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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 000-27525
DSL.net, Inc.
(Exact name of registrant as specified in its charter)
Delaware 06-1510312
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
545 Long Wharf Drive
New Haven, Connecticut 06511
(Address of principal executive offices) (Zip Code)
(203) 772-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes No X
--- ---
As of July 22, 2004, the registrant had 233,617,317 shares of Common Stock
outstanding.
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DSL.net, Inc.
INDEX
Page
Number
------
Part I - Financial Information
Item 1. Consolidated Financial Statements ...................................2
Consolidated Balance Sheets (unaudited) at June 30, 2004
and December 31, 2003 .........................................2
Consolidated Statements of Operations (unaudited) for the three
and six months ended June 30, 2004 and 2003....................3
Consolidated Statements of Cash Flows (unaudited) for the
six months ended June 30, 2004 and 2003........................4
Notes to Consolidated Financial Statements........................5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................23
Item 3. Quantitative and Qualitative Disclosures about Market Risk..........40
Item 4. Controls and Procedures.............................................40
Part II - Other Information
Item 2. Change in Securities and Use of Proceeds............................40
Item 6. Exhibits and Reports on Form 8-K....................................41
Signature ...................................................................43
Exhibit Index ...............................................................44
1
Part I - Financial Information
Item 1. Consolidated Financial Statements
DSL.net, Inc.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share amounts)
(unaudited)
June 30, December 31,
2004 2003
---------- ----------
ASSETS
Current assets:
Cash and cash equivalents $ 6,289 $ 13,779
Accounts receivable (net of allowances of $1,146 and $902
at June 30, 2004 and December 31, 2003, respectively) 7,072 8,054
Inventory 528 477
Deferred costs 648 931
Prepaid expenses and other current assets 1,074 802
---------- ----------
Total current assets 15,611 24,043
Fixed assets, net 18,687 24,357
Goodwill, net (Note 6) 8,482 8,482
Other intangible assets, net (Note 6) 477 1,010
Other assets 973 1,169
---------- ----------
Total assets $ 44,230 $ 59,061
========== ==========
LIABILITIES, MANDATORILY REDEEMABLE, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,659 $ 3,570
Accrued salaries 1,455 1,046
Accrued liabilities 3,449 7,529
Deferred revenue 5,538 6,068
Current portion of capital leases payable 97 105
---------- ----------
Total current liabilities 14,198 18,318
Capital leases payable -- 50
Notes payable, net of discount (Note 7) 7,585 5,374
---------- ----------
Total liabilities 21,783 23,742
---------- ----------
Commitments and contingencies (Note 8)
Preferred stock: 20,000,000 preferred shares authorized (Note 9)
20,000 shares designated as Series X, mandatorily redeemable, convertible
preferred stock, $.001 par value; 14,000 and 20,000 shares issued and outstanding
as of June 30, 2004 and December 31, 2003, respectively (liquidation preference
$18,000 and $24,660 as of June 30, 2004 and December 31, 2003, respectively) 13,188 16,231
15,000 shares designated as Series Y, mandatorily redeemable, convertible
preferred stock, $.001 par value; 0 and 1,000 shares issued and outstanding
as of June 30, 2004 and December 31, 2003, respectively (liquidation preference $0
and $1,211 as of June 30, 2004 and December 31, 2003, respectively) -- 788
Stockholders' equity (Note 3)
Common stock, $.0005 par value; 800,000,000 and 800,000,000 shares authorized
as of June 30, 2004 and December 31, 2003, respectively; 144,126,622 and 105,449,054 shares
issued and outstanding as of June 30, 2004 and December 31, 2003, respectively 72 53
Additional paid-in capital 341,562 337,735
Accumulated deficit (332,375) (319,488)
---------- ----------
Total stockholders' equity 9,259 18,300
---------- ----------
Total liabilities, redeemable preferred stock and stockholders' equity $ 44,230 $ 59,061
========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
2
DSL.net, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)
(unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------- --------------------------------
2004 2003 2004 2003
-------------- -------------- -------------- --------------
Revenue, net $ 17,686 $ 18,097 $ 35,507 $ 34,862
-------------- -------------- -------------- --------------
Operating expenses:
Network (excluding $0, $3, $0 and $11
of stock compensation, respectively) 11,946 13,264 24,146 25,343
Operations (excluding $0, $3, $0 and $10
of stock compensation, respectively) 2,432 2,960 5,621 5,875
General and administrative (excluding $0, $17, $0 and $69
of stock compensation, respectively) 3,525 3,216 6,452 6,272
Sales and marketing (excluding $0, $137, $0 and $348
of stock compensation, respectively) 1,179 1,889 3,521 4,122
Stock compensation -- 160 -- 438
Depreciation and amortization 3,284 4,498 6,602 9,335
-------------- -------------- -------------- --------------
Total operating expenses $ 22,366 $ 25,987 $ 46,342 $ 51,385
-------------- -------------- -------------- --------------
Operating loss $ (4,680) $ (7,890) $ (10,835) $ (16,523)
Interest expense, net (1,177) (847) (2,159) (1,411)
Other income (expense), net 33 37 107 (9)
-------------- -------------- -------------- --------------
Net loss $ (5,824) $ (8,700) $ (12,887) $ (17,943)
============== ============== ============== ==============
Net loss applicable to common stockholders:
Net loss (5,824) (8,700) (12,887) (17,943)
Dividends on preferred stock (420) (1,050) (910) (2,100)
Accretion of preferred stock (588) (3,011) (4,040) (6,021)
-------------- -------------- -------------- --------------
Net loss applicable to common stockholders $ (6,832) $ (12,761) $ (17,837) $ (26,064)
============== ============== ============== ==============
Net loss per share, basic and diluted $ (0.05) $ (0.20) $ (0.13) $ (0.40)
============== ============== ============== ==============
Shares used in computing net loss per share, basic and diluted 144,123,600 65,030,504 140,291,576 64,981,319
============== ============== ============== ==============
The accompanying notes are an integral part of these consolidated financial statements.
3
DSL.net, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands, except per share amounts)
(unaudited)
Six Months Ended
June 30,
------------------------
2004 2003
---------- ----------
Cash flows from operating activities:
Net loss $ (12,887) $ (17,943)
Reconciliation of net loss to net cash provided by (used in)
operating activities:
Depreciation and amortization 6,602 9,335
Bad debt expense 760 1,335
Sales credits and allowances 292 241
Amortization of deferred debt issuance costs and debt
discount 2,023 816
Stock compensation expense -- 438
Loss on sale/write-off of fixed assets 58 117
Net changes in assets and liabilities, net of acquired assets:
(Increase) in accounts receivable (70) (5,009)
(Increase) in prepaid and other current assets (40) (369)
Decrease in other assets 196 293
Increase (decrease) in accounts payable 90 (1,211)
Increase in accrued salaries 409 235
(Decrease) / increase in accrued liabilities (3,890) 6,568
(Decrease) / increase in deferred revenue (531) 1,170
---------- ----------
Net cash used in operating activities (6,988) (3,984)
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment (458) (1,231)
Proceeds from sales of property and equipment -- --
Acquisitions of businesses and customer lines -- (7,917)
(Increase) in restricted cash -- (21)
---------- ----------
Net cash used in investing activities (458) (9,169)
---------- ----------
Cash flows from financing activities:
Proceeds from credit facility -- 6,100
Proceeds from common stock issuance 14 114
Principal payments under notes and capital lease
obligations (58) (797)
---------- ----------
Net cash (used) / provided by financing activities (44) 5,417
---------- ----------
Net increase / (decrease) in cash and cash equivalents (7,490) (7,736)
Cash and cash equivalents at beginning of period 13,779 11,318
---------- ----------
Cash and cash equivalents at end of period $ 6,289 $ 3,582
========== ==========
Supplemental disclosure:
Cash paid: interest $ 7 $ 497
========== ==========
Supplemental disclosure of non-cash investing activities:
On January 10, 2003, the Company purchased network assets and associated subscriber
lines of Network Access Solutions Corporation (Note 5)
The fair value of the assets acquired was $14,750
Supplemental disclosure of non-cash financing activities:
During the first quarter 2004, 6,000 shares of Series X Preferred Stock were converted
into 33,333,333 shares of common stock and $1,560 of accrued dividends pertaining
thereto were paid by issuing 2,316,832 shares of common stock. (Note 9)
Also during the first quarter 2004, 1,000 shares of Series Y Preferred Stock were
converted into 2,260,910 shares of common stock and $221 of accrued dividends pertaining
thereto were paid by issuing 309,864 shares of common stock. (Note 9)
Also during the first quarter of 2004, the Company issued 413,160 shares of its common
stock upon the exercise of 1,358,025 of stock warrants granted in connection with
certain loan guarantees in a cashless exchange (Note 3)
The accompanying notes are an integral part of these consolidated financial statements.
4
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. Summary of Significant Accounting Policies
A. Basis of Presentation
The consolidated financial statements ("financial statements") of DSL.net,
Inc. ("DSL.net" or the "Company") at June 30, 2004 and for the three and six
months ended June 30, 2004 and 2003 are unaudited, but, in the opinion of
management, include all adjustments (consisting only of normal recurring
adjustments) that DSL.net considers necessary for a fair presentation of its
financial position and operating results. Operating results for the three and
six months ended June 30, 2004 are not necessarily indicative of results that
may be expected for any future periods.
The financial statements have been prepared with the assumption that users
of the interim financial information have either read or have access to the
Company's financial statements for the year ended December 31, 2003.
Accordingly, footnote disclosures that would substantially duplicate the
disclosures contained in the Company's December 31, 2003 audited financial
statements have been omitted from these unaudited interim financial statements.
These financial statements have been prepared in accordance with the
instructions to Form 10-Q and the rules and regulations of the Securities and
Exchange Commission ("SEC"). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
instructions, rules and regulations. While management believes the disclosures
presented are adequate to make these financial statements not misleading, these
financial statements should be read in conjunction with the Company's audited
financial statements and related notes included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2003, which has been filed with the
SEC.
Certain prior period amounts have been reclassified to conform to the 2004
presentation.
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
including the recoverability of tangible and intangible assets, disclosure of
contingent assets and liabilities as of the date of the financial statements,
and the reported amounts of revenues and expenses during the reported period.
The markets for the Company's services are characterized by intense competition,
rapid technological development, regulatory and legislative changes, and
frequent new product introductions, all of which could impact the future value
of the Company's assets and liabilities. Actual results may differ from those
estimates.
The Company evaluates its estimates on an on-going basis. The most
significant estimates relate to revenue recognition, goodwill and other
long-lived assets, the allowance for doubtful accounts, taxes, contingencies and
litigation. Such estimates are based on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ materially from those estimates.
The Company believes the following critical accounting policies affect the
Company's more significant judgments and estimates used in the preparation of
its consolidated financial statements:
5
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
REVENUE RECOGNITION
The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin ("SAB") No. 104, "REVENUE RECOGNITION." SAB No. 104's primary purpose
is to rescind guidance contained in SAB No. 101 related to multiple element
revenue arrangements, superceded as a result of the issuance of Emerging Issues
Task Force ("EITF") Issue No. 00-21, "REVENUE ARRANGEMENTS WITH MULTIPLE
DELIVERABLES." SAB No. 104's wording has not changed SAB No. 101's four basic
criteria that must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services have
been rendered; (3) the fee is fixed and determinable; and (4) collectibility is
reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which varies based on the speed of the customer's broadband
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of any leased equipment
installed at the customer's site and other services, as applicable. Revenue that
is billed in advance of the services provided is deferred until the services are
provided by the Company. Revenue related to installation charges is also
deferred and amortized to revenue over 18 months, which is the average customer
life of the existing customer base. Related direct costs incurred (up to the
amount of deferred revenue) are also deferred and amortized to expense over 18
months. Any excess direct costs over installation charges are charged to expense
as incurred. In certain instances, the Company negotiates credits and allowances
for service related matters. The Company establishes a reserve against revenue
for such credits based on historical experience. From time to time the Company
offers sales incentives to its customers in the form of rebates toward select
installation services and customer premise equipment. The Company records a
liability based on historical experience for such estimated rebate costs, with a
corresponding reduction to revenue and deferred revenue, as applicable.
The Company seeks to price its services competitively. The market for
high-speed data communications services and Internet access is rapidly evolving
and intensely competitive. While many competitors and potential competitors may
enjoy competitive advantages over the Company, it is pursuing a significant
market that, it believes, is currently under-served. Although pricing is an
important part of the Company's strategy, management believes that direct
relationships with customers and consistent, high quality service and customer
support will be key to generating customer loyalty. During the past several
years, market prices for many telecommunications services and equipment have
been declining, which is a trend that might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
The Company accounts for its long-lived assets in accordance with Statement
of Financial Accounting Standards ("SFAS") No. 144, "ACCOUNTING FOR THE
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF,"
which requires that long-lived assets and certain intangible assets be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable. If undiscounted expected future cash
flows are less than the carrying value of the assets, an impairment loss is to
be recognized based on the fair value of the assets.
The Company accounts for goodwill and other intangible assets in accordance
with SFAS No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS." This statement
required that the amortization of goodwill be discontinued and instead an
impairment approach be applied. If impairment exists, under SFAS No. 142, the
resulting charge is determined by the recalculation of goodwill through a
6
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
hypothetical purchase price allocation of the fair value and reducing the
current carrying value to the extent it exceeds the recalculated goodwill. The
Company has not recorded any goodwill impairment adjustments resulting from its
impairment reviews.
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result the Company may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company maintains an allowance for doubtful accounts for estimated
losses resulting from the inability of its customers to make required payments.
The Company principally sells its services directly to end users mainly
consisting of small to medium sized businesses, but the Company also sells its
services to certain resellers, such as Internet service providers ("ISPs"). The
Company believes that it does not have significant exposure or concentrations of
credit risk with respect to any given customer. However, if the country or any
region the Company services experiences an economic downturn, the financial
condition of the Company's customers could be adversely affected, which could
result in their inability to make payments to the Company. This could require
additional provisions for allowances. In addition, a negative impact on revenue
and cash flows related to those customers may occur.
With its acquisition of certain of the assets of Network Access Solutions
Corporation ("NAS") on January 10, 2003, the Company acquired a number of end
users, some of whom it serves indirectly through various ISPs. The Company sells
its services to such ISPs who then resell such services to the end user. The
Company has some increased exposure and concentration of credit risk pertaining
to such ISPs. However, no individual customer accounted for more than 5% of
revenue or 10% of accounts receivable for the first six months of 2004 or 2003.
INVENTORY
Inventories consist of modems and routers (customer premise equipment or
"CPE") which the Company sells or leases to customers and are required to
establish a high speed DSL or T-1 digital connection. Inventories are stated at
the lower of cost or market. Cost of inventory is determined on the "first-in,
first-out" ("FIFO") or average cost methods. The Company establishes inventory
reserves for excess, obsolete or slow-moving inventory based on changes in
customer demand, technology developments and other factors.
INCOME TAX
The Company uses the liability method of accounting for income taxes, as
set forth in SFAS No. 109, "ACCOUNTING FOR INCOME Taxes." Under this method,
deferred tax assets and liabilities are recognized for the expected future tax
consequences of temporary differences between the carrying
7
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
amounts and the tax basis of assets and liabilities and net operating loss
carryforwards, all calculated using presently enacted tax rates.
The Company has not generated any taxable income to date and, therefore,
has not paid any federal income taxes or state taxes based on income since
inception. The Company's state and federal net operating loss carryforwards
begin to expire in 2004 and 2019, respectively. Use of the Company's net
operating loss carryforwards may be subject to significant annual limitations
resulting from a change in control due to securities issuances including without
limitation the Company's sales of its mandatorily redeemable convertible Series
X preferred stock (the "Series X Preferred Stock") and its mandatorily
redeemable convertible Series Y preferred stock (the "Series Y Preferred Stock")
in 2001 and 2002 (Note 9) and from the sale of $30,000 in notes and warrants in
2003 (Note 7). The Company is currently assessing the potential impact on the
Company's net operating loss carryforwards resulting from these transactions.
The Company has provided a valuation allowance for the full amount of the net
deferred tax asset since it has not determined that these future benefits will
more likely than not be realized.
LITIGATION
From time to time, the Company may be involved in litigation concerning
claims arising in the ordinary course of its business, including claims brought
by former employees and claims related to acquisitions. The Company records
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on analyses made by internal and external legal counsel who
consider information known at the time. The Company believes it has made
reasonable estimates in the past; however, court decisions and other factors
could cause liabilities to be incurred in excess of estimates.
B. Earnings (Loss) Per Share
The Company computes net loss per share pursuant to SFAS No. 128, "EARNINGS
PER SHARE." Basic earnings (loss) per share is computed by dividing income or
loss applicable to common stockholders by the weighted average number of shares
of the Company's common stock outstanding during the period, after giving
consideration to shares subject to repurchase.
Diluted earnings per share is determined in the same manner as basic
earnings per share except that the number of shares is increased assuming
exercise of dilutive stock options and warrants using the treasury stock method
and dilutive conversion of the Company's outstanding preferred stock. The
diluted earnings per share amount is presented herein as the same as the basic
earnings per share amount because the Company had a net loss during each period
presented, and the impact of the assumed exercise of stock options and warrants
and the assumed conversion of preferred stock would have been anti-dilutive.
The following options and warrants and convertible preferred stock were
excluded from the calculation of earnings per share since their inclusion would
be anti-dilutive for all periods presented:
8
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Shares of Common Stock
-----------------------------------
June 30,
-----------------------------------
2004 2003
--------------- ---------------
Options to purchase
common stock 47,280,413 23,275,784
Warrants to purchase
common stock 171,747,621 13,033,314
Preferred Series X stock
convertible to common
stock 77,777,778 111,111,111
Preferred Series Y stock
convertible to common
stock -- 30,000,000
--------------- ---------------
Total..................... 296,805,812 177,420,209
--------------- ---------------
As of December 31, 2003, the Company had 105,449,054 shares of common stock
issued and outstanding. As of June 30, 2004, the Company had 144,126,621 shares
of common stock issued and outstanding. The increase of 38,677,567 shares
resulted from 38,220,939 shares of common stock issued in connection with
preferred stock conversions, 413,160 shares of common stock issued for stock
warrant exercises and 43,468 shares of common stock issued for employee stock
option exercises and employee stock purchases under the Company's applicable
plans. The weighted average number of shares of common stock outstanding used in
computing earnings per share for the three months ended June 30, 2004 and 2003
was 144,123,600 and 65,030,504, respectively. The weighted average number of
shares of common stock outstanding used in computing earnings per share for the
six months ended June 30, 2004 and 2003 was 140,291,576 and 64,981,319,
respectively.
C. Incentive Stock Award Plans
As of June 30, 2004, the Company had five stock-based employee
compensation plans, four of which are described more fully in the Company's
audited financial statements and related notes included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2003, and the fifth of
which, the Kirby Pickle Stock Plan (as defined below), is more fully described
below.
In April 2004, the Company entered into an employment agreement and related
stock option agreement with Kirby G. Pickle, the Company's new Chief Executive
Officer, as authorized by the Company's Board of Directors. Under the stock
option agreement for Mr. Pickle (the "Kirby Pickle Stock Plan"), an option to
purchase a total of 10,000,000 shares of the Company's common stock was granted
to Mr. Pickle as an inducement to his employment with the Company. Options
granted under the Kirby Pickle Stock Plan vest approximately 16% on the date six
months following the grant date, and thereafter vest ratably over the next
thirty months. Once vested, the options are exercisable at an exercise price per
share equal to the closing price of the Company's common stock, par value $.0005
per share, on the last trading day prior to Mr. Pickle's initial date of hire
with the Company, as listed on the Nasdaq SmallCap Market, for ten years from
the date of the grant.
9
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company accounts for stock-based compensation under the intrinsic value
method in accordance with Accounting Principles Board ("APB") Opinion No. 25,
"ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES." Accordingly, compensation expense is
not recognized when options are granted at the fair market value on the date of
grant.
The Company has elected to continue following APB Opinion No. 25 to account
for its stock-based compensation plans. The following table presents the effect
on the Company's net loss and net loss per share as if the Company had applied
the fair value method of accounting for stock-based compensation in accordance
with SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION":
10
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
2004 2003 2004 2003
-------- -------- -------- --------
Net loss, as reported ($ 5,824) ($ 8,700) ($12,887) ($17,943)
Add stock compensation expense
included in net loss -- 160 -- 438
Deduct: total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (1,655) (1,296) (2,465) (2,809)
-------- -------- -------- --------
Pro forma under SFAS No. 123 ($ 7,479) ($ 9,836) ($15,352) ($20,314)
Net loss applicable to common stockholders:
As reported ($ 6,831) ($12,761) ($17,837) ($26,064)
Pro forma under SFAS No. 123 ($ 8,486) ($13,897) ($20,302) ($28,435)
Basic and diluted net loss per common share:
As reported ($ 0.05) ($ 0.20) ($ 0.13) ($ 0.40)
Pro forma under SFAS No. 123 ($ 0.06) ($ 0.21) ($ 0.14) ($ 0.44)
The estimated fair value at date of grant for options granted during the
three and six months ended June 30, 2004 ranged from $0.33 to $0.71 per share,
and for the three and six months ended June 30, 2003 ranged from $0.49 to $0.53
per share. The minimum value of each option grant is estimated on the date of
grant using the Black-Scholes option pricing model with the following weighted
average assumptions:
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------------- ----------------------------------
2004 2003 2004 2003
---- ---- ---- ----
Risk free interest rate 2.71-3.67 % 2.15% 1.96-3.67% 2.15-2.70%
Expected dividend yield None None None None
Expected life of option 3-4 Years 4 Years 3-4 Years 4 Years
Expected volatility 134-144% 152% 134-145% 152%
As additional options are expected to be granted in future periods, and the
options vest over several years, the above pro forma results are not necessarily
indicative of future pro forma results.
11
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
D. Recently Issued Accounting Pronouncements
For further information regarding Recently Issued Accounting
Pronouncements, refer to the Company's consolidated financial statements and
footnotes thereto included in its annual report on Form 10-K for the year ended
December 31, 2003.
2. Liquidity
As reflected in the Company's audited financial statements and related
notes included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2003, the Company incurred operating losses of approximately
$29,631 and negative operating cash flows of approximately $13,715 during the
year ended December 31, 2003. During the six months ended June 30, 2004, the
Company incurred operating losses of approximately $10,835 and negative
operating cash flows of approximately $6,988. These operating losses and
negative operating cash flows have been financed primarily by proceeds from
equity and note issuances. The Company had accumulated deficits of approximately
$332,375 at June 30, 2004 and approximately $319,488 at December 31, 2003.
The Company expects its operating losses, net operating cash outflows and
capital expenditures to continue throughout 2004. Based on the Company's current
business plan and projections, the Company believes that its existing cash and
cash expected to be generated from operations will be sufficient to fund its
operating losses, capital expenditures, lease payments, and working capital
requirements into the fourth quarter of 2004. Failure to generate sufficient
revenues, contain certain discretionary spending or achieve certain other
business plan objectives could have a material adverse affect on the Company's
results of operations, cash flows and financial position, including its ability
to continue as a going concern.
The Company intends to use its cash resources to finance its capital
expenditures and for working capital and other general corporate purposes. The
Company may also use a portion of its cash resources to acquire complementary
businesses, subscriber lines or other assets and expects to need additional
funding to pursue this strategic objective. The amounts actually expended for
these purposes will vary significantly depending on a number of factors,
including market acceptance of the Company's services, revenue growth, planned
capital expenditures, cash generated from operations, improvements in operating
productivity, the extent and timing of entry into new markets, the availability
of and prices paid for acquisitions, and the availability and terms of any
additional funding.
There can be no assurance that the Company will be able to achieve its
business plan objectives or that it will achieve or maintain cash flow positive
operating results. If the Company is unable to generate adequate funds from its
operations or raise additional capital, the Company may not be able to continue
to operate its network, respond to competitive pressures or fund its operations.
As a result, the Company may be required to significantly reduce, reorganize,
discontinue or shut down its operations. These financial statements do not
include any adjustments that might result from this uncertainty.
3. Stockholders' Equity
During the first quarter of 2004, the Company issued 33,333,333 and
2,316,832 shares of its common stock, respectively, upon the conversion of 6,000
shares of Series X Preferred Stock and as payment for approximately $1,560 of
accrued dividends on such converted shares of Series X
12
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Preferred Stock (Note 9). Also during the first quarter of 2004, the Company
issued 2,260,910 and 309,864 shares of its common stock, respectively, upon the
conversion of 1,000 shares of Series Y Preferred Stock and as payment for
approximately $221 of accrued dividends on such converted shares of Series Y
Preferred Stock (Note 9). In addition, during the first quarter of 2004, the
Company issued 413,160 shares of its common stock, upon the exercise of
1,358,025 of stock warrants granted in connection with certain loan guarantees.
The Company also issued 6,665 and 37,132 shares of common stock, respectively,
upon exercises of stock options during the three and six months ended June 30,
2004. In addition, the Company issued 0 and 6,336 shares of its common stock
during the three and six months ended June 30, 2004, respectively, to employees
participating in the Company's 1999 Employee Stock Purchase Plan.
4. Restructuring
In March, 2004, the Company reduced its workforce by 62 employees at its
locations in New Haven, Connecticut; Herndon, Virginia; Minneapolis, Minnesota
and Wilmington, North Carolina. As a result, the Company incurred approximately
$160 in restructuring charges pertaining to severance and benefits payments.
During the second quarter of 2004, the Company charged approximately $136
against its restructuring reserves which related to facilities expense
associated with the Company's vacated office space in Santa Cruz, California.
The Company's restructuring reserve balance as of June 30, 2004, of
approximately $248, represents estimated costs associated with such vacated
facility and was included in the Company's accrued liabilities.
The following table summarizes the additions and charges to the
restructuring reserve from December 31, 2003 through June 30, 2004, and the
remaining reserve balances at June 30, 2004:
Restructuring Reserve
---------------------
Facility
Lease Severance Total
--------- --------- ---------
Balance December 31, 2003 $ 540 $ -- $ 540
Additions to reserve $ -- $ 160 $ 160
Charges to reserve $ (292) $ (160) $ (452)
--------- --------- ---------
Balance June 30, 2004 $ 248 $ -- $ 248
========= ========= =========
5. Acquisitions
In December of 2002, the U.S. Bankruptcy Court for the District of Delaware
approved the Company's bid to purchase certain network assets, equipment and
associated subscriber lines of NAS for $14,000 consisting of $9,000 in cash and
$5,000 in a note payable to NAS. The Company closed the transaction on January
10, 2003, whereby it acquired certain of NAS' network assets, equipment in
approximately 300 central offices and approximately 11,500 associated subscriber
lines (the "NAS Assets"), pursuant to an Amended and Restated Asset Purchase
Agreement, (the "NAS Asset Purchase Agreement"). Additionally, on January 10,
2003, the Company hired 78 employees formerly employed by NAS. No pre-closing
liabilities were assumed in connection with the NAS transaction. The cash
portion of the consideration was paid from the Company's existing cash. In
accordance with the NAS Asset Purchase Agreement, the Company negotiated a
$1,083 reduction in the cash paid at the closing, representing the Company's
portion of January revenue which was billed and collected by NAS, bringing the
net cash paid for the NAS Assets to $7,917.
13
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
NAS provided high-speed Internet and virtual private network services to
business customers using digital subscriber line, frame relay and T-1 technology
via its own network facilities in the Northeast and Mid-Atlantic markets. The
NAS acquisition significantly increased the Company's subscriber base and its
facilities-based footprint in one of the largest business markets in the United
States.
The acquisition has been accounted for under the purchase method of
accounting in accordance with SFAS No. 141, "BUSINESS COMBINATIONS" ("SFAS No.
141"). The results of NAS' operations have been included in the consolidated
financial statements since January 10, 2003 (the acquisition date). The
estimated fair values of the acquired assets at the date of acquisition exceeded
the purchase price and, accordingly, the acquired assets have been written down
on a pro-rata basis by asset group to the purchase price of approximately
$14,737 ($14,000 plus associated direct acquisition costs of approximately $737)
as follows: (i) intangible assets pertaining to approximately 11,500 acquired
subscriber lines of $1,480, (ii) property and equipment of $13,113 and (iii)
inventory of $144. In July, 2003, the Company paid $1,500 into escrow for the
negotiated repurchase and cancellation of the $5,000 note issued by the Company
to NAS as part of the purchase price for the NAS Assets. The payment was subject
to approval by the bankruptcy court presiding over NAS' bankruptcy petition. On
August 25, 2003, the court approved the transaction, and the $1,500 held in
escrow was paid to NAS in full satisfaction of the note.
With the acquisition of the NAS Assets on January 10, 2003, the Company
acquired a number of end users, some of whom it serves indirectly through
various ISPs. The Company sells its services to such ISPs who then resell such
services to the end user. Accordingly, the Company has some increased exposure
and concentration of credit risk pertaining to such ISPs, however, no individual
customer accounted for more than 5% of revenue for the three and six months
ended June 30, 2004 and 2003.
On April 8, 2003, the Company entered into an asset purchase agreement with
TalkingNets, Inc. and TalkingNets Holdings, LLC (collectively, "TalkingNets")
pursuant to which the Company agreed to acquire certain assets and subscribers
of TalkingNets (the "TalkingNets Assets") for $726 in cash (the "TalkingNets
Asset Purchase Agreement"). As TalkingNets had filed a voluntary petition for
Chapter 11 reorganization in February 2003, the TalkingNets Asset Purchase
Agreement was subject to the approval of the U.S. Bankruptcy Court for the
Eastern District of Virginia. On April 9, 2003, the TalkingNets Asset Purchase
Agreement and the transactions contemplated thereby were approved by the
Bankruptcy Court. On April 11, 2003, the Company paid the full purchase price of
$726 into escrow.
TalkingNets provided voice and high-speed data services to businesses
utilizing soft switched-based voice over Internet protocol ("VoIP") technology.
The TalkingNets acquisition gave the Company the capability to offer business
customers in the business-intensive Mid-Atlantic and Northeast regions a
carrier-class integrated voice and data service which utilizes VoIP.
On September 8, 2003, in accordance with the TalkingNets Asset Purchase
Agreement, the Company completed its acquisition of the TalkingNets Assets.
During the transition period, the Company included the net effect of cash
collections from the proposed acquired customers less certain related operating
costs of TalkingNets' operations in its statements of operations. This net
effect for the three and six months ended June 30, 2003, was approximately $235
in expense.
14
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The TalkingNets acquisition has been accounted for under the purchase
method of accounting in accordance with SFAS No. 141. The results of
TalkingNets' operations have been included in the Company's consolidated
financial statements since September 8, 2003 (the closing date). The estimated
fair values of the acquired assets at the date of acquisition exceeded the
purchase price and, accordingly, the acquired assets have been written down on a
pro-rata basis by asset group to the purchase price of approximately $851 ($726
plus associated direct acquisition costs of approximately $125) as follows: (i)
certain accounts receivables of $55, (ii) intangible assets pertaining to
approximately 90 acquired subscriber lines of $111, and (iii) property and
equipment of $685.
The following table sets forth the unaudited pro forma consolidated
financial information of the Company, giving effect to the acquisition of NAS
customers, as if the transaction had occurred at the beginning of the periods
presented. Inclusion of the TalkingNets Assets would not materially change the
reported unaudited pro forma results. The pro forma table is not applicable for
the six months ended June 30, 2004, as the results of our acquisitions have been
fully integrated into our operating results for the six months ended June 30,
2004.
PRO FORMA
SIX MONTHS ENDED
JUNE 30, 2003
-------------
Pro forma revenue $ 35,620
Pro forma operating loss $(16,496)
Pro forma net loss $(17,962)
Pro forma net loss applicable to common stockholders $(26,083)
Pro forma net loss per share, basic and diluted $ (0.40)
Shares used in computing pro forma net loss
per share, basic and diluted 64,981,319
The pro forma results are not necessarily indicative of the actual results
of operations that would have been obtained had the acquisitions taken place at
the beginning of the respective periods or the results that may occur in the
future.
6. Goodwill and Other Intangible Assets
In accordance with SFAS No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS,"
which became effective January 1, 2002, the Company has ceased to amortize
approximately $8,482 of goodwill. In lieu of amortization, the Company completed
its annual impairment review in December of 2003 and concluded that goodwill was
not impaired. The Company will continue to perform annual impairment reviews,
unless a change in circumstances requires a review in the interim.
The Company's identified intangible assets consist of customer lists, which
are amortized over two years. Amortization expense of intangible assets for the
three and six months ended June 30, 2004 was approximately $267 and $534,
respectively. For the three and six months ended June 30, 2003, amortization
expense was approximately $870 and $2,050, respectively. Accumulated
amortization of customer lists as of June 30, 2004 and 2003 was $15,030 and
$13,791, respectively.
15
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The expected future amortization of customer lists as of June 30, 2004 is $421
for the remainder of 2004 and $56 in 2005.
7. Debt
On January 10, 2003, the Company issued a $5,000 note to NAS in conjunction
with its acquisition of the NAS Assets (Note 5). The Company negotiated
settlement of the note for $1,500, which was approved by the bankruptcy court
presiding over the sale of the NAS Assets on August 25, 2003 and resulted in a
gain of $3,500 included in other income during the third quarter of 2003.
The Company entered into a Revolving Credit and Term Loan Agreement, dated
as of December 13, 2002 (the "Credit Agreement"), with a commercial bank
providing for a revolving line of credit of up to $15,000 (the "Commitment").
Interest on borrowings under the Credit Agreement was payable at 0.5% percent
above the Federal Funds Effective Rate. The Company's ability to borrow amounts
available under the Credit Agreement was subject to the bank's receipt of a like
amount of guarantees from certain of the Company's investors and/or other
guarantors. On February 3, 2003, the Company borrowed $6,100 under the Credit
Agreement. As of March 3, 2003, certain of the Company's investors had
guaranteed $9,100 under the Credit Agreement. On July 18, 2003, the Company
repaid the $6,100 outstanding balance plus accrued interest and terminated the
Credit Agreement. The Company wrote off approximately $184 of the related
unamortized balance of loan origination fees during the second quarter of 2003.
The Company entered into a Reimbursement Agreement and related Security
Agreement, dated as of December 27, 2002, with VantagePoint Venture Partners
(together with its affiliated funds as their interests shall appear,
"VantagePoint") and Columbia Capital and other holders of or affiliates of
holders of the Company's Series X and Series Y Preferred Stock (the
"Guarantors"). Pursuant to the terms of the Reimbursement Agreement, on December
27, 2002, VantagePoint and Columbia Capital issued guarantees in an aggregate
amount of $6,100 to support certain obligations of the Company under the Credit
Agreement. On July 18, 2003, in connection with the termination of the Credit
Agreement, the guarantees, Reimbursement Agreement and related Security
Agreement were terminated.
Pursuant to the terms of the Reimbursement Agreement, on December 27, 2002,
the Company issued warrants to purchase an aggregate of 12,013,893 shares of its
common stock to VantagePoint and Columbia Capital, in consideration for their
guarantees aggregating $6,100. All such warrants have a ten year life and an
exercise price of $0.50 per share. On March 26, 2003, the Company issued
additional warrants, exercisable for ten years, to purchase a total of 936,107
shares of its common stock at $0.50 per share to VantagePoint and Columbia
Capital, bringing the total number of warrants issued in connection with the
Reimbursement Agreement to 12,950,000. On February 3, 2003, the Company borrowed
on the Credit Agreement and the Guarantors' guarantees of the subject loan
became effective.
On February 3, 2003, the Company valued the 12,950,000 warrants at $0.514
each with a total value of approximately $6,656. The valuation was performed
using a Black-Scholes valuation model with the following assumptions: (i) a risk
free interest rate of 4.01% (ten-year Treasury Rate), (ii) a zero dividend
yield, (iii) a ten year expected life, (iv) an expected volatility of 153%, (v)
an option exercise price of $0.50 per share and (vi) a current market price of
$0.52 per share (the closing price of the Company's common stock on February 3,
2003). Since the warrants were issued in consideration for loan guarantees,
which enabled the Company to secure financing at
16
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
below market interest rates, the Company recorded their value as a deferred debt
financing cost to be amortized to interest expense over the term of the loan
(approximately 57 months) using the "Effective Interest Method" of amortization.
On July 18, 2003, the Company repaid its outstanding loan balance that was
secured by these loan guarantees, and terminated the Credit Agreement.
Accordingly, the Company wrote-off approximately $5,747 of the related
unamortized balance of deferred financing costs to other expense during the
second quarter of 2003.
On March 3, 2003, the Company and certain of the Guarantors entered into
Amendment No. 1 to the Reimbursement Agreement, pursuant to which VantagePoint
increased its guarantee by $3,000 bringing the aggregate guarantees by all
Guarantors under the Reimbursement Agreement, as amended, to $9,100. As
consideration for VantagePoint's increased guarantee, if the Company closed an
equity financing on or before December 3, 2003, it was authorized to issue
VantagePoint additional warrants to purchase the type of equity securities
issued by the Company in such equity financing. The number of such additional
warrants would be determined by dividing the per share price of such equity
securities into a thousand dollars. Accordingly, since the Company closed a
financing on July 18, 2003, the Company issued to VantagePoint, in December
2003, additional warrants with a three year life, to purchase 2,260,909 shares
of its common stock at a per share price of $0.4423.
On July 18, 2003, the Company entered into a Note and Warrant Purchase
Agreement (the "Note and Warrant Purchase Agreement") with Deutsche Bank AG
London, acting through DB Advisors LLC as Investment Agent ("Deutsche Bank"),
VantagePoint Venture Partners III (Q), L.P., VantagePoint Venture Partners III,
L.P., VantagePoint Communications Partners, L.P. and VantagePoint Venture
Partners 1996, L.P. (collectively, the "Investors") relating to the sale of an
aggregate of (i) $30,000 in senior secured promissory notes (the "Notes") and
(ii) warrants to purchase an aggregate of 157,894,737 shares of the Company's
common stock for a period of three years at an exercise price of $0.38 per share
(the "Warrants"). The aggregate purchase price for the Notes and Warrants was
$30,000.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, the Company issued an aggregate of $30,000 in principal amount of
Notes to the Investors on July 18, 2003. Principal on the Notes is payable in a
single payment on July 18, 2006. The Notes provide for an annual interest rate
of 1.23%, payable in cash quarterly in arrears commencing on October 31, 2003,
unless the Company elects to defer payment of such interest and pay it together
with the principal amount of the Notes at maturity on July 18, 2006. Pursuant to
the terms of the Security Agreement, the Company's obligations under the Notes
are secured by a security interest in a majority of the personal property and
assets of the Company and certain of its subsidiaries. Interest expense accrued
on the Notes for the six months ended June 30, 2004 approximated $188. Total
accrued interest on the Notes since inception is included in notes payable and
approximated $359 at June 30, 2004. The Company elected to defer all interest
payments until further notice.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, the Company issued a warrant to purchase 12,950,000 shares of its
common stock to Deutsche Bank on or about August 12, 2003. The Company issued
the remaining Warrants to purchase an aggregate of 144,944,737 shares of its
common stock to Deutsche Bank (105,471,053 shares) and VantagePoint (39,473,864
shares) on or about December 9, 2003. All of these warrants were issued with an
exercise price of $0.38 per share.
On July 18, 2003, the Company recorded the Note and Warrant transactions in
accordance with APB Opinion No. 14, "ACCOUNTING FOR CONVERTIBLE DEBT AND DEBT
ISSUED WITH STOCK PURCHASE
17
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
WARRANTS," whereby a fair value was ascribed to the 157,894,737 Warrants to be
issued to the Investors (related to the Note and Warrant Purchase Agreement)
together with the 2,260,909 warrants to be issued to VantagePoint (related to
VantagePoint's increased guarantee under Amendment No. 1 to the Reimbursement
Agreement) using a Black-Scholes valuation model with the following assumptions:
(i) a risk free interest rate of 2.24% (three-year Treasury rate), (ii) a zero
dividend yield, (iii) a three-year life, (iv) an expected volatility of 152%,
(v) a warrant option price of $0.38 per share for the 157,894,737 Warrants and
$0.4423 per share for the 2,260,909 warrants and (vi) a current market price of
$0.83 (the closing price of the Company's common stock on July 18, 2003) per
share. A fair value was ascribed to the Notes using a present value method with
a 19% discount rate. The relative fair value of the warrants representing 87% of
the combined fair value of the warrants and Notes was applied to the $30,000
proceeds to determine a note discount of approximately $26,063 which was
recorded as a reduction to the Notes payable and an increase to additional paid
in capital. The note discount is being amortized to interest expense using the
"Effective Interest Method" of amortization over the 36 month term of the Notes.
For the year ended December 31, 2003, approximately $1,266 of this note discount
had been amortized to interest expense. For the six months ended June 30, 2004,
approximately $2,023 of this note discount had been amortized to interest
expense.
The proceeds from the sale of the Notes and Warrants will be (and portions
already have been) used by the Company for general corporate purposes, including
acquisitions, the roll out of the Company's integrated voice and data service
product offering, the expansion of the Company's sales and marketing activities
and repayment of certain debt and lease obligations. As of December 31, 2003,
the Company had paid approximately $10,200 for the complete repayment of
approximately $14,600 of its debt and lease obligations.
On July 18, 2003, in connection with the Note and Warrant Purchase
Agreement, the Company, the Investors and certain of the stockholders of the
Company entered into an Amended and Restated Stockholders Agreement, which
provides for rights relating to the election of directors, the registration of
the Company's common stock and certain protective provisions.
In February 2004, Columbia Capital exercised their remaining warrants to
purchase 1,358,025 shares of the Company's common stock at an exercise price of
$0.50 per share in a cashless exchange which resulted in the issuance of 413,160
shares of the Company's common stock. The cashless exchange was accomplished by
deducting the per share exercise price from the per share fair market value of
the Company's common stock and multiplying the differential times the total
warrants to determine the aggregate excess of the fair market value over the
exercise price; which was then divided by the per share fair market value of the
Company's common stock to arrive at the number of shares issued. The fair market
value of the Company's common stock of $0.72 was determined in accordance with
the warrant agreement by calculating the average of the close prices for the
five days immediately preceding the exercise date.
8. Commitments and Contingencies
COMMITMENTS
Effective May 1, 2003, the Company entered into a 35 month lease for office
space in Herndon, Virginia. Under the Company's facility operating leases,
minimum office facility operating lease payments are approximately $1,987 in
2004, $520 in 2005, $233 in 2006, $169 in 2007 and $28 in 2008. The Company also
has long-term purchase commitments with MCI and other vendors for data transport
and other services with minimum payments due even if its usage does not reach
the
18
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
minimum amounts. Minimum payments under its long-term purchase commitments are
approximately $1,650 in 2004.
CONTINGENCIES
In certain markets where the Company has not deployed its own local
broadband equipment, the Company utilizes local facilities of wholesale
providers, including Covad Communications, Inc. ("Covad"), in order to provide
service to its end-user customers. These wholesale providers may terminate their
service with little or no notice. The failure of Covad or any of the Company's
other wholesale providers to provide acceptable service on acceptable terms
could have a material adverse effect on the Company's operations. There can be
no assurance that Covad or other wholesale providers will be successful in
managing their operations and business plans.
The Company transmits data across its network via transmission facilities
that are leased from certain carriers, including Level 3 Communications, Inc.
and MCI. The failure of any of the Company's data transport carriers to provide
acceptable service on acceptable terms could have a material adverse effect on
the Company's operations.
9. Mandatorily Redeemable Convertible Preferred Stock
As more fully described in the Company's audited financial statements and
related notes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2003, the Company entered into a Series X Preferred Stock
Purchase Agreement with VantagePoint on November 14, 2001 (the "Series X
Purchase Agreement"), relating to the sale and purchase of up to an aggregate of
20,000 shares of Series X Preferred Stock at a purchase price of $1,000 per
share. On December 24, 2001, the Company entered into a Series Y Preferred Stock
Purchase Agreement (the "Series Y Purchase Agreement") with Columbia Capital
Equity Partners III, L.P., Columbia Capital Equity Partners II, L.P., The
Lafayette Investment Fund, L.P., Charles River Partnership X, a Limited
Partnership, and N.I.G. Broadslate (collectively with their assigns, the "Series
Y Investors"), relating to the sale and purchase of up to an aggregate of 15,000
shares of Series Y Preferred Stock at a purchase price of $1,000 per share.
Pursuant to the Series X Purchase Agreement, in 2001 and 2002, the Company
sold an aggregate of 20,000 shares of Series X Preferred Stock to VantagePoint
for total proceeds of $20,000, before direct issuance costs of approximately
$189. Pursuant to the Series Y Purchase Agreement, in 2001 and 2002, the Company
sold an aggregate of 15,000 shares of Series Y Preferred Stock to the Series Y
Investors for an aggregate purchase price of $15,000, before direct issuance
costs of approximately $300.
During the third and fourth quarters of 2003, the Series Y Investors
converted 14,000 shares of Series Y Preferred Stock into 35,140,012 shares of
the Company's common stock (including shares issued to pay accrued dividends).
In January 2004, 6,000 shares of Series X Preferred Stock were converted
into 33,333,333 shares of the Company's common stock at a conversion price of
$0.18 per share and, in accordance with the terms of the Series X Preferred
Stock, the Company elected to pay accrued dividends approximating $1,560 by
issuing 2,316,832 shares of its common stock, based on the average fair market
value for the ten days preceding the conversion of $0.67 per share.
19
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
In February 2004, the remaining 1,000 shares of Series Y Preferred Stock
were converted into 2,260,910 shares of the Company's common stock at a
conversion price of $0.4423 per share and, in accordance with the terms of the
Series Y Preferred Stock, the Company elected to pay accrued dividends
approximating $221 by issuing 309,864 shares of its common stock, based on the
average fair market value for the ten days preceding the conversion of $0.71 per
share.
As a result of the above described conversions of 6,000 shares of Series X
Preferred Stock and 1,000 shares of Series Y Preferred stock in 2004, the
Company was required to accelerate the unaccreted beneficial conversion feature
("BCF") related to such shares, which amounted to an additional $2,850 of
preferred stock accretion charged in the first quarter of 2004.
The Series X Preferred Stock and Series Y Preferred Stock activity during
the six months ended June 30, 2004 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
--------------------------------------------------
SERIES X SERIES Y
---------------------- ----------------------
SHARES AMOUNT SHARES AMOUNT
-------- -------- -------- --------
Balance December 31, 2003 20,000 $ 16,231 1,000 $ 788
Conversion of Series Y Preferred Stock to common stock (6,000) (6,000) (1,000) (1,000)
Payment of dividends on converted Series Y Preferred Stock (1,560) (221)
Accrued dividends on Series X and Y Preferred Stock 900 10
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock 3,617 423
-------- -------- -------- --------
Balance June 30, 2004 14,000 $ 13,188 -- $ --
======== ======== ======== ========
The Series X Preferred Stock and Series Y Preferred Stock activity during
the six months ended June 30, 2003 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
--------------------------------------------------
SERIES X SERIES Y
---------------------- ----------------------
SHARES AMOUNT SHARES AMOUNT
-------- -------- -------- --------
Balance December 31, 2002 20,000 $ 8,741 15,000 $ 5,381
Accrued dividends on Series X and Y Preferred Stock 1,200 900
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock 3,346 2,675
-------- -------- -------- --------
Balance June 30, 2003 20,000 $ 13,287 15,000 $ 8,956
======== ======== ======== ========
20
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
10. Related Party Transactions
As of June 30, 2004, and as more fully described in the Company's audited
financial statements and related notes included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2003, VantagePoint had options and
warrants issued to acquire approximately 54,176,568 shares of the Company's
common stock. In addition, VantagePoint owned approximately 4,027,820 shares of
the Company's common stock and 14,000 shares of the Company's Series X Preferred
Stock which are convertible into approximately 77,777,778 shares of common stock
(Note 9). As a result, VanatagePoint beneficially owned the equivalent of
approximately 135,982,166 shares of the Company's common stock. Currently, two
affiliates and one former affiliate of VantagePoint are members of the Company's
Board of Directors.
As of June 30, 2004, as a result of the $30,000 financing transaction, and
as more fully described in the Company's audited financial statements and
related notes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2003, Deutsche Bank had warrants issued to acquire
approximately 118,421,053 shares of the Company's common stock. Currently, one
affiliate and one former affiliate of Deutsche Bank, whose employer provides
investment advisory services to Deutsche Bank, are members of the Company's
Board of Directors. Currently, the employer of one of the Company's directors
(namely, the former affiliate of VantagePoint referred to in the immediately
preceding paragraph) provides investment advisory services to Deutsche Bank.
During the third and fourth quarters of 2003, as more fully described in
the Company's audited financial statements and related notes included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003, the
Series Y Investors (including Columbia Capital) converted 14,000 shares of
Series Y Preferred Stock into 35,140,012 shares of the Company's common stock
(including shares issued to pay accrued dividends). As of December 31, 2003,
funds affiliated with one remaining Series Y Investor (Charles River
Partnership, L.P.) owned 1,000 shares of Series Y Preferred Stock which were
converted into 2,570,774 shares of the Company's common stock (including shares
issued to pay accrued dividends) in February, 2004 (Note 9). In addition, in
February 2004, Columbia Capital exercised their remaining warrants to purchase
1,358,025 shares of the Company's common stock at an exercise price of $0.50 per
share in a cashless exchange which resulted in the issuance of 413,160 shares of
the Company's common stock (Note 7). An affiliate of Columbia Capital was a
member of the Company's Board of Directors until August 5, 2003.
11. Subsequent Events
On July 22, 2004, the Company entered into a Recapitalization Agreement
with VantagePoint, the holder of all of the remaining issued and outstanding
shares of Series X Preferred Stock (the "Recapitalization Agreement"). In
accordance with the Recapitalization Agreement, the remaining 14,000 shares of
Series X Preferred Stock were converted into 77,777,775 shares of the Company's
common stock at a conversion price of $0.18 per share and, in accordance with
the terms of the Series X Preferred Stock, the Company elected to pay accrued
dividends approximating $4,040 by issuing 11,710,142 shares of its common stock,
based on the average fair market value for the ten days ending three days
preceding the conversion of $0.345 per share. After the conversion, the Company
had 233,617,317 shares of common stock outstanding. Also, in accordance with the
Recapitalization Agreement, the Company issued to VantagePoint 14,000 shares of
a new Series Z Preferred Stock, par value of $0.001 per share (the "Series Z
Preferred Stock"), with a liquidation preference of $1,120 per share. The Series
Z Preferred Stock does not contain any conversion or mandatory redemption
provisions nor does it have any special dividend or special voting rights. The
Series Z Preferred Stock's liquidation preference will be eliminated, and the
shares of Series Z
21
DSL.net, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Preferred Stock cancelled, on July 18, 2008. In addition, upon the occurrence of
certain events before July 18, 2008, the liquidation preference will be reduced
or eliminated. With respect to the relationships between the Company and
VantagePoint and its affiliates, see Note 10.
On August 4, 2004, the listing and trading of the Company's common stock
moved from the NASDAQ SmallCap Market to the American Stock Exchange.
Accordingly, on such date, the Company's common stock trading symbol changed
from "DSLNC" to "BIZ."
22
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion of the financial condition and results of
operations of DSL.net should be read in conjunction with the financial
statements and the related notes thereto included elsewhere in this Quarterly
Report on Form 10-Q and the audited financial statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations included in our Annual Report on Form 10-K for the year ended
December 31, 2003, which has been filed with the Securities and Exchange
Commission (the "SEC").
OVERVIEW
OUR BUSINESS
We provide high-speed data communications, Internet access, and related
services to small and medium sized businesses and branch offices of larger
businesses and their remote office users, throughout the United States,
primarily utilizing digital subscriber line ("DSL") and T-1 technology. In
September of 2003, we expanded our service offerings to business customers in
select Mid-Atlantic and Northeast markets to include integrated voice and data
services using voice over Internet protocol technology ("VoIP"). Our networks
enable data transport over existing copper telephone lines at speeds of up to
1.5 megabits per second. Our product offerings also include Web hosting, domain
name system management, enhanced e-mail, on-line data backup and recovery
services, firewalls, nationwide dial-up services, private frame relay services
and virtual private networks.
We sell directly to businesses, primarily through our own direct sales
force, and to third party resellers whose end users are typically business-class
customers. We deploy our own local communications equipment primarily in select
first and second tier cities. In certain markets where we have not deployed our
own equipment, we utilize the local facilities of other carriers to provide our
service.
OUR GROWTH STRATEGY
In addition to our internal sales and marketing efforts, our strategic
goals have been focused on accelerating our growth and expanding our network and
customer base through select acquisitions of customer lines, assets and/or
businesses. During 2003, we completed the following strategically significant
acquisitions:
o In January 2003, we acquired the majority of Network Access Solutions
Corporation's ("NAS") operations and assets, including operations and
equipment in approximately 300 central offices extending from Virginia
to Massachusetts, and approximately 11,500 subscriber lines (the "NAS
Assets"). This acquisition significantly increased our
facilities-based footprint in one of the largest business markets in
the United States, providing us with increased opportunities to sell
more higher-margin, facilities-based services. As a result of this
acquisition, we currently operate equipment in approximately 490
central offices located in approximately 340 cities in the United
States.
o In September 2003, we acquired substantially all of the assets and
subscribers of TalkingNets (as defined below), a voice and data
communications provider that offered soft switched-based VoIP and
high-speed data services to businesses. This acquisition gave us the
capability to offer business customers in the business-intensive
Mid-Atlantic and Northeast regions a carrier-class integrated voice
and data service which utilizes VoIP. In
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
December 2003, we introduced in the Washington, D.C. metropolitan
region, an expanded range of VoIP products that offered integrated
voice and data services utilizing DSL-based services in addition to
our T-1 based services. In February 2004, we introduced our full suite
of VoIP and data bundles in the New York City metropolitan area.
We continuously identify and evaluate acquisition candidates, and in many
cases engage in discussions and negotiations regarding potential acquisitions.
Acquisition candidates include both subscriber lines and whole businesses. Our
discussions and negotiations may not result in an acquisition. Further, if we
make any acquisitions, we may not be able to operate any acquired businesses
profitably or otherwise successfully implement our expansion strategy. We intend
to continue to seek additional opportunities for further acquisitions, which we
believe represents a distinct opportunity to accelerate our growth. We may need
to obtain additional funding to finance additional acquisitions, and,
accordingly, we continue to engage and pursue discussions with potential
investors.
We also believe there are significant revenue growth opportunities for our
newly introduced VoIP suite of integrated voice and data services. We may also
seek additional funding to expand our voice network in order to accelerate this
growth opportunity.
OUR CASH FINANCINGS AND CONSTRAINTS
We have not been able to finance our operations from cash provided by
operations. Net cash used in our operating activities was approximately $6,988
during the first six months of 2004 and $13,715 for the full year 2003. We have
made noticeable reductions in cash used for operating activities over the last
three calendar years primarily due to increased revenues and related margins,
resulting primarily from acquisitions, combined with reduced operational
expenses (network, operations, selling, general and administrative expenses),
primarily resulting from our restructuring and cost containment efforts
(discussed below).
We also have incurred operating losses and net losses for each month since
our formation in 1998. For the first six months of 2004 and 2003, we had
operating losses of approximately $10,835 and $16,523, respectively. As of June
30, 2004 and December 31, 2003, we had accumulated deficits of approximately
$332,375 and $319,488, respectively.
In addition, our growth strategies have required significant capital and
cash investments. Our operating cash shortfalls and investments have been
financed principally with the proceeds from the sale of stock and from
borrowings, including equipment lease financings. Our most significant recent
financing occurred in July 2003, when we executed a note and warrant purchase
agreement for the sale of $30,000 in senior secured promissory notes and
issuance of warrants to purchase 157,894,737 shares of our common stock at an
exercise price of $0.38 per share for an aggregate purchase price for the notes
and warrants of $30,000. We used approximately $10,200 of the proceeds from this
financing to prepay (at a discount) approximately $14,600 in pre-existing debt
and lease obligations.
We expect our operating losses, net operating cash outflows and capital
expenditures to continue throughout 2004. Our business plan includes modest
revenue growth for 2004 generated from internal direct marketing sales efforts
and includes additional operational cost savings to be obtained from
streamlining our network and further reducing discretionary and controllable
costs. During the last quarter of 2003 and the first six months of 2004, we
began implementing some of these cost reduction measures, including a
reduction-in-force of 62 employees on March 25, 2004. Based on our current
business plan and projections, we believe that our existing cash and cash
expected to be generated from operations will be sufficient to fund our
operating losses, capital expenditures, lease payments, and working capital
requirements into the fourth quarter of 2004. Failure to generate
24
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
sufficient revenues, contain certain discretionary spending or achieve certain
other business plan objectives could have a material adverse affect on our
results of operations, cash flows and financial position, including our ability
to continue as a going concern.
We intend to use our cash resources to finance our capital expenditures and
for our working capital and other general corporate purposes. We may also need
additional funding to pursue our strategic objective of accelerating our growth
through acquisition of complementary businesses, subscriber lines and other
assets. The amounts actually expended for these purposes will vary significantly
depending on a number of factors, including market acceptance of our services,
revenue growth, planned capital expenditures, cash generated from operations,
improvements in operating productivity, the extent and timing of entry into new
markets, the availability of and prices paid for acquisitions, and the
availability and terms of any additional funding.
Our cash requirements may vary based upon the timing and the success of
implementation of our business plan or if:
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make acquisitions;
o we alter the schedule or targets of our business plan implementation;
or
o we curtail and/or reorganize our operations.
Our financial performance, and whether we achieve profitability or become
cash flow positive, will depend on a number of factors, including:
o development of the high-speed data communications industry and our
ability to compete effectively;
o amount, timing and pricing of customer revenue;
o availability, timing and pricing of acquisition opportunities, and our
ability to capitalize on and integrate such opportunities;
o commercial acceptance of our service and attaining expected
penetration within our target markets;
o our ability to recruit and retain qualified personnel;
o up front sales and marketing expenses;
o cost and utilization of our network components which we lease from
other telecommunications providers, including other competitive
carriers;
o our ability to establish and maintain relationships with marketing
partners;
o successful implementation and management of financial, information
management and
25
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
operations support systems to efficiently and cost-effectively manage
our operational growth;
o favorable outcome of federal and state regulatory proceedings and
related judicial proceedings, including proceedings relating to the
1996 Telecommunications Act and the Federal Communications
Commissions' Triennial Review Order; and
o our ability to raise sufficient additional debt, equity or other
capital on acceptable terms, if at all.
There can be no assurance that we will be able to achieve our business plan
objectives or that we will achieve or maintain cash flow positive operating
results. If we are unable to generate adequate funds from our operations or
raise additional capital, we may not be able to continue to operate our network,
respond to competitive pressures or fund our operations. As a result, we may be
required to significantly reduce, reorganize, discontinue or shut down our
operations. Our financial statements do not include any adjustments that might
result from this uncertainty.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RISKS
Management's discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles. The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, including the
recoverability of tangible and intangible assets, disclosure of contingent
assets and liabilities as of the date of the financial statements, and the
reported amounts of revenues and expenses during the reported period. The
markets for our services are characterized by intense competition, rapid
technological development, regulatory and legislative changes, and frequent new
product introductions, all of which could impact the future value of our assets
and liabilities.
We evaluate our estimates on an on-going basis. The most significant
estimates relate to revenue recognition, goodwill and other long-lived assets,
the allowance for doubtful accounts, taxes, contingencies and litigation. We
base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ materially from those estimates.
The following is a brief discussion of the critical accounting policies and
methods and the judgments and estimates used by us in their application:
REVENUE RECOGNITION
We recognize revenue in accordance with SEC Staff Accounting Bulletin
("SAB") No. 104, "REVENUE RECOGNITION." SAB No. 104's primary purpose is to
rescind guidance contained in SAB No. 101 related to multiple element revenue
arrangements, superceded as a result of the issuance of Emerging Issues Task
Force ("EITF") Issue No. 00-21, "REVENUE ARRANGEMENTS WITH MULTIPLE
DELIVERABLES." SAB No. 104's wording has not changed SAB No. 101's four basic
criteria that must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the fee is fixed and determinable; and (4) collectibility is
reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
26
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which varies based on the speed of the customer's Internet
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of the equipment installed
at the customer's site and the other services we provide, as applicable. Revenue
that is billed in advance of the services provided is deferred until the
services are rendered. Revenue related to installation charges is also deferred
and amortized to revenue over 18 months. Related direct costs incurred (up to
the amount of deferred revenue) are also deferred and amortized to expense over
18 months. Any excess direct costs over installation charges are charged to
expense as incurred. In certain instances, we negotiate credits and allowances
for service related matters. We establish a reserve against revenue for such
credits based on historical experience. From time to time we offer sales
incentives to our customers in the form of rebates toward select installation
services and customer premise equipment. We record a liability based on
historical experience for such estimated rebate costs, with a corresponding
reduction to revenue and deferred revenue, as applicable.
We seek to price our services competitively. The market for high-speed data
communications services and Internet access is rapidly evolving and intensely
competitive. While many of our competitors and potential competitors enjoy
competitive advantages over us, we are pursuing a significant market that, we
believe, is currently under-served. Although pricing is an important part of our
strategy, we believe that direct relationships with our customers and
consistent, high quality service and customer support will be key to generating
customer loyalty. During the past several years, market prices for many
telecommunications services and equipment have been declining, a trend that
might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
We account for our long-lived assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, "ACCOUNTING FOR THE IMPAIRMENT
OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF," which
requires that long-lived assets and certain intangible assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable. If undiscounted expected future cash
flows are less than the carrying value of the assets, an impairment loss is to
be recognized based on the fair value of the assets.
Effective January 1, 2002, we adopted SFAS No. 142, "GOODWILL AND OTHER
INTANGIBLE ASSETS." This statement requires that the amortization of goodwill be
discontinued and instead an impairment approach be applied. The impairment tests
were performed during December 2003, and will be performed annually hereafter
(or more often if adverse events occur) and are based upon a fair value approach
rather than an evaluation of the undiscounted cash flows. If impairment exists,
under SFAS No. 142, the resulting charge is determined by the recalculation of
goodwill through a hypothetical purchase price allocation of the fair value and
reducing the current carrying value to the extent it exceeds the recalculated
goodwill. We did not record any goodwill impairment adjustments resulting from
our impairment reviews during 2003.
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
27
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result we may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
primarily sell our services directly to end users mainly consisting of small to
medium sized businesses, but we also sell our services to certain resellers,
such as to Internet service providers ("ISPs"). We believe that we do not have
significant exposure or concentrations of credit risk with respect to any given
customer. However, if the country or any region we service, experiences an
economic downturn, the financial condition of our customers could be adversely
affected, which could result in their inability to make payments to us. This
could require additional provisions for allowances. In addition, a negative
impact on revenue related to those customers may occur.
With the acquisition of the NAS Assets on January 10, 2003, we acquired a
number of end users, some of whom we service indirectly through various ISPs. We
sell our services to such ISP's who then resell such services to the end user.
We have some increased exposure and concentration of credit risk pertaining to
such ISPs. However, no individual customer accounted for more than 5% of revenue
or 10% of accounts receivable throughout 2003 or during the first six months of
2004.
INVENTORY
Inventories consist of modems and routers (customer premise equipment or
"CPE") which we either sell or lease to customers and are required to establish
a high speed DSL or T-1 digital connection. Inventories are stated at the lower
of cost or market. Cost of inventory is determined on the "first-in, first-out"
("FIFO") or average cost methods. We establish inventory reserves for excess,
obsolete or slow-moving inventory based on changes in customer demand,
technology developments and other factors.
INCOME TAXES
We use the liability method of accounting for income taxes, as set forth in
Statement of Financial Accounting Standards No. 109, "ACCOUNTING FOR INCOME
TAXES." Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of temporary differences between the
carrying amounts and the tax basis of assets and liabilities and net operating
loss carryforwards, all calculated using presently enacted tax rates.
We have not generated any taxable income to date and, therefore, have not
paid any federal income taxes since inception. Our state and federal net
operating loss carryforwards begin to expire in 2004 and 2019, respectively. Use
of our net operating loss carryforwards may be subject to significant annual
limitations resulting from a change in control due to securities issuances
including without limitation our sales of Series X Preferred Stock and Series Y
Preferred Stock in 2001 and 2002 and from the sale of $30,000 in notes and
warrants in 2003. We are currently assessing the potential impact on our net
operating loss carryforwards resulting from these transactions. We have provided
a valuation allowance for the full amount of the net deferred tax asset since
management has not determined that these future benefits will more likely than
not be realized.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
LITIGATION
From time to time, we may be involved in litigation concerning claims
arising in the ordinary course of our business, including claims brought by
current or former employees and claims related to acquisitions. We record
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on an analysis made by legal counsel who consider
information known at the time. We believe we have made reasonable estimates in
the past; however, court decisions could cause liabilities to be incurred in
excess of estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
For further information regarding recently issued accounting
pronouncements, refer to the consolidated financial statements and footnotes
thereto included in our annual report on Form 10-K for the year ended December
31, 2003.
RESULTS OF OPERATIONS
REVENUE. Revenue is recognized pursuant to the terms of each contract on a
monthly service fee basis, which varies based on the speed of the customer's
broadband connection and the services ordered by the customer. The monthly fee
includes all phone line charges, Internet access charges, the cost of any leased
equipment installed at the customer's site and the other services we provide, as
applicable. Revenue that is billed in advance of the provision of services is
deferred until the services are provided. Revenue related to installation
charges is deferred and amortized to revenue over 18 months, which is
approximately the average customer life of the existing customer base. Related
direct costs incurred (up to the amount of deferred revenue) are also deferred
and amortized to expense over 18 months. Any excess direct costs over
installation charges are charged to expense as incurred. In certain instances,
we negotiate credits and allowances for service related matters. We establish a
reserve against revenue for such credits based on historical experience. From
time to time we offer sales incentives to our customers in the form of rebates
toward select installation services and customer premise equipment. We record a
liability based on historical experience for such estimated rebate costs, with a
corresponding reduction to revenue and deferred revenue, as applicable.
Revenue for the three months ended June 30, 2004 decreased by 2% to
approximately $17,686, from approximately $18,097 for the three months ended
June 30, 2003. This decrease in revenue was primarily attributable to a decrease
in new subscriber lines during the second quarter of 2004. Revenue for the six
months ended June 30, 2004 increased by 2% to approximately $35,307 from
approximately $34,862 for the six months ended June 30, 2003. This increase in
revenue in 2004 was primarily due to an increase in subscriber lines resulting
from our acquisition of the NAS Assets.
NETWORK EXPENSES. Our network expenses include costs related to network
engineering and network field operations personnel, costs for telecommunications
lines between customers, central offices, network service providers and our
network, costs for rent and power at our central offices, costs to connect to
the Internet, costs of customer line installations and the costs of customer
premise equipment when sold to our customers. We lease high-speed lines and
other network capacity to connect our central office equipment and our network.
Costs incurred to connect to the Internet are expected to increase as the volume
of data communications traffic generated by our customers varies.
Network expenses for the three months ended June 30, 2004 decreased to
approximately $11,946, from approximately $13,264 for the three months ended
June 30, 2003. This decrease of approximately $1,318 was primarily attributable
to decreases in telecommunications expenses of approximately $1,234, decreases
in personnel expenses of approximately $62, decreases in other equipment costs
of approximately $53 and decreases in other miscellaneous expenses of
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
approximately $70, partially offset by increases in other installation costs of
approximately $101. For the six months ended June 30, 2004, network expenses
decreased to approximately $24,146, from approximately $25,343 for the six
months ended June 30, 2003. This decrease of approximately $1,197 was primarily
attributable to decreases in telecommunications expenses of approximately $1,587
and decreases in other miscellaneous expenses of approximately $87, partially
offset by increases in other installation costs of approximately $477. The above
described reductions in network expenses for the three and six months ended June
30, 2004 were primarily attributable to closure of certain duplicative central
office locations which resulted from the NAS acquisition.
OPERATIONS EXPENSES. Our operations expenses include costs related to
customer care, customer provisioning, customer billing, customer technical
assistance, purchasing, headquarters facilities operations, operating systems
maintenance and support and other related overhead expenses.
Operations expenses for the three months ended June 30, 2004 decreased to
approximately $2,432, from approximately $2,960 for the three months ended June
30, 2003. This decrease of approximately $528 was primarily attributable to
decreases in personnel expenses of approximately $337, decreases in outside
services of approximately $51, decreases in equipment expenses of approximately
$45, and decreases in other miscellaneous expenses of approximately $95. For the
six months ended June 30, 2004, operations expense decreased to approximately
$5,621 from approximately $5,875 for the six months ended June 30, 2003. This
decrease of approximately $254 was primarily attributable to decreases in
personnel expenses of approximately $207 (resulting from our reduction in force
during the first quarter of 2004), decreases in equipment expenses of
approximately $128 and decreases in other miscellaneous expenses of
approximately $50, partially offset by increases in outside services of
approximately $131.
GENERAL AND ADMINISTRATIVE. Our general and administrative expenses consist
primarily of costs relating to human resources, finance, executive,
administrative services, recruiting, insurance, legal and auditing services,
leased office facilities rent and bad debt expenses.
General and administrative expenses were approximately $3,525 for the three
months ended June 30, 2004, compared to approximately $3,216 for the three
months ended June 30, 2003. This increase of approximately $309 was primarily
due to increased professional service fees of approximately $542, increased
personnel expenses of approximately $118, increased public reporting expenses of
approximately $88 and increased other miscellaneous expenses of approximately
$13, partially offset by decreased bad debt expense of approximately $346, and
decreased facilities expense of approximately $106. For the six months ended
June 30, 2004, general and administrative expenses were approximately $6,452
compared to approximately $6,272 for the six months ended June 30, 2003. This
increase of approximately $179 was primarily due to increased professional
service fees of approximately $660, increased public reporting expenses of
approximately $63, increased personnel expenses of approximately $42 and
increased other miscellaneous expenses of approximately $96, partially offset by
decreased bad debt expense of approximately $491 and decreased facilities
expense of approximately $191.
SALES AND MARKETING. Our sales and marketing expenses consist primarily of
expenses for personnel, the development of our brand name, promotional
materials, direct mail advertising and sales commissions and incentives.
Sales and marketing expenses for the three months ended June 30, 2004, were
approximately $1,179, compared to approximately $1,889 for the three months
ended June 30, 2003. This decrease in sales and marketing expenses of
approximately $710 was primarily attributable to decreased salaries, benefits
and commissions of approximately $488 (resulting from our reduction in force
during the first quarter of 2004), decreased advertising expenses of
approximately $162, and
30
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
decreased other miscellaneous expenses of approximately $60. For the six months
ended June 30, 2004, sales and marketing expenses were approximately $3,521,
compared to approximately $4,122 for the six months ended June 30, 2003. This
decrease of approximately $601 was primarily attributable to decreased salaries,
benefits and commissions of approximately $406 (resulting from our reduction in
force during the first quarter of 2004), decreased advertising expense of
approximately $149, and decreased other miscellaneous expenses of approximately
$46.
STOCK COMPENSATION. We incurred non-cash stock compensation expenses during
2003 and prior years as a result of the granting of stock and stock options to
employees, directors and members of our former board of advisors with exercise
prices per share subsequently determined to be below the fair values per share
of our common stock for financial reporting purposes at the dates of grant.
Stock compensation that was vested was charged immediately to expense, while
non-vested compensation was amortized over the vesting period of the applicable
options or stock, which was generally 48 months for initial grants and 36 months
for subsequent grants. Unvested options for terminated employees were cancelled
and the value of such options was recorded as a reduction of deferred
compensation with an offset to additional paid-in-capital.
Non-cash stock compensation expense was approximately $0 and $160 for the
three months ended June 30, 2004 and 2003, respectively. For the six months
ended June 30, 2004 and 2003, non-cash stock compensation expense was
approximately $0 and $438, respectively. As of December 31, 2003, all non-cash
stock compensation had been fully amortized and there were no remaining
balances.
As of June 30, 2004 and December 31, 2003, options to purchase 47,280,413
and 18,671,766 shares of common stock, respectively, were outstanding, which
were exercisable at weighted average exercise prices of $0.72 per share and
$1.07 per share, respectively.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization is primarily
attributable to the following: (i) depreciation of network and operations
equipment and Company-owned modems and routers installed at customer sites, (ii)
depreciation of information systems and computer hardware and software, (iii)
amortization and depreciation of the costs of obtaining, designing and building
our co-location space and corporate facilities and (iv) amortization of
intangible capitalized costs pertaining to acquired businesses and customer line
acquisitions.
Depreciation and amortization expenses were approximately $3,284 for the
three months ended June 30, 2004, compared to approximately $4,498 for the three
months ended June 30, 2003. This decrease in depreciation and amortization
expenses of approximately $1,214 was primarily attributable to certain
intangible and fixed assets having become fully depreciated and amortized during
2003 and 2004. For the six months ended June 30, 2004, depreciation and
amortization expenses were approximately $6,602, compared to approximately
$9,335 for the six months ended June 30, 2003. The decrease in depreciation and
amortization expenses of approximately $2,733 was primarily attributable to
certain intangible and fixed assets having become fully depreciated and
amortized during 2003 and 2004, resulting in a decline in depreciation and
amortization expense of approximately $2,885, which was partially offset by
increased depreciation and amortization expenses relating to our acquisition of
the NAS Assets and TalkingNets Assets (as defined below) of approximately $152.
Our identified intangible assets consist of customer lists, which are
amortized over two years. Amortization expense of intangible assets for the
three and six months ended June 30, 2004 was approximately $267 and $534,
respectively. For the three and six months ended June 30, 2003, amortization
expense of intangible assets was approximately $870 and $2,050. Accumulated
amortization of customer lists as of June 30, 2004 and 2003 was $15,030 and
$13,971, respectively.
31
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The expected future amortization of customer lists as of June 30, 2004 is $421
in 2004 and $56 in 2005.
Depreciation expense pertaining to assets for our network and operations
was approximately $2,734 and $3,285 for the three months ended June 30, 2004 and
2003, respectively, and approximately $5,500 and $6,613 for the six months ended
June 30, 2004 and 2003, respectively. Depreciation and amortization expenses
pertaining to assets related to general and administrative expenses were
approximately $550 and $1,213 for the three months ended June 30, 2004 and 2003,
respectively, and approximately $1,102 and $2,722 for the six months ended June
30, 2004 and 2003, respectively.
INTEREST EXPENSE, NET. Net interest expense of approximately $1,177 for the
three months ended June 30, 2004, included approximately $1,203 of interest
expense, which was partially offset by approximately $26 in interest income. Net
interest expense of approximately $847 for the three months ended June 30, 2003,
included approximately $860 of interest expense, which was partially offset by
approximately $13 of interest income. The increase in net interest expense of
approximately $330 was primarily attributable to the increased amortization of
debt discount of approximately $1,106 which related to the warrants issued under
the Note and Warrant Purchase Agreement (as defined below), partially offset by
a decrease in the amortization of deferred non-cash financing costs of
approximately $501, which related to warrants issued in consideration for loan
guarantees under our Reimbursement Agreement (as defined below) and decreased
other interest expense of approximately $275 due to lower interest rates.
Net interest expense of approximately $2,159 for the six months ended June
30, 2004, included approximately $2,218 of interest expense, which was partially
offset by approximately $59 in interest income. Net interest expense of
approximately $1,411 for the six months ended June 30, 2003, included
approximately $1,449 of interest expense, which was partially offset by
approximately $38 of interest income. The increase in net interest expense of
approximately $748 was primarily attributed to the increased amortization of
debt discount of approximately $2,023 which related to the warrants issued under
the Note and Warrant Purchase Agreement (as defined below), partially offset by
a decrease in the amortization of deferred non-cash financing costs of
approximately $816, which related to warrants issued in consideration for loan
guarantees under our Reimbursement Agreement (as defined below) and decreased
other interest expense of approximately $459 due to lower interest rates.
OTHER INCOME (EXPENSE), NET. Net other income for the three months ended
June 30, 2004 and 2003, was approximately $33 and approximately $37,
respectively, and represented miscellaneous income. For the six months ended
June 30, 2004, net other income was approximately $107 and represented
miscellaneous income. For the six months ended June 30, 2003, net other expenses
were approximately $9 and included approximately $118 in net losses on the sale
of assets, partially offset by approximately $109 of miscellaneous income.
RESTRUCTURING. In March 2004, we reduced our workforce by 62 employees at
our locations in New Haven, Connecticut; Herndon, Virginia; Minneapolis,
Minnesota and Wilmington, North Carolina. As a result, we incurred approximately
$160 in restructuring charges pertaining to severance and benefits payments.
Also, during the first six months of 2004, we charged approximately $292 against
our restructuring reserves which related to facilities expense associated with
our vacated office space in Santa Cruz, California. Our restructuring reserve
balance as of June 30, 2004, of approximately $248, represents estimated costs
associated with such vacated facility and was included in our accrued
liabilities.
32
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
NET LOSS. Net loss was approximately $5,824 and $8,700 for the three months
ended June 30, 2004 and 2003, respectively, and approximately $12,887 and
$17,943 for the six months ended June 30, 2004 and 2003, respectively.
LIQUIDITY AND CAPITAL RESOURCES
We have financed our capital expenditures, acquisitions and operations
primarily with the proceeds from the sale of stock and from borrowings,
including equipment lease financings. As of June 30, 2004, we had cash and cash
equivalents of approximately $6,289 and working capital of approximately $1,413.
CASH USED BY FINANCING ACTIVITIES. Net cash used by financing activities
for the six months ended June 30, 2004 was approximately $44 and primarily
related to principal payments under notes and capital lease obligations of
approximately $58, partially offset by proceeds from the sale of our common
stock of $14. From time to time we have entered into equipment lease financing
arrangements with vendors. In the aggregate, there was approximately $97 and
$155 outstanding under capital leases at June 30, 2004 and December 31, 2003,
respectively.
We entered into a Revolving Credit and Term Loan Agreement, dated as of
December 13, 2002 (the "Credit Agreement"), with a commercial bank providing for
a revolving line of credit of up to $15,000 (the "Commitment"). Interest on
borrowings under the Credit Agreement was payable at 0.5% percent above the
Federal Funds Effective Rate. Our ability to borrow amounts available under the
Credit Agreement was subject to the bank's receipt of a like amount of
guarantees from certain of our investors and/or other guarantors. On February 3,
2003, we borrowed $6,100 under the Credit Agreement. As of March 3, 2003,
certain of our investors had guaranteed $9,100 under the Credit Agreement. On
July 18, 2003, we repaid the $6,100 outstanding balance plus accrued interest,
and terminated the Credit Agreement. We wrote off approximately $184 of the
related unamortized balance of loan origination fees.
We entered into a Reimbursement Agreement, dated as of December 27, 2002
(the "Reimbursement Agreement"), with VantagePoint Venture Partners (together
with its affiliated funds as their interests shall appear, "VantagePoint") and
Columbia Capital and other holders of our Series X Preferred Stock and Series Y
Preferred Stock or their affiliates (the "Guarantors"), and a related Security
Agreement of even date therewith. Pursuant to the terms of the Reimbursement
Agreement, on December 27, 2002, VantagePoint and Columbia Capital issued
guarantees in an aggregate amount of $6,100 to support certain of our
obligations under the Credit Agreement. On July 18, 2003, in connection with the
termination of the Credit Agreement, the guarantees, Reimbursement Agreement and
related Security Agreement were terminated.
Pursuant to the terms of the Reimbursement Agreement, on December 27, 2002,
we issued warrants to purchase 12,013,893 shares of our common stock to
VantagePoint and Columbia Capital, in consideration for their guarantees
aggregating $6,100. All such warrants have a ten year life and an exercise price
of $0.50 per share. On March 26, 2003, we issued additional warrants,
exercisable for ten years, to purchase a total of 936,107 shares of our common
stock at $0.50 per share to VantagePoint and Columbia Capital, bringing the
total number of warrants issued in connection with the Reimbursement Agreement
to 12,950,000. On February 3, 2003, we borrowed $6,100 on the Credit Agreement
and the Guarantors' guarantees of the subject loan became effective.
On February 3, 2003, we valued the 12,950,000 warrants at $0.514 each with
a total value of approximately $6,656. The valuation was performed using a
Black-Scholes valuation model with the following assumptions: (i) a risk free
interest rate of 4.01% (ten-year Treasury rate), (ii) a zero dividend yield,
(iii) a ten year expected life, (iv) an expected volatility of 153%, (v) an
option
33
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
exercise price of $0.50 per share and (vi) a current market price of $0.52 per
share (the closing price of our common stock on February 3, 2003). Since the
warrants were issued in consideration for loan guarantees, which enabled us to
secure financing at below market interest rates, we recorded their value as a
deferred debt financing cost to be amortized to interest expense over the term
of the loan (approximately 57 months) using the "Effective Interest Method" of
amortization. On July 18, 2003, we repaid the outstanding loan balance that was
secured by these loan guarantees and terminated the Credit Agreement.
Accordingly, during the third quarter of 2003, we wrote-off approximately $5,747
of the related unamortized balance of deferred financing costs to other expense.
On March 3, 2003, we and VantagePoint entered into Amendment No. 1 to the
Reimbursement Agreement, pursuant to which VantagePoint increased its guarantee
by $3,000 bringing the aggregate guarantees by all Guarantors under the
Reimbursement Agreement, as amended, to $9,100. As consideration for
VantagePoint's increased guarantee, if we closed an equity financing on or
before December 3, 2003, we were authorized to issue VantagePoint additional
warrants to purchase the type of equity securities issued by us in such equity
financing. The number of such additional warrants would be determined by
dividing the per share price of such equity securities into a thousand dollars.
Accordingly, since we closed a financing on July 18, 2003, we issued to
VantagePoint, in December 2003, additional warrants with a three-year life to
purchase 2,260,909 shares of our common stock at a per share price of $0.4423.
On July 18, 2003, we entered into a Note and Warrant Purchase Agreement
(the "Note and Warrant Purchase Agreement") with Deutsche Bank AG London, acting
through DB Advisors LLC as Investment Agent ("Deutsche Bank"), VantagePoint
Venture Partners III (Q), L.P., VantagePoint Venture Partners III, L.P.,
VantagePoint Communications Partners, L.P. and VantagePoint Venture Partners
1996, L.P. (collectively, the "Investors") relating to the sale and purchase of
an aggregate of (i) $30,000 in senior secured promissory notes (the "Notes") and
(ii) warrants to purchase 157,894,737 shares of our common stock for a period of
three years at an exercise price of $0.38 per share (the "Warrants"). The
aggregate purchase price for the Notes and Warrants was $30,000.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, we issued an aggregate of $30,000 in principal amount of Notes to the
Investors on July 18, 2003. Principal on the Notes is payable in a single
payment on July 18, 2006. The Notes provide for an annual interest rate of
1.23%, payable in cash, quarterly in arrears commencing on October 31, 2003,
unless we were to elect to capitalize such interest and pay it together with the
principal amount of the Notes at maturity on July 18, 2006. Pursuant to the
Security Agreement entered into in connection with this financing transaction,
our obligations under the Notes are secured by a security interest in a majority
of our personal property and assets and certain of our subsidiaries. The terms
of the Notes also contain provisions that limit our ability to incur additional
indebtedness and place other restrictions on our business. We elected to defer
all interest payments on the Notes until further notice. Interest expense
accrued on the Notes for the six months ended June 30, 2004 approximated $188.
Total accrued interest on the Notes since inception is included in notes payable
and approximated $359 at June 30, 2004.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, we issued a warrant to purchase 12,950,000 shares of our common stock
to Deutsche Bank on or about August 12, 2003. We issued the remaining warrants
to purchase an aggregate of 144,944,737 shares of our common stock to Deutsche
Bank (105,471,053 shares) and VantagePoint (39,473,864 shares) on or about
December 9, 2003.
On July 18, 2003, we recorded these Note and Warrant transactions in
accordance with Accounting Principals Board Opinion No. 14, "ACCOUNTING FOR
CONVERTIBLE DEBT AND DEBT ISSUED WITH STOCK PURCHASE WARRANTS," whereby a fair
value was ascribed to the 157,894,737 Warrants to
34
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
be issued to the Investors (related to the Note and Warrant Purchase Agreement)
together with the 2,260,909 warrants to be issued to VantagePoint (related to
VantagePoint's increased guarantee under Amendment No. 1 to the Reimbursement
Agreement) using a Black-Scholes valuation model with the following assumptions:
(i) a risk free interest rate of 2.24% (three-year Treasury rate), (ii) a zero
dividend yield, (iii) a three-year life, (iv) an expected volatility of 152%,
(v) a warrant option price of $0.38 per share for the 157,894,737 Warrants and
$0.4423 per share for the 2,260,909 warrants, and (vi) a current market price of
$0.83 per share (the closing price of our common stock on July 18, 2003). A fair
value was ascribed to the $30,000 Notes using a present value method with a 19%
discount rate. The relative fair value of the warrants representing 87% of the
combined fair value of the warrants and Notes was applied to the $30,000
proceeds to determine a note discount of approximately $26,063, which was
recorded as a reduction to the Notes payable and an increase to additional paid
in capital. The note discount is being amortized to interest expense using the
"Effective Interest Method" over the 36 month term of the Notes. For the six
months ended June 30, 2004, approximately $2,023 of this note discount was
amortized to interest expense. The unamortized balance of the note discount at
June 30, 2004 is approximately $22,774.
The proceeds from the sale of the Notes and Warrants will be (and portions
already have been) used by us for general corporate purposes, including
acquisitions, the expansion of our sales and marketing activities and repayment
of certain debt and lease obligations. As of December 31, 2003, we had paid
approximately $10,200 for the complete repayment (at a discount) of
approximately $14,600 of our debt and lease obligations.
As part of the agreements negotiated in conjunction with our $30,000
financing on July 18, 2003, we and holders of a majority of the Series X
Preferred Stock and Series Y Preferred Stock agreed to extend the redemption
dates of the Series X Preferred Stock and Series Y Preferred Stock from January
1, 2005 to July 18, 2006. Also, as a result of this financing transaction, in
accordance with the terms of the Series Y Preferred Stock, the Series Y
Preferred Stock conversion price was adjusted from $0.50 per share (each share
of Series Y Preferred Stock is convertible into 2,000 shares of common stock) to
$0.4423 per share (each share of Series Y Preferred Stock is convertible into
approximately 2,260.9 shares of common stock). As of June 30, 2004, all
previously issued shares of Series Y Preferred Stock and 6,000 shares of Series
X Preferred Stock had been converted into shares of common stock.
On July 22, 2004, the Company entered into a Recapitalization Agreement
with VantagePoint, the holder of all of the remaining issued and outstanding
shares of Series X Preferred Stock (the "Recapitalization Agreement"). In
accordance with the Recapitalization Agreement, the remaining 14,000 shares of
Series X Preferred Stock were converted into 77,777,775 shares of the Company's
common stock at a conversion price of $0.18 per share and, in accordance with
the terms of the Series X Preferred Stock, the Company elected to pay accrued
dividends approximating $4,040 by issuing 11,710,142 shares of its common stock,
based on the average fair market value for the ten days ending three days
preceding the conversion of $0.345 per share. After the conversion, the Company
had 233,617,317 shares of common stock outstanding. Also, in accordance with the
Recapitalization Agreement, the Company issued to VantagePoint 14,000 shares of
a new Series Z Preferred Stock, par value of $0.001 per share (the "Series Z
Preferred Stock"), with a liquidation preference of $1,120 per share. The Series
Z Preferred Stock does not contain any conversion or mandatory redemption
provisions nor does it have any special dividend or special voting rights. The
Series Z Preferred Stock's liquidation preference will be eliminated, and the
shares of Series Z Preferred Stock cancelled, on July 18, 2008. In addition,
upon the occurrence of certain events before July 18, 2008, the liquidation
preference will be reduced or eliminated.
CASH USED IN OPERATING ACTIVITIES. For the six months ended June 30, 2004,
the net cash used in our operating activities was approximately $6,988. This
cash was used to pay a variety of
35
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
operating expenses, including salaries, professional fees, network expenses,
operations, sales and marketing and overhead expenses.
CASH USED IN INVESTING ACTIVITIES. Net cash used in investing activities
for the six months ended June 30, 2004, was approximately $458 and was used for
the purchase of equipment.
The development and expansion of our business has required significant
capital expenditures. Capital expenditures, including co-location fees, were
approximately $458 and $1,231 for the six months ended June 30, 2004 and 2003,
respectively. The actual amounts and timing of our future capital expenditures
will vary depending on the speed at which we expand and implement our network
and implement service for our customers. Our planned capital expenditures for
2004 are currently expected to be primarily for the upgrade of our network to
support our integrated voice and data service offerings. We currently anticipate
spending approximately $1,100 for capital expenditures, excluding acquisitions,
during the year ended December 31, 2004. The actual amounts and timing of our
capital expenditures could differ materially both in amount and timing from our
current plans.
In December of 2002, the U.S. Bankruptcy Court for the District of Delaware
approved our bid to purchase the on-network assets and associated subscriber
lines of NAS for $14,000, consisting of $9,000 in cash and $5,000 in a note
payable to NAS. We closed the transaction on January 10, 2003, whereby we
acquired NAS' operations and network assets, including associated equipment in
approximately 300 central offices and approximately 11,500 associated subscriber
lines. In connection with the closing of the NAS transaction, on January 10,
2003, we hired 78 former NAS employees. No pre-closing liabilities were assumed
in connection with the NAS transaction. The cash portion of the purchase price
was paid from our existing cash. The NAS note had a term of approximately 5
years and carried interest at 12% and was secured by the NAS network assets
acquired. During August 2003, we paid $1,500 to repurchase and cancel the $5,000
note issued by us to NAS. The difference between the $5,000 note and the $1,500
settlement amount was recorded as other income during 2003.
In connection with the integration of the NAS business, on January 17,
2003, we had a reduction in force of approximately 35 employees at our
headquarters facility in New Haven, Connecticut. We paid approximately $62 in
severance to the terminated employees.
On April 8, 2003, we entered into an asset purchase agreement with
TalkingNets, Inc. and TalkingNets Holdings, LLC (collectively, "TalkingNets")
pursuant to which we agreed to acquire assets and subscribers of TalkingNets
(the "TalkingNets Assets") for $726 in cash (the "TalkingNets Asset Purchase
Agreement"). As TalkingNets had filed a voluntary petition for Chapter 11
reorganization in February 2003, the TalkingNets Asset Purchase Agreement was
subject to the approval of the U.S. Bankruptcy Court for the Eastern District of
Virginia. On April 9, 2003, the TalkingNets Asset Purchase Agreement and the
transactions contemplated thereby were approved by the Bankruptcy Court. On
April 11, 2003, we paid the full purchase price of $726 into escrow.
On September 8, 2003, in accordance with the TalkingNets Asset Purchase
Agreement, we completed our acquisition of the TalkingNets Assets. During the
transition period, the Company included the net effect of cash collections from
the proposed acquired customers less certain related operating costs of
TalkingNets' operations in its statements of operations. This net effect for the
three and six months ended June 30, 2003, was approximately $235 in expense.
The TalkingNets acquisition has been accounted for under the purchase
method of accounting in accordance with SFAS No. 141. The results of
TalkingNets' operations have been included in our consolidated financial
statements since September 8, 2003 (the closing date). The allocated
36
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
estimated fair values of the acquired assets at the date of acquisition exceeded
the purchase price and, accordingly, have been written down on a pro-rata basis
by asset group to the purchase price of approximately $851 ($726 plus associated
direct acquisition costs of approximately $125) as follows: (i) certain accounts
receivables of approximately $55, (ii) intangible assets pertaining to
approximately 90 acquired subscriber lines of approximately $111, and (iii)
property and equipment of $685.
CASH RESOURCES FOR FUTURE ACTIVITIES. As of June 30, 2004, we had cash and
cash equivalents of approximately $6,289 and working capital of approximately
$1,412. On March 25, 2004, we reduced our workforce by 62 employees. As a result
of this action, we incurred approximately $160 in restructuring charges
pertaining to severance and benefits payments and we expect to realize
approximately $3,400 in annualized savings in salary and benefit costs.
We expect our operating losses, net operating cash outflows and capital
expenditures to continue throughout 2004. Based on our current business plan and
projections, we believe that our existing cash and cash expected to be generated
from operations will be sufficient to fund our operating losses, capital
expenditures, lease payments, and working capital requirements into the fourth
quarter of 2004. Failure to generate sufficient revenues, contain certain
discretionary spending or achieve certain other business plan objectives could
have a material adverse affect on our results of operations, cash flows and
financial position, including our ability to continue as a going concern.
We intend to use our cash resources to finance our capital expenditures and
for our working capital and other general corporate purposes. We may also need
additional funding to pursue our strategic objective of accelerating our growth
through acquisitions of complementary businesses, subscriber lines and other
assets. The amounts actually expended for these purposes will vary significantly
depending on a number of factors, including market acceptance of our services,
revenue growth, planned capital expenditures, cash generated from operations,
improvements in operating productivity, the extent and timing of entry into new
markets, the availability of and prices paid for acquisitions, and the
availability and terms of any additional funding.
Our cash requirements may vary based upon the timing and the success of
implementation of our business plan or if:
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make acquisitions;
o we alter the schedule or targets of our business plan implementation;
or
o we curtail and/or reorganize our operations.
There can be no assurance that we will be able to achieve our business plan
objectives or that we will achieve or maintain cash flow positive operating
results. If we are unable to generate adequate funds from our operations or
raise additional capital, we may not be able to continue to operate our network,
respond to competitive pressures or fund our operations. As a result, we may be
required to significantly reduce, reorganize, discontinue or shut down our
operations. Our financial statements do not include any adjustments that might
result from these uncertainties.
37
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
CONTRACTUAL OBLIGATIONS. Since December 31, 2003, there have been no
material changes outside of the ordinary course of our business to the
contractual obligations presented in our Annual Report on Form 10-K for the year
ended December 31, 2003, pursuant to Item 303 of Regulation S-K promulgated by
the SEC.
LISTING OF OUR COMMON STOCK. On August 4, 2004, the listing and trading of
our common stock moved from the Nasdaq SmallCap Market to the American Stock
Exchange ("Amex"). On such date, our common stock trading symbol changed from
"DSLNC" to "BIZ."
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
FORWARD LOOKING STATEMENTS
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). The statements contained in this report, which are not
historical facts, may be deemed to contain forward-looking statements. These
statements relate to future events or our future financial or business
performance, and are identified by terminology such as "may," "might," "will,"
"should," "expect," "scheduled," "plan," "intend," "anticipate," "believe,"
"estimate," "potential," or "continue" or the negative of such terms or other
comparable terminology. These statements are subject to a variety of risks and
uncertainties, many of which are beyond our control, which could cause actual
results to differ materially from those contemplated in these forward-looking
statements. In particular, the risks and uncertainties include, among other
things, those described under "Risk Factors" in our Annual Report on Form 10-K
for the year ended December 31, 2003, which has been filed with the SEC, and (i)
fluctuations in our quarterly operating results, which could adversely effect
the price of our common stock; (ii) our unproven business model, which may not
be successful; (iii) our ability to execute our business plan in a timely manner
to generate the forecasted financial and operating results, which may not be
achieved if our sales force is not able to generate sufficient sales to
customers or if we are not able to install and commence service for customers in
a timely manner; (iv) our failure to generate sufficient revenue, contain
certain discretionary spending or achieve certain other business plan
objectives, which could have a material adverse affect on our results of
operations and financial position; (v) our independent auditors have in the past
raised questions about our ability to continue as a going concern and may also
do so in their future reports on our financial statements, which may have an
adverse impact on our ability to raise additional capital and our stock price;
(vi) our ability to raise sufficient additional capital on acceptable terms, or
at all, to finance our operations or growth opportunities, including
acquisitions; (vii) our ability to comply with Amex continued listing
requirements, which failure could adversely impact the pricing and trading of
our common stock; (viii) risks associated with acquisitions, including
difficulties in identifying, completing and integrating acquisitions and
realizing the revenue, earnings or synergies anticipated from any acquisitions;
(ix) regulatory, legislative, and judicial developments, which could adversely
affect the way we operate our business; (x) risks associated with our reliance
on certain carriers to transmit data across our network; (xi) the challenges
relating to the timely installation of service for customers, including our
dependence on traditional telephone companies to provide acceptable telephone
lines in a timely manner; (xii) our dependence on wholesale providers to provide
us with local broadband facilities in areas where we have not deployed our own
equipment; (xiii) the need for us to achieve sustained market acceptance of our
services at desired pricing levels; (xiv) high levels of competition in the
Company's industry; (xv) the difficulty of predicting the new and rapidly
evolving high-speed data communications industry; (xvi) our ability to
negotiate, enter into, amend and renew interconnection and co-location
agreements with traditional telephone companies; and (xvii) our ability to
recruit and retain qualified personnel, establish the necessary infrastructure
38
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
to support our business, and manage the growth of our operations. Existing and
prospective investors are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. We undertake
no obligation, and disclaim any obligation, to update or revise the information
contained in this report, whether as a result of new information, future events
or circumstances or otherwise.
39
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have no derivative financial instruments in our cash and cash
equivalents. We invest our cash and cash equivalents in investment-grade, highly
liquid investments, consisting of commercial paper, bank money markets and
certificates of deposit and corporate bonds.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
have evaluated our disclosure controls and procedures (as defined in the
Exchange Act, Rules 13a-15(e)) as of the end of the period covered by this
quarterly report on Form 10-Q. Based on this evaluation, the principal executive
officer and principal financial officer concluded that our disclosure controls
and procedures were, as of the end of the period covered by this report,
effective to provide reasonable assurances that material information related to
the Company required to be disclosed in our filings and submissions under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms.
There were no significant changes in our internal controls over financial
reporting that occurred during the last fiscal quarter that materially affected,
or are reasonably likely to materially affect, our internal controls over
financial reporting.
PART II - OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In the first quarter of 2004, we issued 35,650,165 shares of our common
stock upon conversion of 6,000 shares of our Series X Preferred Stock
(33,333,333 shares of common stock upon conversion and 2,316,832 shares of
common stock issued to pay accrued dividends) and we issued 2,570,774 shares of
our common stock upon conversion of 1,000 shares of our Series Y Preferred Stock
(2,260,910 shares of common stock upon conversion and 309,864 shares of common
stock issued to pay accrued dividends). Also in the first quarter of 2004,
Columbia Capital exercised their remaining warrants to purchase 1,358,025 shares
of the Company's common stock at an exercise price of $0.50 per share in a
cashless exchange which resulted in the issuance of 413,160 shares of the
Company's common stock.
On July 22, 2004, the Company entered into the Recapitalization Agreement
with VantagePoint. In accordance with the Recapitalization Agreement, the
remaining 14,000 shares of Series X Preferred Stock were converted into
77,777,775 shares of the Company's common stock at a conversion price of $0.18
per share and, in accordance with the terms of the Series X Preferred Stock, the
Company elected to pay accrued dividends approximating $4,040 by issuing
11,710,142 shares of its common stock, based on the average fair market value
for the ten days ending three days preceding the conversion of $0.345 per share.
After the conversion, the Company had 233,617,317 shares of common stock
outstanding. Also, in accordance with the Recapitalization Agreement, the
Company issued to VantagePoint 14,000 shares of Series Z Preferred Stock, with a
liquidation preference of $1,120 per share. The Series Z Preferred Stock does
not contain any conversion or mandatory redemption provisions nor does it have
any special dividend or special voting rights. The Series Z Preferred Stock's
liquidation preference will be eliminated, and the shares of Series Z Preferred
Stock cancelled, on July 18, 2008. In addition, upon the occurrence of certain
events before July 18, 2008, the liquidation preference will be reduced or
eliminated.
40
No underwriters were involved in the foregoing issuances of securities.
Such issuances were made in reliance upon an exemption from the registration
requirements of the Securities Act of 1933, as amended, set forth in Sections
3(a)(9) and 4(2) thereof.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
Exhibit No. Exhibit
----------- -------
10.01* Employment Agreement, dated as of April 15, 2004, between the
Company and Kirby G. Pickle.
4.01, Stock Option Agreement, dated April 15, 2004, between the Company
10.02* and Kirby G. Pickle.
11.01* Statements of Computation of Basic and Diluted Net Loss Per
Share.
31.1* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
31.2* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
32.1* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith.
(b) Reports on Form 8-K.
The Company furnished a Current Report on Form 8-K on May 12, 2004 under
Item 12 of that form in respect of a press release issued by the Company on May
12, 2004 relating to the Company's financial results for the quarter ended March
31, 2004.
The Company furnished a Current Report on Form 8-K on April 22, 2004 under
Item 9 of that form, in respect of a press release issued by the Company on
April 22, 2004 relating to the Company's receipt of notice from Nasdaq
concerning the listing of its shares of common stock.
The Company furnished a Current Report on Form 8-K on April 20, 2004 under
Item 9 of that form, in respect of a press release issued by the Company on
April 20, 2004 relating to the Company's compliance with Nasdaq Marketplace Rule
4350(b)(1)(B).
The Company furnished a Current Report on Form 8-K on April 16, 2004 under
Item 9 of that form, in respect of a press release issued by the Company on
April 15, 2004 relating to the Company's hiring of a new chief executive
officer.
The Company furnished a Current Report on Form 8-K/A on April 15, 2004
under Item 9 of that form, in respect of a press release issued by the Company
on April 14, 2004 relating to the Company's filing of a Quarterly Report on Form
10-Q/A for the period ended September 30, 2003.
41
The Company furnished a Current Report on Form 8-K on April 14, 2004 (which
was subsequently amended by the Company's Current Report on Form 8-K/A furnished
on April 15, 2004), in respect of a press release issued by the Company on April
14, 2004 relating to the Company's filing of a Quarterly Report on Form 10-Q/A
for the period ended September 30, 2003.
42
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.
DSL.NET, INC.
By:/s/ Robert J. DeSantis
---------------------------------------
Robert J. DeSantis
Chief Financial Officer
(Duly authorized officer and
principal financial officer)
Date: August 13, 2004
43
EXHIBIT INDEX
-------------
Exhibit No. Exhibit
----------- -------
10.01* Employment Agreement, dated as of April 15, 2004, between the
Company and Kirby G. Pickle.
4.01, Stock Option Agreement, dated April 15, 2004, between the Company
10.02* and Kirby G. Pickle.
11.01* Statements of Computation of Basic and Diluted Net Loss Per
Share.
31.1* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
31.2* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
32.1* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith