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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 September 30, 2002
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
DIGEX, INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 59-3582217
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
14400 Sweitzer Lane
Laurel, MD 20707
(Address of principal executive offices)
(240) 264-2000
Telephone Number
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 [_]
As of October 31, 2002, there were 25,519,461 and 39,350,000 shares of the
Registrant's Class A and Class B Common Stock outstanding, respectively.
DIGEX, INCORPORATED
INDEX
Page
No.
-----
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited):
Consolidated Statements of Operations--
Three and nine months ended September 30, 2002 and 2001 .............................. 3
Consolidated Balance Sheets--
September 30, 2002 and December 31, 2001 ............................................. 4
Consolidated Statements of Cash Flows--
Nine months ended September 30, 2002 and 2001 ........................................ 5
Notes to Consolidated Financial Statements ............................................... 6
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations .................................................................. 19
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk ............................... 38
ITEM 4. Controls and Procedures .................................................................. 38
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings ........................................................................ 39
ITEM 2. Changes in Securities and Use of Proceeds ................................................ 39
ITEM 3. Defaults Upon Senior Securities .......................................................... 39
ITEM 4. Submission of Matters to a Vote of Security Holders ...................................... 39
ITEM 5. Other Information ........................................................................ 39
ITEM 6. Exhibits and Reports on Form 8-K ......................................................... 40
Signatures ............................................................................... 42
Certifications ........................................................................... 43
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 Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
2002 2001 2002 2001
------------ ------------ ------------ ------------
Revenue:
Revenue ............................................... $ 30,721 $ 43,130 $ 104,068 $ 144,869
Revenue from WorldCom ................................. 12,431 9,194 39,534 14,298
------------ ------------ ------------ ------------
Total revenue .............................................. 43,152 52,324 143,602 159,167
Costs and expenses:
Cost of operations .................................... 2,988 2,710 10,716 12,241
Cost of services ...................................... 19,465 28,792 67,543 79,792
Selling, general and administrative ................... 15,459 31,048 64,330 97,335
Provision for doubtful accounts ....................... 740 4,916 2,745 12,415
Provision for doubtful accounts for WorldCom .......... -- -- 18,578 --
Deferred compensation ................................. 2,610 683 3,603 2,489
Impairment loss ....................................... -- -- 56,990 --
Depreciation and amortization ......................... 36,899 34,139 119,206 96,029
------------ ------------ ------------ ------------
Total costs and expenses ................................... 78,161 102,288 343,711 300,301
------------ ------------ ------------ ------------
Loss from operations ....................................... (35,009) (49,964) (200,109) (141,134)
Other income (expense):
Interest expense ...................................... (2,279) (1,670) (6,414) (3,115)
Interest income and other ............................. 138 457 434 1,530
------------ ------------ ------------ ------------
Net loss ................................................... (37,150) (51,177) (206,089) (142,719)
Accretion of preferred stock discount ...................... (504) (1,006) (2,013) (3,019)
------------ ------------ ------------ ------------
Net loss available to common stockholders .................. $ (37,654) $ (52,183) $ (208,102) $ (145,738)
============ ============ ============ ============
Net loss per common share--
basic and diluted ..................................... $ (0.58) $ (0.81) $ (3.22) $ (2.28)
============ ============ ============ ============
Shares used in computing basic and diluted net
loss per share ........................................ 64,869,461 64,138,466 64,628,474 64,055,814
============ ============ ============ ============
See accompanying notes to consolidated financial statements.
3
DIGEX, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share information)
September 30, December 31,
2002 2001
------------- ------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ................................................................... $ 16,049 $ 12,096
Restricted investments ...................................................................... 3,136 3,197
Accounts receivable, net of allowance of $3,571 in 2002 and $4,806 in 2001 ................. 13,616 25,159
Due from WorldCom, net of allowance of $18,578 in 2002 and $0 in 2001 ...................... -- 15,179
Deferred costs .............................................................................. 5,928 7,302
Prepaid expenses and other current assets ................................................... 6,313 7,579
--------- ---------
Total current assets ................................................................. 45,042 70,512
Property and equipment, net ...................................................................... 187,716 327,701
Goodwill, net .................................................................................... 11,880 11,880
Intangible assets, net ........................................................................... 4,631 7,351
Notes receivable from employees, net ............................................................. 6,036 6,825
Other assets ..................................................................................... 2,832 3,089
--------- ---------
Total assets ......................................................................... $ 258,137 $ 427,358
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses ....................................................... $ 38,003 $ 43,491
Due to WorldCom ............................................................................. 5,115 4,475
Current portion of deferred liabilities ..................................................... 6,124 7,572
Current portion of note payable ............................................................. 208 56
Current portion of notes payable to Intermedia .............................................. 19,163 --
Current portion of capital lease obligations ................................................ 5,921 5,675
--------- ---------
Total current liabilities ............................................................ 74,534 61,269
Deferred liabilities ............................................................................. 3,779 4,257
Notes payable .................................................................................... 3,314 3,208
Notes payable to Intermedia ...................................................................... 108,037 90,000
Capital lease obligations ........................................................................ 25,735 29,477
--------- ---------
Total liabilities .................................................................... 215,399 188,211
--------- ---------
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 2002 and 2001,
respectively (aggregate liquidation preference of $50,000).................................. 45,244 81,503
Stockholders' equity (deficit):
Class A common stock, $.01 par value; 100,000,000 shares authorized; 25,519,461
and 24,788,466 shares issued and outstanding in 2002 and 2001, respectively ............. 255 248
Class B common stock, $.01 par value; 50,000,000 shares authorized; 39,350,000
shares issued and outstanding in 2002 and 2001 .......................................... 394 394
Additional capital .......................................................................... 587,623 545,020
Accumulated deficit ......................................................................... (590,417) (384,328)
Deferred compensation ....................................................................... -- (3,448)
Accumulated other comprehensive loss ........................................................ (361) (242)
--------- ---------
Total stockholders' equity (deficit) ................................................. (2,506) 157,644
--------- ---------
Total liabilities and stockholders' equity (deficit) ................................. $ 258,137 $ 427,358
========= =========
See accompanying notes to consolidated financial statements.
4
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited (Amounts in thousands)
Nine Months Ended
September 30,
--------------------------
2002 2001
----------- -----------
Operating activities:
Net loss ............................................................... $ (206,089) $ (142,719)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization ........................................ 119,206 96,029
Impairment loss ...................................................... 56,990 --
Provision for doubtful accounts ...................................... 2,745 12,415
Provision for doubtful accounts for WorldCom ......................... 18,578 --
Amortization of deferred compensation ................................ 3,603 2,489
Accretion of interest on note payable and capital lease
obligations ........................................................ 150 84
Changes in operating assets and liabilities:
Accounts receivable .................................................. 8,798 (4,459)
Due from WorldCom, net ............................................... (2,759) (7,486)
Deferred costs ....................................................... 1,374 949
Prepaid expenses and other current assets ............................ 1,266 953
Notes receivable from employees ...................................... 789 --
Other assets ......................................................... 257 1,362
Accounts payable and accrued expenses ................................ (6,225) 6,897
Deferred liabilities ................................................. (1,926) (1,265)
----------- -----------
Net cash used in operating activities .................................. (3,243) (34,751)
Investing activities:
Purchases of property and equipment .................................... (25,620) (83,121)
Purchase of restricted investments ..................................... (61) (1,178)
Proceeds from restricted investments ................................... 122 --
Proceeds from sale of property and equipment ........................... 346 233
----------- -----------
Net cash used in investing activities .................................. (25,213) (84,066)
Financing activities:
Proceeds from issuances of notes payable ............................... 37,350 43,300
Proceeds from exercises of common stock options ........................ -- 2,084
Principal payment on long-term note payable and capital lease
obligations .......................................................... (4,822) (3,333)
----------- -----------
Net cash provided by financing activities .............................. 32,528 42,051
Effect of exchange rate on cash and cash equivalents ...................... (119) (146)
----------- -----------
Net decrease in cash and cash equivalents ................................. 3,953 (76,912)
Cash and cash equivalents at beginning of period .......................... 12,096 83,434
----------- -----------
Cash and cash equivalents at end of period ................................ $ 16,049 $ 6,522
=========== ===========
Supplemental disclosures of cash flow information:
Assets acquired through capital leases ................................. $ 1,273 $ 11,041
Assets purchased with equipment credits granted in connection with
the issuance of preferred stock ..................................... 6,195 4,478
Interest paid .......................................................... 6,687 2,420
See accompanying notes to consolidated financial statements.
5
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The accompanying consolidated financial statements have been prepared by
Digex, Incorporated without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission (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 should be read in conjunction with the Form 10-K of Digex for the
year ended December 31, 2001, including the audited consolidated financial
statements and related notes and the section entitled "Risk Factors."
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. For example, specific line items related to WorldCom, such
as the provision for doubtful accounts, accounts receivable and accounts
payable, have been presented.
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, results of
operations and cash flows for the periods presented. The preparation of
financial statements in accordance with GAAP 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. The results of operations for the interim
periods are not necessarily indicative of the results for the entire year.
On July 1, 2001, pursuant to the terms of the agreement and plan of merger,
dated September 1, 2000, and the amendments thereto, a wholly-owned subsidiary
of WorldCom, Inc. was merged with and into Intermedia Communications Inc., with
Intermedia continuing as the surviving corporation and as a subsidiary of
WorldCom (the "Intermedia - WorldCom Merger"). As a result of the Intermedia -
WorldCom Merger, WorldCom now owns approximately 90.0% of the voting securities
of Intermedia, which includes all of its capital stock other than the 13-1/2%
series B preferred stock. Therefore, WorldCom has acquired an indirect
controlling interest of Digex through Intermedia, which continues to own
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
September 30, 2002.
In connection with the Intermedia - WorldCom Merger and the settlement of
related litigation, WorldCom and Digex have entered into a series of operating
and funding agreements under which Digex sells hosting services to WorldCom, may
borrow to satisfy cash requirements, and purchases certain telecommunication
services from WorldCom. These agreements are discussed in more detail in Note 7
"Related Party Agreements."
Refer also to Note 2 "Recent Events related to WorldCom and Digex."
6
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
2. Recent Events related to WorldCom and Digex
There have been a number of internal and external events which have
impacted Digex in the last two quarters. Some of the significant events include:
. On June 21, the Board named George L. Kerns as President and Chief
Executive Officer (CEO) of Digex.
. On June 24, T. Scott Zimmerman was named Digex Chief Financial
Officer (CFO), after having served as interim CFO for approximately 6
months and as controller since 1999.
. On June 25, WorldCom announced that it would have to restate certain
financial statements from 2001 and the first quarter of 2002 to
reflect as operating expenditures approximately $3.9 billion of
expenses previously accounted for as capital expenditures.
. On June 27, Digex announced a reduction of 86 positions, or
approximately 7.0% of its overall workforce.
. On July 12, the three non-WorldCom members of the Digex board of
directors resigned.
. On July 21, WorldCom and many of its domestic affiliates, but not
including Digex, filed a petition for reorganization in the federal
bankruptcy court in New York.
. On July 22, 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.
. On August 6, Digex announced a reduction of approximately 200
positions, or about 20.0% of its overall workforce.
. On August 8, WorldCom announced that it would have further
multi-billion dollar restatements of its financial statements for
prior years.
. On September 10, WorldCom announced that its board of directors
agreed to a request from John Sidgmore to begin a search for a new
CEO.
. On September 12, George L. Kerns and three independent
directors--Howard Frank, Max D. Hopper, and Paul G. Kozlowski--were
appointed to the Digex board of directors.
. On September 19, WorldCom announced that it is preparing a further
revision of its financial results that could add an additional $2.0
billion to the existing $7.0 billion in restatements previously
disclosed in June and August.
. On September 25, three senior WorldCom employees - Vinton Cerf,
Wayne Huyard and Jon McGuire-- were appointed to the Digex board.
. On October 10, Digex announced that Bert Roberts and Ronald Beaumont
resigned from the Digex board. Board member K. William Grothe, Jr. has
been appointed chairman.
. On October 15, the bankruptcy court approved up to $1.1 billion in
debtor-in-possession (DIP) financing for WorldCom while it reorganizes
under Chapter 11.
. On October 22, WorldCom filed a motion to seek an extension of its
sole right to file a reorganization plan through April 17, 2003. If
the motion is approved and if WorldCom files a plan by that date,
other entities would be further excluded from filing plans for
WorldCom through June 16, 2003 while it solicits plan votes.
. On November 11, Digex announced that its Board of Directors has formed
a Special Committee to explore strategic alternatives, including a
possible sale of the Company.
7
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
Throughout these events, Digex has been focusing on three top
priorities--achieving financial independence by becoming self-sustaining from an
operating and capital expenditures perspective, renewing its focus on its
customers, and expanding the Digex value proposition for current and prospective
customers. The workforce reductions of June and August were part of Digex's
efforts to bring expenses into line with revenues in the present economic
environment. At the same time, Digex is taking steps to minimize the amount of
capital required to deliver customer solutions by implementing customer
furnished equipment offerings and maximizing the usage of existing equipment
inventory along with third party leasing options. Digex remains committed to
retaining its market position and providing quality hosting solutions and
services, and believes that the plan provides Digex with the best opportunity to
succeed in the marketplace.
From WorldCom's bankruptcy filing on July 21, 2002 through November 8,
2002, it has loaned $10.9 million to Digex, through Intermedia. These loans were
necessary, in part, to offset the amounts due from WorldCom to Digex prior to
WorldCom's bankruptcy filing that remain unpaid as of September 30, 2002.
Although WorldCom has permission under its interim credit agreement to loan
Digex up to $10.0 million per month, there can be no assurance that WorldCom
will continue making loans to Digex. WorldCom has indicated that it has not
drawn on its interim credit agreement as of November 5, 2002.
Digex currently projects continued net losses. Digex is currently dependent
on WorldCom to fund its operating cash flow deficits and capital expenditures.
Actual funding from January 1, 2002 through September 30, 2002 was $37.2
million, substantially less than forecasted under the original Digex 2002
business plan. The ultimate amount of borrowings can be affected by WorldCom's
bankruptcy, changes in the economy, and Digex's ability to execute its business
plan, among other factors. Further, as of September 30, 2002, approximately
$56.8 million in notes payable and capital lease obligations come due during
2003. Digex currently believes that some or all of these obligations will need
to be restructured and is pursuing the restructuring of some or all of these
obligations. There can be no assurance that these obligations will be
restructured or that WorldCom will provide Digex with any additional funding.
Digex believes that funding from any source other than WorldCom on appropriate
or commercially acceptable terms will be difficult to secure.
The continuing impact of the above events on Digex remains unclear. Digex
cannot predict what will happen at WorldCom, nor can it predict the effect that
events at WorldCom will have on Digex. Further, it cannot predict how its
customers, vendors, employees and strategic partners will react to the unfolding
events. Digex believes that some of these entities have reacted negatively to
the events or perceptions generated from these events and Digex has been and may
continue to be negatively impacted. As a result, Digex's ability to execute its
plans may be substantially impaired. Over the past few quarters, Digex has
realized a decline in revenue. However, Digex has also reduced expenses and is
establishing customer programs for customer furnished equipment and third party
leasing options to continue to reduce the capital required to operate its
business.
Although no assurances can be given, management believes that Digex has the
ability to continue as a going concern unless WorldCom's bankruptcy filing
negatively impacts any future borrowings necessary to fund Digex's business
operations. The preparation of the Digex business plan for 2003 is currently in
progress and is expected to be submitted for approval to the WorldCom and Digex
boards of directors
8
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
on or before December 1, 2002, as described in Note 7 "Related Party
Agreements." Nonetheless, because of recent events surrounding WorldCom and the
lack of certainty that WorldCom will be able to continue to fund Digex, there is
substantial doubt about Digex's ability to continue as a going concern over the
next twelve months. A 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. The
accompanying unaudited financial statements do not reflect any adjustments to
the carrying value of Digex's net assets or the amount and classification of its
liabilities in the event Digex is not able to continue as a going concern.
3. Recent Accounting Pronouncements
Goodwill and Other Intangible Assets
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets. Under the new rules, goodwill and intangible assets deemed to
have indefinite lives are no longer amortized but are subject to impairment
tests at least once a year based upon estimated fair value. Digex adopted the
provisions of SFAS No. 142, effective January 1, 2002, and ceased amortization
of amounts assigned to goodwill and acquired workforce. Depreciation and
amortization expense, excluding the amortization of goodwill and acquired
workforce, in the third quarter of 2001 was $33.6 million. The net book value of
goodwill and acquired workforce at September 30, 2002 was approximately $11.9
million.
9
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
The following table reconciles reported net loss available to common
stockholders and loss per share to adjusted net loss available to common
stockholders and loss per share, excluding the goodwill and acquired workforce
amortization previously recognized (in thousands):
Three months ended Nine months ended
September 30, September 30,
----------------------------- -------------------------------
2002 2001 2002 2001
------------ ------------- ------------ ---------------
Net loss available to common stockholders,
as reported ................................... $ (37,654) $ (52,183) $ (208,102) $ (145,738)
Add: Goodwill and acquired workforce
amortization .................................. -- 540 -- 1,620
------------ ------------- ------------ ---------------
Adjusted net loss ............................... $ (37,654) $ (51,643) $ (208,102) $ (144,118)
============ ============= ============ ===============
Loss per common share--basic and diluted:
Net loss available to common stockholders,
as reported ................................... $ (0.58) $ (0.81) $ (3.22) $ (2.28)
Add: Goodwill and acquired workforce
amortization .................................. -- 0.01 -- 0.03
------------ ------------- ------------ ---------------
Adjusted net loss ............................... $ (0.58) $ (0.80) $ (3.22) $ (2.25)
============ ============= ============ ===============
Digex completed its fair value assessment of goodwill as of January 1, 2002
and determined that goodwill was not impaired. However, given the decrease in
Digex's market capitalization since January 1, 2002 and the uncertainty created
by WorldCom's recent announcements of its intention to restate its financial
statements, as described above, management reassessed the recoverability of its
goodwill as of June 30, 2002 pursuant to SFAS No. 142. Pursuant to an
independent appraisal, Digex determined that goodwill was not impaired as of
June 30, 2002. Digex has elected to assess impairment of goodwill annually as of
July 1st, unless events or changes in circumstances indicate a more frequent
review is necessary. Any impairment then identified would be recorded in
operations in the period in which the impairment is identified. Digex determined
that there were no events or changes in circumstances which would have affected
the fair value of its goodwill as of July 1st, its annual assessment date,
relative to its valuation performed as of June 30, 2002.
Impairment of Long-Lived Assets
In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which supercedes both No. 121, Impairment of Long-Lived
Assets for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions for the disposal of a segment of a business contained in Accounting
Principle 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. Digex has adopted
the provisions of SFAS No. 144 on January 1, 2002.
10
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
Under SFAS No. 144, Digex reviews its long-lived assets for impairment when
events or changes in circumstances indicate the carrying value of such assets
may not be recoverable. The review consists of a comparison of the carrying
value of the assets with the assets' expected future undiscounted cash flows
without interest costs. Estimates of expected future cash flows represent
management's best estimate based on reasonable and supportable assumptions and
projections. If the expected future undiscounted cash flow exceeds the carrying
value of the asset, no impairment is considered present. If the carrying value
exceeds the future undiscounted cash flow, an impairment indicator is considered
present. The amount of impairment may be measured using discounted cash flows or
other means of determining fair value.
The events surrounding WorldCom, as described above, caused management to
revise its estimates of future financial projections. Digex also performed an
undiscounted cash flow analysis related to its long-lived assets. The result of
that analysis indicated that an impairment to the carrying value of its fixed
assets and other intangible assets may have existed as of June 30, 2002. Based
upon an independent appraisal, Digex adjusted its long-lived assets down to fair
value by recording an impairment loss related to its property and equipment of
$55.4 million and identifiable intangible assets of $1.6 million for the three
months ended June 30, 2002. Should Digex fail to meet its operating budget
during the balance of 2002, management's estimates of future cash flows may be
further adjusted downward. Such downward adjustments could trigger a further
impairment of Digex's long-lived assets.
Accounting for Costs Associated with Exit or Disposal Activities
In July 2002, the FASB has 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 does not expect the adoption of SFAS No. 146 to have a
material impact on its consolidated results of operations or financial position.
11
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)
4. Comprehensive Loss
The following table reflects the calculation of comprehensive loss (in
thousands):
Three months ended Nine months ended
September 30, September 30,
----------------------------- -------------------------------
2002 2001 2002 2001
------------ ------------- ------------ ---------------
Net loss available to common stockholders ....... $ (37,654) $ (52,183) $ (208,102) $ (145,738)
Other comprehensive loss:
Foreign currency translation adjustments ...... (240) 60 (119) (146)
------------ ------------- ------------ ---------------
Comprehensive loss available to common
stockholders .................................. $ (37,894) $ (52,123) $ (208,221) $ (145,884)
============ ============= ============ ===============
5. Commitments and Contingencies
In 2001, Digex entered into master lease and financing agreements with two
vendors for lines of credit to facilitate the leasing of computer hardware and
software. The terms of the associated schedules range from 12 months for
financing a maintenance contract to 36 months for leasing computer equipment.
Digex will have an option to purchase the equipment at the end of the initial
lease term. Interest and principal are payable monthly with interest rates
ranging from 7.2% to 12.3% per annum. As of September 30, 2002 and December 31,
2001, Digex had acquired $12.2 million and $11.0 million of computer equipment
and maintenance services under these leasing and financing arrangements,
respectively.
In July 2002, Digex 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 initiative. Repayment of principal will be
deferred each year through December 31, 2005 if Digex maintains at least 1,290
permanent, full time employees at any of its Maryland facilities during the
three year period from December 31, 2002. At December 31, 2005, the principal
amount may convert to a grant upon the achievement of certain requirements by
Digex. In accordance with the grant agreement, Digex 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 Digex defaults in performance or fails to cure such a default
within a ten day period after receipt of default notification. If Digex does not
hire and retain at least 796 employees at its Maryland facilities at December
31, 2002, the full amount of the loan will be payable immediately. Currently,
Digex does not expect to be in compliance for deferring full repayment of the
loan at December 31, 2002 based on its projected business plan. As a result, the
$150,000 loan has been recorded as a short-term note payable as of September 30,
2002.
Digex is also indebted to Intermedia as discussed in Note 7 "Related Party
Agreements."
12
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
6. Restructuring Charges
In June 2002, Digex terminated the employment of 86 employees, or
approximately 7.0% of its overall workforce, in an effort to streamline
expenses. In connection with the reduction in its employee base, Digex also
vacated certain excess office space. Digex recognized a liability of $1.4
million for severance benefits, estimated amount of future rent payments for
permanently vacated properties, and estimated amount of lease termination fees
as of June 30, 2002.
In August 2002 and September 2002, Digex completed a reduction of
approximately 200 positions, or about 20% of its overall workforce in the United
States and around the world. These efforts are part of an overall plan for Digex
to become financially self-sustaining, and to align and focus resources on
servicing its customer base by eliminating certain positions primarily in its
non-service delivery organizations. During the three months ended September 30,
2002, Digex recorded a restructuring charge of $2.4 million in its results of
operations, of which $2.3 million was related to severance benefits for
employees terminated as of September 30, 2002. Other exit costs were primarily
related to early terminated real property leases and legal costs. No formal
plans have been adopted by management for any additional restructuring
activities.
Reserve at Reserve at
December 31, Cash September 30,
2001 Accrual Paid 2002
------------- ---------- ---------- -------------
Severance benefits ............ -- $ 3,175 $ (2,285) $ 890
Other exit costs .............. -- 590 (322) 268
------------- ---------- ---------- -------------
Total restructuring charges ... -- $ 3,765 $ (2,607) $ 1,158
============= ========== ========== =============
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. The
four agreements are also subject to termination by either party upon insolvency
of the other. WorldCom has not notified Digex of any intentions to modify or
terminate any of the agreements. There can be no assurance that changes to the
commercial agreements
13
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
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. WorldCom has agreed to purchase up to a total of $500.0
million of managed Web hosting services during the period from 2001 through 2003
if Digex satisfies certain service level and data center capacity commitments.
WorldCom purchased $50.0 million of managed hosting services in 2001 and has
agreed to purchase $192.0 million in 2002. WorldCom has 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"). WorldCom also agreed to compensate Digex, on a quarterly basis,
for the full amount of operating losses before depreciation and amortization
incurred in servicing WorldCom customers under the sales channel agreement,
during 2001. However, since 2001, to the extent that Digex generates operating
income before depreciation and amortization in servicing WorldCom customers
under the sales channel agreement, Digex has agreed to share such operating
income with WorldCom. WorldCom's participation in operating results is
recognized as adjustments to revenue recognized under the sales channel
agreement.
Total revenue from WorldCom under the sales channel agreement include (1)
actual managed hosting services purchased for resale by WorldCom and (2) the
difference, if any, between actual managed hosting services purchased by
WorldCom and WorldCom's Minimum Annual Commitment. These amounts are further
adjusted for compensation due to or due from WorldCom as discussed above based
upon the net results of activity under the sales channel agreement.
14
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
For the three and nine months ended September 30, Digex recognized revenue
from WorldCom, under the sales channel agreement, of $12.4 million and $39.5
million in 2002, respectively, and $9.2 million and $14.3 million in 2001,
respectively. All revenue recognized under the sales channel agreement in 2002
resulted from actual managed hosting services purchased for resale by WorldCom.
Since July 1, 2002, Digex has recognized revenue from WorldCom only upon
collection due to the bankruptcy of WorldCom. Approximately $3.6 million of
pre-petition revenue from WorldCom was billed for the period from July 1, 2002
through July 21, 2002, but has not been recognized as revenue because it has not
been collected as of September 30, 2002. All receivables due from WorldCom
recorded prior to July 1, 2002, which have not been collected subsequent to June
30, 2002, are fully reserved. Revenue from the sales channel agreement may be
adversely affected by WorldCom's bankruptcy filing.
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 $0.8 million and $2.3 million for the three and nine months ended September
30, 2002, respectively, and $1.0 million for the three and nine months ended
September 30, 2001.
Network Agreement. This agreement, effective January 1, 2001, provides
terms for Digex to purchase bandwidth and connectivity from WorldCom in the
United States to support its managed Web hosting activities. The expense for the
dedicated Internet connections and WorldCom network services amounted to $0.6
million and $2.3 million for the three and nine months ended September 30, 2002,
respectively, and $1.4 million and $4.4 million for the three and nine months
ended September 30, 2001, respectively.
WorldCom also provides certain operational services to Digex under vendor
contracts or agreements in the ordinary course of business, such as facilities,
telephone, software maintenance, 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 Nine months ended
September 30, September 30,
-------------------- ---------------------
2002 2001 2002 2001
--------- -------- --------- ---------
Other circuit related expense $ 1,136 $ 2,679 $ 4,438 $ 5,069
Telephone expense 1,078 693 2,846 2,018
Rent expense 161 -- 544 --
Network maintenance expense 525 -- 1,575 --
--------- -------- --------- ---------
$ 2,900 $ 3,372 $ 9,403 $ 7,087
========= ======== ========= =========
15
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
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 2002 presented above.
Borrowings from Related Parties
On July 31, 2001, Digex entered into a note purchase agreement with
WorldCom whereby WorldCom agreed to provide funding for the Digex business plans
for 2001 and 2002 as approved by the Digex and WorldCom boards of directors. The
Digex and WorldCom boards of directors approved the Digex business plans for
2001 and 2002. The preparation of the Digex business plan for 2003 is currently
underway and is expected to be submitted to the WorldCom and Digex boards of
directors for approval no later than December 1, 2002. Subject to the terms and
conditions of the agreement, Digex will issue and WorldCom will purchase (or
cause an affiliate to purchase) a series of senior notes up to an aggregate
principal amount sufficient to satisfy Digex's net cash requirements under the
approved business plan. Given WorldCom's bankruptcy filing, there can be no
assurance that WorldCom will honor its contractual commitments to Digex. See
Note 2 "Recent Events related to WorldCom and Digex."
As of September 30, 2002 and December 31, 2001, Digex issued and WorldCom
caused Intermedia to purchase, under the note purchase agreement, a series of
senior notes totaling $102.2 million and $65.0 million, respectively, to satisfy
Digex's net cash requirements under its approved 2002 and 2001 business plans.
Through September 30, 2002, variable interest on the unpaid principal balance
was paid monthly at an interest rate of 300 basis points over LIBOR rate
(weighted average interest rate of 4.96%). Interest cost incurred and charged to
expense related to the funding agreement with WorldCom was $1.2 million and $3.0
million for the three and nine months ended September 30, 2002, respectively.
Interest cost incurred and charged to expense related to the funding agreement
with WorldCom was $0.2 million for each of the three and nine months ended
September 30, 2001. Digex has made and continues to make the monthly interest
payments to Intermedia. Repayment of principal is due on December 31, 2002, but
may be extended to December 31, 2006 upon the election of Digex by written
notice. Management intends to make this election by December 13, 2002, at which
time amounts then outstanding will be repaid in equal monthly straight-line
amortization payments of principal through December 31, 2006. As a result, all
payments after the election due in periods after September 30, 2003 have been
classified as long-term. Any changes to its business plans that require
increased funding would require the WorldCom board of directors' approval before
WorldCom would be obligated to fund any such increase.
On January 14, 2002, Digex entered into a note purchase agreement, dated
July 31, 2001, with Intermedia to refinance the $13.0 million intercompany loan
and $12.0 million promissory note to Intermedia under a senior note totaling
$25.0 million. The terms of the agreement are substantially the same as the
original note purchase agreement, dated July 31, 2001 between Digex and
WorldCom, with the repayment of principal due on December 31, 2003. There is no
option to extend the maturity date of the notes. Through September 30, 2002,
variable interest on the unpaid principal balance was paid monthly at an
interest rate of 300 basis points over LIBOR rate (weighted average interest
rate of 5.20%). Interest cost incurred and charged to expense related to the
funding agreement with Intermedia was $0.3
16
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
million and $0.9 million for the three and nine months ended September 30, 2002,
respectively. Digex has made and continues to make the monthly interest payments
to Intermedia.
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 $6.0 million and $6.8 million as of September 30, 2002
and December 31, 2001, 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 occurred 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 the amounts (1) if he or
she is actively employed with Digex through and including November 1, 2003 or
(2) if prior to November 1, 2003 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
September 30, 2002, the potential retention bonus pool payable in 2003 under
these agreements totaled $12.1 million.
8. Stockholders' Equity
On April 1, 2002, Microsoft converted its 50,000 shares of Series A
convertible preferred stock into 730,995 shares of Digex Class A common stock.
Prior to conversion into common stock on April 1, 2002, Microsoft's redeemable
preferred stock was classified outside of stockholders' equity. Upon conversion
into common stock, the then carrying amount of the redeemable preferred stock of
approximately $44.5 million was recorded as a component of stockholders' equity.
A component of the then carrying value of Microsoft's redeemable preferred stock
was a discount that had been recorded upon the original issuance of the
preferred stock. That discount was being accreted into net loss available to
common stockholders through additional capital on the consolidated balance
sheets. After the conversion, neither further accretion of the preferred stock
discount will be recorded nor will the preferred stock be subject to future
redemption or conversion.
Digex does not anticipate paying any dividends on any of its common stock
in the foreseeable future. Moreover, Digex is subject to restrictions under the
Intermedia indentures, which restrict any subsidiary of Intermedia from paying
dividends unless Intermedia meets certain financial tests. Intermedia does not
currently meet and is not expected to meet these financial tests in the
foreseeable future. Therefore, Digex is effectively prohibited from paying
dividends. Digex may also incur indebtedness in the future, which may prohibit
or effectively restrict the payment of dividends.
17
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Unaudited)
In accordance with the Digex Long-Term Incentive Plan, all stock options
granted to participants who were employed by Digex as of July 1, 2001, the
consummation date of the Intermedia - WorldCom Merger, have become fully vested
on July 1, 2002 through a provision for accelerated vesting upon a change of
control of Digex. Accordingly, deferred compensation of $2.6 million as of June
30, 2002 for options granted with exercise prices at less than fair market value
was expensed in the third quarter of 2002. The lowest exercise price of these
options is $5.00.
18
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the
accompanying 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, as filed with the SEC on April 1,
2002.
Overview
We are a provider of advanced hosting services for companies conducting
business on the Internet. Our services include server management, application
support, managed networking services, and customer care and support services. We
also offer value-added IT services, such as enhanced security, database
services, high-availability and application optimization services, stress
testing, and consulting services. As part of our services, we provide the
installation and maintenance of computer hardware and software, network
technology, and systems management to offer our customers a broad range of
managed hosting solutions. From major corporations to Internet-based businesses,
our customers use our services to rapidly deploy their business solutions
including on-line financial services, on-line procurement, electronic retailing,
and customer self-service applications.
Recent Events
There have been a number of internal and external events which have
impacted us in the last two quarters. Some of the significant events include:
. On June 21, the Board named George L. Kerns as President and Chief
Executive Officer (CEO) of Digex.
. On June 24, T. Scott Zimmerman was named Digex Chief Financial Officer
(CFO), after having served as interim CFO for approximately 6 months
and as controller since 1999.
. On June 25, WorldCom announced that it would have to restate certain
financial statements from 2001 and the first quarter of 2002 to
reflect as operating expenditures approximately $3.9 billion of
expenses previously accounted for as capital expenditures.
. On June 27, we announced a reduction of 86 positions, or approximately
7.0% of our overall workforce.
. On July 12, the three non-WorldCom members of our board of directors
resigned.
. On July 21, WorldCom and many of its domestic affiliates, but not
including Digex, filed a petition for reorganization in the federal
bankruptcy court in New York.
. On July 22, 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.
. On August 6, we announced a reduction of approximately 200 positions,
or about 20.0% of our overall workforce.
. On August 8, WorldCom announced that it would have further
multi-billion dollar restatements of its financial statements for
prior years.
. On September 10, WorldCom announced that its board of directors agreed
to a request from John Sidgmore to begin a search for a new CEO.
. On September 12, George L. Kerns and three independent
directors--Howard Frank, Max D. Hopper, and Paul G. Kozlowski--were
appointed to our board of directors.
. On September 19, WorldCom announced that it is preparing a further
revision of its financial results that could add an additional $2.0
billion to the existing $7.0 billion in restatements previously
disclosed in June and August.
19
. On September 25, three senior WorldCom employees - Vinton Cerf, Wayne
Huyard and Jon McGuire--were appointed to our board.
. On October 10, we announced that Bert Roberts and Ronald Beaumont
resigned from our board. Board member K. William Grothe, Jr. has been
appointed chairman.
. On October 15, the bankruptcy court approved up to $1.1 billion in
debtor-in-possession (DIP) financing for WorldCom while it reorganizes
under Chapter 11.
. On October 22, WorldCom filed a motion to seek an extension of its
sole right to file a reorganization plan through April 17, 2003. If
the motion is approved and if WorldCom files a plan by that date,
other entities would be further excluded from filing plans for
WorldCom through June 16, 2003 while it solicits plan votes.
. On November 11, we announced that our Board of Directors has formed a
Special Committee to explore strategic alternatives, including a
possible sale of the company.
Throughout these events, we have been focusing on three top
priorities--achieving financial independence by becoming self-sustaining from an
operating and capital expenditures perspective, renewing our focus on our
customers, and expanding our value proposition for current and prospective
customers. The workforce reductions of June and August were part of our efforts
to bring expenses into line with revenues in the present economic environment.
At the same time, we are taking steps to minimize the amount of capital required
to deliver customer solutions by implementing customer furnished equipment
offerings and maximizing the usage of existing equipment inventory along with
third party leasing options. We remain committed to retaining our market
position and providing quality hosting solutions and services, and believe that
the plan provides us with the best opportunity to succeed in the marketplace.
From WorldCom's bankruptcy filing on July 21, 2002 through November 8,
2002, it has loaned $10.9 million to us, through Intermedia. These loans were
necessary, in part, to offset the amounts due from WorldCom to Digex prior to
WorldCom's bankruptcy filing that remain unpaid as of September 30, 2002.
Although WorldCom has permission under its interim credit agreement to loan us
up to $10.0 million per month, there can be no assurance that WorldCom will
continue making loans to us. WorldCom has indicated that it has not drawn on its
interim credit agreement as of November 5, 2002.
We currently project continued net losses. We are currently dependent on
WorldCom to fund our operating cash flow deficits and capital expenditures.
Actual funding from January 1, 2002 through September 30, 2002 was $37.2
million, substantially less than forecasted under the original Digex 2002
business plan. The ultimate amount of borrowings can be affected by WorldCom's
bankruptcy, changes in the economy, and our ability to execute our business
plan, among other factors. Further, as of September 30, 2002, approximately
$56.8 million in notes payable and capital lease obligations come due during
2003. We currently believe that some or all of these obligations will need to be
restructured and we are pursuing the restructuring of some or all of these
obligations. There can be no assurance that these obligations will be
restructured or that WorldCom will provide us with any additional funding. We
believe that funding from any source other than WorldCom on appropriate or
commercially acceptable terms will be difficult to secure.
The continuing impact of the above events on us remains unclear. We cannot
predict what will happen at WorldCom, nor can we predict the effect that events
at WorldCom will have on us. Further, we cannot predict how our customers,
vendors, employees and strategic partners will react to the unfolding events. We
believe that some of these entities have reacted negatively to the events or
perceptions generated from these events and we have been and may continue to be
negatively impacted. As a result, our ability to execute our plans may be
substantially impaired. Over the past few quarters, we have realized a decline
in revenue. However, we have also reduced expenses and we are establishing
customer programs for customer furnished equipment and third party leasing
options to continue to reduce the capital required to operate our business.
20
Although no assurances can be given, management believes that we have the
ability to continue as a going concern unless WorldCom's bankruptcy filing
negatively impacts any future borrowings necessary to fund our business
operations. The preparation of the Digex business plan for 2003 is currently in
progress and is expected to be submitted for approval to the WorldCom and Digex
boards of directors on or before December 1, 2002, as described in Note 7
"Related Party Agreements" to the accompanying unaudited consolidated financial
statements. Nonetheless, because of recent events surrounding WorldCom and the
lack of certainty that WorldCom will be able to continue to fund us, there is
substantial doubt about our ability to continue as a going concern over the next
twelve months, unless we are successful in restructuring some or all of our
existing debt obligations. A 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. The
accompanying unaudited consolidated financial statements do not reflect any
adjustments to the carrying value of our net assets or the amount and
classification of our liabilities in the event we are not able to continue as a
going concern.
Related Party Transactions
WorldCom is our majority stockholder, primary lender, significant channel
partner, and one of our largest vendors. In particular, under the funding
agreement and subject to the bankruptcy proceedings, WorldCom is obligated to
provide funding for the approved Digex business plan through 2002 only. WorldCom
will then have an option to continue funding us beyond 2002, but may not
exercise such option. Through 2002, we currently anticipate that our only source
to fund our working capital needs and capital expenditure requirements, above
cash generated from operations, will be WorldCom.
At September 30, 2002, we served approximately 650 customers, of which
approximately 270 customers are WorldCom channel customers. We also managed
3,758 Windows- and UNIX-based servers in our data centers, which are positioned
on the east and west coasts of the United States, and in Europe and Asia.
Approximately 1,200 of our total managed servers were sold through the WorldCom
sales channel agreement.
Through the sales channel agreement, WorldCom resells our portfolio of
managed hosting products. We also have access to WorldCom's sales force to
enhance our global presence. WorldCom has agreed to purchase up to a total of
$500.0 million of managed hosting services during the period from 2001 through
2003 if we satisfy certain service level and data center capacity commitments.
WorldCom purchased $50.0 million of managed hosting services in 2001 and has
agreed to purchase $192.0 million in 2002. WorldCom has 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"). 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, since 2001, to the extent that we generate operating income before
depreciation and amortization in servicing WorldCom under the sales channel
agreement, we have agreed to share such operating income with WorldCom.
WorldCom's participation in operating results is recognized as adjustments to
revenue recognized under the sales channel agreement.
Total revenue from WorldCom under the sales channel agreement include (1)
actual managed hosting services purchased for resale by WorldCom and (2) the
difference, if any, between actual managed hosting
21
services purchased by WorldCom and WorldCom's Minimum Annual Commitment. These
amounts are further adjusted for compensation due to or due from WorldCom as
discussed above based upon the net results of activity under the agreement.
For the three and nine months ended September 30, we recognized revenue
from WorldCom, under the sales channel agreement, of $12.4 million and $39.5
million in 2002, respectively, and $9.2 million and $14.3 million in 2001,
respectively. All revenue recognized under the sales channel agreement in 2002
resulted from actual managed hosting services purchased for resale by WorldCom.
Since July 1, 2002, we have recognized revenue from WorldCom only upon
collection due to the bankruptcy of WorldCom. Approximately $3.6 million of
pre-petition revenue from WorldCom was billed for the period from July 1, 2002
through July 21, 2002, but has not been recognized as revenue because it has not
been collected as of September 30, 2002. All receivables due from WorldCom
recorded prior to July 1, 2002, which have not been collected subsequent to June
30, 2002, are fully reserved. Revenue from the sales channel agreement may be
adversely affected by WorldCom's bankruptcy filing.
Through our facilities agreement with WorldCom, we 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. The expense for the data center space and connections from
the space to a WorldCom Internet Protocol network hub amounted to $0.8 million
and $2.3 million for the three and nine months ended September 30, 2002,
respectively, and $1.0 million for each of the three and nine months ended
September 30, 2001.
Our network agreement with WorldCom provides us with terms to purchase
bandwidth and connectivity from WorldCom in the United States to support our
managed hosting activities. The expense for the dedicated Internet connections
and WorldCom network services amounted to $0.6 million and $2.3 million for the
three and nine months ended September 30, 2002, respectively, and $1.4 million
and $4.4 million for the three and nine months ended September 30, 2001,
respectively. Effective March 2002, WorldCom serves as our primary bandwidth
provider for the U.K. We have secured secondary providers for the U.S. and U.K.
in the third quarter of 2002.
The agreements are subject to termination by either party upon insolvency
of the other. WorldCom has not notified us of any intentions to modify or
terminate any of the agreements. 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
The following discussion and analysis of financial condition and results of
operations should be read in conjunction with the accompanying unaudited
consolidated financial statements and related notes herein, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. We evaluate our estimates on a continual basis, including those
related to revenue recognition, allowance for doubtful accounts, property and
equipment, intangible assets, and redeemable preferred stock. We base our
estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
22
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
Revenue Recognition. We generate most of our revenue from monthly fees
charged to customers under contracts having terms that typically range from one
to three years. We also charge installation fees for new and existing customers
upgrading service. In accordance with Staff Accounting Bulletin No. 101 ("SAB
101"), we recognize installation revenue and related direct costs of performing
the installation over a period that we estimate to be the longer of the
estimated life of the customer relationship or the average life of all customer
contracts. We continually analyze the average life of our customer relationships
and contracts and have determined that a 24-month period is a reasonable
estimate. Any revisions in the estimated contract period will be charged to
income in the period in which the facts that give rise to the revision become
known.
The difference between the actual amount invoiced to WorldCom through the
sales channel agreement and the minimum annual revenue commitment is recognized
as revenue at the end of the measurement period, net of our share of operating
income before depreciation and amortization in servicing WorldCom. Since July 1,
2002, we have recognized revenue from WorldCom only upon collection due to the
bankruptcy of WorldCom. Approximately $3.6 million of pre-petition revenue from
WorldCom was billed for the period from July 1, 2002 through July 21, 2002, but
has not been recognized as revenue because it has not been collected as of
September 30, 2002. All receivables due from WorldCom recorded prior to July 1,
2002, which have not been collected subsequent to June 30, 2002, are fully
reserved. Revenue from the sales channel agreement may be adversely affected by
WorldCom's bankruptcy filing.
We also recognize revenue from early termination fees upon collection from
customers not fulfilling the contract terms. This includes certain configuration
changes initiated by the customer or early terminations from the contract terms.
These fees are typically comprised of monthly fees through the remaining term of
the contract period and any unpaid balances.
Allowance for Doubtful Accounts. We regularly assess the credit standing of
our customers and the collectibility of receivables. We cease revenue
recognition when collectibility is not probable. Allowances for doubtful
accounts are maintained for estimated losses resulting from the inability of our
customers to make required payments. If the financial condition of our customers
becomes uncertain or deteriorates, impairing their ability to make payments,
additional allowances may be required. All receivables due from WorldCom
recorded prior to July 1, 2002, which have not been collected subsequent to June
30, 2002, are fully reserved. Since July 1, 2002, we have recognized revenue
from WorldCom only upon collection. Ultimately, our judgment regarding the
realizability of WorldCom's receivables will be determined by WorldCom's
bankruptcy proceedings.
Impairment of Long-lived Assets. We review our long-lived assets for
impairment when events or changes in circumstances indicate the carrying value
of such assets may not be recoverable. We also evaluate the useful life of
assets periodically. The review consists of a comparison of the carrying value
of the assets with the assets' expected future undiscounted cash flows without
interest costs. Estimates of expected future cash flows represent management's
best estimate based on reasonable and supportable assumptions and projections.
As discussed in Note 3 "Recent Accounting Pronouncements" to the accompanying
unaudited consolidated financial statements, we recognized an impairment loss of
$57.0 million, of which $55.4 million relates to property and equipment and $1.6
million relates to identifiable intangible assets, for the quarter ended June
30, 2002. If actual market conditions are less favorable than those projected by
management, additional asset write-downs may be required. Management will
continue to evaluate overall industry and company specific circumstances and
conditions to determine whether a future analysis of our long-lived assets is
necessary.
23
Redeemable Preferred Stock. We are accreting the preferred stock discount
to the mandatory conversion date in January 2005. To date, management believes
that a redemption event is not probable due to the covenants contained in
Intermedia's indentures, which restrict redemption, and the requirement of legal
availability of funds. These conditions currently prohibit the redemption of the
securities. If these conditions change, our estimate of when the preferred stock
becomes redeemable or will be converted may require an adjustment to the
accretion amount. Management will continue to evaluate the conditions as
necessary.
Refer to "Business - Risk Factors" in our Form 10-K as filed with the SEC
on April 1, 2002 for known trends or uncertainties that are reasonably likely to
affect our financial condition or results of operations.
Refer to Note 1 "Basis of Presentation" to the accompanying unaudited
consolidated financial statements for further discussion of our significant
accounting policies.
General
Revenue. 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
continually analyze the average life of our customer relationships and contracts
and have determined that a 24-month period is a reasonable estimate. Certain
customer payments for managed Web hosting services received in advance of
service delivery are deferred until the service is performed. Additional
services are recognized in the month the services are performed. Revenue earned
from the sale of third party equipment is also included. We also only recognize
revenues from early termination fees upon collection from customers not
fulfilling the contract terms. This includes certain configuration changes
initiated by the customer or early terminations from the contract terms. These
fees are typically comprised of monthly fees through the remaining term of the
contract period and any unpaid balances.
Costs and Expenses. Costs and expenses include:
. cost of operations;
. cost of services;
. selling, general and administrative expenses;
. provision for doubtful accounts;
. deferred compensation; and
. depreciation and amortization expenses.
Cost of operations consist primarily of the costs for our network
connectivity and firewall services. We expect our network connectivity
requirements to be directly related to the movement of our overall business.
Expenses directly attributed to the sale of third party equipment are also
included.
24
Cost of services consist primarily of facilities administration expenses
including rent, maintenance and utilities to support our data centers and
salaries and related benefits for our technical operations. If our business
grows, we expect our cost of services to marginally increase in dollar amount,
but to decline as a percentage of revenue due to economies of scale and expected
improvements in technology and productivity.
Selling, general and administrative expenses consist primarily of salaries
and benefits for our marketing, sales and support personnel, advertising costs,
consultants' fees, and other miscellaneous expenses. We expect selling, general
and administrative expenses to decline as a percentage of revenue over time due
to the growth of our business.
Provision for doubtful accounts is maintained to reserve against trade
account receivables that have been estimated to be uncollectible due to the
inability of our customers to make the required payment.
Deferred compensation expense relates to stock options that were granted by
Digex to certain employees at exercise prices below market value. We expensed
deferred compensation as of June 30, 2002 in the third quarter of 2002 as these
options fully vested on July 1, 2002.
Depreciation and amortization expense consists primarily of depreciation of
our data centers, servers and related equipment and amortization of our
definite-lived intangible assets. We currently expect future decreases in
depreciation charges related to our existing tangible and certain identifiable
intangible assets base due to a write-down of our long-lived assets to fair
market value as a result of SFAS No. 144 and as our existing assets become fully
depreciated.
25
Results of Operations
The following table presents amounts as reported in our unaudited
consolidated financial statements (in thousands) and certain information derived
from these statements as a percentage of revenue for the three months ended
September 30, 2002 and 2001, respectively.
Three months ended
September 30,
---------------------------------------------
2002 2001
--------------------- ---------------------
Revenue:
Revenue ......................................... $ 30,721 71.2% $ 43,130 82.4%
Revenue from WorldCom ........................... 12,431 28.8 9,194 17.6
---------- -------- ---------- --------
Total revenue ...................................... 43,152 100.0 52,324 100.0
Costs and expenses:
Cost of operations .............................. 2,988 6.9 2,710 5.2
Cost of services ................................ 19,465 45.1 28,792 55.0
Selling, general and administrative ............. 15,459 35.8 31,048 59.3
Provision for doubtful accounts ................. 740 1.7 4,916 9.4
Provision for doubtful accounts for WorldCom .... -- -- -- --
Deferred compensation ........................... 2,610 6.0 683 1.3
Impairment loss ................................. -- -- -- --
Depreciation and amortization ................... 36,899 85.6 34,139 65.3
................................................... ---------- -------- ---------- --------
Total costs and expenses ........................... 78,161 181.1 102,288 195.5
---------- -------- ---------- --------
Loss from operations ............................... (35,009) (81.1) (49,964) (95.5)
Other income (expense):
Interest expense ............................... (2,279) (5.3) (1,670) (3.2)
Interest income and other ...................... 138 0.3 457 0.9
---------- -------- ---------- --------
Net loss ........................................... $ (37,150) (86.1%) $ (51,177) (97.8)%
========== ======== ========== ========
Three months ended September 30, 2002 Compared to Three months ended September
30, 2001
Revenue
Total revenue decreased 17.5% to $43.2 million in the third quarter of 2002
compared to $52.3 million for the same period in 2001. Although our customer
base increased 8.3% to approximately 650 at September 30, 2002 from
approximately 600 at September 30, 2001, average annualized revenue per customer
decreased 14.7% to approximately $272,000 from $319,000 for the same period in
2001. This is primarily due to our customers rightsizing their configurations,
the deferred customer ramp up of services due to economic cost pressures, and
the uncertainty surrounding WorldCom. We recognized revenue of $12.4 million
from WorldCom in the third quarter of 2002, under the sales channel agreement,
compared to total revenues of $9.2 million for the same period in 2001. All
revenue recognized under the sales channel agreement for the three months ended
September 30, 2002 and 2001 resulted from actual managed hosting services
purchased for resale by WorldCom. Since July 1, 2002, we have recognized revenue
from WorldCom only upon collection. Approximately $3.6 million of pre-petition
revenue from WorldCom was billed for the period from July 1, 2002 through July
21, 2002, but has not been recognized as revenue because it has not been
collected as of September 30, 2002. Included in our third quarter revenue is
$0.8 million in fees collected in the third quarter of 2002 for early
termination with no similar fees collected in the same period in 2001.
26
Cost of Operations
Cost of operations increased 10.3% to $3.0 million in the third quarter of
2002 compared to $2.7 million for the same period in 2001. The increase was
primarily due to an increase in customers selecting data streaming products
which more than offset decreases in network circuit costs. As a percentage of
revenue, cost of operations increased to 6.9% in the third quarter of 2002
compared to 5.2% for the same period in 2001.
Cost of Services
Cost of services decreased 32.4% to $19.5 million in the third quarter of
2002 compared to $28.8 million for the same period in 2001. The decrease was
primarily related to a reduction in payroll-related costs associated with a
reduced workforce in 2002, elimination of accrued employee bonuses for 2002 of
$1.1 million, and reduction in outside consultants' fees, partly offset by costs
associated with the 24-month amortization of potential retention bonus amounts
compared to 2001. As a percentage of revenue, total cost of services decreased
to 45.1% in the third quarter of 2002 compared to 55.0% for the same period in
2001.
Selling, General and Administrative
Selling, general and administrative expenses decreased 50.2% to $15.5
million in the third quarter of 2002 compared to $31.0 million for the same
period in 2001. The decrease was primarily attributable to a large decrease in
payroll-related costs associated with a reduction in workforce. Additional
factors contributing to the decline in selling, general and administrative
expense include the elimination of $2.4 million of accrued employee bonuses for
2002, a reduction in marketing and advertising costs, a reduction in travel
costs associated with the regional deployment of the sales force and workforce
reduction, a reduction in telephone-related costs, a reduction in outside
consultants' fees, a reduction in utilities as a result of the consolidation of
several office space leases, and lower property taxes as a result of a
revaluation of fiscal year 2002 property value assessments. These reductions
were partly offset by costs associated with the 24-month amortization of
potential retention bonus amounts. Marketing and advertising expenses for the
third quarter were approximately $0.3 million in 2002 compared with $3.2 million
in 2001. As a percentage of revenue, total selling, general and administrative
expenses decreased to 35.8% in the third quarter of 2002 compared to 59.3% in
the same period in 2001, primarily due to our planned reductions in certain
selling, general and administrative costs in 2002.
Provision for Doubtful Accounts
Provision for doubtful accounts, other than doubtful accounts for WorldCom,
decreased 84.9% to $0.7 million in the third quarter of 2002 compared to $5.0
million for the same period in 2001 as we improved collections on customer
accounts in 2002 and many of our customers, particularly Internet-based
businesses, ceased operations or reduced or eliminated our Web hosting services
during 2001.
27
Deferred Compensation
Deferred compensation expense increased 282.1% to $2.6 million in the third
quarter of 2002 compared to $0.7 million for the same period in 2001. In
accordance with the Digex Long-Term Incentive Plan, all stock options granted to
participants who were employed by Digex as of July 1, 2001, the consummation
date of the Intermedia - WorldCom Merger, became fully vested on July 1, 2002
through a provision for accelerated vesting upon a change of control of Digex.
Accordingly, deferred compensation of $2.6 million as of June 30, 2002 for
options granted with exercise prices at less than fair market value was expensed
in the third quarter of 2002.
Depreciation and Amortization
Depreciation and amortization expenses increased 8.1% to $36.9 million in
the third quarter of 2002 compared to $34.1 million for the same period in 2001.
The increase was principally due to the additional servers and other facilities
and equipment placed in service subsequent to September 30, 2001, partly offset
by decreases in depreciation charges related to our existing tangible and
certain identifiable intangible assets base due to a write-down of our
long-lived assets to fair market value as a result of SFAS No. 144 in the second
quarter of 2002. We have electronics, computer hardware, and computer software
with useful lives ranging from three to five years.
Interest Expense
Interest expense increased 36.5% to $2.3 million in the third quarter of
2002 compared to $1.7 million for the same period in 2001. The increase resulted
primarily from an increase of approximately $1.2 million of equipment acquired
under capital leases and from the issuance of $74.2 million of notes payable to
Intermedia since September 30, 2001.
Interest Income and Other
Interest income and other decreased 69.8% to $0.1 million in the third
quarter of 2002 compared to $0.5 million for same period in 2001. The decrease
resulted principally from declining cash balances and falling interest rates
during the period.
EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, improved $19.6 million to
$4.5 million in the third quarter of 2002 compared to $(15.1) million for the
same period in 2001. The change is primarily attributable to planned operating
cost reductions in 2002, such as payroll-related costs associated with a reduced
workforce, the elimination of accrued employee bonuses for 2002, and a reduction
in provision for doubtful accounts.
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest income and other, merger-related expenses, foreign exchange
gains (losses), income tax benefit, deferred compensation, impairment loss, and
depreciation and amortization. EBITDA before certain charges does not represent
funds available for management's discretionary use and is not intended to
represent cash flow from operations. EBITDA before certain charges should also
not be construed as a substitute for operating income or a better measure of
liquidity than cash flow from operating activities, which are
28
determined in accordance with generally accepted accounting principles. This
caption excludes components that are significant in understanding and assessing
our results of operations and cash flows. In addition, EBITDA before certain
charges is not a term defined by generally accepted accounting principles and as
a result our measure of EBITDA before certain charges might not be comparable to
similarly titled measures used by other companies. However, we believe that
EBITDA before certain charges is relevant and useful information which is often
reported and widely used by analysts, investors and other interested parties in
the Web and application hosting industry. Accordingly, we are disclosing this
information to permit a more comprehensive analysis of our operating
performance, as an additional meaningful measure of performance and liquidity,
and to provide additional information with respect to our ability to meet future
debt service, capital expenditure and working capital requirements. See the
accompanying unaudited consolidated financial statements and notes thereto
contained elsewhere in this report for more detailed information.
The following table presents amounts as reported in our unaudited
consolidated financial statements (in thousands) and certain information derived
from these statements as a percentage of revenue for the nine months ended
September 30, 2002 and 2001, respectively.
Nine months ended
September 30,
------------------------------------------------
2002 2001
------------------------ ---------------------
Revenue:
Revenue ........................................ $ 104,068 72.5% $ 144,869 91.0%
Revenue from WorldCom .......................... 39,534 27.5 14,298 9.0
---------- ------- --------- -----
Total revenue ..................................... 143,602 100.0 159,167 100.0
Costs and expenses:
Cost of operations ............................. 10,716 7.5 12,241 7.7
Cost of services ............................... 67,543 47.0 79,792 50.1
Selling, general and administrative ............ 64,330 44.8 97,335 61.2
Provision for doubtful accounts ................ 2,745 1.9 12,415 7.8
Provision for doubtful accounts for WorldCom ... 18,578 12.9 -- --
Deferred compensation .......................... 3,603 2.5 2,489 1.6
Impairment loss ................................ 56,990 39.7 -- --
Depreciation and amortization .................. 119,206 83.0 96,029 60.3
---------- ------- --------- -----
Total costs and expenses .......................... 343,711 239.3 300,301 188.7
---------- ------- --------- -----
Loss from operations .............................. (200,109) (139.3) (141,134) (88.7)
Other income (expense):
Interest expense .............................. (6,414) (4.5) (3,115) (2.0)
Interest income and other ..................... 434 0.3 1,530 1.0
---------- ------- --------- -----
Net loss .......................................... $ (206,089) (143.5)% $ 142,719) (89.7)%
========== ======= ========= =====
Nine months ended September 30, 2002 Compared to Nine months ended September 30,
2001
Revenue
Total revenue decreased 9.8% to $143.6 million for the nine months ended
September 30, 2002 compared to $159.2 million for the same period in 2001.
29
This is primarily due to our customers rightsizing their configurations, the
deferred customer ramp up of services due to economic cost pressures, and the
uncertainty surrounding WorldCom. We recognized revenue of $39.5 million from
WorldCom in the first nine months of 2002 under the sales channel agreement
compared to total revenues of $14.3 million for the same period in 2001. All
revenue recognized under the sales channel agreement for the nine months ended
September 30, 2002 resulted from actual managed hosting services purchased for
resale by WorldCom. Since July 1, 2002, we have recognized revenue from WorldCom
upon collection. Approximately $3.6 million of pre-petition revenue from
WorldCom was billed for the period from July 1, 2002 through July 21, 2002, but
has not been recognized as revenue because it has not been collected as of
September 30, 2002. Included in our revenue is $3.7 million in fees collected in
2002 for early termination and a one-time sale of third party equipment,
compared to 0.2 million for the same period in 2001.
Cost of Operations
Cost of operations decreased 12.5% to $10.7 million for the nine months
ended September 30, 2002 compared to $12.2 million for the same period in 2001.
The decrease was primarily due to improved network and facility, partly offset
by increased costs from customers selecting data streaming products. As a
percentage of revenue, cost of operations decreased to 7.5% for the nine months
ended September 30, 2002 compared to 7.7% for the same period in 2001 as a
result of improved network utilization.
Cost of Services
Cost of services decreased 15.4% to $67.5 million for the nine months ended
September 30, 2002 compared to $79.8 million for the same period in 2001. The
decrease was primarily related to a reduction in payroll-related costs
associated with a reduced workforce in 2002, elimination of $1.1 million of
accrued employee bonuses for 2002, and reduction in outside consultants' fees,
partly offset by costs associated with the 24-month amortization of potential
retention bonus amounts compared to 2001. As a percentage of revenue, total cost
of services decreased to 47.0% for the nine months ended September 30, 2002
compared to 50.1% for the same period in 2001.
Selling, General and Administrative
Selling, general and administrative expenses decreased 33.9% to $64.3
million for the nine months ended September 30, 2002 compared to $97.3 million
for the same period in 2001. The decrease was primarily attributable to a large
decrease in payroll-related costs associated with a reduced workforce.
Additional factors contributing to the decline in selling, general and
administrative expense include the elimination of $2.4 million of accrued
employee bonuses for 2002, a reduction in marketing and advertising costs, a
reduction in travel costs associated with the regional deployment of the sales
force and workforce reduction, a reduction in telephone-related costs, a
reduction in outside consultants' fees, a reduction in utilities as a result of
the consolidation of several office space leases, and lower property taxes as a
result of a revaluation of fiscal year 2002 property value assessments. These
reductions were partly offset by costs associated with the 24-month amortization
of potential retention bonus amounts. Marketing and advertising expenses for the
third quarter were approximately $3.6 million in 2002 compared with $16.4
million in 2001. As a percentage of revenue, total selling, general and
administrative expenses decreased to 44.8% for the nine months ended September
30, 2002 compared to 61.2% in the same period in 2001, primarily due to our
planned reductions in certain selling, general
30
and administrative costs in 2002.
Provision for Doubtful Accounts
Provision for doubtful accounts, other than doubtful accounts for WorldCom,
decreased 77.9% to $2.7 million for the nine months ended September 30, 2002
compared to $12.4 million for the same period in 2001 as we improved collections
on customer accounts in 2002 and many of our customers, particularly
Internet-based businesses, ceased operations or reduced or eliminated our Web
hosting services during 2001.
Provision for Doubtful Accounts for WorldCom
Provision for doubtful accounts for WorldCom was established in the second
quarter of 2002 due to recent events surrounding WorldCom's planned restatement
of its financial results and subsequent bankruptcy filing. Since July 1, 2002,
we have recognized revenue from WorldCom upon collection and expect to continue
to do so in the foreseeable future, which could have a material impact on future
reported revenue. All receivables due from WorldCom recorded prior to July 1,
2002, which have not been collected subsequent to June 30, 2002, are fully
reserved.
Deferred Compensation
Deferred compensation expense increased 44.8% to $3.6 million for the nine
months ended September 30, 2002 compared to $2.5 million for the same period in
2001. In accordance with the Digex Long-Term Incentive Plan, all stock options
granted to participants who were employed by Digex as of July 1, 2001, the
consummation date of the Intermedia - WorldCom Merger, became fully vested on
July 1, 2002 through a provision for accelerated vesting upon a change of
control of Digex. Accordingly, deferred compensation of $2.6 million as of June
30, 2002 for options granted with exercise prices at less than fair market value
was expensed in the third quarter of 2002.
Impairment Loss
Impairment loss related to our long-lived assets of $57.0 million, of which
$55.4 million relates to property and equipment and $1.6 million relates to
identifiable intangible assets, was recognized in the second quarter of 2002 as
a result of the events surrounding WorldCom as described in "Management's
Discussion and Analysis -- Overview." Under SFAS No. 144, we review our
long-lived assets for impairment when events or changes in circumstances
indicate that carrying value of such assets may not be recoverable. We adjusted
our long-lived assets down to fair value as determined by an independent
appraisal.
Depreciation and Amortization
Depreciation and amortization expenses increased 24.1% to $119.2 million
for the nine months ended September 30, 2002 compared to $96.0 million for the
same period in 2001. The increase was principally due to the additional servers
and other facilities and equipment placed in service subsequent to September 30,
2001, offset by decreases in depreciation charges related to our existing
tangible and certain identifiable intangible assets base due to a write-down of
our long-lived assets to fair market value as a
31
result of SFAS No. 144 in the second quarter of 2002. We have electronics,
computer hardware, and computer software with useful lives ranging from three to
five years.
Interest Expense
Interest expense increased 105.9% to $6.4 million for the nine months ended
September 30, 2002 compared to $3.1 million for the same period in 2001. The
increase resulted primarily from the increase of approximately $1.2 million of
equipment acquired under capital leases and from the issuance of $74.2 million
of notes payable to Intermedia since September 30, 2001.
Interest Income and Other
Interest income and other decreased 71.6% to $0.4 million for the nine
months ended September 30, 2002 compared to $1.5 million for same period in
2001. The decrease resulted principally from declining cash balances and falling
interest rates during the period.
EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, improved 52.3% to $(20.3)
million for the nine months ended September 30, 2002 compared to $(42.6) million
for the same period in 2001. The change is primarily attributable to planned
operating cost reductions in 2002, such as payroll-related costs associated with
a reduced workforce, the elimination of accrued employee bonuses for 2002, and a
reduction in provision for doubtful accounts.
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest income and other, merger-related expenses, foreign exchange
gains (losses), income tax benefit, deferred compensation, impairment loss, and
depreciation and amortization. EBITDA before certain charges does not represent
funds available for management's discretionary use and is not intended to
represent cash flow from operations. EBITDA before certain charges should also
not be construed as a substitute for operating income or a better measure of
liquidity than cash flow from operating activities, which are determined in
accordance with generally accepted accounting principles. This caption excludes
components that are significant in understanding and assessing our results of
operations and cash flows. In addition, EBITDA before certain charges is not a
term defined by generally accepted accounting principles and as a result our
measure of EBITDA before certain charges might not be comparable to similarly
titled measures used by other companies. However, we believe that EBITDA before
certain charges is relevant and useful information which is often reported and
widely used by analysts, investors and other interested parties in the Web and
application hosting industry. Accordingly, we are disclosing this information to
permit a more comprehensive analysis of our operating performance, as an
additional meaningful measure of performance and liquidity, and to provide
additional information with respect to our ability to meet future debt service,
capital expenditure and working capital requirements. See the accompanying
unaudited consolidated financial statements and notes thereto contained
elsewhere in this report for more detailed information.
32
Liquidity and Capital Resources
Cash Flows
WorldCom is our majority stockholder, primary lender, significant channel
partner, and one of our largest vendors. In particular, under the funding
agreement and subject to the bankruptcy proceedings, WorldCom is obligated to
provide funding for the approved Digex business plan through 2002 only. WorldCom
will then have an option to continue funding us beyond 2002, but may not
exercise such option. Through 2002, we currently anticipate that our only source
to fund our working capital needs and capital expenditure requirements, above
cash generated from operations, will be WorldCom. There can be no assurance that
WorldCom will provide us with any additional funding. We believe that funding
from any source other than WorldCom on appropriate or commercially acceptable
terms will be difficult to secure.
Net cash used in operating activities was $3.2 million and $34.8 million
during the nine months ended September 30, 2002 and 2001, respectively. Net cash
used for operating activities in each of these periods was for changes in
working capital and operating losses. Net cash used in 2002 was lower than the
same period in 2001 primarily due to lower costs associated with a reduced
workforce, reduction in marketing and advertising costs, and other costs due to
efforts to align expenses with revenue. Net cash used in 2002 has decreased
largely due to changes in accounts receivable, accounts payable and accrued
expenses, amounts due to/from WorldCom, and deferred liabilities compared to the
same period in 2001. We expect our operating cash flow to increase throughout
the year due to continuing internal initiatives to reduce costs and accounts
receivable balances measured by days sales outstanding.
Net cash used for investing activities was $25.2 million and $84.1 million
during the nine months ended September 30, 2002 and 2001, respectively. Net cash
used for investing activities in each of these periods was primarily the result
of capital expenditures for data center infrastructure, which includes servers
purchased for customer use, as well as leasehold improvements, furniture and
fixtures, and computers and other equipment. We have reduced our capital
expenditures in 2002 in accordance with our business needs, economic downturn,
and as a result of our customer programs for customer furnished equipment and
third party leasing. Although we have plans to invest in property and equipment,
we have no material commitments for such items at this time.
Net cash provided by financing activities was $32.5 million and $42.1
million during the nine months ended September 30, 2002 and 2001, respectively.
Net cash provided by financing activities resulted principally from proceeds
from our notes payable issued to Intermedia offset by payments on our increased
capital lease obligations in 2002.
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 Holdings, Inc., a subsidiary of Compaq Computer
Corporation, for an aggregate of $100.0 million, of which $85.0 million was in
cash, and $15.0 million was in the form of equipment purchase credits. Of the
$15.0 million of equipment purchase credits, approximately $6.2 million and $4.5
million was used for equipment purchases in the nine month period ended
September 30, 2002 and 2001, respectively. The equipment purchase credit has
been substantially depleted at this time. On April 1, 2002, Microsoft converted
its 50,000 shares of Series A convertible preferred stock into 730,995 shares of
Digex Class A common stock.
33
Funding from Affiliates
On July 31, 2001, we entered into a note purchase agreement with WorldCom
whereby WorldCom agreed to provide funding for the Digex business plans for 2001
and 2002 as approved by the Digex and WorldCom boards of directors. The Digex
and WorldCom boards of directors approved the Digex business plan for 2002. The
preparation of the Digex business plan for 2003 is currently in progress and is
expected to be submitted to the WorldCom and Digex boards of directors for
approval no later than December 1, 2002. Subject to the terms and conditions of
the agreement, we will issue and WorldCom will purchase (or cause an affiliate
to purchase) a series of senior notes up to an aggregate principal amount
sufficient to satisfy our net cash requirements under the approved business
plan. Given WorldCom's bankruptcy filing, there can be no assurance that
WorldCom will honor its contractual commitments to Digex. See Note 2 "Recent
Events related to WorldCom and Digex" to the accompanying unaudited consolidated
financial statements.
In 2002, Digex issued and WorldCom caused Intermedia to purchase a series
of senior notes totaling $37.2 million, under the note purchase agreement, to
satisfy our net cash requirements under our approved 2002 business plan. Total
principal outstanding under the note purchase agreement with WorldCom was $102.2
million at September 30, 2002. Through September 30, 2002, variable interest on
the unpaid principal balance was paid monthly at an interest rate of 300 basis
points over LIBOR rate (weighted average interest rate of 4.96%). We have made
and continue to make the monthly interest payments to Intermedia. Repayment of
principal is due on December 31, 2002 and may be extended to December 31, 2006
upon our election by written notice. We expect to make this election by December
13, 2002, at which time amounts then outstanding will be repaid in equal monthly
straight-line amortization payments of principal through December 31, 2006. As a
result, any amounts due after September 30, 2003 have been classified as
long-term. Approximately $19.2 million of our total notes payable to Intermedia
has been classified as current as of September 30, 2002. Any changes to our
business plan that require increased funding would require the WorldCom board of
directors' approval before WorldCom would be obligated to fund any such
increase.
On January 14, 2002, we entered into a note purchase agreement, dated July
31, 2001, with Intermedia to refinance the $13.0 million intercompany loan and
$12.0 million promissory note to Intermedia under a senior note totaling $25.0
million. The terms of the agreement are substantially the same as the original
note purchase agreement, dated July 31, 2001 between Digex and WorldCom, with
the repayment of principal due on December 31, 2003. There is no option to
extend the maturity date of the notes. Interest is payable monthly at an
interest rate of 300 basis points over LIBOR. We have made and continue to make
the monthly interest payments to Intermedia.
Other Indebtedness
In the first and second quarters of 2001, we entered into master lease and
financing agreements with two vendors for lines of credit to facilitate the
leasing of computer hardware and software. The terms of the associated schedules
range from 12 months for financing a maintenance contract to 36 months for
leasing computer equipment. We will have an option to purchase the equipment at
the end of the initial lease term. Interest and principal are payable monthly
with interest rates ranging from 7.2% to 12.3% per annum. As of September 30,
2002, we acquired $12.2 million of computer equipment and maintenance services
under these leasing and financing arrangements.
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 initiative.
34
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. If
we do not hire and retain at least 796 employees at our Maryland facilities at
December 31, 2002, the full amount of the loan will be payable immediately.
Currently, we do not expect to be in compliance for deferring full repayment of
the loan at December 31, 2002 based on our projected business plan. As a result,
the $150,000 loan has been classified as a current liability as of September 30,
2002.
Contractual Obligations and Contingent Commitments
Our contractual obligations and contingent commitments as of September 30,
2002 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 ...... $ 127,200 $ 19,163 $ 76,100 $ 31,937 $ --
Notes payable to third parties ... 3,522 208 3,275 39 --
Capital lease obligations ........ 41,845 8,546 12,171 9,885 11,243
Operating leases ................. 21,273 3,610 7,161 7,268 3,234
Contingent Commitments:
-----------------------
Redeemable preferred stock ....... 50,000 -- 50,000 -- --
Employee retention bonuses ...... 12,127 -- 12,127 -- --
---------- -------- --------- -------- --------
Total ............................... $ 255,967 $ 31,527 $ 160,834 $ 49,129 $ 14,477
========== ======== ========= ======== ========
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, 2001, as filed with the SEC on April 1, 2002, 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 September 30,
2002, the potential retention bonus pool payable in 2003 under these agreements
totaled $12.1 million.
35
Increases in interest rates on variable rate debt would have an adverse
effect upon our reported net loss and cash flow. We believe that we will have
adequate cash flow to service our debt and capital requirements in 2002 under
our funding agreement with WorldCom. However, economic downturns, increased
interest rates and other adverse developments, including factors beyond our
control, could impair our ability to service our indebtedness. In addition, the
cash flow required to service our debt may reduce our ability to fund internal
growth and capital improvements.
We currently project continued net losses. We are currently dependent on
WorldCom to fund our operating cash flow deficits and capital expenditures.
Actual funding from January 1, 2002 through September 30, 2002 was $37.2
million, substantially less than forecasted under the original Digex 2002
business plan. The ultimate amount of borrowings can be affected by WorldCom's
bankruptcy, changes in the economy, and our ability to execute our business
plan, among other factors. Further, as of September 30, 2002, approximately
$56.8 million in notes payable and capital lease obligations come due during
2003. We currently believe that some or all of these obligations will need to be
restructured and we are pursuing the restructuring of some or all of these
obligations. There can be no assurance that these obligations will be
restructured or that WorldCom will provide us with any additional funding. We
believe that funding from any source other than WorldCom on appropriate or
commercially acceptable terms will be difficult to secure.
The continuing impact of the above events on us remains unclear. We cannot
predict what will happen at WorldCom, nor can we predict the effect that events
at WorldCom will have on us. Further, we cannot predict how our customers,
vendors, employees and strategic partners will react to the unfolding events. We
believe that some of these entities have reacted negatively to the events or
perceptions generated from these events and we have been and may continue to be
negatively impacted. As a result, our ability to execute our plans may be
substantially impaired. Over the past few quarters, we have realized a decline
in revenue. However, we have also reduced expenses and we are establishing
customer programs for customer furnished equipment and third party leasing
options to continue to reduce the capital required to operate our business.
Although no assurances can be given, management believes that we have the
ability to continue as a going concern unless WorldCom's bankruptcy filing
negatively impacts any future borrowings necessary to fund our business
operations. The preparation of the Digex business plan for 2003 is currently in
progress and is expected to be submitted for approval to the WorldCom and Digex
boards of directors on or before December 1, 2002, as described in Note 7
"Related Party Agreements" to the accompanying unaudited consolidated financial
statements. Nonetheless, because of recent events surrounding WorldCom and the
lack of certainty that WorldCom will be able to continue to fund us, there is
substantial doubt about our ability to continue as a going concern over the next
twelve months, unless we are successful in restructuring some or all of our
existing debt obligations. A 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. The
accompanying unaudited consolidated financial statements do not reflect any
adjustments to the carrying value of our net assets or the amount and
classification of our liabilities in the event we are not able to continue as a
going concern.
We encourage you to read "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources" in
WorldCom's Form 10-K for the year ended December 31, 2001, as well as its
subsequent periodic filings with the SEC, since our ability to succeed is
dependent on WorldCom.
36
Recent Accounting Pronouncements
Goodwill and Other Intangible Assets
In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. Under the new rules, goodwill and intangible assets deemed to have
indefinite lives are no longer amortized but are subject to annual impairment
tests based upon estimated fair value. We adopted the provisions SFAS No. 142,
effective January 1, 2002, and ceased amortization of amounts assigned to
goodwill and acquired workforce. Depreciation and amortization expense excluding
the amortization of goodwill and acquired workforce in the third quarter of 2001
was $33.6 million. The net book value of goodwill and acquired workforce at
September 30, 2002 was approximately $11.9 million.
We completed our fair value assessment of goodwill as of January 1, 2002
and determined that goodwill was not impaired. However, given the decrease in
our market capitalization since January 1, 2002 and the uncertainty created by
WorldCom's recent announcements of its intention to restate its financial
statements, as described above, we reassessed the recoverability of our goodwill
as of June 30, 2002 pursuant to SFAS No. 142. Pursuant to an independent
appraisal, we determined that goodwill was not impaired as of June 30, 2002. We
have elected to assess impairment of goodwill annually as of July 1st, unless
events or changes in circumstances indicate a more frequent review is necessary.
Any impairment then identified would be recorded in operations in the period in
which the impairment is identified. We determined that there were no events or
changes in circumstances which would have affected the fair value of our
goodwill as of July 1st, our annual assessment date, relative to the valuation
performed as of June 30, 2002.
Impairment of Long-Lived Assets
In August 2001, the FASB issued SFAS No. 144, Impairment or Disposal of
Long-Lived Assets, which supercedes both No. 121, Impairment of Long-Lived
Assets for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions for the disposal of a segment of a business contained in APB Opinion
No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions. We have adopted the provisions of SFAS No.
144 as of January 1, 2002.
Under SFAS No. 144, we review our long-lived assets for impairment when
events or changes in circumstances indicate the carrying value of such assets
may not be recoverable. The review consists of a comparison of the carrying
value of the assets with the assets' expected future undiscounted cash flows
without interest costs. Estimates of expected future cash flows represent
management's best estimate based on reasonable and supportable assumptions and
projections. If the expected future undiscounted cash flow exceeds the carrying
value of the asset, no impairment indicator is considered present. If the
carrying value exceeds the future undiscounted cash flow, an impairment
indicator is considered present. The amount of impairment may be measured using
discounted cash flows or other means of determining fair value.
The events surrounding WorldCom, as described above, caused management to
revise its estimates of future financial projections. We also performed an
undiscounted cash flow analysis related to our long-lived assets. The result of
that analysis indicated that an impairment to the carrying value of our fixed
assets and other intangible assets may have existed as of June 30, 2002. Based
upon an independent appraisal, we adjusted our long-lived assets down to fair
value by recording an impairment loss related to our property and equipment of
$55.4 million and identifiable intangible assets of $1.6 million for the quarter
ended June 30, 2002. Should we fail to meet our operating budget during the
balance of 2002,
37
management's estimates of future cash flows may be further adjusted downward.
Such downward adjustments could trigger a further impairment of our long-lived
assets.
Accounting for Costs Associated with Exit or Disposal Activities
In July 2002, the FASB has issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities, which supercedes 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.
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 do not expect the adoption of SFAS No. 146 to have a
material impact on our consolidated results of operations or financial position.
Information Regarding Forward-Looking Statements
The information set forth above in "Management's Discussion and Analysis of
Financial Conditions and Results of Operations" includes forward-looking
statements that involve numerous risks and uncertainties. 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, 2001 as filed
with the SEC on April 1, 2002.
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.
38
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
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
On July 17, 2002, we announced that we received correspondence from The
Nasdaq Stock Market, Inc. indicating that the price of our common stock had
closed below the minimum USD$1.00 per share requirement for continued inclusion
under Nasdaq Marketplace Rule 4450(a)(5), and therefore in accordance with
Marketplace Rule 4450(e)(2), we had until September 5, 2002 to regain
compliance.
According to the Nasdaq rule, compliance requires the bid price of our
common stock to close at USD$1.00 per share or more for a minimum of ten
consecutive trading days before September 5, 2002. Under certain circumstances,
to ensure that we can sustain long-term compliance, Nasdaq may require that the
closing bid price equals USD$1.00 per share or more for more than ten
consecutive trading days before determining that we comply. Alternatively, we
could apply to transfer our common stock to the Nasdaq SmallCap Market.
On or about July 18, 2002, we received notification from the Nasdaq
indicating that we no longer complied with Nasdaq's independent director and
audit committee requirements under Nasdaq Marketplace Rule 4350(c) and
4350(d)(2). Based on a further review and materials submitted on July 31, 2002,
the Nasdaq determined to grant us an extension to regain compliance with the
rules. We submitted to the Nasdaq documentation, including biographies of our
recently appointed independent directors, evidencing compliance with the rules
on September 12, 2002.
39
On August 9, 2002, we received notification from the Nasdaq indicating that
our common stock had not maintained a minimum market value of publicly held
shares of $5,000,000 for the previous 30 consecutive trading days as required
for continued inclusion by Marketplace Rule 4450(a)(2), and therefore in
accordance with Marketplace Rule 4450(e)(1), we had until November 7, 2002 to
regain compliance. Alternatively, we could apply to transfer our common stock to
the Nasdaq SmallCap Market.
On September 27, 2002, we received notification from the Nasdaq indicating
that our request to transfer from the Nasdaq National Market to the Nasdaq
SmallCap Market was approved, effective September 30, 2002. The Nasdaq also
indicated that Digex met all of the continued inclusion criteria for the Nasdaq
SmallCap Market, except for the minimum $1.00 bid price per share requirement
set forth in Marketplace Rule 4310(c)(4). The transfer to the Nasdaq SmallCap
Market extends the grace period to achieve the minimum USD$1.00 bid price
requirement to December 4, 2002. We may also be eligible for an additional 180
calendar day grace period provided that we meet the initial listing criteria for
the SmallCap Market under Marketplace Rule 4310(c)(2)(A). If Nasdaq determines
that we do not qualify for an extension under Marketplace Rule 4310(c)(2)(A), we
will be provided with written notification that our securities will be delisted.
At that time, we may appeal the Staff Determination to delist our securities to
a Nasdaq Listing Qualification Panel.
If our appeal to the Nasdaq is unsuccessful, we could be delisted from the
Nasdaq SmallCap Market and may be traded on the over-the-counter electronic
bulletin board (OTCBB), which is operated by the National Association of
Securities Dealers, Inc. If our common stock is not eligible to transfer back to
the Nasdaq National Market in the future or is delisted from the Nasdaq SmallCap
Market, this could result in a number of negative implications, including
continued reduced liquidity in our common stock as a result of the loss of
market efficiencies associated with the Nasdaq National Market and the loss of
federal preemption of state securities laws as well as the potential loss of
confidence by suppliers, customers and employees, the loss of analyst coverage
and institutional investor interest, fewer business development opportunities
and greater difficulty in obtaining financing.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Number Exhibit
------ -------
3.1 -- Certificate of Incorporation of Digex and amendments
thereto, including the Certificate of Designation for
the Series A Preferred Stock. Incorporated herein by
reference from Digex's Form 10-K (File No. 000-26873)
filed with the SEC on April 1, 2002.
3.2 -- Bylaws of Digex, as amended. Incorporated herein by
reference to Digex's Form 10-Q (File No. 000-26873)
filed with the SEC on May 12, 2000.
10.1 -- Employment letter dated January 4, 2002 between Digex
and Thomas Walton. (1)
10.2 -- Employment letter dated June 25, 2002 between Digex
and T. Scott Zimmerman. (1)
40
________________
(1) Management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K
The following reports on Form 8-K of Digex were filed during the third
quarter of 2002:
Digex filed a Current Report on Form 8-K, dated July 15, 2002,
reporting under Item 5 announcing changes to the Digex board of directors.
Digex filed a Current Report on Form 8-K, dated July 24, 2002,
reporting under Item 5 the issuance of a press release discussing Digex's
second quarter 2002 financial highlights. 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 September 12, 2002,
reporting under Item 5 the issuance of a press release announcing the
appointment of four additional board members. 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 September 27, 2002,
reporting under Item 5 the issuance of a press release announcing its
transfer to the Nasdaq SmallCap Market effective September 30, 2002. Digex
also reported under Item 7 the filing of the press release as an exhibit to
the Form 8-K.
41
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)
/s/ T. SCOTT ZIMMERMAN
----------------------------------
T. Scott Zimmerman
Chief Financial Officer
/s/ ELIZABETH HAIGHT
----------------------------------
Elizabeth Haight
Vice President and Controller
Dated: November 14, 2002
42
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 period 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 we 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 was 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 function):
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
43
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.
Date: November 14, 2002
/s/ GEORGE L. KERNS
--------------------------------------
George L. Kerns
President and Chief Executive Officer
44
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 period 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 we 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 was 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 function):
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
45
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.
Date: November 14, 2002
/s/ T. SCOTT ZIMMERMAN
--------------------------------
T. Scott Zimmerman
Chief Financial Officer
46
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 September 30, 2002 (the
"Report"), I, George L. Kerns, President and Chief Executive Officer of the
Company, certify, pursuant to 18 U.S.C. ss.1350, as adopted pursuant to ss.906
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.
/s/ GEORGE L. KERNS
-------------------------
Name: George L. Kerns
Date: November 14, 2002
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.
47
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 September 30, 2002 (the
"Report"), I, T. Scott Zimmerman, Chief Financial Officer of the Company,
certify, pursuant to 18 U.S.C. ss.1350, as adopted pursuant to ss.906 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.
/s/ T. SCOTT ZIMMERMAN
---------------------------
Name: T. Scott Zimmerman
Date: November 14, 2002
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.
48