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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Quarter Ended March 31, 2003
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number: 000-26873
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DIGEX, INCORPORATED
(Exact name of registrant as specified in its charter)
DELAWARE 59-3582217
(State or other (I.R.S. Employer
jurisdiction Identification Number)
of incorporation or
organization)
14400 Sweitzer Lane
Laurel, MD 20707
(Address of principal executive offices)
(240) 264-2000
Telephone Number
-----------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [_] No [X]
As of April 30, 2003, there were 25,519,461 and 39,350,000 shares of the
Registrant's Class A and Class B Common Stock outstanding, respectively.
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DIGEX, INCORPORATED
INDEX
Page No.
--------
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited):
Consolidated Statements of Operations--Three months ended March 31, 2003 and
2002...................................................................... 3
Consolidated Balance Sheets--March 31, 2003 and December 31, 2002........... 4
Consolidated Statements of Cash Flows--Three months ended March 31, 2003 and
2002...................................................................... 5
Notes to Consolidated Financial Statements.................................. 6
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations................................................................ 16
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk.................. 27
ITEM 4. Controls and Procedures..................................................... 27
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings........................................................... 28
ITEM 2. Changes in Securities and Use of Proceeds................................... 29
ITEM 3. Defaults Upon Senior Securities............................................. 29
ITEM 4. Submission of Matters to a Vote of Security Holders......................... 29
ITEM 5. Other Information........................................................... 29
ITEM 6. Exhibits and Reports on Form 8-K............................................ 29
Signatures.................................................................. 30
2
PART 1: FINANCIAL INFORMATION
ITEM 1. Financial Statements
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited (Amounts in Thousands, Except Share and Per Share Data)
Three Months Ended
March 31,
------------------------
2003 2002
----------- -----------
Revenue:
Revenue..................................................................... $ 27,412 $ 40,868
Revenue from WorldCom....................................................... 12,416 10,889
----------- -----------
Total revenue........................................................... 39,828 51,757
Costs and expenses:
Cost of operations.......................................................... 3,310 4,288
Cost of services............................................................ 20,706 25,070
Selling, general and administrative......................................... 14,690 28,011
Provision for doubtful accounts............................................. 125 1,265
Provision for doubtful accounts for WorldCom................................ -- 908
Deferred compensation....................................................... -- 597
Depreciation and amortization............................................... 25,192 40,223
----------- -----------
Total costs and expenses................................................ 64,023 100,362
----------- -----------
Loss from operations........................................................... (24,195) (48,605)
Other income (expense):
Interest expense............................................................ (2,063) (1,992)
Interest income and other................................................... 139 161
----------- -----------
Loss before cumulative effect of change in accounting principle................ (26,119) (50,436)
Cumulative effect of change in accounting principle............................ (869) --
----------- -----------
Net loss....................................................................... (26,988) (50,436)
Accretion of preferred stock discount.......................................... (503) (1,006)
----------- -----------
Net loss available to common stockholders...................................... $ (27,491) $ (51,442)
=========== ===========
Loss per common share--basic and diluted:
Loss before cumulative effect of change in accounting principle............. $ (0.41) $ (0.80)
=========== ===========
Cumulative effect of change in accounting principle......................... $ (0.01) $ --
=========== ===========
Net loss per common share................................................... $ (0.42) $ (0.80)
=========== ===========
Pro forma net loss and loss per common share, assuming the accounting change is
applied retroactively:
Net loss available to common stockholders................................... $ (51,506)
===========
Net loss per common share................................................... $ (0.80)
===========
Shares used in computing basic, diluted and pro forma net loss per share....... 64,869,461 64,138,466
=========== ===========
See accompanying notes to consolidated financial statements.
3
DIGEX, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Amounts in Thousands, Except Share Information)
March 31, December 31,
2003 2002
----------- ------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents................................................................ $ 20,047 $ 20,897
Restricted investments................................................................... 2,017 3,059
Accounts receivable, net of allowance of $3,257 in 2003 and $3,563 in 2002............... 7,836 12,165
Due from WorldCom, net of allowance of $18,264 in 2003 and 2002.......................... -- --
Deferred costs........................................................................... 3,898 4,908
Notes receivable from employees.......................................................... 5,829 6,008
Prepaid expenses and other current assets................................................ 5,307 5,999
--------- ---------
Total current assets.................................................................. 44,934 53,036
Property and equipment, net.................................................................. 126,976 149,195
Goodwill..................................................................................... 11,880 11,880
Intangible assets, net....................................................................... 4,144 4,388
Other assets................................................................................. 2,749 2,340
--------- ---------
Total assets.......................................................................... $ 190,683 $ 220,839
========= =========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Accounts payable and accrued expenses.................................................... $ 37,717 $ 38,510
Due to WorldCom.......................................................................... 14,423 11,557
Current portion of deferred liabilities.................................................. 4,108 5,071
Current portion of notes payable......................................................... 3,651 209
Current portion of notes payable to Intermedia........................................... 122,942 50,550
Current portion of capital lease obligations............................................. 6,391 6,374
--------- ---------
Total current liabilities............................................................. 189,232 112,271
Deferred liabilities......................................................................... 1,176 1,680
Other long-term liabilities.................................................................. 1,539 --
Notes payable................................................................................ -- 3,299
Notes payable to Intermedia.................................................................. -- 76,650
Capital lease obligations.................................................................... 22,489 23,989
--------- ---------
Total liabilities..................................................................... 214,436 217,889
--------- ---------
Commitments and contingencies
Redeemable preferred stock, $.01 par value; 5,000,000 shares authorized; 100,000 shares
designated as Series A Convertible; 50,000 and 100,000 Series A Convertible shares issued
and outstanding in 2003 and 2002, respectively(aggregate liquidation preference of
$50,000).................................................................................... 46,478 45,748
Stockholders' deficit:
Class A common stock, $.01 par value; 100,000,000 shares authorized; 25,519,461 shares
issued and outstanding in 2003 and 2002................................................. 255 255
Class B common stock, $.01 par value; 50,000,000 shares authorized; 39,350,000 shares
issued and outstanding in 2003 and 2002................................................. 394 394
Additional capital....................................................................... 586,616 587,119
Accumulated deficit...................................................................... (657,549) (630,561)
Accumulated other comprehensive income (loss)............................................ 53 (5)
--------- ---------
Total stockholders' deficit........................................................... (70,231) (42,798)
--------- ---------
Total liabilities and stockholders' deficit........................................... $ 190,683 $ 220,839
========= =========
See accompanying notes to consolidated financial statements
4
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited (Amounts in Thousands)
Three Months Ended
March 31,
------------------
2003 2002
-------- --------
Operating Activities:
Net loss.............................................................................. $(26,988) $(50,436)
Cumulative effect of change in accounting principle................................... 869 --
-------- --------
Loss before cumulative effect of change in accounting principle....................... (26,119) (50,436)
Adjustments to reconcile net loss to cash provided by (used in) operating activities:
Depreciation and amortization..................................................... 25,192 40,223
Provision for doubtful accounts................................................... 125 1,265
Provision for doubtful accounts for WorldCom...................................... -- 908
Amortization of deferred compensation............................................. -- 597
Accretion expense on asset retirement obligation.................................. 44 --
Accretion of interest on note payable and capital lease obligations............... 157 150
Changes in operating assets and liabilities:
Accounts receivable............................................................... 4,204 2,969
Due to WorldCom, net.............................................................. 2,866 2,491
Deferred costs.................................................................... 1,012 858
Prepaid expenses and other current assets......................................... 691 2,002
Notes receivable from employees................................................... 179 (423)
Other assets...................................................................... (408) 546
Accounts payable and accrued expense.............................................. (793) 63
Deferred liabilities.............................................................. (1,467) (1,343)
-------- --------
Net cash provided by (used in) operating activities............................ 5,683 (130)
Investing Activities:
Purchases of property and equipment................................................... (1,996) (12,676)
Purchase of restricted investments.................................................... -- (20)
Maturity of restricted investments.................................................... 1,042 --
Proceeds from sale of property and equipment.......................................... 156 200
-------- --------
Net cash used in investing activities.......................................... (798) (12,496)
Financing Activities:
Proceeds from issuances of notes payable.............................................. -- 13,200
Payments on notes payable............................................................. (4,259) --
Principal payment on long-term note payable and capital lease obligations............. (1,534) (1,808)
-------- --------
Net cash (used in) provided by financing activities............................ (5,793) 11,392
Effect of exchange rate on cash and cash equivalents..................................... 58 22
-------- --------
Net decrease in cash and cash equivalents................................................ (850) (1,212)
Cash and cash equivalents at beginning of period......................................... 20,897 12,096
-------- --------
Cash and cash equivalents at end of period............................................... $ 20,047 $ 10,884
======== ========
Supplemental Disclosures of Cash Flow Information:
Interest paid......................................................................... $ 2,007 $ 4,400
Assets purchased with equipment credits granted in connection with the issuance of
preferred stock..................................................................... 227 1,486
Assets acquired through capital leases................................................ 36 981
See accompanying notes to consolidated financial statements.
5
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Organization and Recent Events
Organization
Digex, Incorporated's ("Digex") 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. ("Intermedia")
in July 1997. In contemplation of Digex's initial public offering, the Company
was incorporated as Digex, Incorporated in April 1999, and Business Internet
contributed assets to the newly formed Digex, Incorporated in order to effect a
recapitalization of Digex's business.
Digex is a provider of Web, application, and enterprise managed hosting
services for business worldwide. Today, Digex customers, from Fortune 1000
companies to leading Internet-based businesses, leverage Digex's services to
successfully deploy business-critical and mission-critical Web sites,
enterprise applications and Web services on the Internet. These companies use
Digex's services to power various types of business solutions including
corporate Web sites, on-line commerce, and back-office applications. Digex
operates in a single segment, primarily in the United States.
WorldCom has an indirect controlling interest of Digex through Intermedia as
Intermedia owns approximately 60.7% of Digex's equity interests and controls
93.9% of Digex's voting interests, calculated based on total common stock
outstanding, as of March 31, 2003.
In connection with 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, borrows to satisfy cash requirements, and
purchases certain telecommunication services from WorldCom. These agreements
are discussed in more detail in Note 7.
Digex's operations are subject to certain risks and uncertainties. Please
review the "Risk Factors" section of the Digex 10-K for the year ended December
31, 2002 as filed with the Securities and Exchange Commission ("SEC") on March
31, 2003 for discussion of these risks and uncertainties.
Recent Events Related to WorldCom and Digex
Digex's revenues have been negatively impacted by both the market and the
impact of the issues surrounding WorldCom's bankruptcy. Even though Digex
successfully implemented a number of expense reduction initiatives during 2002
and the first quarter of 2003, Digex needs to grow its revenues, either from
existing customers or new customers. Digex's 2003 business plan still requires
funding to support its cash needs for operations and debt repayment. The timing
and amount of Digex's funding needs can and will materially change due to the
uncertainties surrounding WorldCom, changes in the economy, changes to Digex's
target market, Digex's ability to execute on its business plan, and the outcome
of the strategic alternatives process, among other factors.
Digex's board of directors has formed a special committee to explore
strategic alternatives, including a possible sale of the company. The special
committee, which is comprised of independent directors, has retained Lane Berry
& Co. International as its financial advisor. There can be no assurance that
any transaction or other corporate action will result from this effort. The
exploration of strategic alternatives for Digex may result in, among other
things, increased expenses, interference with customer relationships and
diversion of management's attention.
6
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Digex did not borrow funds from WorldCom during the first quarter of 2003.
The funding agreement Digex had in place with WorldCom expired on December 31,
2002 and Digex currently does not have other funding arrangements in place.
Although Digex has had, through the special committee of its board of
directors, discussions with potential funding sources, there can be no
assurance that Digex will be successful in obtaining funding for its 2003
requirements. Additionally, Digex has filed proofs of claim in the WorldCom
bankruptcy proceedings for more than $157 million of claims related to the
amounts due to Digex from WorldCom under the Digex-WorldCom Master Channel
Agreement, along with other pre-petition amounts due to Digex from WorldCom
(see Note 7). Some portion of those claims may entitle Digex to set off those
amounts against amounts due to WorldCom. In connection with Digex's proofs of
claim filed in the WorldCom related bankruptcy proceedings and the impact those
claims may have on amounts finally determined to be due to or from WorldCom,
Digex has withheld principal and interest payments under the funding agreements
totaling $5.1 million potentially due to WorldCom pending the resolution of
those claims. WorldCom has objected to Digex withholding these amounts, but has
expressed its intent to resolve these issues with Digex. Although Digex has not
received, and would contest vigorously, any acceleration notice from WorldCom
related to the outstanding amounts, until the proofs of claim are resolved, the
Company has classified all outstanding notes payable as current obligations at
March 31, 2003.
Without funding from an external source, receiving payment for Digex's
proofs of claim and/or obtaining the right of offset between the amounts due to
Digex from WorldCom and amounts due to WorldCom under the note purchase
agreements, Digex may not have sufficient cash to meet its projected needs for
debt service, working capital and capital expenditures through the end of 2003.
The liquidity issues discussed above raise substantial doubt about Digex's
ability to continue as a going concern. Substantial doubt about an entity's
ability to continue as a going concern exists when the entity is unable to
continue to meet its obligations as they become due without substantial
disposition of assets outside the ordinary course of business, restructuring of
debt, externally forced revisions of its operations, or similar actions for a
reasonable period of time, not to exceed one year beyond the date of the
financial statements. Digex's ability to continue as a going concern is
dependent upon a number of factors, including, but not limited to, attainment
of funding from external sources, settlement of the proofs of claim with
WorldCom, and future revenue retention and growth plans.
2. 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.
Basis of Presentation
The accompanying consolidated financial statements have been prepared by
Digex, Incorporated without audit, pursuant to the rules and regulations of the
SEC. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles ("GAAP") have been omitted pursuant to such rules and regulations.
The unaudited consolidated financial statements
7
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
contained herein should be read in conjunction with the consolidated financial
statements, notes thereto and other information included in the Form 10-K of
Digex for the year ended December 31, 2002 as filed with the SEC on March 31,
2003.
The accompanying unaudited 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 accompanying unaudited consolidated financial statements reflect, in the
opinion of management, all adjustments, which are of a normal and recurring
nature, necessary for a fair presentation of the financial condition and
results of operations and cash flows for the periods presented.
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.
Digex has adopted the disclosure only provisions of Statement of Financial
Accounting Standards (SFAS) No. 148, Accounting for Stock-Based
Compensation--Transition and Disclosure. 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. 148, is as follows (in thousands, except
per share information):
Three Months Ended
March 31,
------------------
2003 2002
-------- --------
Net loss, as reported(1)................................................ $(26,988) $(50,436)
Deduct: Total stock-based employee compensation expense determined under
fair value based method for all awards, net of related tax effects (2) -- (3,856)
-------- --------
Pro forma net loss...................................................... $(26,988) $(54,292)
======== ========
Net loss per common share:
Basic and diluted--as reported....................................... $ (0.42) $ (0.80)
======== ========
Basic and diluted--pro forma......................................... $ (0.42) $ (0.86)
======== ========
- --------
(1) Reported net loss includes stock-based employee compensation costs, net of
tax, of $0.0 million and $0.6 million for the three months ended March 31,
2003 and 2002, respectively.
(2) All outstanding options became fully vested in 2002 following the
Intermedia-WorldCom Merger. Additionally, no options have been granted
since January 2001.
Recent Accounting Pronouncements
Accounting for Asset Retirement Obligations
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, Accounting for Asset Retirement Obligations. This statement addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. SFAS No. 143 applies to legal obligations associated with the retirement
of long-lived assets that result from the acquisition, construction,
development and (or) the normal operation of a long-lived asset, except for
certain obligations of lessees. SFAS No. 143 is effective for financial
statements issued for fiscal years beginning after June 15, 2002.
8
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Digex leases the property and buildings in which its data centers reside.
Under those lease agreements, Digex may be required to remove certain capital
equipment and other related improvements upon termination of the lease.
Effective January 1, 2003, Digex adopted the provisions of SFAS No. 143.
Prior to the adoption, Digex recognized amounts related to asset retirement
obligations as operating expenses only when expenses were incurred. Under SFAS
No. 143, Digex now recognizes asset retirement obligations, at their estimated
fair value, in the period in which the obligation is incurred.
Digex recorded the effect of the adoption of SFAS No. 143 of approximately
$0.9 million on January 1, 2003, as a cumulative effect of a change in
accounting principle in the accompanying unaudited consolidated statement of
operations for the three-month period ended March 31, 2003. There is no income
tax impact as the potential tax benefit associated with this amount has been
offset by a corresponding increase in Digex's valuation allowance. In addition
to the cumulative effect of change in accounting principle recorded in the
statement of operations as of January 1, 2003, Digex recorded an asset
retirement obligation and capitalized the cost of the obligation as part of the
carrying amount of the data center facilities. As of January 1, 2003, the asset
retirement obligation approximated $1.5 million and the net book value of the
related capitalized asset approximated $0.6 million.
For the three-month period ending March 31, 2003, Digex recorded accretion
expense related to the asset retirement obligation of approximately $44,000 and
depreciation expense of approximately $25,000 for the costs capitalized related
to the asset retirement obligation.
The following table provides a roll-forward of Digex's asset retirement
obligations (in thousands):
Liabilities
Obligation at Incurred Liabilities Accretion Obligation at
December 31, 2002 in Transition Settled Expense March 31, 2003
----------------- ------------- ----------- --------- --------------
$-- $1,495 $-- $44 $1,539
=== ====== === === ======
Accounting for Costs Associated with Exit or Disposal Activities
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which supercedes Emerging Issues Task Force
(EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring), to be applied prospectively to exit or disposal activities
initiated after December 31, 2002, with early adoption permitted.
SFAS No. 146 requires companies to recognize costs associated with exit or
disposal activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. Costs covered by the standard include
lease termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, plant closing, or
other exit or disposal activity. Digex adopted SFAS No. 146 as of January 1,
2003, and it has not had a material impact on its consolidated results of
operations or financial position.
Accounting for Guarantees
In November 2002, the FASB issued Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). FIN 45
9
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
requires certain guarantees to be recorded at fair value. This is different
from current practice, which is generally to record a liability only when a
loss is probable and reasonably estimable, as those terms are defined in FASB
Statement No. 5, Accounting for Contingencies. FIN 45 also requires a guarantor
to make new disclosures, even when the likelihood of making any payments under
the guarantee is remote, which is another change from current practice. The
initial recognition and measurement provisions of FIN 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements under FIN 45 are effective for financial statements of
interim or annual periods ending after December 15, 2002. Currently, Digex does
not believe it has entered into any guarantees that fall within the guidance of
FIN 45.
Accounting for Variable Interest Entities
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"), which clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements, to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. Certain disclosure requirements of FIN 46 are
effective for financial statements of interim or annual periods issued after
January 31, 2003. FIN 46 applies immediately to variable interest entities
created, or in which an enterprise obtains an interest, after January 31, 2003.
For variable interest entities in which an enterprise holds a variable interest
that it acquired before February 1, 2003, FIN 46 applies to interim or annual
periods beginning after June 15, 2003. Digex does not believe that FIN 46 will
have a material impact on its consolidated financial statements.
3. Comprehensive Loss
The following table reflects the calculation of comprehensive losses (in
thousands):
Three Months Ended
March 31,
------------------
2003 2002
-------- --------
Net loss available to common stockholders.......... $(27,491) $(51,442)
Other comprehensive income:
Foreign currency translation adjustments........ 58 22
-------- --------
Comprehensive loss available to common stockholders $(27,433) $(51,420)
======== ========
4. Notes Payable
Notes payable consisted of the following (in thousands):
March 31, December 31,
2003 2002
--------- ------------
Notes payable to Intermedia................... $ 122,942 $127,200
Note payable to State of MD--Sunny Day Fund... 3,307 3,150
Note payable to State of MD--MITP............. 150 150
Note payable to Prince George's County........ 194 208
--------- --------
Total notes payable, including current portion 126,593 130,708
Less: current portion......................... (126,593) (50,759)
--------- --------
Long-term notes payable....................... $ -- $ 79,949
========= ========
10
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In connection with Digex's proofs of claim filed in the WorldCom related
bankruptcy proceedings and the impact those claims may have on amounts finally
determined to be due to or from WorldCom, Digex has withheld principal and
interest payments under the funding agreements totaling $5.1 million
potentially due to WorldCom pending the resolution of those claims. WorldCom
has objected to Digex withholding these amounts, but has expressed its intent
to resolve these issues with Digex. Although Digex has not received, and would
contest vigorously, any acceleration notice from WorldCom related to the
outstanding amounts, until the proofs of claim are resolved, the Company has
classified all outstanding notes payable as current obligations at March 31,
2003.
For a discussion of the notes payable to Intermedia, see Note 7 below.
5. Commitments and Contingencies
On August 1, 2002, the law firm of Richards Layton & Finger ("Richards
Layton") requested that the Delaware Chancery Court enter judgment against
Digex for payment of success bonuses of $500,000 each to Richards Layton and a
second law firm, Cahill Gordon & Reindel ("Cahill Gordon"), in connection with
their representation of the former Special Committee ("FSC") of the Digex board
of directors in In re Digex, Inc. Shareholders Litigation, Consolidated Civil
Action No. 18336 (Del. Ch.) (the "Shareholder Action"). The request sought
modification of a Chancery Court order of July 29, 2002 (the "Order"), which
required WorldCom to pay $1,860,187.14 to reimburse certain expenses approved
by the FSC pursuant to the settlement of the Shareholder Action, including the
success bonuses for Richards Layton and Cahill Gordon. Insofar as the
bankruptcy of WorldCom prevented immediate enforcement of the Order against
WorldCom, Richards Layton sought the requested modification to obtain payment
directly from Digex. On August 23, 2002, the Chancery Court denied Richards
Layton's request on the grounds that WorldCom's bankruptcy, commenced before
the issuance of the Order, deprived the Chancery Court of authority to
adjudicate WorldCom's liability for expenses of the FSC, and, therefore,
rendered the Order void ab initio. The FSC subsequently sought leave of the
Bankruptcy Court to pursue collection of the expenses from Digex
notwithstanding the WorldCom bankruptcy. By order dated January 30, 2003, the
Bankruptcy Court denied that request on the grounds that (i) the Chancery Court
had correctly determined that the Order was void ab initio and (ii) separate
proceedings seeking payment of the expenses directly by Digex would
"necessarily implicate WorldCom because of the interrelationship of the parties
in the underlying dispute."
Neither the FSC nor its counsel have subsequently instituted any proceedings
to collect the claimed fees and expenses directly from Digex. It is not
possible to determine at this point whether the FSC will elect to pursue its
claims for the fees and expenses directly against Digex, either before or after
the conclusion of the WorldCom bankruptcy proceedings.
In December 2002 and January 2003, Digex was sued in two separate cases
brought by employees alleging discrimination. The first alleges that Digex
discriminated against the employee when she was not selected for the CEO
position in June 2002 following Digex's termination of its then CEO, and
further claims that Digex has subsequently retaliated against her in the terms
and conditions of her employment, even though her compensation package remains
unchanged. The second alleges discrimination based on an alleged failure by
Digex to promote this individual to a newly created position, and further
claims that she has been demoted, even though her title and compensation remain
unchanged. Both complaints include multi-million dollar claims for damages;
however, neither details the basis for such damages. Although Digex is not able
to predict the outcome of these cases, Digex believes the claims are without
merit and is defending itself vigorously.
In February, 2003, Digex was sued by Computer Associates International, Inc.
The complaint alleges breach of contract on the part of Digex, and seeks
damages of $6,427,815.90. This matter is in its initial stages.
11
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Although Digex is not able to predict with any reasonable certainty the likely
outcome of this arbitration, Digex believes that Computer Associates' complaint
is without merit and Digex has filed a counterclaim for damages exceeding
amounts sought by Computer Associates in the litigation.
In the ordinary course of business, Digex is party to litigation. Management
does not believe that the outcome of such litigation will materially affect
Digex or these unaudited consolidated financial statements.
Digex is also indebted to WorldCom as discussed in Note 7 below.
6. Restructuring Charges
In the first quarter of 2003, Digex paid approximately $0.4 million in lease
costs for office properties which have been permanently vacated. As of March
31, 2003 and December 31, 2002, Digex has $3.4 million and $3.8 million,
respectively, accrued in the caption "Accounts payable and accrued expenses" of
its consolidated balance sheet to account for future obligations for severance
benefits and permanently vacated office properties. The following table
provides a roll-forward of Digex's restructuring liabilities (in thousands):
Reserve at Reserve at
December 31, Cash March 31,
2002 Accrual Paid 2003
------------ ------- ----- ----------
Severance benefits............. $ 326 $-- $ -- $ 326
Other exit costs............... 3,514 -- (435) 3,079
------ --- ----- ------
Total restructuring charges. $3,840 $-- $(435) $3,405
====== === ===== ======
7. Related Party Agreements
WorldCom
In connection with the Intermedia-WorldCom Merger and the settlement of
related litigation, Digex and certain subsidiaries of WorldCom entered into
four commercial agreements, including a sales channel agreement, funding
agreement, facilities agreement, and network agreement. Except for the funding
agreement, these agreements run through December 31, 2003 and permit either
party to request 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. Neither party gave notice of extension to the other party by
December 31, 2002. As such, the agreements, excluding the funding agreement,
expire on December 31, 2003. The four agreements are also subject to
termination by either party upon insolvency of the other. There can be no
assurance that changes to the commercial agreements will not be made, or that
WorldCom will be in a position to honor the terms of the commercial agreements,
as WorldCom's bankruptcy filing progresses. 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. Through the sales channel agreement, WorldCom has sold the
Digex portfolio of managed hosting products; however, it has not met committed
sales targets. WorldCom agreed to purchase up to a total of $500.0 million
during the period from 2001 through 2003, contingent on Digex's satisfaction of
certain levels of service and data center capacity. WorldCom agreed to purchase
$50.0 million and $192.0 million of managed hosting services in 2001 and 2002,
respectively. WorldCom also agreed to 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"). In addition, WorldCom
agreed to compensate Digex, on a quarterly basis, for the full amount of
operating losses before depreciation and amortization incurred
12
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
Digex recognized revenue from WorldCom of $12.4 million and $10.9 million
for the three months ended March 31, 2003 and 2002, respectively, all of which
was recorded under the sales channel agreement. All revenue recognized under
the sales channel agreement for the three months ended March 31, 2003 and 2002
resulted from actual managed hosting services purchased for resale by WorldCom.
On June 25, 2002, WorldCom announced that it would restate certain financial
statements, and it filed for bankruptcy on July 21, 2002. As a result of these
events, Digex fully reserved for approximately $18.3 million in sales channel
agreement related receivables as of June 30, 2002. Further, since July 1, 2002,
Digex has recognized revenues from WorldCom only upon collection. As a result,
approximately $3.6 million in service related billings for the period from July
1, 2002 until WorldCom filed for bankruptcy on July 21, 2002, have not yet been
recognized as revenue as such amounts have not yet been collected. Future
revenues from the sales channel agreement may be adversely affected by
WorldCom's bankruptcy filing.
Although Digex submitted proofs of claim to the bankruptcy court for amounts
due from WorldCom for the difference between the actual 2002 WorldCom Annual
Volume Commitment and amounts billed to WorldCom for actual managed Web hosting
services in 2002, Digex has not yet recognized these amounts as revenues in
2002 or 2003 due to the uncertainties surrounding collection of such amounts
from WorldCom.
Funding Agreement. Refer to "Borrowings from Related Parties" below.
Facilities Agreement. Effective January 1, 2001, managed Web hosting
facilities for Digex were built in several WorldCom data centers in the United
States and around the world. Digex has leased space from WorldCom at these data
centers based on customer demand. The expense for the data center space and
connections from the space to a WorldCom Internet Protocol network hub amounted
to $0.5 million and $1.0 million for the three months ended March 31, 2003 and
2002, respectively.
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 expense for
the dedicated Internet connections and WorldCom network services amounted to
$0.5 million and $0.6 million for the three months ended March 31, 2003 and
2002, respectively.
WorldCom also provides certain operational services to Digex under vendor
contracts or agreements in the ordinary course of business, including
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):
Three Months Ended
March 31,
-------------------
2003 2002
-------- --------
Other circuit related expense.... $708 $1,701
Telephone expense................ 160 734
Rent expense..................... 129 455
-------- --------
$997 $2,890
======== ========
13
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 the three months ended March 31, 2003 and 2002
presented above.
The agreements are subject to termination by either party upon insolvency of
the other. There can be no assurance that changes to the commercial agreements
will not be made, or that WorldCom will be in a position to honor the terms of
the commercial agreements, as WorldCom's bankruptcy filing progresses.
Borrowings from Related Parties
On July 31, 2001, Digex entered into a note purchase agreement with WorldCom
whereby WorldCom agreed to provide funding, in the form of floating rate
interest senior notes, for the Digex business plans for 2001 and 2002 as
approved by the Digex and WorldCom boards of directors.
In 2002 and 2001, Digex issued and WorldCom caused Intermedia to purchase,
under the note purchase agreement, a series of senior notes totaling $102.2
million to satisfy Digex's net cash requirements under its approved 2002 and
2001 business plans. Variable interest on the unpaid principal balance is
accrued monthly at an interest rate of 300 basis points over LIBOR rate
(weighted average interest rate of 5.0% in 2003 and 5.1% in 2002). Interest
cost incurred and charged to expense related to the funding agreement with
WorldCom was $1.1 million and $0.8 million for the three months ended March 31,
2003 and 2002, respectively. On December 11, 2002, Digex notified WorldCom and
Intermedia that it had elected to extend the maturity date of all outstanding
notes under the agreement from December 31, 2002 to December 31, 2006, as
permitted by the note purchase agreement. Due to this election, outstanding
amounts under the agreement will be due in equal monthly straight-line
amortization payments of principal through December 31, 2006. From inception of
the note through March 31, 2003, Digex has paid an aggregate of $10.1 million
in interest and principal payments to Intermedia under this note purchase
agreement.
Prior to the issuance of the floating rate senior notes discussed above,
Digex 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; or (4) an event of 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 4.5% per annum.
On June 26, 2001, Digex borrowed $6.0 million from Intermedia as an
intercompany loan at an interest rate of 14.1%. 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 5.7%.
On January 14, 2002, Digex entered into a note purchase agreement with
Intermedia to refinance the $13.0 million intercompany loan and $12.0 million
promissory note to Intermedia under a senior note totaling $25.0 million. The
terms of the agreement are substantially the same as the original note purchase
agreement (see above), 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. Variable interest on the unpaid
14
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
principal balance is accrued monthly at an interest rate of 300 basis points
over LIBOR rate (weighted average interest rate of 5.0% in 2003 and 5.4% in
2002). Interest cost incurred and charged to expense related to the funding
agreement with Intermedia was $0.3 million in the three months ended March 31,
2003 and 2002. Through March 31, 2003, Digex has paid an aggregate of $2.0
million in interest payments to Intermedia under this note purchase agreement.
Notes Receivable from Employees
Digex made personal loans to various executive officers and employees in
November 2001 and February 2002. Amounts outstanding, net of reserves for
doubtful accounts, are $5.8 million and $6.0 million as of March 31, 2003 and
December 31, 2002, respectively. 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 or (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. Since March 31, 2002, personal loans to officers have not been made
and are not permitted.
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 a bonus (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 March 31, 2003 and December 31, 2002, the potential retention
bonus payable in November 2003 under these agreements totaled $12.2 million, of
which $9.3 million and $6.8 million was accrued as of March 31, 2003 and
December 31, 2002, respectively.
8. Subsequent Events
On May 8, 2003, MCI executive Jonathan Crane replaced William Grothe as a
member of the Digex board of directors and its chairman.
15
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion should be read in conjunction with the unaudited
consolidated financial statements and related notes herein, and with the
Management's Discussion and Analysis of Financial Condition and Results of
Operations and audited consolidated financial statements and related notes
included in Digex's Form 10-K for the year ended December 31, 2002, as filed
with the SEC on March 31, 2003.
Overview
We are a provider of Web, application, and enterprise managed hosting
services for businesses. Our services include server management, application
support, managed networking services, and customer care and support services.
We also offer advanced 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 March 31, 2003, we served 566 customers, of which 228 came through the
WorldCom channel. For those customers, we manage 3,165 Windows-based,
UNIX-based and Linux-based servers in our data center facilities. Our data
center facilities are positioned on the east and west coasts of the United
States, in Europe and in Asia. Of the 3,165 total managed servers, 1,038 were
sold through the sales channel agreement with WorldCom.
Related Party Transactions
WorldCom is our majority stockholder, primary lender, a significant customer
and one of our largest vendors. On July 21, 2002, WorldCom and many of its
domestic affiliates, but not including Digex, filed a petition for
reorganization in the federal bankruptcy court of New York. The following day,
the bankruptcy court approved an interim credit agreement between WorldCom and
certain banks, which allows WorldCom to continue to make investments in Digex
of up to $10.0 million per month.
Our 2003 business plan will require external funding. Due to the
uncertainties surrounding WorldCom, and our historical dependency on WorldCom
to provide funding, our board of directors formed a special committee to
explore strategic alternatives, including a possible sale of the company. The
special committee, which is comprised of independent directors, has retained
Lane Berry & Co. International as its financial advisor. There can be no
assurance that any transaction or other corporate action will result from this
effort.
During 2002, we borrowed $37.2 million, including $13.2 million in the first
quarter, from WorldCom which was significantly less than the budgeted amounts
included in the 2002 business plan. We did not borrow funds from WorldCom
during either the fourth quarter of 2002 or the first quarter of 2003. The
funding agreement we had in place with WorldCom expired on December 31, 2002
and we currently do not have other funding arrangements in place. Although we
have had, through the special committee of our board of directors, discussions
with potential funding sources, there can be no assurance that we will be
successful in obtaining funding for our 2003 requirements. Additionally, we
have filed proofs of claim in the WorldCom bankruptcy proceedings for more than
$157 million of claims related to the amounts due to us from WorldCom under the
Digex-WorldCom Master Channel Agreement, along with other pre-petition amounts
due to us from WorldCom. Some portion of those claims may entitle us to set off
those amounts against amounts due to WorldCom. Without funding from an external
source, receiving payment for our proofs of claim and/or obtaining the right of
offset between the amounts due to us from WorldCom and the amounts due to
WorldCom under the note purchase agreements, we may not have sufficient cash to
meet our projected needs for debt service, working capital and capital
expenditures through the end of 2003.
16
Effective January 1, 2001, WorldCom and Digex entered into a sales channel
agreement, whereby WorldCom agreed to purchase the Digex portfolio of managed
Web hosting products for resale to WorldCom customers. Through the sales
channel agreement, WorldCom has sold our portfolio of managed hosting products;
however, it has not met committed sales targets. WorldCom agreed to purchase up
to a total of $500.0 million during the period from 2001 through 2003,
contingent on our satisfaction of certain levels of service and data center
capacity. WorldCom agreed to purchase $50.0 million and $192.0 million of
managed hosting services in 2001 and 2002, respectively. WorldCom also agreed
to 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"). In addition, 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.
We recognized revenue from WorldCom of $12.4 million and $10.9 million for
the three months ended March 31, 2003 and 2002, respectively, all of which was
recorded under the sales channel agreement. All revenue recognized under the
sales channel agreement for the three months ended March 31, 2003 and 2002
resulted from actual managed hosting services purchased for resale by WorldCom.
On June 25, 2002, WorldCom announced that it would restate certain financial
statements, and it filed for bankruptcy on July 21, 2002. As a result of these
events, we fully reserved for approximately $18.3 million in sales channel
agreement related receivables as of June 30, 2002. Further, since July 1, 2002,
we have recognized revenues from WorldCom only upon collection. As a result,
approximately $3.6 million in service related billings for the period from July
1, 2002 until WorldCom filed for bankruptcy on July 21, 2002, have not yet been
recognized as revenue as such amounts have not yet been collected. Future
revenues from the sales channel agreement may be adversely affected by
WorldCom's bankruptcy filing.
Although we submitted proofs of claim to the bankruptcy court for amounts
due from WorldCom for the difference between the actual 2002 WorldCom Annual
Volume Commitment and amounts billed to WorldCom for actual managed Web hosting
services in 2002, we have not yet recognized these amounts as revenues in 2002
or 2003 due to the uncertainties surrounding collection of such amounts from
WorldCom.
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 space from WorldCom at these data
centers based on customer demand. These hosting facilities were patterned after
the Digex SmartCenter(R) 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. The payments for the data center space and
connections from the space to a WorldCom Internet Protocol (IP) network hub
amounted to $0.5 million and $0.6 million for the three months ended March 31,
2003 and 2002, respectively.
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
the Americas, Asia-Pacific, Europe, the Middle East and Africa with over 4,500
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 $0.5 million and $1.0 million for the three months ended March
31, 2003 and 2002, respectively. We maintain separate agreements with Level 3
and PacketExchange to provide additional network services.
17
The funding agreement with WorldCom is discussed in "Liquidity and Capital
Resources--Funding From Affiliates" below. Except for the funding agreement,
these agreements run through December 31, 2003 and permit either party to
request 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. Neither party gave notice of extension to the other party by
December 31, 2002. As such, the agreements, excluding the funding agreement,
expire on December 31, 2003. The four agreements are also subject to
termination by either party upon insolvency of the other. There can be no
assurance that changes to the commercial agreements will not be made, or that
WorldCom will be in a position to honor the terms of the commercial agreements,
as WorldCom's bankruptcy filing progresses.
Critical Accounting Policies and Estimates
For a summary of our critical accounting policies and estimates used in the
preparation of the consolidated financial statements, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
our 10-K for the year ended December 31, 2002 as filed with the SEC on March
31, 2003.
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 costs of performing
the installation are recognized over the estimated contract period. We analyze
the average life of our customer contracts, as it pertains to installation
fees, 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. We also recognize
revenue from early termination fees upon collection from customers not
fulfilling their contract terms, including certain changes initiated by a
customer to the current compilation of services it receives or a customer's
early termination of its contract with us. These fees are typically comprised
of monthly fees through the remaining term of the contract period and any
unpaid balances.
Revenue recognized from sales made through WorldCom result substantially
from activity under the sales channel agreement and include monthly fees from
managed Web hosting services, installation fees pro-rated over the average life
of the end customer contracts, and the differential between the WorldCom Annual
Volume Commitment and the actual annual amount billed to WorldCom for actual
managed hosting services (the "underutilization"). Revenue is reduced by
discounts and commissions afforded WorldCom for actual managed hosting services
sold, and a percentage share of any operating income generated under the sales
channel agreement.
On June 25, 2002, WorldCom announced that it would restate certain financial
statements, and it filed for bankruptcy on July 21, 2002. As a result of these
events, we fully reserved for approximately $18.3 million in sales channel
agreement related receivables as of June 30, 2002. Further, since July 1, 2002,
we have recognized revenues from WorldCom only upon collection. As a result,
approximately $3.6 million in service related billings for the period from July
1, 2002 until WorldCom filed for bankruptcy on July 21, 2002, have not yet been
recognized as revenue as such amounts have not yet been collected. Future
revenues from the sales channel agreement may be adversely affected by
WorldCom's bankruptcy filing.
Although we submitted proofs of claim to the bankruptcy court for amounts
due from WorldCom for the difference between the actual 2002 WorldCom Annual
Volume Commitment and amounts billed to WorldCom for actual managed Web hosting
services in 2002, we have not yet recognized these amounts as revenues in 2002
or 2003 due to the uncertainties surrounding collection of such amounts from
WorldCom.
18
Costs and Expenses. Costs and expenses include cost of operations, cost of
services, selling, general and administrative expenses, provision for doubtful
accounts, provision for doubtful accounts for WorldCom, deferred compensation,
depreciation and amortization expense, and cumulative effect of change in
accounting principle.
Cost of operations consists primarily of the costs for network connectivity
and firewall services. Expenses directly attributed to the sale of third party
equipment are also included. We expect sales of third party equipment to
increase as our third party leasing program grows.
Cost of services consists primarily of facilities administration expenses
including rent, maintenance and utilities to support data centers, and salaries
and related benefits for technical operations.
Selling, general and administrative expenses consist primarily of salaries
and benefits for marketing, sales and support personnel, advertising costs,
consultants' fees, and other miscellaneous expenses.
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.
Provision for doubtful accounts for WorldCom is maintained to reserve
against receivables from WorldCom recorded prior to July 1, 2002 that have been
uncollectible due to WorldCom's inability to make the required payments as a
result of its bankruptcy proceedings.
Deferred compensation expense relates to stock options that were granted 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.
Cumulative effect of change in accounting principle represents estimated
depreciation expense and accretion expense through December 31, 2002 associated
with the potential future retirement of certain long-lived assets placed in
leased facilities.
19
Results of Operations
The following table presents amounts as reported in our unaudited
consolidated financial statements (in thousands) and certain information
derived from these unaudited statements as a percentage of revenue for the
three months ended March 31, 2003 and 2002, respectively.
Three Months Ended March 31,
---------------------------------
2003 2002
--------------- ---------------
Revenue:
Revenue..................................................... $ 27,412 68.8% $ 40,868 79.0%
Revenue from WorldCom....................................... 12,416 31.2 10,889 21.0
-------- ----- -------- -----
Total revenue........................................... 39,828 100.0 51,757 100.0
Costs and expenses:
Cost of operations.......................................... 3,310 8.3 4,288 8.3
Cost of services............................................ 20,706 52.0 25,070 48.4
Selling, general and administrative......................... 14,690 36.9 28,011 54.1
Provision for doubtful accounts............................. 125 0.3 1,265 2.4
Provision for doubtful accounts for WorldCom................ -- -- 908 1.8
Deferred compensation....................................... -- -- 597 1.2
Depreciation and amortization............................... 25,192 63.3 40,223 77.7
-------- ----- -------- -----
Total costs and expenses................................ 64,023 160.8% 100,362 193.9%
-------- ----- -------- -----
Loss from operations........................................... (24,195) (60.7) (48,605) (93.9)
Other income (expense):
Interest expense............................................ (2,063) (5.2) (1,992) (3.8)
Interest income and other................................... 139 0.3 161 0.3
-------- ----- -------- -----
Loss before cumulative effect of change in accounting principle (26,119) (65.6) (50,436) (97.4)
Cumulative effect of change in accounting principle............ (869) (2.2) -- --
-------- ----- -------- -----
Net loss....................................................... $(26,988) (67.8)% $(50,436) (97.4)%
======== ===== ======== =====
Three Months Ended March 31, 2003 Compared to Three Months Ended March 31,
2002
Revenue
Total revenue decreased 23.0% to $39.8 million in the first quarter of 2003
compared to $51.8 million for the same period in 2002. The decrease is
primarily due to a reduction in our customer base, and a reduction in services
provided to these customers. Our installed base of servers decreased 7.5% to
3,165 at March 31, 2003 from 3,420 at March 31, 2002. The average revenue per
server decreased 16.3% to $3,880 in the first quarter of 2003 from $4,638 for
the same period in 2002. Revenue recognized through our sales channel agreement
with WorldCom has increased as the customer base under this agreement has
grown. We recognized revenue of $12.4 million and $10.9 million from WorldCom
in the three months ended March 31, 2003 and 2002, respectively, all of which
was recorded under the sales channel agreement. All revenue recognized under
the sales channel agreement for the three months ended March 31, 2003 and 2002
resulted from actual managed hosting services purchased for resale by WorldCom.
Revenue was reduced by $0.4 million in the first quarter of 2003 for WorldCom's
share in the net operating income related to activity under the sales channel
agreement. Revenue was not reduced for this reason in the prior year quarter,
as there was a net loss related to activity under the sales channel agreement.
Included in our revenue for the three months ended March 31, 2003 is $0.7
million in early termination fees as compared to $3.0 million for the same
period in 2002.
Cost of Operations
Cost of operations decreased 22.8% to $3.3 million in the first quarter of
2003 compared to $4.3 million for the same period in 2002. The decrease was
primarily due to lower network costs resulting from negotiation of
20
lower rates from our suppliers, and a decrease in network lines. As a
percentage of revenue, cost of operations was 8.3% for both three month periods.
Cost of Services
Cost of services decreased 17.4% to $20.7 million in the first quarter of
2003 compared to $25.1 million for the same period in 2002. The decrease was
primarily related to reduced employee-related costs and maintenance fees as a
result of our downsizing and cost containment efforts subsequent to March 31,
2002. As a percentage of revenue, total cost of services increased to 52.0% in
the first quarter of 2003 compared to 48.4% for the same period in 2002.
Selling, General and Administrative
Selling, general and administrative expenses decreased 47.6% to $14.7
million in the first quarter of 2003 compared to $28.0 million for the same
period in 2002. The decrease was attributable to planned reductions in
workforce, and operating and support costs in order to align our expenses with
our revenues. As a percentage of revenue, total selling, general and
administrative expenses decreased to 36.9% in the first quarter of 2003
compared to 54.1% in the same period in 2002, primarily due the aforementioned
workforce, operations, and support costs.
Provision for Doubtful Accounts
Provision for doubtful accounts decreased 90.1% to $0.1 million in the first
quarter of 2003 compared to $1.3 million in the prior year quarter. The
decrease is due to the fact that many of our customers, particularly
Internet-based businesses, ceased operations or reduced or eliminated our Web
hosting services in the prior year quarter. Also contributing to the decrease
in the provision for doubtful accounts is our improved collections of accounts
receivable.
Provision for Doubtful Accounts for WorldCom
In the prior year quarter, we recorded a provision for doubtful accounts
related to WorldCom in the amount of $0.9 million. Since July 1, 2002, we have
recognized revenue from WorldCom only upon collection.
Deferred Compensation
In the prior year quarter we recorded $0.6 million in deferred compensation
expense, representing the amortization of in-the-money stock options of certain
employees. In July 2002, we expensed the remaining deferred compensation, as
all options became immediately vested upon the one year anniversary of the
WorldCom-Intermedia merger.
Depreciation and Amortization
Depreciation and amortization expenses decreased 37.4% to $25.2 million in
the first quarter of 2003 compared to $40.2 million for the same period in
2002. The decrease was principally due to the fact that we recognized an
impairment of certain long-lived assets and equipment sold to outside parties
in 2002 and the first quarter of 2003, which significantly lowered our
depreciable base.
Interest Expense
Interest expense increased 3.6% to $2.1 million in the first quarter of 2003
compared to $2.0 million for the same period in 2002. The increase resulted
primarily from the issuance of $24.0 million of notes payable to Intermedia
since March 31, 2002.
21
Interest Income and Other
Interest income and other decreased 13.7% to $0.1 million in the first
quarter of 2003 compared to $0.2 million for same period in 2002. The decrease
resulted principally from falling interest rates during the period.
Cumulative Effect of Change in Accounting Principle
We adopted the provisions of SFAS No. 143, Accounting for Asset Retirement
Obligations, as of January 1, 2003, under which we recorded a cumulative effect
of change in accounting principle in the amount of $0.9 million. The charge
represents estimated depreciation expense and amortization expense through
December 31, 2002 associated with the potential future retirement of certain
long-lived assets placed in leased facilities.
Liquidity and Capital Resources
Cash Flows
Net cash provided by (used in) operating activities was $5.7 million and
$(0.1) million during the three months ended March 31, 2003 and 2002,
respectively. We experienced positive cash flow from operations in the first
quarter of 2003 primarily due to lower costs associated with a reduced
workforce, and reduction of other operating costs in aligning our expenses with
our revenues.
Net cash used for investing activities was $0.8 million and $12.5 million
during the three months ended March 31, 2003 and 2002, respectively. We have
reduced our capital expenditures in 2003 in accordance with our business needs,
current economic conditions, and as a result of our customer programs for
customer furnished equipment, our redeployed hardware program, and third party
leasing. See discussion of our third-party equipment leasing program below.
Additionally, one of our letters of credit securing a real estate lease, of
approximately $1.0 million, was scheduled to expire on April 5, 2003; however,
on March 25, 2003, we amended the real estate lease arrangements to enable us
to obtain a substitute letter of credit while still providing security to our
landlord and landlord's lender for our obligations as tenant under the lease.
On March 28, 2003, the beneficiary of the letter of credit exercised its right
to draw on the letter of credit and to hold the drawn funds as security until a
replacement letter of credit is issued. As a result, we reclassified
approximately $1.0 million of cash collateral that secured the letter of credit
from restricted investments to security deposits (included within prepaid
expenses and other current assets in the unaudited consolidated balance sheet
as of March 31, 2003) upon the notification of the draw.
Net cash (used in) provided by financing activities was $(5.8) million and
$11.4 million during the three months ended March 31, 2003 and 2002,
respectively. Net cash used in financing activities in the first quarter of
2003 primarily represents $4.3 million in principal payments on outstanding
notes payable to Intermedia. Net cash provided by financing activities for the
first quarter of 2002 resulted from proceeds from our notes payable issued to
Intermedia in 2002, and proceeds from exercises of employee stock options,
offset by payments on the long-term note payable to Prince George's County
Economic Development Corporation and on our increased capital lease obligations
in 2002.
We currently project continued losses and overall cash flow deficits due to
declining recurring revenue caused by an increase in customer attrition and a
decrease in the amount of services provided to customers. Without funding from
an external source, receiving payment for our proofs of claim and/or obtaining
the right of offset between the amounts due to us from WorldCom and the amounts
due to WorldCom under the note purchase agreements, we may not have sufficient
cash to meet our projected needs for debt service, working capital and capital
expenditures through the end of 2003.
In connection with our proofs of claim filed in the WorldCom related
bankruptcy proceedings and the impact those claims may have on amounts finally
determined to be due to or from WorldCom, we have withheld principal and
interest payments under the funding agreements totaling $5.1 million
potentially due to WorldCom
22
pending the resolution of those claims. WorldCom has objected to us withholding
these amounts, but has expressed its intent to resolve these issues with us.
Although we have not received, and would contest vigorously, any acceleration
notice from WorldCom related to the outstanding amounts, until the proofs of
claim are resolved, we have classified all outstanding notes payable as current
obligations at March 31, 2003.
Equipment Leasing
In November 2002, we began offering new customers an improved source of
funding for their equipment, through a third party equipment leasing program
branded "Digex Financial Services". This program was created to provide
customers with attractive hardware terms and financing options, while reducing
our capital requirements and facilitating sales. Under the program, we
anticipate recovering outlays for capital expenditures for hardware to support
new services from the third party leasing company in a more expeditious
timeframe, which we expect will free up cash to be used for other corporate
purposes.
Stock Offerings
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, a wholly-owned subsidiary of HP, 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. As of March 31, 2003, we
have utilized all $15.0 million of equipment purchase credits. We utilized the
remaining $0.2 million of equipment purchase credits in the three months ended
March 31, 2003, as compared to $1.5 million used for equipment purchases in the
prior year first quarter. On April 1, 2002, Microsoft converted its 50,000
shares of Series A convertible preferred stock into 730,995 shares of our Class
A common stock. The warrants, which were exerciseable at any time on or before
January 12, 2003 at an initial price of $57.00 per share, subject to certain
adjustments, expired on January 12, 2003, without being exercised. The proceeds
from the offering were allocated between the preferred stock and the warrants
based upon their relative fair values.
Funding from Affiliates
On July 31, 2001, we entered into a note purchase agreement with WorldCom
whereby WorldCom agreed to provide funding, in the form of floating rate senior
notes, 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
approved the Digex business plans for 2001 and 2002. The Digex 2003 business
plan was submitted to our board of directors at its meeting on December 4,
2002, and the plan was unanimously approved by the board members on that date.
In 2002 and 2001, we issued and WorldCom caused Intermedia to purchase,
under the note purchase agreement, a series of senior notes totaling $102.2
million to satisfy our net cash requirements under our approved 2002 and 2001
business plans. Variable interest on the unpaid principal balance is accrued
monthly at an interest rate of 300 basis points over LIBOR rate (weighted
average interest rate of 5.0% in 2003 and 5.1% in 2002). Interest cost incurred
and charged to expense related to the funding agreement with WorldCom was
$1.1 million and $0.8 million for the three months ended March 31, 2003 and
2002, respectively. On December 11, 2002, we notified WorldCom and Intermedia
that we were electing to extend the maturity date of all outstanding notes
under the agreement from December 31, 2002 to December 31, 2006, as permitted
by the note purchase agreement. Due to this election, outstanding amounts under
the agreement will be due in equal monthly straight-line amortization payments
of principal through December 31, 2006. Through March 31, 2003, we have paid an
aggregate of $10.1 million in interest and principal payments to Intermedia
under this note purchase agreement.
23
Prior to the issuance of the floating rate senior notes discussed above, 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; or (4) an event of 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.
On June 26, 2001, we borrowed $6.0 million from Intermedia as an
intercompany loan at an interest rate of 14.1%. 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 5.7%.
On January 14, 2002, we entered into a note purchase agreement with
Intermedia to refinance the $13.0 million intercompany loan and $12.0 million
promissory note to Intermedia under a senior note totaling $25.0 million. The
terms of the agreement are substantially the same as the original note purchase
agreement (see above), 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. Variable interest on the unpaid principal
balance is accrued monthly at an interest rate of 300 basis points over LIBOR
rate (weighted average interest rate of 5.0% in 2003 and 5.4% in 2002).
Interest cost incurred and charged to expense related to the funding agreement
with Intermedia was $0.3 million in the three months ended March 31, 2003 and
2002. Through March 31, 2003, we have paid an aggregate of $2.0 million in
interest payments to Intermedia under this note purchase agreement.
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.
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 have made and continue to make the monthly principal
and interest payments in accordance with the terms of the loan.
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 were
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. We have notified the State
of Maryland and Prince George's County that we will not pursue the additional
loans under these agreements.
In July 2002, we received proceeds of $150,000 from a loan from the State of
Maryland Department of Business and Economic Development under the Maryland
Industrial Training Program (MITP) initiative.
24
Repayment of principal will be deferred each year through December 31, 2005 if
we maintain at least 1,290 permanent, full time employees at any of our
Maryland facilities during the three year period from December 31, 2002. At
December 31, 2005, the principal amount may convert to a grant upon our
achievement of certain requirements. In accordance with the grant agreement, we
will be required to repay the principal in an amount equal to $303 multiplied
by the difference between the 1,290 permanent, full time employees and the
actual number of employees on December 31, 2002 and December 31, 2005, provided
that the repayment amount does not exceed the principal amount. The State of
Maryland may terminate the agreement whenever we default in performance or fail
to cure such a default within a ten day period after receipt of default
notification. Based on the number of Digex permanent, full-time employees as of
December 31, 2002, we were not in compliance for deferring full repayment of
the loan at December 31, 2002. As a result, the $150,000 loan has been
classified as a current liability as of March 31, 2003 and December 31, 2002.
In 2001 and 2002, 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 March 31, 2003, we acquired
$12.5 million of computer equipment and maintenance services under these
leasing and financing arrangements.
Contractual Obligations and Contingent Commitments
Our contractual obligations and contingent commitments as of March 31, 2003
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.... $122,942 $122,942 $ -- $ -- $ --
Notes payable to third parties. 3,651 3,651 -- -- --
Capital lease obligations...... 37,697 8,728 10,266 10,023 8,680
Operating leases............... 16,655 3,540 6,728 3,904 2,483
Contingent Commitments:
Redeemable preferred stock..... 50,000 -- 50,000 -- --
Employee retention bonuses..... 12,203 12,203 -- -- --
-------- -------- ------- ------- -------
Total...................... $243,148 $151,064 $66,994 $13,927 $11,163
======== ======== ======= ======= =======
We lease certain property and equipment under various operating and capital
lease arrangements that expire over the next 10 years. Refer also to the notes
to our consolidated financial statements in our Form 10-K for the year ended
December 31, 2002, as filed with the SEC on March 31, 2003, 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 March 31,
2003, the potential retention bonus pool payable in 2003 under these agreements
totaled $12.2 million, of which $9.3 million and $6.8 million was accrued as of
March 31, 2003 and December 31, 2002, respectively.
25
Increases in interest rates on variable rate debt would have an adverse
effect upon our reported net loss and cash flow. We may not have adequate cash
flow to service our debt and capital requirements in 2003, unless we are
successful in obtaining funding from external sources. We have experienced
declining revenues due to decreases in monthly recurring revenue (MRR) from
WorldCom and other customers. Our business plan for 2003 requires external
funding in order to be able to pay current obligations as they arise. Without
funding from an external source, we may not have the liquidity necessary to pay
principal and interest payments potentially due in 2003 and beyond under the
note purchase agreements with Intermedia and WorldCom.
The liquidity issues discussed above raise substantial doubt about our
ability to continue as a going concern. Substantial doubt about an entity's
ability to continue as a going concern exists when the entity is unable to
continue to meet its obligations as they become due without substantial
disposition of assets outside the ordinary course of business, restructuring of
debt, externally forced revisions of its operations, or similar actions for a
reasonable period of time, not to exceed one year beyond the date of the
financial statements. Our ability to continue as a going concern is dependent
upon a number of factors, including, but not limited to, attainment of funding
from external sources, settlement of the proofs of claim with WorldCom, and
future revenue retention and growth plans.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, Accounting for Asset Retirement Obligations. This statement addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. SFAS No. 143 applies to legal obligations associated with the retirement
of long-lived assets that result from the acquisition, construction,
development and (or) the normal operation of a long-lived asset, except for
certain obligations of lessees. SFAS No. 143 is effective for financial
statements issued for fiscal years beginning after June 15, 2002. We adopted
the provisions of SFAS No. 143 as of January 1, 2003. Refer to Note 2 "Summary
of Significant Accounting Policies--Asset Retirement Obligations" to the
unaudited consolidated financial statements set forth elsewhere herein for the
disclosures required by SFAS No. 143.
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which supercedes Emerging Issues Task Force
("EITF") Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring), to be applied prospectively to exit or disposal activities
initiated after December 31, 2002, with early adoption permitted.
SFAS No. 146 requires companies to recognize costs associated with exit or
disposal activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. Costs covered by the standard include
lease termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, plant closing, or
other exit or disposal activity. We adopted SFAS No. 146 as of January 1, 2003,
and it has not had a material impact on our consolidated results of operations
or financial position.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation--Transition and Disclosure. This statement amends SFAS No. 123,
Accounting for Stock-Based Compensation to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results.
We account for employee stock-based compensation in accordance with APB
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. We have adopted the disclosure-only provisions of SFAS No.
148. Refer to Note 2 "Summary of Significant Accounting Policies--Stock-Based
Compensation" to the unaudited consolidated financial statements set forth
elsewhere herein for the disclosures required by SFAS No. 148.
26
In November 2002, the FASB issued Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). FIN 45 requires certain
guarantees to be recorded at fair value. This is different from current
practice, which is generally to record a liability only when a loss is probable
and reasonably estimable, as those terms are defined in FASB Statement No. 5,
Accounting for Contingencies. FIN 45 also requires a guarantor to make new
disclosures, even when the likelihood of making any payments under the
guarantee is remote, which is another change from current practice. The initial
recognition and measurement provisions of FIN 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements under FIN 45 are effective for financial statements of
interim or annual periods ending after December 15, 2002. Currently, we do not
believe that we have entered into any guarantees that fall within the guidance
of FIN 45.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"), which clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements, to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. Certain disclosure requirements of FIN 46 are
effective for financial statements of interim or annual periods issued after
January 31, 2003. FIN 46 applies immediately to variable interest entities
created, or in which an enterprise obtains an interest, after January 31, 2003.
For variable interest entities in which an enterprise holds a variable interest
that it acquired before February 1, 2003, FIN 46 applies to interim or annual
periods beginning after June 15, 2003. We do not believe that FIN 46 will have
a material impact on our consolidated financial statements.
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. 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. This report
includes forward-looking statements, which could differ from actual results.
See "Risk Factors" in our Form 10-K for the year ended December 31, 2002 as
filed with the SEC on March 31, 2003.
Item 3. Quantitative And Qualitative Disclosures About Market Risk
No changes.
Item 4. Controls And Procedures
Based on management's evaluation of the overall system of disclosure
controls and procedures (as defined in Exchange Act Rules 13a-14(c) and
15d-14(c)) of Digex as of a date within 90 days prior to the filing date of
this quarterly report, management determined that the system is operating
effectively and is adequate to meet Digex's Securities Exchange Act reporting
obligations. The certifying officers of this quarterly report have determined
that there were no significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent to the date of
their most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
27
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On August 1, 2002, the law firm of Richards Layton & Finger ("Richards
Layton") requested that the Delaware Chancery Court enter judgment against
Digex for payment of success bonuses of $500,000 each to Richards Layton and a
second law firm, Cahill Gordon & Reindel ("Cahill Gordon"), in connection with
their representation of the former Special Committee ("FSC") of the Digex board
of directors in In re Digex, Inc. Shareholders Litigation, Consolidated Civil
Action No. 18336 (Del. Ch.) (the "Shareholder Action"). The request sought
modification of a Chancery Court order of July 29, 2002 (the "Order"), which
required WorldCom to pay $1,860,187.14 to reimburse certain expenses approved
by the FSC pursuant to the settlement of the Shareholder Action, including the
success bonuses for Richards Layton and Cahill Gordon. Insofar as the
bankruptcy of WorldCom prevented immediate enforcement of the Order against
WorldCom, Richards Layton sought the requested modification to obtain payment
directly from Digex. On August 23, 2002, the Chancery Court denied Richards
Layton's request on the grounds that WorldCom's bankruptcy, commenced before
the issuance of the Order, deprived the Chancery Court of authority to
adjudicate WorldCom's liability for expenses of the FSC, and, therefore,
rendered the Order void ab initio. The FSC subsequently sought leave of the
Bankruptcy Court to pursue collection of the expenses from Digex
notwithstanding the WorldCom bankruptcy. By order dated January 30, 2003, the
Bankruptcy Court denied that request on the grounds that (i) the Chancery Court
had correctly determined that the Order was void ab initio and (ii) separate
proceedings seeking payment of the expenses directly by Digex would
"necessarily implicate WorldCom because of the interrelationship of the parties
in the underlying dispute."
Neither the FSC nor its counsel have subsequently instituted any proceedings
to collect the claimed fees and expenses directly from Digex. It is not
possible to determine at this point whether the FSC will elect to pursue its
claims for the fees and expenses directly against Digex, either before or after
the conclusion of the WorldCom bankruptcy proceedings.
In December 2002 and January 2003, Digex was sued in two separate cases
brought by employees alleging discrimination. The first alleges that Digex
discriminated against the employee when she was not selected for the CEO
position in June 2002 following Digex's termination of its then CEO, and
further claims that Digex has subsequently retaliated against her in the terms
and conditions of her employment, even though her compensation package remains
unchanged. The second alleges discrimination based on an alleged failure by
Digex to promote this individual to a newly created position, and further
claims that she has been demoted, even though her title and compensation remain
unchanged. Both complaints include multi-million dollar claims for damages;
however, neither details the basis for such damages. Although Digex is not able
to predict the outcome of these cases, Digex believes the claims are without
merit and is defending itself vigorously.
In February, 2003, Digex was sued by Computer Associates International, Inc.
The complaint alleges breach of contract on the part of Digex, and seeks
damages of $6,427,815.90. This matter is in its initial stages. Although Digex
is not able to predict with any reasonable certainty the likely outcome of this
arbitration, Digex believes that Computer Associates' complaint is without
merit and Digex has filed a counterclaim for damages exceeding amounts sought
by Computer Associates in the litigation.
In the ordinary course of business, Digex is party to litigation. Management
does not believe that the outcome of such litigation will materially affect
Digex or its unaudited consolidated financial statements set forth elsewhere
herein.
28
Item 2. Changes in Securities and Use of Proceeds
Recent Sales of Unregistered Securities
None.
Use of Proceeds from a Sale of Registered Securities
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
None.
(b) Reports on Form 8-K
The following reports on Form 8-K of Digex were filed during the first
quarter of 2003:
Digex filed a Current Report on Form 8-K, dated January 15, 2003,
reporting under Item 5 the issuance of a press release discussing Digex's
preliminary fourth quarter cash metrics. 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 February 27, 2003,
reporting under Item 5 the issuance of a press release discussing the
delisting of Digex's common stock from the Nasdaq SmallCap Market. 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 March 19, 2003, reporting
under Item 5 the issuance of a press release discussing Digex's fourth
quarter and full year 2002 results. Digex also reported under Item 7 the
filing of the press release as an exhibit to the Form 8-K.
29
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIGEX, INCORPORATED
(Registrant)
By: /s/ T. SCOTT ZIMMERMAN
-----------------------------
T. Scott Zimmerman
Senior Vice President and
Chief Financial Officer
By: /s/ ELIZABETH A. HAIGHT
-----------------------------
Elizabeth A. Haight
Vice President and Controller
Dated: May 15, 2003
30
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO SECURITIES EXCHANGE ACT RULE 13A-14
AS ADOPTED PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, George L. Kerns, certify that:
(1) I have reviewed this quarterly report on Form 10-Q of Digex,
Incorporated;
(2) Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
(3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
(4) The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
(5) The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
(6) The registrant's other certifying officer and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
By: /s/ GEORGE L. KERNS
-----------------------------
George L. Kerns
Chief Executive Officer
Date: May 15, 2003
31
CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO SECURITIES EXCHANGE ACT RULE 13A-14
AS ADOPTED PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, T. Scott Zimmerman, certify that:
(1) I have reviewed this quarterly report on Form 10-Q of Digex,
Incorporated;
(2) Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
(3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
(4) The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
(5) The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
(6) The registrant's other certifying officer and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
By: /s/ T. SCOTT ZIMMERMAN
-----------------------------
T. Scott Zimmerman
Chief Financial Officer
Date: May 15, 2003
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CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 906
OF THE SARBANES-OXLEY ACT OF 2002
In connection with the accompanying Quarterly Report of Digex, Incorporated
(the "Company") on Form 10-Q for the quarter ended March 31, 2003 (the
"Report"), I, George L. Kerns, President and Chief Executive Officer of the
Company, certify, pursuant to 18 U.S.C. Section1350, as adopted pursuant to
Section906 of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) of
the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
By: /s/ GEORGE L. KERNS
-----------------------------
George L. Kerns
Date: May 15, 2003
This certification is being furnished solely pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, is not a part of the Form 10-Q to which it refers
and is, to the extent permitted by law, provided by the above signatory to the
extent of his knowledge.
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CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 906
OF THE SARBANES-OXLEY ACT OF 2002
In connection with the accompanying Quarterly Report of Digex, Incorporated
(the "Company") on Form 10-Q for the quarter ended March 31, 2003 (the
"Report"), I, T. Scott Zimmerman, Chief Financial Officer of the Company,
certify, pursuant to 18 U.S.C. Section1350, as adopted pursuant to Section906
of the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) of
the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
By: /s/ T. SCOTT ZIMMERMAN
-----------------------------
T. Scott Zimmerman
Date: May 15, 2003
This certification is being furnished solely pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, is not a part of the Form 10-Q to which it refers
and is, to the extent permitted by law, provided by the above signatory to the
extent of his knowledge.
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