ten years following the date of the
grant.
Under the 1999 Plan, Digex is authorized to issue options up to 15,000,000
shares of Class A common stock. As of December 31, 2001, the Board has 7,914,758
shares of common stock reserved for issuance to employees, officers, and
directors of Digex pursuant to the 1999 Plan.
The following table summarizes the stock option activity related to
employees of Intermedia and Digex:
Number of Per Share
Shares Option Price
---------- -------------
Digex options granted on July 29, 1999 ........... 5,031,500 $ 5.00-17.00
Granted .................................... 1,360,170 5.00-54.19
Exercised .................................. -- --
Canceled ................................... (687,650) 17.00-54.19
---------- -------------
Outstanding Digex options at December 31, 1999 ... 5,704,020 5.00-54.19
Granted .................................... 4,545,993 11.00-139.38
Exercised .................................. (396,543) 5.00-29.13
Canceled ................................... (1,927,421) 5.00-139.38
---------- -------------
F-26
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Outstanding Digex options at December 31, 2000 ... 7,926,049 5.00-139.38
Granted .................................... 615,927 7.13-27.13
Exercised .................................. (241,923) 5.00-17.00
Canceled ................................... (2,491,743) 5.00-139.38
---------- -------------
Outstanding Digex options at December 31, 2001 ... 5,808,310 $ 5.00-139.38
========== =============
Exercisable Digex options at December 31, 1999 ... 30,000 $ 17.00
========== =============
Exercisable Digex options at December 31, 2000 ... 1,320,256 $ 5.00-54.19
========== =============
Exercisable Digex options at December 31, 2001 ... 2,920,330 $ 5.00-139.38
========== =============
Digex has adopted the disclosure only provisions of SFAS No. 123,
Accounting for Stock Compensation. Pro forma net loss and net loss per share,
assuming that Digex had applied the fair value model (Black-Scholes Pricing
Model) required by SFAS No. 123, is as follows (in thousands):
Year ended
December 31,
------------------------------------------
2001 2000 1999
---------- ---------- ----------
Net loss ....................... $ (244,966) $ (185,803) $ (71,800)
Net loss per share ............. $ (3.82) $ (2.93) $ (1.31)
The following table summarizes the significant assumptions used in
developing the information:
Year ended
December 31,
---------------------------------
2001 2000 1999
------- ------- -------
Risk-free interest rate ................. 4.3% 5.5% 5.6%
Volatility factor ....................... 1.45 1.38 .60
Dividend yield .......................... -- -- --
Weighted average life ................... 5 years 5 years 5 years
F-27
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the weighted average exercise prices of
option activity:
Year ended
December 31,
----------------------
2001 2000
-------- --------
Balance at beginning of year ....................... $ 42.55 $ 18.45
Granted ...................................... 25.74 78.36
Exercised .................................... 8.42 15.55
Canceled ..................................... 39.93 60.63
-------- --------
Balance at end of year ............................. $ 43.31 $ 42.55
The weighted average exercise price of exercisable options was $39.16 in
2001, $16.60 in 2000, and $17.00 in 1999. The per share weighted average fair
value of options granted were $24.67 in 2001 and $40.66 in 2000, and $12.67 in
1999.
Under the 1999 Plan, options were granted to certain employees of Digex at
exercise prices below the fair market value of Digex common stock at the date of
the grant. The options granted during 2001 and 2000 are summarized as follows:
2001 2000
------------------------- -------------------------
Weighted Weighted
Weighted average Weighted average
average exercise average exercise
fair value price fair value price
---------- -------- ---------- --------
Exercise Price = Fair Market Value .................. $24.58 $27.13 $64.60 $79.30
Exercise Price (greater than) Fair Market Value ..... -- -- -- --
Exercise Price (less than) Fair Market Value ........ 25.92 7.13 57.69 41.15
------ ------ ------ ------
Total $24.67 $25.74 $40.66 $78.36
The range of option exercise prices for options outstanding as of December
31, 2001 was $5.00 to $139.38. The range of exercise prices for options is wide
due primarily to the increasing price of Digex common stock over the period in
which the option grants were awarded. The options outstanding as of December 31,
2001 are summarized in ranges as follows:
F-28
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Options Outstanding Options Exercisable
--------------------------------------------------- --------------------------
Weighted
Weighted average Weighted
average remaining average
exercise contractual life exercise
Range of exercise prices Shares price (in years) Shares price
- ------------------------ --------- -------- ---------------- --------- ---------
$ 5.00 -- $ 10.00 ...... 487,500 $ 5.45 7.72 329,376 $ 5.42
$17.00 -- $ 17.00 ...... 1,828,852 17.00 7.25 1,191,653 17.00
$21.18 -- $ 42.25 ...... 1,190,233 34.02 8.45 409,066 36.04
$45.50 -- $ 71.50 ...... 1,211,863 59.45 8.37 460,574 59.70
$73.81 -- $139.38 ...... 1,089,862 96.59 8.38 529,661 94.51
--------- ------- ---- --------- -------
Total 5,808,310 $ 43.31 7.98 2,920,330 $ 39.16
Retirement Plan
Digex has a 401(k) plan, whereby employees 21 years or older with at least
three months of service are eligible to participate in the plan. Participants
may elect to contribute, on a tax-deferred basis, up to 15% of their
compensation, not to exceed $11,000 during the taxable year. Digex will match
one-half of a participant's contribution, up to a maximum of 7% of the
participant's compensation. Digex's matching contribution fully vests after
three years of service. Digex's contributions to the plan were $1.8 million in
2001, $1.1 million in 2000, and $0.5 million in 1999.
12. Income Tax Information
Digex files a consolidated income tax return with its wholly-owned
domestic subsidiary. Separate returns are filed for its foreign subsidiaries.
For federal and most state purposes, Digex is not consolidated in the income tax
returns of Intermedia and WorldCom. The consolidated tax provision, therefore,
is based upon the separate tax provisions of the domestic and foreign
jurisdictions.
F-29
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Domestic and foreign loss before the benefit from income taxes consists of
the following (in thousands):
Year ended
December 31,
--------------------------------------------
2001 2000 1999
--------- --------- --------
Domestic .................. $(173,558) $(135,171) $(69,838)
Foreign ................... (14,901) (7,764) --
--------- --------- --------
Total ........... $(188,459) $(142,935) $(69,838)
========= ========= ========
Income tax benefit for the tax years ended December 31 is comprised of the
following (in thousands):
Year ended
December 31,
--------------------------------
2001 2000 1999
------ ------ ------
Current ................................. $ -- $ -- $ --
Deferred:
Federal ....................... -- -- 4,244
State ......................... -- -- 595
------ ------ ------
$ -- $ -- $4,839
====== ====== ======
The following table reconciles the assumed statutory tax rate with the
effective rate to income tax expense:
Year ended
December 31,
------------------------------
2001 2000 1999
------ ------ ------
Tax benefit at statutory rate .............. (34.0)% (34.0)% (34.0)%
Reconciling items:
State income taxes, net .............. (2.8)% (3.2)% (3.2)%
Non-deductible items ................. 0.5% 0.7% 3.3%
Change in valuation allowance ........ 35.7% 36.3% 19.1%
Foreign taxes ........................ 0.3% 0.2% --
Other items .......................... 0.3% -- 7.8%
------ ------ ------
Effective tax rate ......................... (0.0)% (0.0)% (7.0)%
------ ------ ------
F-30
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2001 and 2000, Digex had temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the deferred
tax assets and liabilities were as follows (in thousands):
December 31,
2001 2000
--------- --------
Deferred tax liabilities:
Depreciation and amortization ................. $ -- $ (6,485)
Identifiable intangible assets ................ (2,975) (3,748)
--------- --------
Total deferred tax liabilities ............. (2,975) (10,233)
Deferred tax assets:
Net operating loss carryforwards - U.S. ....... 129,554 74,567
Net operating loss carryforwards - Foreign .... 6,930 2,320
Provision for doubtful accounts ............... 2,506 2,289
Depreciation and amortization ................. 313 --
Other ......................................... 3,120 266
Deferred revenue .............................. 113 4,410
Stock-based compensation ...................... 1,728 1,630
--------- --------
Total deferred tax assets .................. 144,264 85,482
Less: valuation allowance .................. (141,289) (75,249)
--------- --------
Net deferred tax asset ............... 2,975 10,233
--------- --------
Net deferred tax asset (liability) .................. $ -- $ --
========= ========
As a result of the recapitalization of Digex on April 30, 1999, the net
operating loss carryforwards of Digex as of December 31, 1998 did not transfer
to Digex after the recapitalization. A net deferred tax liability of $4.8
million relating to identifiable intangible assets was recorded as a result of
the recapitalization on April 30, 1999. Digex generated net operating losses and
non-deductible expenses in excess of the deferred tax liability after the
recapitalization and recorded the deferred tax asset associated with the future
deductible items. Accordingly, Digex recorded a $4.8 million deferred tax
benefit during the year ended December 31, 1999.
SFAS No. 109 requires a valuation allowance to reduce the deferred tax
assets reported if, based on the weight of the evidence, it is more likely than
not that some portion or all of the deferred tax assets will not be realized.
After consideration of all the evidence, both positive and negative, management
has determined that a full valuation allowance at December 31, 2001 is necessary
to reduce the deferred tax assets to the amount that will more likely than not
be realized. The increase in the valuation allowance for the current year is
$66.0 million. At December 31, 2001, Digex's net operating loss carryforwards
for income tax purposes are approximately $350.1 million, with expiration
periods beginning in 2019 through 2021. Digex's ability to utilize the net
operating loss carryforwards against any future taxable income may be limited
by, among other things, past and future changes in ownership of the company.
F-31
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13. Loss Per Share
Digex has applied the provisions of SFAS No. 128, Earnings Per Share,
which establishes standards for computing and presenting earnings per share. On
April 30, 1999, Digex issued 1,000 shares of Class B common stock to Intermedia
in connection with the contribution of assets to Digex. Loss per share is
presented on a pro forma basis prior to that period assuming that the common
shares issued in connection with the recapitalization on April 30, 1999 were
outstanding for all periods of Digex presented. On July 23, 1999, the Board of
Directors authorized a 50,000-for-one split of the Class B common stock,
effective as of August 4, 1999 and paid in the form of a stock dividend for
shares outstanding as of July 8, 1999. The basic and diluted net loss per common
share were calculated assuming that the stock split was effective for all
periods presented. All share information presented gives effect to the stock
split.
The following table sets forth computation of basic and diluted loss per
share of common stock (amounts in thousands, except share and per share
information):
Year ended
December 31,
-------------------------------------------
2001 2000 1999
----------- ----------- ------------
Net loss applicable to common stockholders,
as reported ............................ $ (192,484) $ (143,101) $ (64,999)
=========== =========== ============
Weighted average number of common shares ..... 64,076,647 63,404,839 54,726,027
=========== =========== ============
Loss per share:
basic and diluted ...................... $ (3.00) $ (2.26) $ (1.19)
=========== =========== ============
Convertible securities (convertible preferred stock, warrants, and stock
options) to purchase 8,335,310 common shares in 2001, 10,453,049 common shares
in 2000, and 5,704,020 common shares in 1999 were outstanding, but were excluded
from the computation of diluted loss per share because assumed exercise or
conversion would be anti-dilutive.
14. Related Party Agreements
WorldCom
In connection with the Intermedia - WorldCom Merger, Digex and certain
subsidiaries of WorldCom have entered into four commercial agreements, including
a sales channel agreement, funding agreement, facilities agreement, and network
agreement. Except for the funding agreement, all agreements expire on December
31, 2003 and permit either party to request for a 12-month extension from the
initial term, provided that written notice be given to the other party by
December 31, 2002 for the initial extension. The principal terms of the
agreements are as follows:
Sales Channel Agreement. Effective January 1, 2001, WorldCom agreed to
purchase the Digex portfolio of managed Web hosting products for resale to
WorldCom customers. If Digex satisfies certain service level and data center
capacity commitments, WorldCom has agreed to purchase up to a total of
F-32
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$500.0 million during the period from 2001 through 2003. WorldCom has agreed to
purchase $50.0 million and $192.0 million of managed hosting services in 2001
and 2002, respectively. In 2003, WorldCom has agreed to purchase a minimum
amount of managed hosting services equal to the lesser of $260.0 million or an
amount equal to four times the actual services purchased by WorldCom for resale
in the fourth quarter of 2002 ("the Minimum Annual Commitment"). WorldCom agreed
to compensate Digex, on a quarterly basis, for the full amount of operating
losses before depreciation and amortization incurred in servicing WorldCom
customers under the sales channel agreement, during 2001. However, in 2001 and
thereafter, to the extent that Digex generates operating income before
depreciation and amortization in servicing WorldCom under the sales channel
agreement, Digex has agreed to share such operating income with WorldCom.
WorldCom's participation in operating results is recognized as adjustments to
revenue recognized under the sales channel agreement.
Total revenues from WorldCom under the sales channel agreement include (1)
actual managed hosting services purchased for resale by WorldCom and (2) the
difference, if any, between actual managed hosting services purchased by
WorldCom and WorldCom's Minimum Annual Commitment. These amounts are further
adjusted for compensation due to or due from WorldCom as discussed above based
upon the net results of activity under the agreement.
For the year ended December 31, 2001, Digex recognized revenue from
WorldCom of $29.3 million, of which total revenues of $29.1 million were
recorded under the sales channel agreement. Total revenues from actual managed
hosting services were $14.8 million. Total revenues for the difference between
actual managed hosting services sold and the Minimum Annual Commitment were
$32.3 million. These amounts were reduced by $18.0 million, representing
WorldCom's share in the net earnings related to activity under the sales channel
agreement.
Funding Agreement. Refer to Note 6 to the consolidated financial
statements for borrowings from related parties under the note purchase
agreement.
Facilities Agreement. Effective January 1, 2001, managed Web hosting
facilities for Digex were built and may continue to be built in several WorldCom
data centers in the United States and around the world. Digex has leased and
intend to continue to lease space from WorldCom at these data centers based on
customer demand. The payments for the data center space and connections from the
space to a WorldCom Internet Protocol network hub amounted to $1.7 million for
the year ended December 31, 2001.
Network Agreement. This agreement, effective January 1, 2001, provides
terms for Digex to purchase bandwidth and connectivity from WorldCom in the
United States to support its managed Web hosting activities. The payments for
the dedicated Internet connections and WorldCom network services amounted to
approximately $6.0 million for the year ended December 31, 2001.
WorldCom also provides certain operational services to Digex under vendor
contracts or agreements in the ordinary course of business, such as facilities,
telephone and other circuit related services. The following table reflects
charges related to services provided by WorldCom in the ordinary course of
business to Digex (in thousands):
F-33
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Year ended
December 31,
-----------------------
2001 2000
------- ------
Other circuit related expense ................. $ 7,734 $3,234
Telephone expense ............................. 2,480 291
Rent expense .................................. 300 --
------- ------
$10,514 $3,525
======= ======
In January 2002, Digex entered into an affiliates facilities agreement,
effective July 1, 2001, with WorldCom which permits Digex to rent general office
space from WorldCom at certain facilities. The agreement expires when Digex
ceases to be an affiliate of WorldCom, unless earlier terminated by either
party. Rent expense for office space attributed to this agreement is included in
the rent expense for 2001 presented above.
Intermedia
Note Purchase Agreement. Refer to Note 6 to the consolidated financial
statements for borrowings from related parties.
General and Administrative Services Agreement. On April 30, 1999, Digex
entered into a general and administrative services agreement with Intermedia for
Intermedia to provide Digex with back office and administrative services such as
human resources, finance and accounting, tax services, investor relations,
treasury, and information management services. This agreement had an initial
term of two years and expired in April 2001. Under the terms of this agreement,
as amended to date, Intermedia provided Digex with treasury services in the
first quarter of 2001. The charge for these services was minimal for the three
months ended March 31, 2001. The charge for general and administrative services
was $15.0 million in 2000 and $16.5 million in 1999.
Rates charged to Digex in 1999 for these services prior to the G&A
Agreement are believed to be consistent with the allocations in the accompanying
financial statements. Rates for services not previously provided to Digex (e.g.
investor relations) were based upon Intermedia and Digex's best estimate of the
fair value of those services.
Network Services Agreements. Under the terms of the network services
agreements, effective July 1999, with Intermedia, which expired in July 2001,
Intermedia provided Digex with east and west coast Internet transit and Internet
access. Subsequent to the expiration date, Digex continued with Intermedia's
network services at the current monthly rate under the expired network
agreement. Additionally,
F-34
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Intermedia granted a $1.0 million credit for services provided during the first
half of 2001 to Digex in the third quarter of 2001. The charges for the Internet
transit and access services amounted to $0.8 million in 2001, $5.0 million in
2000 and $7.8 million in 1999. Rates charged to Digex in 1999 prior to the
network services agreements were generally consistent with rates incurred during
the periods presented in the accompanying consolidated financial statements.
Asset Migration Agreement. On June 1, 2000, Digex entered into an asset
migration agreement with Intermedia. Under the terms of the agreement, Digex
purchased certain assets, including certain licensed third-party software,
machinery, and equipment from Intermedia at cost to provide independent managed
firewall services. In connection with the purchase of firewall-related assets
from Intermedia, the managed firewall services agreement between Digex and
Intermedia was terminated. Digex paid a purchase price of $4.5 million for the
net book value of these assets and services on June 30, 2000, the closing date
of the agreement. Under the asset migration agreement, Digex has made equal
monthly installments of $0.9 million for Intermedia's support and consultation
for the six months ended December 31, 2000.
Expense Sharing and Indemnity Arrangements. On January 24, 2000, Digex
agreed with Intermedia to allocate and pay the expenses of its February 2000
public offering, including any amounts arising from any indemnification or
contribution obligations, in proportion to the number of shares of Class A
common stock sold by Digex and by Intermedia. Expenses of $0.3 million were
allocated to Digex in 2000 and were netted against offering proceeds.
Sale of Telecommunications Related Assets to Intermedia. Digex entered
into three use of proceeds agreements with Intermedia on June 2, 1999, January
11, 2000, and January 24, 2000, respectively, to sell to Intermedia certain
telecommunications related assets that were purchased by Digex with the net
proceeds of certain offerings of Digex securities and the cash proceeds of the
investments by Microsoft and Compaq. The assets were sold to Intermedia at
Digex's cost. The proceeds from the sale of telecommunications related assets to
Intermedia were approximately $33.7 million and $25.3 million during the years
ended December 31, 2000 and 1999, respectively. These proceeds were unrestricted
and used to fund Digex's operating expenses. Net proceeds from the equity
offerings were fully used as of December 31, 2000.
Guaranty Agreement. On October 31, 2000, Intermedia increased the
commitments available to it under its revolving credit facility from $100.0
million to $350.0 million. As a subsidiary of Intermedia, Digex was a limited
guarantor under the credit facility to the greater of $90.0 million or the
amounts borrowed by Digex. The credit facility was terminated by WorldCom
effective August 1, 2001.
Software, Equipment and Services Purchased from Microsoft and Compaq
In January 2000, Digex entered into strategic development agreements and
joint marketing arrangements with Microsoft and Compaq. Digex and Microsoft will
work together to advance Digex's capabilities to more rapidly install, manage
and upgrade large numbers of Microsoft Windows-based servers for Web site and
application hosting. Digex and Compaq will work jointly to streamline the order,
delivery and installation of Compaq's server hardware and storage devices. There
are no revenues to Digex under these agreements. In connection with these
agreements, Microsoft and a subsidiary of Compaq made a
F-35
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$100.0 million equity investment in Digex, of which $85.0 million was paid in
cash and $15.0 million was paid in the form of equipment credits from Compaq.
Digex has in the past purchased and expects to continue to purchase
computer hardware, software and certain consulting services from both Microsoft
and Compaq pursuant to certain arrangements negotiated prior to or in connection
with the investment by Microsoft and Compaq in Digex. Digex purchased $3.8
million in 2001, $2.7 million in 2000, and $3.1 million in 1999 of products and
services provided by Microsoft. Digex purchased $9.9 million (includes $5.9
million of equipment credits and $1.3 million of equipment financed under a
master lease and financing agreement) in 2001, $29.3 million (includes $2.7
million of equipment credits) in 2000, and $18.7 million in 1999 of products and
services provided by Compaq.
Notes Receivable from Employees
In November 2001, Digex made personal loans to various executive officers
and employees in the amount of $6.8 million as of December 31, 2001. Interest
accrues on these loans at a rate of 3.82% per annum. Principal and accrued
interest on the loan is payable in full on the earlier of (1) November 1, 2003
and (2) the termination of employment of such officer or employee with Digex for
any reason, including termination by Digex with or without cause, termination as
a result of death or disability, resignation for any reason or termination
resulting from constructive discharge.
Digex also entered into retention bonus agreements with certain of its
executive officers and employees. Under the agreements, each such officer or
employee (or his or her estate) is entitled to receive the amounts (1) if he or
she is actively employed with Digex through and including November 1, 2003 or
(2) if prior to that time Digex terminates his or her employment without cause
or his or her employment is terminated as a result of death or permanent
disability. No officer or employee is entitled to the retention bonus under this
agreement, or any pro rata portion thereof, if his or her employment terminates
prior to November 1, 2003 by reason of termination for cause, resignation for
any reason or termination resulting from constructive discharge by Digex. As of
December 31, 2001, the potential retention bonus pool payable in 2003 under
these agreements totaled $11.8 million.
In January 2002, Digex entered into additional retention bonus agreements
for $0.7 million and personal loans of $0.4 million with certain key officers
and employees.
15. Contingencies
On March 2, 2001, Digex, WorldCom, and Intermedia entered into a
definitive Stipulation of Settlement with all relevant parties to settle all
claims related to the consolidated class action and derivative action in
accordance with the terms agreed to in the February 15, 2001 memorandum of
understanding. On April 6, 2001, a final settlement of the consolidated
derivative and class action suits was approved by the Delaware Court of Chancery
in Wilmington, Delaware. On May 7, 2001, the appeals period for appealing the
Chancery Court's approval of the settlement expired with no appeals having been
filed.
Pursuant to the settlement, WorldCom made a payment of WorldCom common
stock having a total value of $165.0 million for distribution to Digex common
stock holders following the closing of the Intermedia - WorldCom Merger in July
2001. One half of the settlement fund net of plaintiffs' attorneys
F-36
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
fees was distributed to record holders of Digex common stock as of September 1,
2000. The balance of the settlement fund net of attorneys' fees was paid to
record holders of Digex stock as of June 29, 2001. Neither Intermedia nor its
affiliates was entitled to any distribution from the settlement fund. The merger
agreement between Intermedia and WorldCom was amended, among other things, to
change the consideration to be paid to Intermedia shareholders in connection
with the merger. The fees and expenses of all plaintiffs and all counsel
representing all plaintiffs in the action were paid out of the settlement fund.
In connection with the settlement, WorldCom has agreed to reimburse Digex for
certain fees and expenses incurred by Digex associated with the merger and the
consolidated lawsuit in an amount not to exceed $15.0 million. A further
provision of the settlement makes Section 203 of the Delaware General
Corporation Law inapplicable to future transactions between WorldCom and Digex.
For every one share of WorldCom Group common stock paid into the
settlement fund, 1/25th of a share of MCI Group common stock was also paid into
such fund. The value of the WorldCom Group common stock and the MCI Group common
stock was based upon the average trading price of 10 trading days randomly
selected from a 20-day trading period from May 31, 2001 through June 27, 2001.
Based on a randomly selected average trading price of $16.672 per share,
WorldCom deposited 9,896,833 shares of WorldCom Group common stock and 395,873
shares of MCI Group common stock into the settlement fund on July 2, 2001.
Approximately 7.5% of the shares deposited into the settlement fund was
distributed to the legal counsel for the plaintiffs in the litigation,
approximately 46.25% of the settlement fund was distributed to the holders of
record of Digex Class A common stock as of September 1, 2000 (based on an
exchange rate of 0.18838 shares of WorldCom Group common stock and 0.00754
shares of MCI Group common stock for each share of Digex Class A common stock),
and the remaining 46.25% was distributed to holders of record of Digex Class A
common stock as of June 29, 2001 (based on an exchange rate of 0.18465 shares of
WorldCom Group common stock and 0.00739 shares of MCI Group common stock for
each share of Digex Class A common stock). On July 9, 2001, Digex received $12.5
million from WorldCom for the reimbursement of certain merger-related fees and
expenses associated with the litigation. Digex does not expect to incur any
future liability from the outcome of this litigation.
Digex does not believe that there are any pending or threatened legal
proceedings that, if adversely determined, would have a material adverse effect
on Digex's consolidated results of operations, cash flows, or financial
position.
16. Selected Quarterly Financial Data (Unaudited)
The following is a summary of unaudited quarterly results of operations
for the years ended December 31, 2001 and 2000 (in thousands):
2001
--------------------------------------------------
First Second Third Fourth
-------- --------- --------- ---------
Revenues .......................... $ 53,052 $ 53,791 $ 52,324 $ 55,186
Operating expenses ................ 97,442 100,571 102,288 99,901
-------- --------- --------- ---------
Loss from operations .............. (44,390) (46,780) (49,964) (44,715)
F-37
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other income (expense) ............ 171 (543) (1,213) (1,025)
-------- --------- --------- ---------
Net loss .......................... (44,219) (47,323) (51,177) (45,740)
Accretion of preferred stock
discount ....................... (1,007) (1,006) (1,006) (1,006)
-------- --------- --------- ---------
Net loss available to common
stockholders ................... $(45,226) $ (48,329) $ (52,183) $ (46,746)
======== ========= ========= =========
Loss per Common Share:
basic and diluted (2) .......... $ (0.71) $ (0.76) $ (0.81) $ (0.73)
======== ========= ========= =========
2000
--------------------------------------------------
First Second Third Fourth
-------- --------- --------- ---------
Revenues .......................... $ 25,796 $ 40,368 $ 43,979 $ 57,942
Operating expenses ................ 54,568 78,325 84,875 100,930
-------- --------- --------- ---------
Loss from operations .............. (28,772) (37,957) (40,896) (42,988)
Other income (expense) ............ 3,057 3,472 (393) 1,542
-------- --------- --------- ---------
Loss before cumulative effect
of change in accounting
principle ...................... (25,715) (34,485) (41,289) (41,446)
Cumulative effect of change in
accounting principle ........... (166) -- -- --
-------- --------- --------- ---------
Net loss .......................... $(25,881) $ (34,485) $ (41,289) $ (41,446)
======== ========= ========= =========
Loss per Common Share (1):
basic and diluted (2) .......... $ (0.41) $ (0.54) $ (0.65) $ (0.65)
======== ========= ========= =========
- ----------
(1) Represents loss before cumulative effect of change in accounting principle
and net loss per common share.
(2) The sum of the net loss for the four quarters in both years differs from
the annual loss per share due to the required method of computing the
weighted average number of common shares outstanding in the interim
period.
17. Subsequent Events (Unaudited)
During the first quarter of 2002, WorldCom caused Intermedia to purchase a
series of senior notes totaling $8.2 million from Digex under the note purchase
agreement. Through March 31, 2002, variable interest on the unpaid principal
balance was paid monthly at an average interest rate of 5.11% per annum.
Repayment of principal is due on December 31, 2002, unless otherwise extended at
the election of Digex.
F-38
DIGEX, INCORPORATED
SCHEDULE II
VALULATION AND QUALIFYING ACCOUNTS
(Amounts in thousands)
Additions
----------------------
Balance at Charged to Charged Deductions Balance at
Beginning Costs and To Other -- End of
Description Of Period Expenses Accounts Describe Period
- ----------------------------------------- ---------- ---------- -------- ---------- ----------
For the year ended December 31, 1999:
Deducted from asset accounts:
Allowance for doubtful accounts $ 719 $ 4,265 -- $ 622(1) $ 4,362
==================================================================
Allowance for deferred tax accounts $ 5,349 $13,143 -- -- $ 18,492
==================================================================
For the year ended December 31, 2000:
Deducted from asset accounts:
Allowance for doubtful accounts $ 4,362 $10,649 -- $10,270(1) $ 4,741
==================================================================
Allowance for deferred tax accounts $18,492 $56,757 -- -- $ 75,249
==================================================================
For the year ended December 31, 2001:
Deducted from asset accounts:
Allowance for doubtful accounts $ 4,741 $15,374 -- $15,309(1) $ 4,806
==================================================================
Allowance for deferred tax accounts $75,249 $66,040 -- -- $141,289
==================================================================
- ----------
(1) Uncollectible accounts written off, net of recoveries.
F-39