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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended February 28, 2003

Commission File Number: 0-17932

Interland, Inc.

303 Peachtree Center Avenue, Suite 500, Atlanta, GA 30303
(Address, including Zip Code, of principal executive offices)

(404) 720-8301

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Registered on The Nasdaq National Market

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, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ No o

The number of outstanding shares of the registrant’s Common Stock on March 31, 2003 was 144,745,765.

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PART I. Financial Information
Item 1. Financial Statements

Interland, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands except per share amounts)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements

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Interland, Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands)

     The accompanying notes are an integral part of these consolidated financial statements.

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INTERLAND, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

     The accompanying notes are an integral part of these consolidated financial statements.

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INTERLAND, INC.
Notes to Consolidated Financial Statements

1. GENERAL

Business — Interland, Inc. (known as Micron Electronics, Inc. prior to August 6, 2001), together with its subsidiaries (collectively the “Company”), is a leading Web hosting company that offers a broad range of business-to-business Internet products and services, including standardized shared and dedicated hosting services, electronic commerce services, applications hosting and other Web hosting products.

Historically, the Company provided a variety of computer products and related services through its PC Systems, SpecTek, and Web hosting business segments. The Company disposed of its PC Systems and SpecTek business segments during the third quarter of fiscal 2001. The Company’s Web hosting business remains as the Company’s sole continuing operation. Prior to its disposal, the PC Systems business consisted of developing, marketing, manufacturing, selling and supporting a wide range of desktop and notebook systems and network servers under the micronpc.com brand name and selling, reselling, and supporting a variety of additional peripherals, software and services. Prior to its disposal, the SpecTek business consisted of processing and marketing various grades of memory products in either component or module form for specific applications.

History of operating losses — The Company’s Web hosting business has incurred net losses and losses from operations for each period from inception through the first six-months of fiscal 2003. The Company’s future success is dependent upon its ability to achieve positive cash flow prior to the depletion of cash resources and its ability to raise funds, if needed. Nonetheless, the Company’s current financial forecast supports management’s expectation that the Company will have adequate cash resources to fund operations throughout fiscal 2003.

2. SIGNIFICANT ACCOUNTING POLICIES

Interim Unaudited Financial Information — The accompanying unaudited consolidated financial statements as of February 28, 2003 and for the three and six-month periods ended February 28, 2003 and 2002, have been prepared in accordance with generally accepted accounting principles for interim financial information. In management’s opinion, these statements include all adjustments necessary for a fair presentation of the results of the interim periods shown. All adjustments are of a normal recurring nature unless otherwise disclosed. Operating results for the three and six-month periods ended February 28, 2003 are not necessarily indicative of the results that may be expected for the full year.

Effective with the Company’s filing of Form 10-Q for the quarterly period ended February 28, 2003, the Company has revised the presentation of its consolidated statements of operations for all periods presented to conform to presentations used by others in the web-hosting industry. As the Company has migrated from a manufacturing entity to a web-hosting company, it believes its revised presentation reflects more appropriately its results of operation and allows for more comparability to its peers. The revised presentation removes the gross margin sub-total and instead classifies all operating expenses and costs in their respective line item. Additionally, depreciation and amortization expense, previously presented as components of network operating costs, general and administrative costs, sales and marketing costs and technical support costs is now presented separately. These reclassifications, none of which affect net loss, have been made to all periods presented to present the financial statements on a consistent basis.

Basis of Presentation — This report on Form 10-Q (“10-Q”) for the second quarter ended February 28, 2003 should be read in conjunction with the Company’s Annual Report on Form 10-K (“10-K”) for the fiscal year ended August 31, 2002. The financial statements include the accounts of Interland, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Use of estimates — The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. The amounts that the Company will ultimately incur or recover could differ materially from its current estimates. The underlying estimates and facts supporting these estimates could change in 2003 and thereafter.

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

Revenue recognition — Revenues are primarily generated from shared and dedicated hosting, managed services, e-commerce services, applications hosting and domain name registrations. Revenues are recognized as the services are provided. Hosting contracts generally are for service periods ranging from one to twenty-four months and typically require up-front fees. These fees, including set-up fees for hosting services, are deferred and recognized ratably over the customers’ expected service period. Deferred revenues represent the liability for advance billings to customers for services not yet provided.

Basic and diluted loss per share — Basic loss per share is computed using the weighted average number of common shares outstanding. Diluted loss per share is computed using the weighted average number of common shares outstanding and potential common shares outstanding when their effect is dilutive. Potential common shares result from the assumed exercise of outstanding stock options and warrants. Because the Company has reported a loss from continuing operations during the second quarter of fiscal 2003 and 2002, the effect of potential common shares is excluded from the calculation of per share amounts for those periods as their effect would be anti-dilutive.

In addition to net loss per share, the Company has also reported per share amounts on the separate income statement components required by Accounting Principles Board (“APB”) Opinion No. 30, “Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.”

Comprehensive income — The Company reports comprehensive income in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income.” This statement requires the disclosure of accumulated other comprehensive income or loss (excluding net income or loss) as a separate component of shareholders’ equity. For all periods presented, comprehensive income is the same as net income.

Income taxes — The Company accounts for income taxes under the provisions of SFAS No. 109, “Accounting for Income Taxes.” SFAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the difference is expected to reverse.

Recently issued accounting standards — In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies 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).” The principal difference between this Statement and Issue 94-3 relates to its requirement for recognition of a liability for a cost associated with an exit or disposal activity. This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. This Statement eliminates the definition and requirements for recognition of exit costs in Issue 94-3 and establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, but the Company adopted this Statement beginning September 1, 2002.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure - an Amendment of FASB Statement No. 123.” This Statement amends FASB Statement 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, this Statement amends the disclosure requirements of Statement 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. This Statement is effective for financial statements with fiscal years ending after December 15, 2002, and is effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. The Company will adopt the disclosure provisions of this Statement effective with its report on Form 10-Q for the third quarter ending May 31, 2003, in accordance with this Statement.

The FASB issued FIN No. 45 for all financial statements of interim or annual reports ending after December 15, 2002. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation does not prescribe a specific approach for subsequently measuring the guarantor’s recognized liability over the term of the related guarantee. This Interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The provisions of this interpretation have no material impact on the Company.

3. RESTRUCTURING COSTS

During the fourth quarter of 2001, the Company approved and implemented a restructuring program in connection with its acquisition of Interland-Georgia. This finalized restructuring plan, for which all payments are expected to be completed by December 31, 2003, provides for the consolidation of the Company’s operations and elimination of duplicative facilities obtained as a result of previous business acquisitions. In accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit and Activity,” the restructuring costs, excluding asset impairments, were recognized as liabilities at the time management committed to the plan. Management determined that these costs provided no future economic benefit, they were incremental to other costs incurred by the Company prior to the restructuring, or were contractual obligations that existed prior to the date the plan was approved and were either continued after the exit plan was completed with no economic benefit to the Company or were non-cancelable without a penalty; and they were incurred as a direct result of the plan to exit the identified activities. The asset impairments were accounted for in accordance with SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”. Accordingly, during 2001, the Company recorded a charge of approximately $110.3 million related to employee termination benefits, facility closure costs, asset disposals and other exit costs which the Company has recorded in operating expenses.

During the second quarter of 2003, the Company approved and initiated a program to exit certain facilities and consolidate those operations into other existing facilities. This restructuring plan is part of management’s continued plan to streamline the Company’s operations and to reduce the long-term operating costs. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” costs associated with these activities have been recognized and measured at their fair value in the period in which the liabilities are incurred. One-time termination benefits for employees required to render services until they are terminated in order to receive termination benefits are being recognized ratably over the future service period. The plan provides for the closure of three data center facilities, a reduction of those related workforces of approximately 150 employees, and the termination of bandwidth and data connectivity contracts in place at these facilities. Management expects to completely exit the facilities by May 31, 2003. The Company expects to incur $3.2 million in lease termination costs of which $1.3 million has been incurred through February 28, 2003; $1.6 million in bandwidth termination fees of which $1.6 million has been incurred through February 28, 2003; and $0.6 million in employee termination benefits of which $0.2 million has been incurred through February 28, 2003.

The following table shows a reconciliation of the beginning and ending liability balances from August 31, 2002 through February 28, 2003, related to all restructuring activities recorded by the Company under both of the restructuring programs described in the above two paragraphs. The current period costs recorded in accordance with SFAS 146 are classified in the following table as “Plan charges”, except for the $0.9 million charge to property, plant and equipment; this charge represents the write down of remaining book value of fixed assets originally written down to their estimated salvage value included in the restructuring charge recorded during the fourth quarter of 2001. These accrued restructuring charges are reflected in the consolidated balance sheet in “Accrued expenses”:

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

During the six-month period ended February 28, 2003, the Company settled certain data connectivity contracts obligations for amounts less than original estimates. In connection with the settlements, the bandwidth termination costs accrual was reduced by $0.5 million and is reflected in the above table in “Other adjustments.” In addition, one of the Company’s lease abandonment liabilities was reduced by $0.2 million in connection with the reduction of the Company’s obligation due to a sublease arrangement for the facility.

For the quarter and six-months ending February 28, 2002, the Company recorded $(0.3) million to “Restructuring costs”. In connection with the sale of the consumer dial-up accounts to SolutionPro, Inc., the Company assigned and transferred certain data connectivity contracts to SolutionPro, which released the Company from future termination penalties that had previously been accrued during the restructuring program. Accordingly, the Company reversed the accrual for these termination penalties.

4. MERGER AND INTEGRATION COSTS

During the quarter and six-month periods ended February 28, 2003, the Company recorded $0.4 million and $0.5 million of merger and integration costs for severance and relocation expenses.

During the quarter and six-month period ended February 28, 2002, the Company recorded $3.7 million and $7.1 million for financial advisory services, legal, accounting, relocation, employee stay bonuses and other non-capitalizable expenses directly related to merger and integration of the business following the Interland-Georgia acquisition.

5. ACQUISITIONS

Effective August 1, 2002, the Company acquired iNNERHOST, Inc. for an aggregate purchase price of $17.7 million consisting of approximately $5.2 million in cash and 4,171,538 shares of Interland common stock. In addition, the purchase agreement stipulated that the purchase consideration was subject to adjustment based on the following provisions:

	•		An earn-out provision that specified that the realization of the full purchase price by the shareholders of iNNERHOST would be contingent upon the iNNERHOST revenues for the three-month period following the date of acquisition being at least 95% of the historical monthly revenues. iNNERHOST revenues for the subject three-month period were in fact in compliance with this requirement and thus no modification to the purchase price and related consideration was necessary.
	•		A price protection provision that specified that a pro-rata payback of shares to Interland if the average closing price for the five business days preceding the effective date of the registration statement covering shares issued in this acquisition is greater than $3.70 but less than $5.00 per share by the amount of the closing price over $2.50 per share. The agreement also provides additional payment of shares to the iNNERHOST shareholders on a pro-rata basis if the average closing price of five business days preceding the effective date of the registration statement covering shares issued in this acquisition is less than $2.50 per share but greater than $1.00 per share by the amount of the closing price below $2.50 per share. Although the registration statement is not yet effective, based upon Interland’s current value additional shares of Interland common stock will have to be issued to the iNNERHOST

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

shareholders, and if the average closing price for the five-day period prior to the effective date of the registration statement is $1.00 or less, the number of additional shares to be issued will be 5,530,285, bringing the total number of shares issued for the acquisition to 9,701,823.

The acquisition of iNNERHOST was accounted for in accordance with SFAS No. 141, “Business Combinations,” and accordingly, the contingently issuable shares of the Company’s stock based on a future stock price will not affect the aggregate cost of the acquisition when the contingency is resolved.

In connection with the acquisition, 0.5 million shares of stock and $0.3 million were placed into escrow for one year to satisfy unidentified claims that occurred prior to the acquisition date. To date, there has been no notice of claim of dispute under the escrow agreement. The results of iNNERHOST’s operations have been included in the consolidated financial statements since August 1, 2002, the effective date of acquisition. The aggregate purchase price was $17.7 million, including direct acquisition costs of $0.1 million.

During the second quarter ended February 28, 2003, the iNNERHOST purchase price allocation was completed and amounts were allocated to identifiable intangible assets and goodwill. The following table summarizes the purchase price allocation based on the fair values of the assets acquired and liabilities assumed at the date of acquisition.

On January 3, 2003, the Company acquired Trellix Corporation, a privately held developer of software-based Web site solutions. Founded in 1995, Trellix is a provider of private-label Web site publishing solutions, integrated business services, and low-cost hosting technology. The primary reason for the acquisition is that Trellix offers a suite of site-building tools and services that enable users to create professional Web sites. Trellix’s product line offers an expansion of the existing Interland product line. Trellix financial results are included in Interland’s financial results beginning in January 2003. Initially, the estimated aggregate purchase price was approximately $12.2 million, however, based on Trellix’s financial position on the date of close and a contractual working capital adjustment contained in the merger agreement, the actual aggregate purchase price was approximately $11.6 million consisting of $3.2 million in cash, three million shares of Interland stock, and six million warrants to purchase shares of Interland stock at a price of $5.00 per warrant. The fair value of the warrants at the date of acquisition was $0.55 each using the Black-Scholes pricing model. The acquisition of Trellix accounted for the majority of the significant change in shareholder’s equity by increasing the balance of additional capital by $4.9 million and warrants by $3.3 million.

The following table summarizes the purchase price allocation based on the fair values of the assets acquired and liabilities assumed at the date of acquisition.

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

On December 19, 2002, the Company entered into a merger agreement to acquire Hostcentric, Inc. for $25.8 million in cash and stock. Formed in 2000, Hostcentric is a privately held provider of a broad range of Web hosting services to small business and enterprise customers. In return for all outstanding shares of Hostcentric, Hostcentric shareholders will receive $3 million in cash and approximately 13.5 million shares of Interland stock. The number of shares to be issued was fixed as of the agreement’s execution date. The transaction, which requires the approval of a majority of Hostcentric’s shareholders, is expected to close by June 2003.

6. ACQUIRED INTANGIBLES AND GOODWILL

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141 “Business Combinations” (“SFAS 141”) and SFAS No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS 141 also specifies the criteria applicable to intangible assets acquired in a purchase method business combination to be recognized and reported apart from goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment, at least annually. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and be reviewed for impairment.

The Company adopted SFAS 141 and 142 effective September 1, 2001. Upon adoption of SFAS 142, the Company no longer amortizes goodwill.

In accordance with the requirements of SFAS 142, the Company tests for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. The Company performed its impairment test of goodwill as of May 31, 2002 and determined that goodwill was not impaired. Given the significant decline in the Company’s stock price during the six-month period ended February 28, 2003, management examined the events and circumstances during the period to determine whether there has been a significant adverse change in the business climate making it more likely than not that an impairment occurred. Specifically, the Company carefully reviewed impairment triggering events as specified in SFAS 142 and concluded that it does not believe that a triggering event has occurred such that an interim goodwill impairment test was required at February 28, 2003. The Company will perform its annual impairment test of goodwill as of May 31, 2003. If the price of the Company’s stock stays at its current levels, the impairment test may result in a significant impairment loss equal to the carrying amount of goodwill in excess of its fair value.

As disclosed in the following table, the carrying amount of goodwill from August 31, 2002 through February 28, 2003 increased by $17.4 million, due to the acquisition of Trellix Corporation and completion of the purchase price allocation for iNNERHOST:

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

The following table summarizes intangible assets by asset class and related accumulated amortization as required by SFAS 142:

At August 31, 2002, included in “Other” was $12.8 million related to the acquisition of iNNERHOST. Upon completion of the purchase price allocation for iNNERHOST, this balance was allocated to the appropriate intangible asset categories and goodwill.

Core technology is amortized over a weighted average of five years, customer account acquisitions and customer relationships are amortized over a weighted average of three years and trademarks are amortized over a weighted average of seven years and all other intangible assets are amortized on a weighted average of three years. The weighted average amortization period for all intangible assets as a group is four years. None of the goodwill balance is deductible for tax purposes.

7. PURCHASE BUSINESS COMBINATION LIABILITIES

In connection with the acquisitions of Interland-Georgia in fiscal 2001, iNNERHOST in fiscal 2002, and Trellix Corporation in January 2003, the Company accrued certain liabilities representing estimated costs of exiting certain facilities, termination of bandwidth contracts and involuntary termination of employees in accordance with EITF No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” These amounts are included in “Accrued expenses” on the

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

balance sheet and are not included in the restructuring reserves discussed in Note 3. The following table shows the changes in the accrual from August 31, 2002:

In accordance with EITF 95-3, the additional $0.7 million of liabilities accrued during the six-month period ended February 28, 2003 represent termination benefits for Trellix employees who are being involuntarily terminated and for former iNNERHOST founders who had contracts entitling them to termination benefits under contractual obligations that existed prior to the acquisition date.

8. CONTINGENCIES

Interland is defending an employee class action lawsuit filed in the U.S. District Court for Idaho. In this case five individual plaintiffs claim they were employees of Micron Electronics Inc. (“MEI”) between 1999 and April 2001. This potential liability remains with Interland even though it sold the PC Systems business. The plaintiffs claim that they, and other similarly situated employees, did not receive overtime pay to which they were entitled under the Fair Labor Standards Act. Interland disputes these claims and believes the plaintiffs are not entitled to any material additional wages. The court conditionally certified a class of not more than eight hundred former employees and notices of the litigation are being sent to these persons to give them the opportunity to “opt in” to the litigation. The parties are continuing to conduct discovery. At this early stage of the litigation Interland is unable to estimate its total expenses, possible loss or range of loss that may ultimately be connected with the matter.

In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel Murphy, one of the former principals of Communitech, which was acquired by Interland in February 2002. The Company’s lawsuit claims, among other things, that Mr. Murphy breached certain covenants under his employee agreement, and also demands payment from Mr. Murphy under his delinquent $2.7 million promissory notes. These notes are collateralized by 2,735,275 shares of the Company’s common stock and the receivable balance is shown on the balance sheet as a reduction in equity. Interland is seeking an injunction against further violations of Mr. Murphy’s obligations, compensatory and punitive damages in an unspecified amount for the covenant violations, and immediate foreclosure on the shares securing the note. On March 31, 2003, the court heard oral argument on Interland’s motion for a preliminary injunction. A ruling is expected within the next [60] days.

In February 2003, Messrs. Heitman and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel Kocher, and Interland’s subsidiary, Communitech.net, Inc., in Jackson County, Missouri claiming, among other things, that Interland acted unreasonably in failing to have the related S-3 registration statement declared effective by the SEC on a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in connection with Interland’s acquisition of Communitech. The complaint asks for compensatory and punitive damages in an unspecified amount. Interland believes that these claims are without merit and will not have a material adverse effect on Interland, and intends to vigorously defend the claims.

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INTERLAND, INC.
Notes to Consolidated Financial Statements - Continued

On March 14, 2003 Halo Management, LLC, filed a suit against Interland in the U.S. District Court for the Northern District of California. The suit alleges that Interland’s use of “blueHALO” (U.S. Patent and Trademark Office Serial No. 78/135,621) to describe its proprietary web hosting architecture infringes the plaintiff’s registered trademark Halo (U.S. Patent and Trademark Office Serial No. 75/870,390; Registration No. 2,586,017). The suit requests an injunction against Interland’s use of its blueHALO mark and money damages. Interland believes the claims are without merit, will not have a material adverse effect on Interland, and plans to vigorously defend the matter.

From time to time, the Company is made aware that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has evaluated all such claims and, if necessary and appropriate, sought to obtain licenses for the use of such technology. If the Company or its suppliers were unable to obtain licenses necessary to use intellectual property in its discontinued operation’s products or processes, it may be forced to defend legal actions taken against it relating to allegedly protected technology. The Company evaluates all such claims and has accrued a liability and charged discontinued operations for the estimated costs of settlement or adjudication of claims for alleged infringement as of the respective dates of the balance sheets included in this report. As of February 28, 2003, the Company had an aggregate amount of $0.6 million accrued for such matters.

In accordance with SFAS No. 5 “Accounting for Contingencies” the Company believes it has adequately reserved for the contingencies arising from the above legal matters where an adverse outcome was deemed probable and the loss amount could be reasonably estimated. As such, the Company does not believe that the outcome of the aforementioned proceedings will have a materially adverse impact on its results of operations, its financial condition or its cash flows.

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INTERLAND, INC.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Statements contained in this Form 10-Q that are not purely historical are forward-looking statements and are being provided in reliance upon the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding Interland’s expectations of the Company’s future liquidity needs, its expectations regarding its future operating results including its planned increase in its revenue levels and the actions the Company expects to take in order to maintain its existing customers and expand its operations and customer base. All forward-looking statements are made as of the date hereof and are based on current management expectations and information available to it as of such date. The Company assumes no obligation to update any forward-looking statement. It is important to note that actual results could differ materially from historical results or those contemplated in the forward-looking statements. Forward-looking statements involve a number of risks and uncertainties, and include risks associated with our target markets and risks pertaining to our ability to successfully integrate the operations and personnel of the recent acquisitions. Factors that could cause actual results to differ materially from expected results are identified in “Risk Factors” in the Company’s annual report on Form 10-K for the year ended August 31, 2002 and in the Company’s other filings with the Securities and Exchange Commission. All quarterly references are to the Company’s fiscal periods ended February 28, 2003, or February 28, 2002 unless otherwise indicated. All annual references are also on a fiscal August 31^st year-end basis, unless otherwise indicated. All tabular dollar amounts are stated in thousands.

OVERVIEW

Interland is a leading Web hosting company focused on small- and medium-sized businesses. Interland offers a broad range of business-class hosting products and services, including shared and dedicated hosting services, electronic commerce and other applications hosting services, and other Web hosting-related products and services. Prior to its transformation in fiscal 2001, the Company provided a variety of computer products and related services through its PC Systems, computer manufacturing business, SpecTek, its memory products business, and its Web hosting business segments. During fiscal 2001, the Company discontinued its PC Systems and SpecTek businesses. Following the disposition of these business segments, the Company’s ongoing operations became exclusively those of a Web hosting company that also provides Web site development solutions to small business.

The current Web hosting business was formed through twelve company or account acquisitions since 1999. On August 2, 1999, the Company acquired 100% of the outstanding stock of NetLimited, Inc. d.b.a. “HostPro”, a Web and applications hosting provider. On September 2, 1999, the Company acquired the property and equipment of Micron Internet Services, formerly a division of Micron Technology, a provider of dedicated, nationwide dial-up and broadband Internet access, virtual private network solutions and e-commerce services. On December 14, 1999, the Company acquired LightRealm, Inc., (“LightRealm”), a Kirkland, Washington-based Web and applications hosting and Internet access company serving small- and medium-sized businesses. On March 16, 2000, the Company acquired Worldwide Internet Publishing Corporation, (“Worldwide Internet”), a Boca Raton, Florida-based Web hosting company that also served small- and medium-sized businesses. On August 6, 2001, the Company acquired Interland, Inc. (“Interland-Georgia”), an Atlanta, Georgia-based provider of a broad range of Web hosting, applications hosting and other related Web-based business solutions specifically designed to meet the needs of small- and medium-sized businesses. In connection with the acquisition of Interland-Georgia, Micron Electronics, Inc., (“MEI”), changed its name to Interland, Inc. and its trading symbol to “INLD.”

In October 2001, January 2002 and May 2002, the Company acquired the small business-focused shared and dedicated Web hosting customer accounts of Interliant, Inc., (“Interliant”), AT&T Corp., (“AT&T”), and Burlee Networks LLC, (“Burlee”).

On February 8, 2002, the Company acquired CommuniTech.Net, Inc., (“CommuniTech.Net”), a Kansas City, Missouri-based Web hosting company. On May 3, 2002, the Company acquired Dialtone, Inc., (“Dialtone”), a Fort Lauderdale, Florida-based leading dedicated Web hosting company.

As of August 1, 2002, the Company acquired iNNERHOST, Inc., (“iNNERHOST”), a Miami, Florida-based Web hosting company serving small- and medium-sized businesses.

On January 3, 2003, the Company acquired Trellix Corporation (“Trellix”), a privately held developer of software-based Web site solutions. Founded in 1995, Trellix is a provider of private-label Web site publishing solutions, integrated business

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INTERLAND, INC.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

services, and low-cost hosting technology. Trellix offers a suite of site building tools and services that enable users to create professional Web sites.

On December 19, 2002, the Company entered into a merger agreement to acquire Hostcentric, Inc. for $25.8 million in cash and stock. Formed in 2000, Hostcentric is a privately held provider of a broad range of Web hosting services to small business and enterprise customers. In return for all outstanding shares of Hostcentric, Hostcentric shareholders will receive $3 million in cash and approximately 13.5 million shares of Interland stock. The transaction, which requires the approval of a majority of Hostcentric’s shareholders, is expected to close by June 2003.

Interland’s business is rapidly evolving as a result of the acquisitions detailed above. The Company also has a limited operating history as a Web hosting company. The Company’s rapid annual hosting revenue growth primarily has been the result of its acquisitions. In this regard the Company has successfully exited redundant facilities and reduced the associated work force, and terminated contracts related to unused bandwidth. As a result, the Company does not believe its historical financial results are indicative of expected future results. Going forward the Company expects to reduce the pace of its acquisitions in favor of organic growth strategies including execution of its mass-market initiative. Furthermore, the Company expects to realize substantial cost efficiencies by capitalizing on several expense reduction opportunities resulting from the continuing integration of previously acquired companies. Management expects that these efforts will result in more than $25.0 million of annualized operating cost savings effective with the fourth quarter of fiscal 2003.

DISCONTINUED OPERATIONS

PC Systems

In fiscal 2001, the Company discontinued the operations of its PC Systems business segment, which was accounted for as discontinued operations in accordance with Accounting Principles Board Opinion (APB) No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” On May 31, 2001, the Company sold its PC Systems business to GTG PC Holdings, LLC, (“GTG PC”) an affiliate of the Gores Technology Group. Under the terms of the agreement, GTG PC received assets, which included $76.5 million in cash, and assumed specified liabilities of the PC Systems business. The Company retained all liabilities of the PC Systems business not assumed by GTG PC, including, for example, liabilities for taxes arising prior to the closing of the transaction, employee termination and related expenses and any contingent liabilities arising prior to the closing date.

Through May 31, 2003, or for the applicable statute of limitations with respect to taxes and government contracts, the Company is obligated to indemnify the purchaser and affiliated entities for any breaches of the representations and warranties contained in the agreement. In addition, the Company is obligated for an indefinite period of time to indemnify the purchaser and affiliated entities for any breaches in covenants. The agreement provides that the maximum aggregate liability of the Company for indemnification under the agreement is $10.0 million. To date the Company has not made any indemnification payments in regards to these matters. Furthermore, the Company believes that it is unlikely that any material claims will be made and therefore has not recorded any liability for this indemnification.

For the quarter and six-months ending February 28, 2003, the Company recorded expenses of $281,000 and $315,000 respectively for the write down of certain receivable balances to their net realizable value and legal settlements and related expenses in connection with the disposal of the PC systems business.

RESULTS OF CONTINUING OPERATIONS

The Company has revised the presentation of its consolidated statements of operations for all periods presented to conform to presentations used by others in the industry. The revised presentation removes the gross margin sub-total and instead classifies all operating expenses and costs in their respective line item. Additionally, depreciation and amortization have been removed as components of network operating costs, general and administrative costs, sales and marketing costs and technical support costs and are instead presented on a separate line item. These reclassifications, none of which affect net loss, have been made to all periods presented to present the financial statements on a consistent basis.

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The Company’s consolidated financial information presents the net effect of discontinued operations separate from the results of the Company’s continuing operations. Historical financial information has been reclassified to consistently present the discontinued operations, and the discussion and analysis that follow generally focuses on continuing operations. The following table sets forth, for the periods indicated, certain data derived from the Company’s consolidated statements of operations as a percentage of revenues:

The loss from continuing operations increased $2.3 million, or 11.5% for the quarter ended February 28, 2003, and decreased $3.1 million, or 7.8%, respectively, for the six-months ended February 28, 2003 when compared to the same periods of the prior fiscal year. The loss per share, basic and diluted, increased $0.02 per share, or 14.3% for the quarter ended February 28, 2003, and decreased $0.03 per share, or 10.3%, respectively, for the six-months ended February 28, 2003 when compared to the same periods of the prior fiscal year.

COMPARISON OF THE QUARTERS ENDED FEBRUARY 28, 2003 AND 2002

Revenues

Total revenues increased $0.9 million, or 3.4%, and $4.2 million, or 8.6%, respectively, for the quarter and for the six-months ended February 28, 2003 when compared to the same periods of the prior fiscal year. Hosting revenues increased 4.8% to $25.3 million and 11.3% to $52.2 million, respectively, for the quarter and for the six-months ended February 28, 2003 when compared to the same periods of the prior fiscal year. Hosting revenues are comprised of shared and dedicated hosting services and domain name registrations. The growth in hosting revenues attributable to acquisitions has been partially offset by a degradation of the legacy Interland-Georgia and HostPro customer base related to the implementation of stricter credit policies and the writing off / deprovisioning of delinquent accounts. As noted, the Company expects to reduce the pace of

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acquisitions, although it has acquired Trellix and has announced an agreement to acquire Hostcentric, which the Company expects will provide additional revenue.

The Company has begun to focus on organic growth and is realizing the emergence of new customers as a result of new pricing strategies and the launching of its blueHalo product line. In the fourth quarter, the Company will initiate its mass-market strategy utilizing Trellix’s web-based business solutions.

Other revenues decreased $0.3 million, or 27.3%, and $1.1 million, or 46.9%, respectively, for the quarter and for the six-months ended February 28, 2003 when compared to the same periods of the prior fiscal year. Other revenues are primarily comprised of consulting, co-location, and web-based business solution services. The decrease is the result of the sale of consumer dial-up accounts in 2002, and the Company’s strategy to move away from the sale of hardware due to the low margins and profitability of these products and services. The change is not expected to have a substantial adverse impact on future operating income. Trellix revenue, which consists of the provision of Web based business solutions, is included in other revenue and contributed $0.4 million in revenue in the quarter ending February 28, 2003.

As of February 28, 2003, the Company had approximately 181,000 paid shared hosting customer accounts and managed approximately 7,000 dedicated servers, many of which host multiple web sites, compared to approximately 225,000 paid shared hosting customer accounts and approximately 4,400 dedicated servers at February 28, 2002. The decrease in shared hosting customer accounts is primarily due to the deactivation of non-paying accounts during the last two quarters. The significant increase in dedicated servers, net of dedicated account churn, is primarily attributable to the Company’s acquisitions completed during fiscal 2002.

Operating Costs and Expenses

Network Operating Costs

Network operating expenses increased 11.5% to $9.8 million and 3.4% to $19.2 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $8.8 million and $18.5 million in the same periods of the prior year. As a percentage of revenues, the Company’s network operating expenses were 37.6% and 35.9%, respectively, for the quarter and for the six-months ended February 28, 2003 as compared to 34.9% and 37.7% in the same periods of the prior fiscal year. The increase in network operating expense in the second quarter was primarily related to the buyout of a connectivity bandwidth contract for the Company’s Atlanta data center. The underlying unit costs for this contract were much greater than prevailing market rates. The conversion to a lower cost provider will significantly lower future operating costs. As a result of completing the company’s restructuring, integration, and transition plans with an in-year cost of approximately $18.0 million, management expects to realize more than $25.0 million of annualized operating cost savings effective with the fourth quarter of fiscal 2003.

Sales and Marketing

Sales and marketing expenses decreased 34.8% to $5.0 million and 40.4% to $9.9 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $7.7 million and $16.6 million in the same periods of the prior year. The Company’s sales and marketing expenses as a percentage of revenues was 19.3% and 18.5%, respectively, for the quarter and for the six-months ended February 28, 2003 as compared to 30.6% and 33.7% in the same periods of the prior fiscal year. The decrease in sales and marketing expenses in the second quarter and six-month period from the same period of the prior fiscal year was primarily attributable to a decrease of $0.5 million and $1.2 million, respectively, in personnel costs due to integration and consolidation initiatives related to headcount reductions, and a decrease of $1.8 million and $2.5 million, respectively, in marketing and advertising costs resulting from a greater emphasis on web-based versus direct mail programs.

Technical Support

Technical support expenses decreased 13.3% to $3.8 million and 5.1% to $7.5 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $4.4 million and $7.9 million in the same periods of the prior year. The Company’s technical support expenses as a percentage of revenues was 14.5% and 14.1%, respectively, for the quarter and for the six-months ended February 28, 2003 compared to 17.3% and 16.1% in the same periods of the prior fiscal year. The

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decrease in technical support expenses in the second quarter from the same quarter of the prior fiscal year was attributable to a $0.6 million reduction in contract labor and service costs facilitated by the execution of workforce management and process efficiencies.

General and Administrative

General and administrative expenses increased 17.0% to $10.5 million and decreased 0.3% to $20.3 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $8.9 million and $20.3 million in the same periods of the prior year. As a percentage of revenues the Company’s general and administrative expenses was 40.0% and 37.9%, respectively, for the quarter and for the six-months ended February 28, 2003 as compared to 35.4% and 41.3% in the same periods of the prior fiscal year. The primary factors causing the increase in general and administrative expenses in the second quarter were a $0.8 million increase in personnel costs caused by the addition of staff to address critical skill resource deficiencies, a $0.5 million increase in professional fees associated with infrastructure and process reengineering, and a $0.4 million increase in legal expenses related to recent acquisitions and SEC filings.

Bad Debt Expense

Bad debt expense decreased 26.9% to $1.8 million and increased 27.0% to $3.8 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $2.4 million and $3.0 million in the same periods of the prior year. The decrease in bad debt expense for the second quarter of fiscal 2003 versus the same quarter of fiscal 2002 is essentially due to the write off and deactivation of non-paying accounts that occurred during the last two quarters. The increase in bad debt expense during the six-month period of fiscal 2003 as compared to the same period of fiscal 2002 was a direct consequence of the acquisition of the customer accounts of Interland-Georgia, CommuniTech.Net, Dialtone Internet, Interliant, and AT&T. Following these transactions, the Company experienced short-term customer churn and “breakage” during the account integration and migration process. The combination of higher than expected customer churn and breakage and the integration of our billing and collection functions resulted in unusually high bad debt expense. In response to the higher bad debt expense, the Company increased its collection efforts to bring the past due accounts back down to a more normal level and instituted a more stringent credit policy, suspending service to customers with balances over 30 days due. The new credit policy and the clean up of acquired accounts are the primary reasons for the year-to-date increase in bad debt expense.

Depreciation and Amortization

Depreciation and amortization expenses increased 55.8% to $13.2 million and 65.2% to $25.4 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $8.5 million and $15.4 million in the same periods of the prior year. The Company’s depreciation and amortization expenses as a percentage of revenues was 50.6% and 47.6%, respectively, for the quarter and for the six-months ended February 28, 2003 as compared to 33.6% and 31.3% in the same periods of the prior fiscal year. The increase in depreciation and amortization expense is due to $1.2 million of accelerated depreciation relating to the closure of the Los Angeles data center, $3.0 million associated with acquisitions, and $0.5 million related to fixed asset additions for ongoing operations.

Restructuring Costs

Restructuring costs increased to $3.7 million and to $3.4 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $(0.3) million and $(0.3) million in the same periods of the prior year. During the quarter the Company’s restructuring costs were associated with the closure and consolidation of data centers and were comprised of $1.6 million for termination of bandwidth connectivity contracts, $1.3 million for lease termination charges, $0.9 million for fixed asset write downs, and $0.3 million for employee severance payments. During the second quarter of fiscal 2002 the Company reversed $0.3 million of previously accrued restructuring charges associated with a bandwidth connectivity contract termination for which the contract was ultimately assigned to SolutionPro, Inc.

Merger and Integration Costs

Merger and integration costs decreased 88.4% to $0.4 million and 92.6% to $0.5 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $3.7 million and $7.1 million in the same periods of the prior year. During the

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second quarter of 2003, the Company incurred $0.4 in merger and integration costs to settle severance obligations to former employees and to pay relocation expenses to retained employees. Merger and integration costs are significantly reduced from the same periods last year, which is consistent with the magnitude of integration activities undertaken in connection with the Interland-Georgia acquisition and other acquisitions consummated in fiscal 2002. The Company expects to incur continued merger and integration costs during fiscal 2003 primarily related to severance and relocation costs for select personnel associated with the Innerhost and Trellix businesses, although such costs will be significantly lower than that experienced during fiscal 2002.

Interest Income (Expense), net

Interest income (expense), net, decreased 173.5% to $(0.1) million and 52.7% to $0.2 million, respectively, for the quarter and for the six-months ended February 28, 2003 from $0.1 million and $0.3 million in the same periods of the prior year. Interest income, net consists of interest income earned on the Company’s combined cash and cash equivalents, short-term investments, and restricted investments of $105.7 million, less interest expense on debt (primarily capital leases) of $17.3 million. The reduction in interest income, net is primarily due to the lower levels of cash and liquid investments that were available for investment and lower interest rates during the second quarter of fiscal 2003 versus the same period in fiscal 2002. Interest expense exceeded interest income for the quarter ended February 28, 2003 due to interest expense incurred in the early payoff of an outstanding line of credit.

Income Tax Expense

No income tax benefit was recorded for the quarter and for the six-months ended February 28, 2003 and 2002. A valuation allowance has been established against the potential benefit and deferred tax assets under the guidelines of SFAS 109.

Net Cash Used in Operating Activities and Earnings from Continuing Operations Before Interest, Taxes, Depreciation
and Amortization (EBITDA)

EBITDA is defined as net income less (i) provision for income taxes, (ii) interest income or expense, and (iii) depreciation and amortization. EBITDA is not an indicator of financial performance under generally accepted accounting principals and may not be comparable to similarly captioned information reported by other companies. In addition, it does not replace net income (loss), operating income (loss), or cash flow from continuing operations as indicators of operating performance. The effect of taxes and interest on Interland’s net loss is not significant, but depreciation and amortization, primarily as a result of acquisitions, is significant. The Company believes that measuring the performance of the business without regard to non-cash depreciation and amortization can make trends in operating efficiencies more readily apparent.

For the second quarter ending February 28, 2003, the Company’s EBITDA improved $2.6 million or 22.4% to a loss of $8.9 million as compared to a loss of $11.4 million for the second quarter of fiscal 2002. The improvement in EBITDA is primarily the result of reduced merger and integration expenses ($3.3 million) and sales and marketing expenses ($2.7 million) and increased revenues ($0.9 million), partially offset by an increase in restructuring costs ($4.0 million) in conjunction with higher non-cash expenses. For the six-months ending February 28, 2003, the Company’s EBITDA improved $13.3 million or 54.1% to a loss of $11.3 million as compared to a loss of $24.6 million for the six-months ended February 28, 2002. The improvement in EBITDA is attributable to reduced sales and marketing costs ($6.7 million), reduced merger and integration costs ($6.6 million), and increased revenues ($4.2 million), partially offset by an increase in restructuring costs ($3.8 million), in conjunction with higher non-cash expenses.

Reconciliation of EBITDA from continuing operations to net cash used in operating activities of continuing operations (the most directly comparable financial measure presented in accordance with generally accepted accounting principles) is as follows:

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