<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Date of Report (Date of earliest event reported): February 24, 1999
MINDSPRING ENTERPRISES, INC.
----------------------------
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C> <C>
DELAWARE 0-27890 58-2113290
- ------------------------------------------- ---------------------------- --------------------------
(State or other jurisdiction (Commission (IRS Employer
of incorporation) File Number) Identification No.)
</TABLE>
1430 WEST PEACHTREE ST., SUITE 400, ATLANTA, GA 30309
-----------------------------------------------------
(Address of principal executive offices)
Registrant's telephone number, including area code: (404) 815-0770
----------------
<PAGE> 2
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS.
(c) Exhibits.
23.1. Consent of Arthur Andersen LLP.
27.1. Financial Data Schedule.
99.1. Management's Discussion and Analysis of Financial Condition
and Results of Operations and Audited Financial Statements of
MindSpring Enterprises, Inc. as of December 31, 1998 and 1997.
99.2 Risk Factors.
99.3 Description of Secured Credit Facility.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
MINDSPRING ENTERPRISES, INC.
/s/ Michael S. McQuary
---------------------------------------------
Michael S. McQuary
President and Chief Operating Officer
Date: February 24, 1999
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the
incorporation by reference of our report dated February 17, 1999 on the
financial statements of MindSpring Enterprises, Inc., included in this Form
8-K, into MindSpring Enterprises, Inc.'s previously filed Registration
Statements No. 333-17807 and No. 333-44411.
/s/ Arthur Andersen LLP
Atlanta, Georgia
February 23, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF MINDSPRING ENTERPRISES FOR THE YEAR ENDED DECEMBER 31,
1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS
FILED AS EXHIBIT 99.1.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 167,743,000
<SECURITIES> 0
<RECEIVABLES> 4,507,000
<ALLOWANCES> 1,224,000
<INVENTORY> 81,000
<CURRENT-ASSETS> 175,200,000
<PP&E> 49,947,000
<DEPRECIATION> 14,106,000
<TOTAL-ASSETS> 247,599,000
<CURRENT-LIABILITIES> 38,094,000
<BONDS> 0
0
0
<COMMON> 283,000
<OTHER-SE> 206,798,000
<TOTAL-LIABILITY-AND-EQUITY> 247,599,000
<SALES> 0
<TOTAL-REVENUES> 114,673,000
<CGS> 34,336,000
<TOTAL-COSTS> 106,887,000
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 3,123,000
<INTEREST-EXPENSE> (1,214,000)
<INCOME-PRETAX> 9,000,000
<INCOME-TAX> (1,544,000)
<INCOME-CONTINUING> 10,544,000
<DISCONTINUED> 0
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<NET-INCOME> 10,544,000
<EPS-PRIMARY> 0.43
<EPS-DILUTED> 0.41
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<PAGE> 1
EXHIBIT 99.1
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
All common stock numbers and per share amounts in this report give effect to a
3-for-1 stock split effected by MindSpring in June 1998.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The following discussion includes "forward-looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E
of the Exchange Act of 1934, as amended. We intend the forward-looking
statements to be covered by the safe harbor provisions for forward-looking
statements in these sections. All statements regarding our expected financial
position and operating results, our business strategy and our financing plans
are forward-looking statements. These statements can sometimes be identified by
our use of forward-looking words such as "may," "will," "anticipate,"
"estimate," "expect" or "intend." Known and unknown risks, uncertainties and
other factors could cause the actual results to differ materially from
those contemplated by the statements. The forward-looking information is based
on various factors and was derived using numerous assumptions.
Although we believe that our expectations that are expressed in these
forward-looking statements are reasonable, we cannot promise that our
expectations will turn out to be correct. Our actual results could be materially
different from and worse than our expectations. Important risks and factors that
could cause our actual results to be materially different from our expectations
include, without limitation, (1) that MindSpring will not retain or grow its
subscriber base, (2) that MindSpring will not be able to successfully integrate
new subscribers and/or assets obtained through acquisitions, (3) that MindSpring
will fail to be competitive with existing and new competitors, (4) that
MindSpring will not be able to sustain its current growth, (5) that MindSpring
will not adequately respond to technological developments impacting the
Internet, and (6) that financing will not be available to MindSpring if and as
needed. This list is intended to identify some of the principal factors that
could cause actual results to differ materially from those described in the
forward-looking statements included elsewhere in this report. These factors are
not intended to represent a complete list of all risks and uncertainties
inherent in MindSpring's business, and should be read in conjunction with the
more detailed cautionary statements included in "Risk Factors" included in
Exhibit 99.2 to this Current Report, as well as MindSpring's other publicly
filed reports and documents.
OVERVIEW
MindSpring is a leading national Internet service provider, or ISP. We
focus on serving individuals and small businesses. Our subscribers use their
MindSpring accounts to, among other things, communicate, retrieve information,
and publish information on the Internet. Our primary service offerings are
dial-up Internet access and Web hosting, both of which we offer in various price
and usage plans designed to meet the needs of our
<PAGE> 2
subscribers. Web hosting complements our Internet access business and is one of
the fastest growing segments of the Internet marketplace. In addition to dial-up
Internet access and Web hosting, we offer other value-added services, such as
Web page design.
We offer our subscribers:
- user-friendly software, containing a complete set of the most
popular Internet applications including electronic mail, World
Wide Web access, Network News, File Transfer Protocol and
Internet Relay Chat;
- highly responsive customer service and technical support
which is available 24 hours a day, seven days a week; and
- a reliable network that enables subscribers in the 48
contiguous United States and the District of Columbia to access
the Internet via a local telephone call.
Our nationwide network consists of MindSpring-owned points of presence
("POPs") and POPs that are owned by other companies with which we have service
agreements. Through these service agreements, we have the flexibility to offer
Internet access in a particular market through a MindSpring-owned POP, a
third-party network provider's POP or a combination of the two. As part of our
efforts to control quality and cost, we typically seek to increase the number of
MindSpring-owned POPs in markets where we have higher numbers of subscribers.
MindSpring has grown rapidly by:
- providing superior customer service and technical support;
- expanding marketing and distribution activities;
- making strategic acquisitions; and
- creating additional revenue streams by offering value-added
services such as Web hosting that build on our basic operating
capabilities and services.
We have increased our subscriber base from approximately 12,000 subscribers
at December 31, 1995 to approximately 693,000 subscribers at December 31, 1998,
including the Spry, Inc. ("Spry") subscribers acquired from America On-Line,
Inc. ("AOL") in October 1998, but excluding the approximately 421,000
subscribers acquired from NETCOM On-Line Communication Services, Inc. ("NETCOM")
in February 1999. These acquisitions are described below. As of December 31,
1998, approximately 21,000 of these 693,000 subscribers were Web hosting
subscribers.
In addition, we have rapidly increased revenues and have achieved
profitability ahead of other national ISPs. We believe that providing superior
service and support to our subscribers has contributed to our achieving
significant market penetration in a number of our target markets. We also
believe that high geographic concentrations of satisfied subscribers in a
particular market reduces the costs of adding new subscribers in that market
relative to revenues. This tends to result in higher margins and greater
profitability in these markets.
2
<PAGE> 3
From our inception in February 1994 through 1997, we experienced annual
net operating losses as a result of efforts to build our network infrastructure
and internal staffing, develop our systems, and expand into new markets. During
1997, we generated positive cash flows from operations, with EBITDA of
approximately $5 million. We had our first year of profitability in 1998. For
the year ended December 31, 1998, we had revenues of approximately $115 million,
EBITDA of approximately $23 million, net income of approximately $8.8 million
and earnings per share of $0.35, in each case excluding a one-time tax benefit
of approximately $1.7 million. Including the one-time tax benefit, our net
income for 1998 was approximately $10.5 million and our earnings per share were
$0.41.
We expect to continue to focus on increasing our subscriber base.
Increases in our subscriber base will cause our revenues to increase,
but will also cause our costs of revenue, selling, general and administrative
expenses, capital expenditures, and depreciation and amortization to increase.
Our purchases of subscriber bases such as the Spry and NETCOM acquisitions cause
an immediate increase in our amortization expense. We generally amortize
subscriber acquisitions over a three-year period in approximately equal amounts
each year. As more fully described below, we anticipate that, while we will
continue to generate positive cash flows from operations and EBITDA during 1999
and 2000, we expect to incur net losses into 2000, principally as a result of
amortization expenses related to the Spry and NETCOM acquisitions. If our
assumptions are incorrect, our business plans change and/or we undertake
additional acquisitions of subscriber bases in the near future, we could
continue to incur net losses for a longer period of time. We do not currently
have any agreements to make additional acquisitions. There can be no assurance
that we will be able to sustain growth in our subscriber base, revenues, cash
flows or EBITDA. Also, there can be no assurance that we will be able to achieve
or sustain net income in the future.
Spry Acquisition. On September 10, 1998, we entered into an Asset Purchase
Agreement with AOL and Spry, a wholly owned subsidiary of AOL, to purchase
assets used in connection with the consumer dial-up Internet access business
operated by Spry (the "Spry Agreement"). In that transaction, we acquired Spry's
subscriber base of approximately 130,000 individual Internet access customers
in the United States and Canada as well as various assets used in serving those
customers. These assets included a customer support facility and a leased
network operations facility in Seattle, Washington. MindSpring also acquired
all rights held by Spry to the "Sprynet" name. On October 15, 1998, the
acquisition was completed, at which time, as required by the Spry Agreement, we
made an initial cash payment to AOL of $25 million. In late February 1999, we
expect to make an additional and final payment to AOL of approximately $7
million. The total purchase price of approximately $32 million for the Spry
subscribers and assets was primarily a function of the number of acquired
subscribers who remained active with MindSpring as continuing users in good
standing after two billing cycles, measured as of December 31, 1998.
NETCOM Acquisition. On January 5, 1999, we entered into an Asset Purchase
Agreement with NETCOM, a wholly owned subsidiary of ICG Communications, Inc.
("ICG"), to purchase assets used in connection with the United States Internet
access and Web hosting business operated by NETCOM (the "NETCOM Agreement"). In
that transaction, we acquired NETCOM's subscriber base of approximately 400,000
individual Internet access accounts, 18,000 Web hosting accounts, and 3,000
dedicated Internet access accounts in the United States. The acquisition closed
3
<PAGE> 4
on February 17, 1999. We paid NETCOM approximately $245 million, consisting of
$215 million in cash and $30 million in MindSpring common stock (376,116 shares,
at a price per share of $79.76). In addition to the NETCOM subscriber base,
MindSpring also acquired various assets used in serving those subscribers,
including leased operations facilities in San Jose, California and Dallas, Texas
and all of NETCOM's rights to the "NETCOM" name (except in Brazil, Canada and
the United Kingdom). NETCOM, which will change its name in the near future, has
retained the network assets used to serve those subscribers. MindSpring will be
able to purchase access to that network at favorable rates under a network
services agreement (the "Network Agreement"). The Network Agreement has a term
of one year with an option for a second year on potentially different terms to
be agreed upon by the parties. During the first year under the Network
Agreement, we are obligated to pay at least $27 million for network services,
as long as the services provided meet specified performance levels.
Credit Facility. On February 17, 1999, we entered into a credit agreement
with First Union National Bank and several other lenders. The credit agreement
provides for a $100 million revolving credit facility that may be increased at
our option to $200 million with the approval of First Union and the other
lenders under the credit agreement. The credit facility will mature on February
17, 2002. The credit facility is to be used to fund working capital and for
general corporate purposes, including permitted acquisitions. On February 17,
1999, we borrowed approximately $80 million under the credit facility to finance
the NETCOM acquisition. Our obligations under the credit facility are secured by
substantially all of MindSpring's assets. The credit facility is described more
fully under "Description of Secured Credit Facility" included as Exhibit 99.3
to this report.
Anticipated Effects of the Spry and NETCOM Acquisitions. The Spry and
NETCOM acquisitions represent significant growth opportunities and challenges
for MindSpring. Both acquisitions were of large customer bases and related
assets which, as previously operated stand-alone entities, were historically
unprofitable. We expect to incur net losses into 2000, primarily as a result of
the amortization expense associated with the Spry and NETCOM acquisitions. We
expect that annual amortization expense attributable to these transactions will
be between approximately $85 million and $90 million per year for the next
three years. In addition, we face the significant challenge of integrating the
acquired customers and assets into MindSpring's operations. The integration
process is most time and resource intensive during the sixty- to ninety-day
period immediately after completion of an acquisition, and involves, among
other things:
- communication with and increased technical and customer support
to acquired subscribers;
- network supervision, provisioning and maintenance, including of
third-party networks;
- increased management time and resources related to hiring and
integration of new employees to support acquired subscribers;
- integration of acquired subscribers into MindSpring's billing
systems; and
- attempting to bring the cost structures associated with the
acquired subscribers and assets into alignment with
MindSpring's historical cost structure.
4
<PAGE> 5
The Spry subscribers and assets were substantially integrated into
MindSpring's operations as of December 31, 1998. Net income for the fourth
quarter of 1998 was $1.9 million, excluding a one-time tax benefit of $1.8
million, compared to approximately $4.0 million for the third quarter of 1998.
This decrease resulted primarily from $2.3 million in amortization costs during
the fourth quarter attributable to the Spry acquisition.
The NETCOM acquisition will significantly increase MindSpring's customer
base from 693,000 to approximately 1,100,000. Principally as a result of the
NETCOM acquisition, we expect that we will incur net losses into 2000. Even
though we expect to incur net losses, we expect to continue to generate
increased revenues and EBITDA as we continue to increase our subscriber base.
We believe that reducing the historical costs associated with the acquired
NETCOM subscribers to levels that approximate MindSpring's historical costs of
providing Internet access to its subscribers will contribute to our ability to
reduce net losses in the future. We expect that these cost reductions will be
achieved in part as a function of:
- the Network Agreement, through which MindSpring expects
initially to provide service to the majority of the acquired
NETCOM subscribers and which MindSpring expects will be at a
lower cost than that reported by NETCOM; and
- economies of scale in selling, general and administrative
costs, particularly in the areas of numbers of employees and
salaries, operating leases, and marketing expenses.
By "economies of scale" we mean that, as the number of subscribers we
serve increases, the costs and expenses per subscriber decrease. There can be no
assurance that we will achieve these anticipated cost reductions in a timely
manner or at all. If the cost reductions are lower than anticipated, other costs
increase, and/or revenues decline, our EBITDA and net income would also decline,
which would have a material adverse effect on our business, results of
operations and financial condition, including our liquidity and capital
resources.
Revenues. MindSpring derives revenue primarily from monthly subscriptions
from individuals for dial-up access to the Internet. Monthly subscription fees
vary by billing plan. Under MindSpring's current pricing plans, customers have a
choice of two "flat rate" plans (The Works and Unlimited Access) and two
"usage-sensitive" plans (Standard and Light). MindSpring also has a prepayment
plan available to all dial-up subscribers which allows subscribers to prepay
their access fees for either one or two years at a discounted rate. For the
years ended December 31, 1998 and 1997, the average monthly recurring revenue
per dial-up subscriber was approximately $20. Average monthly recurring revenue
is calculated by dividing monthly recurring revenue plus usage charges for
non-"flat rate" subscribers by the total number of subscribers. Start-up fees
for new subscribers vary depending upon the promotional method by which the
subscriber is acquired, ranging from $0 up to a maximum of $25. Aggregate
subscriber start-up fees are sufficient to cover the aggregate costs of direct
materials, mailing expenses, and licensing fees associated with new subscribers.
A majority of MindSpring's individual subscribers pay their MindSpring fees
automatically by pre-authorized monthly charges to the subscriber's credit card.
In addition, MindSpring earns revenue by providing Web-hosting, domain
registration and Web page design services, Web-server co-location and full-time
dedicated access
5
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connections to the Internet. MindSpring's Web-hosting services
allow a business or individual to post information on the World Wide Web so that
the information is available to anyone who has access to the Internet.
MindSpring currently offers three price plans for Web hosting subscribers
ranging from $19.95 to $99.95 per month. MindSpring had approximately 21,000 Web
hosting subscribers as of December 31, 1998, not including the Web-hosting
subscribers acquired from NETCOM. Through our domain registration services,
MindSpring offers subscribers the ability to personalize electronic mail
addresses and URLs (Uniform Resource Locators). The services described in this
paragraph have been classified as business services in MindSpring's statements
of operations and in the "Results of Operations" table shown below.
Costs. MindSpring's costs include (1) costs of revenue that are primarily
related to the number of subscribers; (2) selling, general and administrative
expenses that are associated more generally with operations; and (3)
depreciation and amortization, which are related to the number of
MindSpring-owned POPs and servers, and the deferred costs associated with
acquired customer bases.
Costs of revenue that are primarily related to the number of subscribers
include both recurring costs and subscriber start-up expenses. Recurring costs
of revenue consist primarily of the costs of telecommunications facilities
necessary to provide service to subscribers. Telecommunications facilities costs
include (1) the costs of providing local telephone lines into each
MindSpring-owned POP; (2) costs related to the use of third-party networks
pursuant to services agreements; and (3) costs associated with leased lines
connecting each MindSpring-owned POP and third-party network to MindSpring's hub
and connecting MindSpring's hub to the Internet backbone. Start-up expenses for
each subscriber include primarily the cost of diskettes and other product media,
manuals, and packaging and delivery costs associated with the materials provided
to new subscribers. MindSpring does not defer any subscriber start-up expenses.
Selling, general and administrative costs are incurred in the areas of
sales and marketing, customer service and support, network operations and
maintenance, engineering, accounting and administration. Selling, general and
administrative costs will increase over time as MindSpring's scope of operations
increases. We may determine to significantly increase the level of marketing
activity to increase the rate of subscription growth. A significant increase in
marketing activity would have a short-term negative impact on net income. We
believe that these increased costs would be more than offset by anticipated
increases in revenue attributable to overall subscriber growth. However, there
can be no assurance that we will be able build, increase or maintain our
subscriber base in a given market to the extent necessary to generate sufficient
revenues to offset these marketing expenses. MindSpring does not defer any sales
or marketing expenses.
As MindSpring expands into new markets, both costs of revenue and selling,
general and administrative expenses will increase. To the extent MindSpring
opens MindSpring POPs in new markets, these costs and expenses may also increase
as a percentage of revenue in the short-term for the period immediately after a
new MindSpring POP is opened. Many of the fixed costs of providing service in a
new market through a new MindSpring POP are incurred before significant revenue
can be expected from that market. However, to the extent that we expand into new
markets by using third-party POPs instead of opening our own POPs, MindSpring's
incremental monthly recurring costs will consist primarily of the
6
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fees to be paid to third parties under network services agreements. In general,
the margins on those subscribers will initially be higher than if we had opened
our own POP in new markets. When a market matures, if the market is served
through purchased, third-party network services rather than MindSpring-owned
POPs, costs of revenue as a percentage of revenue will tend to be higher, and
therefore, margins on subscribers will tend to be lower. This is because the
full costs of using third-party networks is included in costs of revenue, as
compared to the costs of using MindSpring-owned POPs, a portion of which is
included in depreciation and amortization. In addition, in more mature markets,
where we have greater concentrations of subscribers, we generally can provide
services at a lower cost per subscriber through MindSpring-owned POPs after the
initial period when related expenses are higher. This depends in part on how
much we must pay for local area telecommunications charges.
For the first year of the Network Agreement with NETCOM, we will pay
favorable rates for use of NETCOM's POPs. These rates are generally comparable
to the costs of using MindSpring POPs. We have an option for a second year under
that agreement, but on potentially different terms to be negotiated and agreed
upon by both parties. The Network Agreement should contribute to our ability to
reduce future net losses. However, the cost advantages of providing services to
MindSpring subscribers through the Network Agreement may be offset if there are
operating inefficiencies, network reliability issues or technical support
difficulties due to the fact that NETCOM is just beginning to offer network
services as a third-party provider for companies such as MindSpring.
We have added, and may in the future continue to add, MindSpring
subscribers by purchasing customer bases from other ISPs. MindSpring amortizes
such purchased customer bases using the straight-line method over a period of
three years, commencing when the purchase is completed. This amortization has a
negative effect on net income. Therefore, to the extent we continue to expand
our subscriber base through acquisitions such as the Spry and NETCOM
acquisitions, we will continue to experience increased amortization expense.
7
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RESULTS OF OPERATIONS
The following table shows financial data for the years ended December 31,
1998, 1997, and 1996. Operating results shown for 1998 do not reflect the
NETCOM acquisition. Operating results for any period are not necessarily
indicative of results for any future period. Dollar amounts (except per share
data) are shown in thousands.
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
December 31, 1998 December 31, 1997 December 31, 1996
-------------------- -------------------- --------------------
% of % of % of
(000's) Revenue (000's) Revenue (000's) Revenue
<S> <C> <C> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA:
Revenues:
Dial-up access to Internet..................... $ 95,852 84 $ 40,925 78 $ 13,420 74
Business services.............................. 14,735 13 7,711 15 2,286 13
Start-up fees.................................. 4,086 3 3,920 7 2,426 13
------------ ---- --------- ---- --------- ----
Total revenue............................ $ 114,673 100 $ 52,556 100 $ 18,132 100
Cost and expenses:
Cost of revenues-recurring..................... $ 31,724 28 $ 15,202 29 $ 6,332 35
Cost of revenues-start-up fees................. 2,612 2 1,620 3 1,876 10
Selling, general, and administrative........... 57,324 50 30,784 59 14,161 78
------------ ---- --------- --- ------ ---
Customer base amortization..................... 7,048 6 4,210 8 1,521 8
Depreciation................................... 8,179 7 4,485 9 1,764 10
------------ ---- --------- --- ------ ---
Operating income (loss)........................... 7,786 7 (3,745) (7) (7,522) (42)
Interest income (expense), net................ 1,214 1 (338) (1) (90) (1)
------------ ---- --------- --- ------ ---
Pre tax income (loss)............................. 9,000 8 (4,083) (8) (7,612) (42)
Provision for income taxes..................... 1,544 1 - - - -
------------ ---- --------- --- ------ ---
Net income (loss)................................. $ 10,544 9 $ (4,083) (8) $ (7,612) (42)
============ ==== ========= === ====== ===
PER SHARE DATA:
Diluted net income (loss) per share............... $ 0.41 $ (0.18) $ (0.48)
Weighted average common shares
outstanding....................................... 25,431 22,542 15,758
OPERATING DATA:
Approximate number of subscribers at end of year.. 693,000 278,300 121,794
Number of MindSpring employees at end of year..... 977 502 321
EBITDA (1)........................................ $ 23,013 20 $ 4,950 9 $ (4,237) (23)
------------ ---- --------- ---- ------ ---
CASH FLOW DATA:
Cash Flow (used in) from operations............... $ 35,501 $ 11,354 $ (2,005)
Cash flow (used in) from investing activities..... $ (47,647) $ (9,002) $ (21,336)
Cash flow (used in) from financing activities..... $ 170,503 $ (2,619) $ 32,569
</TABLE>
(1) EBITDA represents operating income (loss) plus depreciation and
amortization. EBITDA is provided because it is a measure commonly used by
investors to analyze and compare companies on the basis of operating
performance. EBITDA is not a measurement of financial performance under
generally accepted accounting principles and should not be construed as a
substitute for operating income, net income or cash flows from operating
activities for purposes of analyzing MindSpring's operating performance,
financial position and cash flows. EBITDA is not necessarily comparable with
similarly titled measures for other companies.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues. Revenue for the year ended December 31, 1998 totaled
approximately $114.7 million, as compared to approximately $52.6 million for the
year ended December 31, 1997. This approximately 118% increase in period
revenues resulted primarily from an approximately 150% increase in subscribers.
The greater proportional increase in subscribers was principally due to the
acquisition of Spry subscribers from AOL during the
8
<PAGE> 9
fourth quarter of 1998. Revenues from dial-up access to the Internet for the
year ended December 31, 1998 represented approximately 84% of the revenue,
compared to approximately 78% for the year ended December 31, 1997. Business
services revenue decreased as a percentage of revenue to approximately 13% for
the year ended December 31, 1998, compared to approximately 15% for the year
ended December 31, 1997. This decrease is primarily attributable to the large
amount of dial-up customers added through acquisitions in 1998. Subscriber
start-up fees accounted for 3% of revenue for the year ended December 31, 1998,
as compared to approximately 7% for the year ended December 31, 1997. MindSpring
anticipates that as its customer base continues to expand, subscriber start-up
fees will progressively represent a smaller percentage of revenue.
Cost of revenues-recurring. For the year ended December 31, 1998, cost of
revenues-recurring decreased to approximately 28% of total revenue, compared to
approximately 29% of total revenue for the year ended December 31, 1997. Cost of
revenues-recurring also decreased as a percentage of dial-up access revenue to
approximately 33% for the year ended December 31, 1998 from approximately 37%
for the year ended December 31, 1997. Not taking into account approximately $2
million in discounts we received in 1998 under our network services agreement
with PSINet, Inc., cost of revenues-recurring would have been approximately 35%
of total dial-up access revenue. Not taking into account approximately $2.1
million in discounts we received in 1997 under the network services agreement
with PSINet, Inc., cost of revenues-recurring would have been approximately 42%
of total dial-up access revenue. The discounts earned under the network
services agreement with PSINet ended in October 1998. This decrease of cost of
revenues-recurring as a percentage of total revenue and as a percentage of
dial-up access revenue resulted primarily from increased efficiency and reduced
network costs associated with MindSpring-owned POPs.
Selling, general, and administrative expenses. Selling, general, and
administrative expenses were approximately 50% of revenue for the year ended
December 31, 1998, compared to approximately 59% of revenue for the year ended
December 31, 1997. The decrease in selling, general, and administrative expenses
as a percentage of revenue resulted from economies of scale with respect to
costs such as payroll that do not increase in direct proportion to increases in
revenue and from cost control efforts implemented by MindSpring's management.
EBITDA Margin. EBITDA margin refers to EBITDA as a percentage of revenues.
EBITDA margin increased to approximately 20% for the year ended December 31,
1998, compared to 9% for the year ended December 31, 1997. The increase is
attributable to the significant revenue growth outpacing the related cost
increases principally as a result of economies of scale related to selling,
general, and administrative expenses as well as efficiencies and economies of
scale associated with MindSpring-owned POPs.
Depreciation and amortization. Depreciation and amortization expenses
decreased to approximately 13% of revenues for the year ended December 31, 1998,
compared to approximately 17% of revenues for the year ended December 31, 1997.
Amortization expense declined slightly to 6% of total revenues for the year
ended December 31, 1998, compared to approximately 8% for the year ended
December 31, 1997. Amortization expense resulted solely from acquired subscriber
bases, which are being amortized over three years. Depreciation expense was
approximately 7% of total revenues for the year ended December 31, 1998,
compared to approximately 9% for the year ended December 31,
9
<PAGE> 10
1997. The decrease in depreciation expense as a percentage of total revenues
resulted from adding capacity through increased use of network services
purchased from third-party providers, as opposed to increasing capacity by
building additional MindSpring-owned POPs, and from reductions in the cost of
new equipment and improved operating efficiencies within MindSpring's network.
MindSpring anticipates amortization expense to increase as a percentage of
revenues as a result of the Spry and NETCOM acquisitions.
Interest income (expense). The following table details the increase in
interest income in 1998 compared to 1997:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Interest on capital leases..................................... $ (754,000) $(473,000)
Interest on PSINet notes....................................... (136,000) (276,000)
Interest income - other........................................ 2,104,000 411,000
--------- --------
Interest income (expense) net.................................. $1,214,000 $(338,000)
========= ========
</TABLE>
Interest on capital leases increased for the year ended December 31, 1998,
compared to the year ended December 31, 1997, because MindSpring entered into
several new capital leases for equipment at the end of 1997. Interest income
increased in 1998 due to the increase in outstanding cash balances available for
investment as a result of positive operating cash flows and two public equity
offerings completed during the year. See "Liquidity and Capital Resources".
Income tax provision. For the year ended December 31, 1998 MindSpring
recorded a benefit for income taxes due to a one time benefit taken in the
fourth quarter of the year as a result of the removal of the valuation allowance
associated with MindSpring's deferred tax assets. MindSpring is continually
assessing its income tax situation and management believes that it is "more
likely than not" that the deferred tax assets will be realized in the future. In
the future, MindSpring expects to report taxable earnings, even though we expect
to be incurring net losses at the same time. This is principally due to the
requirement that, for tax purposes, subscriber acquisition costs must be
amortized over 15 years, compared to the three-year period applied for
accounting purposes. For the year ended December 31, 1997, no income tax benefit
was recognized as MindSpring had a net taxable loss for the year.
Net income (loss) and income (loss) per share. As a result of the factors
discussed above, MindSpring's net income for the year ended December 31, 1998
was $10.5 million, or $0.41 income per diluted share, compared to a net loss of
$4.1 million, or $0.18 basic and diluted loss per share, for the year ended
December 31, 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Revenues. Revenues for the year ended December 31, 1997 totaled
approximately $52.6 million, as compared to approximately $18.1 million for the
year ended December 31, 1996. The approximately 190% increase in revenues
resulted primarily from an approximately
10
<PAGE> 11
129% increase in subscribers. Revenues increased in a greater proportion than
subscribers due to the subscribers acquired from PSINet Inc. during the fourth
quarter of 1996. Revenues from dial-up access to the Internet for the year ended
December 31, 1997 represented approximately 78% of the revenue, compared to
approximately 74% for the year ended December 31, 1996. Business services
revenue increased slightly to approximately 15% of revenues for the year ended
December 31, 1997, compared to approximately 13% for the year ended December 31,
1996. This increase is primarily attributable to the increase in the number of
MindSpring's web hosting customers. Subscriber start-up fees accounted for 7% of
revenues for the year ended December 31, 1997, as compared to approximately 13%
for the year ended December 31, 1996. MindSpring anticipates that as its
customer base continues to expand, subscriber start-up fees will progressively
represent a smaller percentage of revenues.
Cost of revenues-recurring. For the year ended December 31, 1997, cost of
revenues-recurring decreased to approximately 29% of total revenues, compared to
approximately 35% of total revenues for the year ended December 31, 1996. Cost
of revenues-recurring also decreased as a percentage of dial-up access revenue
from approximately 47% for the year ended December 31, 1996 to approximately 37%
for the year ended December 31, 1997. Not taking into account approximately $2.1
million in discounts we received in 1997 under the PSINet Services Agreement,
cost of revenues-recurring would have been approximately 42% of total dial-up
revenue for the year ended December 31, 1997, compared to approximately 47% for
the year ended December 31, 1996. This decrease in cost of revenues-recurring as
a percentage of total revenues and as a percentage of dial-up access revenues
resulted primarily from increased efficiency and reduced network costs
associated with MindSpring-owned POPs.
Selling, general, and administrative expenses. Selling, general, and
administrative expenses were approximately 59% of revenues for the year ended
December 31, 1997, compared to approximately 78% of revenues for the year ended
December 31, 1996. The decrease in selling, general, and administrative expenses
as a percentage of revenues resulted from economies of scale with respect to
costs such as payroll that do not increase in direct proportion to increases in
revenue and to cost control efforts implemented by MindSpring's management.
EBITDA Margin. EBITDA margin increased to approximately 9% for the year
ended December 31, 1997, compared to (23)% for the year ended December 31, 1996.
The increase is attributable to the significant revenue growth outpacing the
related cost increases principally as a result of economies of scale related to
selling, general, and administrative expenses, as well as efficiencies and
economies of scale associated with MindSpring-owned POPs.
Depreciation and amortization. Depreciation and amortization expenses
decreased to approximately 16% of revenues for the year ended December 31, 1997,
compared to approximately 18% of revenues for the year ended December 31, 1996.
Amortization expense remained steady at approximately 8% of revenue for both the
years ended December 31, 1997 and December 31, 1996. Amortization expense
resulted primarily from acquired customer bases which are being amortized over
three years. Depreciation expense was approximately 8% of total revenues for the
year ended December 31, 1997, compared to approximately 10% for the year ended
December 31, 1996. The decrease in depreciation
11
<PAGE> 12
expense as a percentage of total revenues resulted from adding capacity through
increased use of network services purchased from third-party providers, as
opposed to increasing capacity by building additional MindSpring-owned POPs, and
from reductions in cost of new equipment and improved operating efficiencies
within MindSpring's network.
Interest income (expense). The following table details the increase in
interest expense in 1997 compared to 1996:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Interest on capital leases..................................... $ (473,000) $ (91,000)
Interest on PSINet notes....................................... (276,000) (324,000)
Interest income - other........................................ 411,000 325,000
-------- --------
Interest expense, net.......................................... $ (338,000) $ (90,000)
======== ========
</TABLE>
Interest on capital leases increased for the year ended December 31, 1997,
compared to the year ended December 31, 1996, because MindSpring entered into
several new capital leases for equipment. Interest income increased in 1997 due
to the increase in outstanding cash balances available for investment as a
result of positive operating cash flows.
Income tax provision. For the years ended December 31, 1997 and 1996,
no income tax benefit was recognized because MindSpring had a net taxable loss
for the year.
Net income (loss) and income (loss) per share. As a result of the factors
discussed above, MindSpring's net loss for the year ended December 31, 1997 was
$4.1 million, or $(0.18) basic and diluted loss per share, compared to a net
loss of $7.6 million, or $(0.48) basic and diluted loss per share, for the year
ended December 31, 1996.
LIQUIDITY AND CAPITAL RESOURCES
For the year ended December 31, 1998, MindSpring generated net cash from
operations of approximately $35.5 million, compared to $11.4 million for the
year ended December 31, 1997, an increase of approximately 212.7%. During 1998,
we used approximately $27.3 million from cash flows from operations to fund
purchases of subscriber bases. $25 million of this amount was paid to AOL on
October 15, 1998 in partial payment for the Spry acquisition with the balance of
$7 million to be paid in late February 1999. During 1998, we spent a total of
approximately $20.2 million related to purchases of telecommunications equipment
necessary for the provision of service to subscribers. We did not enter into any
capital lease agreements in 1998, compared to approximately $8.4 million
incurred in 1997 under capital leases for equipment acquisition. At December 31,
1998, MindSpring's capital lease obligations and minimum rental commitments
under non-cancelable operating leases with initial or remaining terms of more
than one year amounted to approximately $5.7 million for capital leases, and
approximately $10 million for non-cancelable operating leases.
During 1998, MindSpring generated approximately $170.5 million from
financing activities, consisting primarily of two public equity offerings. In
June 1998, MindSpring
12
<PAGE> 13
sold 3,000,000 shares of common stock at a public offering price of $17.67 per
share. Proceeds from the June offering, net of underwriting discounts and
offering expenses, were approximately $49.8 million. In December 1998,
MindSpring sold 2,300,000 shares of common stock at a public offering price of
$57 per share. Proceeds from the December offering, net of underwriting
discounts and offering expenses, were approximately $124.8 million. Cash used
for financing activities consisted of approximately $4.6 million for capital
lease obligations and the final payment to PSINet Inc. due under a promissory
note issued in connection with MindSpring's 1996 purchase from PSINet of
subscribers and certain other assets and rights related to PSINet's U.S.
consumer dial-up Internet access business. The final payment to PSINet was made
in December 1998. During 1997, cash used for financing activities consisted
primarily of approximately $2.6 million in payments for capital lease
obligations and repayments of promissory notes to PSINet.
As of December 31, 1998, MindSpring had cash on hand of approximately
$167.7 million. On February 17, 1999, we paid $215 million in cash in connection
with the closing of the NETCOM acquisition, approximately $80 million of which
we borrowed under our $100 million secured revolving credit facility. The
credit facility, which matures on February 17, 2002, is more fully described
under the "Description of Secured Credit Facility" included in Exhibit 99.3
to this report. After paying the amounts indicated for the NETCOM acquisition on
February 17, 1999, we had remaining cash on hand of approximately $35 million,
of which we expect to pay approximately $7 million to AOL for the balance of the
consideration due for the Spry acquisition.
MindSpring's future capital requirements depend on various factors
including, without limitation:
- our ability to integrate successfully the subscribers and
assets acquired from Spry and NETCOM, which requires us to
reduce the costs previously associated with those subscribers
and assets to approximate MindSpring's historical cost
structure;
- the rate of market acceptance of MindSpring's services;
- our ability to maintain and expand our subscriber base;
- the rate of expansion of MindSpring's network infrastructure;
- the resources required to expand our marketing and sales
efforts, and
- the availability of hardware and software provided by third-
party vendors.
We currently estimate that our cash and financing needs for 1999, assuming
reasonable internal growth, can be met by cash on hand, amounts available under
the credit facility, additional capital financing arrangements, and cash flow
from operations. If our expectations change regarding our capital needs due to
market conditions, strategic opportunities or otherwise, then our capital
requirements may vary materially
13
<PAGE> 14
from those currently anticipated. We do not currently have any commitments for
any additional financing, and there can be no assurance that if and when we
need additional capital it will be available on terms that are acceptable to
us, if at all. If additional capital financing arrangements, including public
or private sales of debt or equity securities, or additional borrowings from
commercial banks are insufficient or unavailable, or if we experience
shortfalls in anticipated revenues or increases in anticipated expenses, we
will be required to modify our growth and operating plans to match available
funding. Any additional equity financing may be on terms that are dilutive or
potentially dilutive to MindSpring's stockholders. Debt financing, if
available, may involve restrictive covenants with respect to dividends, raising
future capital and other financial and operational matters and incurring
additional debt may further limit MindSpring's ability to raise additional
capital. In addition, the credit facility contains restrictions on our ability
to incur additional debt and to issue some types of convertible or redeemable
capital stock, as described under the "Description of Secured Credit Facility"
included in Exhibit 99.3 to this report.
MindSpring frequently engages in discussions involving potential business
acquisitions. Depending on the circumstances, MindSpring may not disclose
material acquisitions until completion of a definitive agreement. MindSpring may
determine to raise additional debt or equity capital to finance potential
acquisitions and/or to fund accelerated growth. Any significant acquisitions or
increases in MindSpring's growth rate could materially affect MindSpring's
operating and financial expectations and results, liquidity and capital
resources.
Market Risks. We believe our exposure to market rate fluctuations on our
investments is nominal due to the short-term nature of those investments. We
have no material future earnings or cash flow exposures with respect to our
outstanding capital leases, which are all at fixed rates. To the extent
MindSpring has borrowings outstanding under the credit facility, we would have
market risk relating to those amounts because the interest rates under the
credit facility are variable. At present, we have no plans to enter into any
hedging arrangements with respect to those borrowings.
RECENT ACCOUNTING PRONOUNCEMENTS
In 1998, MindSpring was subject to the provisions of Statement of Financial
Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income"
and Statement of Financial Accounting Standards No. 131 ("SFAS 131"),
"Disclosures about Segments of an Enterprise and Related Information" applied
to MindSpring. Neither statement had any impact on MindSpring's financial
statements as MindSpring does not have any "comprehensive income" type earnings
(losses) and its financial statements reflect how the "key operating decisions
maker" views the business. MindSpring will continue to review these statements
over time, in particular, SFAS 131, to determine if any additional disclosures
are necessary based on evolving circumstances.
YEAR 2000
Introduction. The term "Year 2000 issue" is a general term used to
describe the various problems that may result from the improper processing of
dates and date-sensitive calculations by computers and other machinery as the
year 2000 is approached and reached. These problems generally arise from the
fact that most of the world's computer hardware and software have historically
used only two digits to identify the year in a date, often meaning that the
computer will fail to distinguish dates in the "2000's" from dates in the
14
<PAGE> 15
"1900's." These problems may also arise from other sources as well, such as the
use of special codes and conventions in software that make use of the date
field.
State of Readiness. MindSpring has established a Year 2000 Program Office
to coordinate appropriate activity and report to the Board of Directors on a
continuing basis with regard to the Year 2000 issue. MindSpring's Year 2000
Program Office has developed and is currently implementing a comprehensive plan
(the "Year 2000 Program") for MindSpring to become Year 2000 ready. The Year
2000 Program consists of six phases: (1) project planning and inventory of all
of MindSpring's assets, (2) assessment, (3) renovation (whether by upgrade or
replacement), (4) testing and validation, (5) implementation and (6) creation
of contingency plans in the event of year 2000 failures.
The Year 2000 Program covers: (1) software products which are
supplied by MindSpring to its customers, (2) MindSpring's information
technology and operating systems ("IT Systems"), and (3) MindSpring's
non-information technology systems, including embedded technology ("Non-IT
Systems"). In addition, the Program calls for MindSpring to identify and assess
the systems and services of MindSpring's major vendors, third party network
service providers and other material service providers ("Third Party Systems"),
and take appropriate remedial actions and develop contingency plans where
appropriate in connection with such Third Party Systems.
MindSpring supplies its customers with a software package which, among
other things, allows its customers to access MindSpring's services. The software
package consists of internally developed software (e.g., the MindSpring Internet
Desktop interface) which is bundled with third party software (collectively, the
"Access Product"). MindSpring believes that the current shipping version of its
software package (including the MindSpring Internet Desktop) is Year 2000 ready.
MindSpring has substantially completed the inventory phase of the Year
2000 Program for both its IT Systems and Non-IT Systems and has completed a
majority of the assessment phase of the Year 2000 Program for the IT Systems and
Non-IT Systems. MindSpring anticipates that it will complete the first two
phases for those systems during the first quarter of 1999. The Year 2000 Program
calls for the completion of all six phases for both IT and Non-IT Systems by the
end of the second quarter of 1999.
MindSpring has performed a technical review of many of the more critical
Third Party Systems and has surveyed the publicly available statements issued by
the vendors of those systems. Additionally, MindSpring has recently sent inquiry
letters to its significant providers of Third Party Systems requesting
information regarding their vulnerability to Year 2000 issues and whether the
products and services purchased from those entities are Year 2000 compliant.
MindSpring intends to pursue appropriate responses to those inquiries and will
evaluate the responses it receives.
MindSpring recently completed its acquisition of Spry, Inc. MindSpring is
developing appropriate plans to identify and address Year 2000 related concerns
with Spry as part of the natural integration of the Spry operation into
MindSpring. Management believes that the Spry operation will not present any
significant Year 2000 issues to MindSpring.
15
<PAGE> 16
MindSpring also recently acquired customers and assets of NETCOM, and
intends to develop plans to identify and address Year 2000 related concerns
with NETCOM as part of the natural integration of the NETCOM operation into
MindSpring.
MindSpring has not deferred any specific IT project due to the Year 2000
Program. MindSpring has engaged a consulting firm to assist it in completing the
inventory and assessment phases of its Year 2000 Program, and to assist it in
its Year 2000 Program management.
Costs. As of December 31, 1998, MindSpring has incurred expenses of
approximately $75,000 in connection with the implementation of the Year 2000
Program Office and Year 2000 Program. MindSpring estimates that an additional
$250,000 to $300,000 in expenses will be incurred by MindSpring through the
remainder of the Year 2000 Program. These costs will be expensed as incurred.
The costs and estimates provided include MindSpring's estimate of the cost of
internal resources directly attributable to MindSpring's Year 2000 Program, but
do not yet include additional costs which may be incurred in connection with
expanding the Year 2000 Program to include the systems and products acquired in
the Spry and NETCOM transactions. MindSpring has funded, and anticipates that it
will continue funding, the costs of the Year 2000 Program from cash flows. The
estimates for the costs of the Year 2000 Program are based upon management's
best estimates and may be updated or revised as additional information becomes
available. MindSpring currently believes these costs will not have a material
effect on MindSpring's financial condition, liquidity or results of operations.
MindSpring's estimates of Year 2000-related costs may change, however, depending
on MindSpring's Year 2000 evaluation of the assets acquired from NETCOM.
Risks. The failure by MindSpring to correct a material Year 2000 problem
could result in an interruption in, or a failure of, certain normal business
activities or operations. Presently, however, MindSpring perceives that its most
reasonably likely worst case scenario related to the Year 2000 is associated
with potential concerns with third party services or products.
Specifically, MindSpring is heavily dependent on a significant number of
third party vendors to provide both network services and equipment. A
significant Year 2000-related disruption of the network services or equipment
provided to MindSpring by third party vendors could cause customers to consider
seeking alternate providers or cause an unmanageable burden on customer service
and technical support, which in turn could materially and adversely affect
MindSpring's results of operations, liquidity and financial condition.
MindSpring is not presently aware of any vendor related Year 2000 issue that is
likely to result in this type of disruption.
Furthermore, MindSpring's business depends on the continued operation of,
and widespread access to, the Internet. To the extent that the normal operation
of the Internet is disrupted by the Year 2000 issue, MindSpring's results of
operations, liquidity and financial condition could be materially and adversely
affected.
Although there is inherent uncertainty in the Year 2000 issue, MindSpring
expects that as it progresses in its Year 2000 Program the level of uncertainty
about the impact of
16
<PAGE> 17
the Year 2000 issue on MindSpring will be reduced significantly and MindSpring
should be better positioned to identify the nature and extent of material risk
to MindSpring as a result of any Year 2000 disruptions.
Contingency Plans. The Year 2000 Program calls for the development of
contingency plans for at-risk functions. MindSpring has established a
Contingency Plan Committee to monitor and address the development of contingency
plans. Due to the current phase in which MindSpring is in of its Year 2000
Program, MindSpring is currently unable at this time to fully assess its risks
and determine what contingency plans, if any, need to be implemented by
MindSpring. As MindSpring progresses in its Year 2000 Program and identifies
specific risk areas, MindSpring intends to timely implement appropriate remedial
actions and contingency plans.
The estimates and conclusions included in this discussion contain
forward-looking statements and are based on management's best estimates of
future events. MindSpring's expectations about risks, future costs and the
timely completion of its Year 2000 modifications may turn out to be incorrect
and any variance from these expectations could cause actual results to differ
materially from what has been discussed above. Factors that could influence
risks, amount of future costs and the effective timing of remediation efforts
include MindSpring's success in identifying and correcting potential Year 2000
issues and the ability of third parties to appropriately address their Year
2000 issues. The foregoing Year 2000 discussion and the information contained
herein is provided as a "Year 2000 Readiness Disclosure" as defined in the Year
2000 Information and Readiness Disclosure Act of 1998 (Public Law 105-271, 112
Stat. 2386) enacted on October 19, 1998.
17
<PAGE> 18
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
MINDSPRING ENTERPRISES, INC.
PAGE
<S> <C>
Report of Independent Public Accountants ....................................... F-2
Balance Sheets as of December 31, 1998 and 1997................................. F-3
Statement of Operations for the years ended December 31, 1998, 1997
and 1996............................................................ F-4
Statement of Stockholders' Equity for the years ended December 31,
1998, 1997 and 1996................................................. F-5
Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996................................................. F-6
Notes to Financial Statements................................................... F-7
</TABLE>
F-1
<PAGE> 19
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To MindSpring Enterprises, Inc.:
We have audited the accompanying balance sheets of MINDSPRING ENTERPRISES, INC.
(a Delaware corporation) as of December 31, 1998 and 1997 and the related
statements of operations, stockholders' equity, and cash flows for the three
years ended December 31, 1998, 1997 and 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of MindSpring Enterprises, Inc. as
of December 31, 1998 and 1997 and the results of its operations and its cash
flows for the three years ended December 31, 1998, 1997 and 1996 in conformity
with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Atlanta, Georgia
February 17, 1999
F-2
<PAGE> 20
MINDSPRING ENTERPRISES, INC.
BALANCE SHEETS
AS OF DECEMBER 31, 1998 AND 1997
(IN THOUSANDS)
<TABLE>
<CAPTION> 1998 1997
-------------- ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . $ 167,743 $ 9,386
Trade receivables, net of allowance for doubtful accounts of
$1,224 and $751 at December 31, 1998 and 1997, respectively . . . . . 3,278 2,002
Deferred income taxes (Note 8) . . . . . . . . . . . . . . . . . . . . . 3,421 -
Prepaids and other current assets......... . . . . . . . . . . . . . . . 758 1,042
-------------- ------------
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . 175,200 12,430
--------------- ------------
PROPERTY AND EQUIPMENT:
Computer and telecommunications equipment . . . . . . . . . . . . . . . 35,580 18,050
Assets under capital lease . . . . . . . . . . . . . . . . . . . . . . . 9,546 9,916
Other............. . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,821 1,805
-------------- ------------
49,947 29,771
Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . . (14,106) (6,133)
-------------- ------------
Property and equipment, net . . . . . . . . . . . . . . . . . . . . 35,841 23,638
-------------- ------------
OTHER ASSETS:
Acquired customer base, net (Notes 1 and 2) . . . . . . . . . . . . . . 34,742 7,478
Deferred income taxes (Note 8) . . . . . . . . . . . . . . . . . . . . . 1,123 -
Other............. . . . . . . . . . . . . . . . . . . . . . . . . . . . 693 740
-------------- ------------
Total other assets . . . . . . . . . . . . . . . . . . . . . . . . . 36,558 8,218
-------------- ------------
$ 247,599 $ 44,286
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,462 $ 4,306
Current portion of capital lease liability (Note 7) . . . . . . . . . . . 2,695 2,607
Telecommunications costs payable. . . . . . . . . . . . . . . . . . . . . 2,831 2,233
Deferred revenue (Note 1) . . . . . . . . . . . . . . . . . . . . . . . . 7,443 2,198
Current portion of notes payable (Note 6) . . . . . . . . . . . . . . . . - 2,043
Other accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . 5,105 1,776
Due to America Online, Inc. (Note 2). . . . . . . . . . . . . . . . . . . 7,000 -
Accrued compensation expense. . . . . . . . . . . . . . . . . . . . . . . 2,550 1,404
Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,566 -
Network services payable . . . . . . . . . . . . . . . . . . . . . . . 4,442 1,216
-------------- ------------
Total current liabilities . . . . . . . . . . . . . . . . . . . . . 38,094 17,783
-------------- ------------
LONG-TERM LIABILITIES:
Capital lease liability (Note 7) . . . . . . . . . . . . . . . . . . 2,424 5,090
-------------- ------------
Total long-term liabilities . . . . . . . . . . . . . . . . . . . . 2,424 5,090
-------------- ------------
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 40,518 22,873
-------------- ------------
COMMITMENTS AND CONTINGENCIES (Note 7)
STOCKHOLDERS' EQUITY (Note 3):
Common stock, $.01 par value; 60,000 and 45,000 shares
authorized at December 31, 1998 and 1997
and 28,284 and 22,603 issued and outstanding at
December 31, 1998 and 1997, respectively . . . . . . . . . . . . . . 283 226
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . 209,983 34,916
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . (3,185) (13,729)
-------------- ------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . . . 207,081 21,413
-------------- ------------
$ 247,599 $ 44,286
============== ============
</TABLE>
The accompanying Notes to Financial Statements
are an integral part of these statements.
F-3
<PAGE> 21
MINDSPRING ENTERPRISES, INC.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
(IN THOUSANDS EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
1998 1997 1996
------------ ---------- -------------
<S> <C> <C> <C>
REVENUES:
Access . . . . . . . . . . . . . . . . . . . . . . $ 95,852 $ 40,925 $ 13,420
Business services . . . . . . . . . . . . . . . . 14,735 7,711 2,286
Subscriber start-up fees . . . . . . . . . . . . . 4,086 3,920 2,426
--------------- -------------- -----------
Total revenues . . . . . . . . . . . . . . . . . 114,673 52,556 18,132
--------------- -------------- -----------
COST AND EXPENSES:
Cost of revenues -- recurring . . . . . . . . . . 31,724 15,203 6,332
Cost of subscriber start-up fees. . . . . . . . . 2,612 1,619 1,876
General and administrative . . . . . . . . . . . . 38,443 22,265 10,072
Selling........... . . . . . . . . . . . . . . . . 18,881 8,519 4,089
Depreciation and amortization . . . . . . . . . . 15,227 8,695 3,285
--------------- -------------- -----------
Total operating expenses . . . . . . . . . . . . 106,887 56,301 25,654
--------------- -------------- -----------
OPERATING INCOME (LOSS) . . . . . . . . . . . . . . . . 7,786 (3,745) (7,522)
INTEREST INCOME (EXPENSE), NET . . . . . . . . . . . . 1,214 (338) (90)
--------------- -------------- -----------
INCOME (LOSS) BEFORE TAXES . . . . . . . . . . . . . . $ 9,000 $ (4,083) $ (7,612)
--------------- -------------- -----------
INCOME TAX BENEFIT 1,544 - -
--------------- -------------- -----------
NET INCOME (LOSS) $ 10,544 $ (4,083) $ (7,612)
=============== ============== ===========
NET INCOME (LOSS) PER SHARE:
Basic . . . . . . . . . . . . . . . . . . . . . . . $ 0.43 $ (0.18) $ (0.48)
=============== ============== ===========
Diluted . . . . . . . . . . . . . . . . . . . . . . $ 0.41 $ (0.18) $ (0.48)
=============== ============== ===========
SHARES USED FOR COMPUTING NET
INCOME (LOSS) PER SHARE:
Basic . . . . . . . . . . . . . . . . . . . . . . . 24,611 22,542 15,758
=============== ============== ==========
Diluted........ . . . . . . . . . . . . . . . . . 25,431 22,542 15,758
=============== ============== ==========
</TABLE>
The accompanying Notes to Financial Statements
are an integral part of these statements.
F-4
<PAGE> 22
MINDSPRING ENTERPRISES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
(IN THOUSANDS)
<TABLE>
<CAPTION>
Additional Total
Common Stock Paid-in Preferred Stock Accumulated Stockholders'
--------------------------- -------------------------
Shares Amount Capital Shares Amount Deficit Equity
---------- -------- ---------- ---------- -------- --------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1995 3,802 $ 38 $ 95 1,933 $ 2,383 $ (2,034) $ 482
Conversion of Class A
preferred stock to common 3,563 36 709 (1,188) (745) - -
Conversion of Class B
preferred stock to common 1,937 19 981 (645) (1,000) - -
Issuance of additional
common stock, net of
related offering expenses 6,075 60 14,089 - - - 14,149
Conversion of Class C
preferred stock to common 300 3 635 (100) (638) - -
Issuance of additional
common stock, net of
related offering expenses 6,750 68 18,319 - - - 18,387
Issuance of common stock
pursuant to exercise of
options . . . . 4 - 1 - - - 1
Net loss . . . . - - - - - (7,612) (7,612)
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 1996 22,431 $ 224 $ 34,829 - $ - $ (9,646) $ 25,407
Issuance of common stock
pursuant to exercise of
options . . . . 172 2 87 - - - 89
Net loss . . . . - - - - - (4,083) (4,083)
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 1997 22,603 $ 226 $ 34,916 - $ - $ (13,729) $ 21,413
Issuance of additional
common stock, net of
related offering expenses 3,000 30 49,726 - - - 49,756
Issuance of additional
common stock, net of
related offering expenses 2,300 23 124,761 - - - 124,784
Issuance of common stock
pursuant to exercise of
options . . . . 381 4 580 - - - 584
Net income . . . . - - - - - 10,544 10,544
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 1998 28,284 $ 283 $ 209,983 - $ - $ (3,185) $ 207,081
========= ========= ========= ========= ========= ========= =========
</TABLE>
The accompanying Notes to Financial Statements
are an integral part of these statements.
F-5
<PAGE> 23
MINDSPRING ENTERPRISES, INC.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
(IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997 1996
----------------- ----------------- --------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) . . . . . . . . . . . . . . . . . . . . $ 10,544 $ (4,083) $ (7,612)
------------- -------------- -----------
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization . . . . . . . . . . . . . . 15,227 8,695 3,285
Deferred income taxes . . . . . . . . . . . . . . . . . . (4,544) - -
Changes in operating assets and liabilities:
Trade receivables . . . . . . . . . . . . . . . . . . (1,276) (5) (1,477)
Other current assets . . . . . . . . . . . . . . . . . 284 (565) (158)
Trade accounts payable . . . . . . . . . . . . . . . . (844) 2,352 1,106
Telecommunications cost payable . . . . . . . . . . . 598 1,332 700
Deferred revenue . . . . . . . . . . . . . . . . . . . 5,245 1,782 80
Other accrued expenses . . . . . . . . . . . . . . . . 3,329 1,166 246
Accrued compensation expense . . . . . . . . . . . . . 1,146 769 520
Income taxes payable . . . . . . . . . . . . . . . . . 2,566 - -
Network services payable . . . . . . . . . . . . . . . 3,226 (89) 1,305
------------- -------------- -----------
Total adjustments . . . . . . . . . . . . . . . . . 24,957 15,437 5,607
------------- -------------- -----------
Net Cash Provided By (Used In) Operating Activities 35,501 11,354 (2,005)
------------ -------------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment . . . . . . . . . . . (20,176) (8,042) (8,298)
Purchase of customer base . . . . . . . . . . . . . . . . (27,312) (960) (12,249)
Other........... . . . . . . . . . . . . . . . . . . . . . (159) - (789)
------------- -------------- -----------
Net Cash Used In Investing Activities . . . . . . . . (47,647) (9,002) (21,336)
------------- -------------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds of loan from preferred stockholder . . . . . . . - - 1,000
Payments of loan from preferred stockholder - - (3,500)
Proceeds from notes payable . . . . . . . . . . . . . . . - - 11,488
Payments of notes payable . . . . . . . . . . . . . . . . (2,043) (624) (8,822)
Payments of capital lease obligations . . . . . . . . . . (2,578) (2,084) (134)
Issuance of common stock . . . . . . . . . . . . . . . . . 175,124 89 32,537
------------- -------------- ------------
Net Cash Provided By (Used In) Financing Activities . 170,503 (2,619) 32,569
------------- -------------- ------------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS . . . . . . . . . . . . . . . . . . . . . . . 158,357 (267) 9,228
CASH AND CASH EQUIVALENTS, beginning of year . . . . . . . . . 9,386 9,653 425
------------- -------------- ------------
CASH AND CASH EQUIVALENTS, end of year . . . . . . . . . . . . $ 167,743 $ 9,386 $ 9,653
============= ============== ============
SUPPLEMENTAL DISCLOSURE FOR CASH FLOW
INFORMATION:
Interest paid . . . . . . . . . . . . . . . . . . . . . . $ 890 $ 749 $ 402
============= ============== ============
Income taxes paid . . . . . . . . . . . . . . . . . . . . $ 434 $ - $ -
============= ============== ============
SUPPLEMENTAL NONCASH DISCLOSURES:
Assets acquired under capital lease . . . . . . . . . . . $ - $ 8,443 $ 1,473
============= ============== ============
Noncash accrual for acquired subscriber base . . . . . . . $ 7,000 $ - $ -
============= ============== ============
</TABLE>
The accompanying Notes to Financial Statements
are an integral part of these statements.
F-6
<PAGE> 24
MINDSPRING ENTERPRISES, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997, AND 1996
1. ORGANIZATION AND NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES
MindSpring Enterprises, Inc. ("MindSpring" or the "Company") is a
national provider of Internet access. The Company was incorporated in Georgia
on February 24, 1994 and began marketing its services in June 1994. The
Company reincorporated in Delaware and effected a recapitalization in December
1995.
ESTIMATES AND ASSUMPTIONS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the period.
Actual results could differ from those estimates.
PRESENTATION
Certain amounts in the prior year financial statements have been
reclassified to conform to the current year presentation.
SOURCES OF SUPPLIES
The Company relies on third-party networks, local telephone companies,
and other companies to provide data communications capacity. Although
management feels alternative telecommunications facilities could be found in a
timely manner, any disruption of these services could have an adverse effect on
operating results.
CASH AND CASH EQUIVALENTS
The Company considers all short-term, highly liquid investments with
an original maturity date of three months or less to be cash equivalents. Cash
and cash equivalents are stated at cost, which approximates fair value.
CREDIT RISK
The Company's accounts receivable potentially subject the Company to
credit risk, as collateral is generally not required. The Company's risk of
loss is limited due to advance billings to customers for services, the use of
preapproved charges to customer credit cards, and the ability to terminate
access on delinquent accounts. In addition, the concentration of credit risk
is mitigated by the large number of customers comprising the customer base.
The carrying amount of the Company's receivables approximates their fair value.
F-7
<PAGE> 25
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation and
amortization are provided for using the straight-line method over the estimated
useful lives of the assets, commencing when assets are installed or placed in
service. The estimated useful life for all assets is five years or, for
leasehold improvements, the life of the lease, if shorter.
EQUIPMENT UNDER CAPITAL LEASE
The Company leases certain of its data communication and other
equipment under lease agreements accounted for as capital. The assets and
liabilities under capital leases are recorded at the lesser of the present
value of aggregate future minimum lease payments, including estimated bargain
purchase options, or the fair value of the assets under lease. Assets under
capital lease are depreciated over their estimated useful lives of five years,
which are longer than the terms of the leases.
ACQUIRED CUSTOMER BASE
The Company capitalizes specific costs incurred for the purchase of
customer bases from other Internet Service Providers ("ISPs"). The customer
acquisition costs include the actual fee paid to the selling ISP, as well as
legal and other expenses specifically related to the transactions. Subscriber
acquisition costs capitalized at December 31, 1998 and 1997 were $47,521,000
and $13,209,000, respectively. Amortization is provided using the
straight-line method over three years commencing when the customer base is
received. Amortization expense for the years ended December 31, 1998, 1997,
and 1996 was $7,048,000, $4,210,000, and $1,521,000, respectively. See Note 2
for further discussion.
LONG-LIVED ASSETS
The Company periodically reviews the values assigned to long-lived
assets, such as property and equipment and acquired customer bases, to
determine whether any impairments are other than temporary. Management
believes that the long-lived assets in the accompanying balance sheets are
appropriately valued.
INCOME TAXES
Deferred income taxes are recorded using enacted tax laws and rates
for the years in which the taxes are expected to be paid. Deferred income
taxes are provided for items when there is a temporary difference in recording
such items for financial reporting and income tax reporting.
STOCK-BASED COMPENSATION PLANS
The Company accounts for its stock-based compensation plans under
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees." The disclosure option of Statement of Financial
Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation" requires that companies which do not choose to account for
stock-based compensation as prescribed by this statement shall disclose the pro
forma effects on earnings and earnings per share as if SFAS No. 123 had been
adopted.
F-8
<PAGE> 26
REVENUE RECOGNITION
The Company recognizes revenue when services are provided. Services
are generally billed one month in advance. During 1998, the Company began
offering prepaid services. Advance billings including prepaid services and
collections relating to future access services are recorded as deferred revenue
and recognized as revenue when earned.
BARTER TRANSACTIONS
The Company engages in certain exchanges of services for advertising
and promotional services. The Company records these transactions at the market
value of the services provided. Such transactions are not material for the
periods presented.
ADVERTISING COSTS
The Company expenses all advertising costs as incurred.
NET INCOME (LOSS) PER SHARE
The Company calculates net income (loss) per share as required by SFAS
No. 128, "Earnings Per Share." Basic earnings (loss) per common share
("EPS") was computed by dividing net income (loss) by the weighted average
number of shares of common stock outstanding for the year ended. The effect of
the Company's stock options (using the treasury stock method) was included in
the computation of diluted EPS for the year ended December 31, 1998. For the
years ended December 31, 1997 and 1996, the effect of the options is excluded
as their effect is anti-dilutive. The following table summarizes the shares
used in the calculations:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
1998 1997 1996
---------- ---------- ----------
(In Thousands)
<S> <C> <C> <C>
Weighted average shares
Outstanding-basic 24,611 22,542 15,758
Effect of dilutive stock options 820 - -
---------- ---------- ----------
Shares used for diluted earnings per share 25,431 22,542 15,758
========== ========== ==========
</TABLE>
RECENT ACCOUNTING PRONOUNCEMENTS
In 1998, the Company was subject to the provisions of Statement of
Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive
Income" and Statement of Financial Accounting Standards No. 131 ("SFAS 131"),
"Disclosures about Segments of an Enterprise and Related Information." Neither
statement had any impact on the Company's financial statements as the Company
does not have any "comprehensive income" type earnings (losses) and its
financial statements reflect how the "key operating decisions maker" views the
business. The Company will continue to review these statements over time, in
particular SFAS 131, to determine if any additional disclosures are necessary
based on evolving circumstances.
F-9
<PAGE> 27
2. CUSTOMER BASE ACQUISITIONS
On June 28, 1996, the Company entered into a purchase agreement (as
amended on January 27, 1997, the "Purchase Agreement") with PSINet Inc.
("PSINet"), pursuant to which the Company agreed to acquire certain of the
tangible and intangible assets and rights related to the consumer dial-up
Internet access services provided by PSINet in the United States, including (i)
certain of PSINet's individual subscriber accounts and (ii) the lease for a
customer support call center near Harrisburg, Pennsylvania (the "Harrisburg
Facility"), and all related telephone switches and other equipment (the
"Assets") for $12,929,000 (excluding accrued interest and increases in
principal amount under the First and Second PSINet Notes previously paid by the
Company) (the "Purchase Price"). In connection with fixing the aggregate
amount of the Purchase Price, the Company and PSINet amended the Second PSINet
Note to, among other things, reduce the principal amount owed thereunder to
$3,078,000, an amount equal to the remaining balance of the Purchase Price as
of January 24, 1997. As amended, the Second PSINet Note no longer accrued
interest, was payable over a two-year period, and was discounted for financial
statement purposes using the same rate of interest (Prime + 3%) as the prior
PSINet Notes. The Company accreted the difference between the principal and
total payable amount of $3,078,000 over the two years of the note.
In connection with the PSINet transaction, the parties also entered
into a network services agreement (as amended, the "Services Agreement") which
enables MindSpring to offer nationwide Internet access through PSINet's network
of over 200 points of presence ("POPs"). The term of the Services Agreement is
5 years commencing on June 28, 1996 and is automatically renewable annually
thereafter unless either party notifies the other in writing not less than 12
months prior to the end of such 5-year period or any 12-month extension
thereof. Either party may terminate the Services Agreement at any time upon 60
days' written notice without penalty. The Company and PSINet amended the
Services Agreement effective January 1, 1997 to provide for certain discounts
to the monthly service fees which otherwise would have been payable by the
Company to PSINet. The Company earned credits of $2,000,000 and $2,050,000
during 1998 and 1997, respectively, and the discounts are reflected as
reductions of cost of revenue. This arrangement ended in October 1998.
On September 10, 1998, MindSpring entered into an Asset Purchase
Agreement with America Online, Inc. ("AOL") and Spry, Inc. ("Spry"), a wholly
owned subsidiary of AOL, to purchase certain assets used in connection with the
consumer dial-up Internet access business operated by Spry (the "Spry
Agreement"). Pursuant to the Spry Agreement, MindSpring acquired Spry's
subscriber base of individual Internet access customers in the United States
and Canada as well as various assets used in serving those customers, including
a customer support facility and a network operations facility in Seattle,
Washington. MindSpring also acquired all rights held by Spry to the "Spry"
name. The acquisition was closed on October 15, 1998 and in accordance with
the agreement MindSpring paid the initial payment of $25,000,000 in cash to AOL
The ultimate purchase price for these assets was based primarily upon the
number of acquired subscribers who remain active with MindSpring as continuing
users in good standing as of December 31, 1998. The Company has calculated the
final purchase price to be approximately $32,000,000 and has accordingly
accrued an additional $7,000,000 in the accompanying balance sheet. The
transaction is being accounted for as a purchase. See Note 10 for further
discussion.
3. STOCKHOLDERS' EQUITY
At the annual meeting of stockholders in May 1998 the Company voted to
approve and adopt an amendment to Article 4 of the Company's Amended and
Restated Certificate of Incorporation to increase the number of authorized
shares of $.01 par value common stock from 15,000,000 to 60,000,000 and to
eliminate the Company's Class C Preferred Stock.
F-10
<PAGE> 28
STOCK SPLIT
On June 24, 1998 the Company effected a three-for-one stock split of
the outstanding shares of common stock in the form of a stock dividend.
Accordingly, all data shown in the accompanying financial statements and notes
has been retroactively adjusted to reflect the stock split.
COMMON STOCK
In June 1998, the Company issued 3,000,000 shares at a public
offering price of $17.67. The total proceeds of the offering, net of
underwriting discounts and offering expenses, were approximately $49,756,000.
In December 1998, the Company issued 2,300,000 shares at a public
offering price of $57.00. The total proceeds of the offering, net of
underwriting discounts and offering expenses were approximately $124,784,000.
4. STOCK-BASED COMPENSATION PLANS
EMPLOYEE STOCK OPTION PLAN
Under the Company's 1995 Stock Option Plan, as amended (the "Stock
Option Plan"), 3,000,000 shares of common stock are reserved and authorized for
issuance upon the exercise of options. All employees of the Company are
eligible to receive options under the Stock Option Plan. The compensation
committee of the board of directors administers the Stock Option Plan. Options
granted under the Stock Option Plan are intended to qualify as incentive stock
options under Section 422 of the Internal Revenue Code of 1986, as amended.
Options generally become exercisable as follows: (i) 50% of the options become
exercisable two years after the date of grant or, in certain cases, the
commencement date of the holder's employment; (ii) an additional 25% of the
options become exercisable three years after the date of grant or, in certain
cases, the commencement date of the holder's employment; and (iii) the
remaining 25% of the options become exercisable four years after the date of
grant or, in certain cases, the commencement date of the holder's employment.
Except as noted in the next sentence, all options were granted at an exercise
price equal to the estimated fair value of the common stock on the dates of
grant as determined by the board of directors based on equity transactions and
other analyses. Options granted to holders of 10% or more of the outstanding
common stock were granted at an exercise price equal to 110% of the estimated
fair value of the common stock on the dates of grant as determined by the board
of directors based on equity transactions and other analyses. The options
expire ten years from the date of grant or, in certain circumstances, the
commencement date of the option holder's employment.
F-11
<PAGE> 29
DIRECTORS' STOCK OPTION PLAN
Under the Company's Directors' Stock Option Plan (the "Directors'
Plan"), adopted in December 1995, 210,000 shares of common stock are authorized
for issuance to nonemployee directors (in the form of 30,000 options per
director) upon their initial election or appointment to the board or, in the
case of directors who joined the board prior to the creation of the Directors'
Plan, upon the adoption of the Directors' Plan by the board of directors. The
Directors' Plan, as amended by the board of directors on March 25, 1998 and
approved by the stockholders on May 20, 1998, provides for discretionary option
grants. Options become exercisable as follows: (i) 50% of the options become
exercisable two years after the date of grant, (ii) an additional 25% of the
options become exercisable three years after the date of grant, and (iii) the
remaining 25% of the options become exercisable four years after the date of
grant. All options were granted at an exercise price equal to the estimated
fair value of the common stock at the dates of grant as determined by the board
of directors based upon equity transactions and other analyses. The options
expire ten years from the date of grant.
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 123
During 1995, the Financial Accounting Standards Board issued SFAS
No.123, which defines a fair value-based method of accounting for an employee
stock option or similar equity instrument and encourages all entities to adopt
that method of accounting for all of their employee stock-based compensation
plans. However, it also allows an entity to continue to measure compensation
cost for those plans using the method of accounting prescribed by APB No. 25.
Entities electing to remain with the accounting in APB No. 25 must make pro
forma disclosures of net income and, if presented, earnings per share as if the
fair value-based method of accounting defined in this statement had been
applied.
The Company has elected to account for its stock-based compensation
plans under APB No. 25; however, the Company has computed for pro forma
disclosure purposes the value of all options granted during 1998, 1997, and
1996 using the Black-Scholes option-pricing model as prescribed by SFAS No. 123
using the following weighted average assumptions used for grants in 1998, 1997,
and 1996:
<TABLE>
<CAPTION>
1998 1997 1996
--------------- ---------------- ----------------
<S> <C> <C> <C>
Risk-free interest rate 5.3% 6.4% 6.4%
Expected dividend yield 0% 0% 0%
Expected lives 3.5 years 3.5 years 3.5 years
Expected volatility 95.0% 58.4% 69.3%
</TABLE>
The total value of options granted during 1998, 1997, and 1996 was
computed as approximately $38,679,000, $3,735,000 and $601,000, respectively,
which would be amortized on a pro forma basis over the four-year vesting period
of the options. If the Company had accounted for these plans in accordance
with SFAS No. 123, the Company's net income (loss) and pro forma net income
(loss) per share for the years ended December 31, 1998, 1997 and 1996 would have
been as follows:
F-12
<PAGE> 30
<TABLE>
<CAPTION>
(In Thousands Except Per Share Data) As Reported Pro Forma
--------------- -----------------
<S> <C> <C>
1996
Net loss $ (7,612) $ (7,836)
Net loss per share $ (0.48) $ (0.50)
1997
Net loss $ (4,083) $ (5,402)
Net loss per share $ (0.18) $ (0.24)
1998
Net income $ 10,544 $ 2,291
Net income per diluted share $ 0.41 $ 0.09
</TABLE>
A summary of the status of the Company's two stock options plans at
December 31, 1998, 1997 and 1996 and changes during the years then ended are
presented in the following table:
<TABLE>
<CAPTION>
Weighted
Average
Shares Price Per
(In Thousands) Share
---------------- ----------------
<S> <C> <C>
December 31, 1995 1,071 $0.62
Grants 756 2.87
Exercised (3) 0.21
Forfeitures (90) 2.01
----------------
December 31, 1996 1,734 1.53
Grants 453 4.21
Exercised (171) 0.29
Forfeitures (174) 3.12
----------------
December 31, 1997 1,842 2.15
Grants 861 37.53
Exercised (382) 1.53
Forfeitures (198) 7.96
----------------
December 31, 1998 2,123 16.10
================
Weighted average fair value of options
granted in 1998 $ 45
================
</TABLE>
The following table summarizes the number of options outstanding by
year of grant:
<TABLE>
<CAPTION>
Weighted
Number Average
Year Of Exercise Weighted Remaining
Of Shares Price Average Contractual
Grant (In Thousands) Range Price Life
---------------- ---------------- ---------------- --------------- -------------
<S> <C> <C> <C> <C>
1998 808 $10.94-60.69 $38.59 9.6 years
1997 341 2.33 - 9.71 4.40 8.4
1996 388 2.13-4.13 2.79 7.6
1995 586 0.21-2.13 0.67 6.5
</TABLE>
F-13
<PAGE> 31
The following table summarizes the options exercisable as of December 31,
1998, 1997 and 1996:
<TABLE>
<CAPTION>
Weighted
Number Average
of Weighted Remaining
Shares Average Contractual
As of (In Thousands) Price Life
------------------ ------------------ ------------------ ----------------
<S> <C> <C> <C>
Dec. 31, 1998 537 $1.16 6.8 years
Dec. 31, 1997 366 $0.73 7.5
Dec. 31, 1996 210 0.21 8.1
</TABLE>
EMPLOYEE BENEFIT PLAN
The Company has a savings plan (the "Savings Plan") that qualifies as
a deferred salary arrangement under Section 401(k) of the Internal Revenue
Code. Under the Savings Plan, participating employees may defer a portion of
their pretax earnings, up to the Internal Revenue Service annual contribution
limit. Annually, the Company determines whether to make a discretionary
matching contribution equal to a percentage, determined by the Company, of the
employee's deferred compensation contribution. The Company has not made any
matching contributions to the Savings Plan.
5. RELATED-PARTY TRANSACTIONS
The Company has entered into certain business relationships with
several subsidiaries and affiliates of ITC Holding Company, Inc. ("ITC
Holding"). Except as noted below, none of these transactions were material for
the periods presented.
The Company purchases long-distance telephone services and wide area
network transport service from ITC/\DeltaCom, Inc. ("ITC/\DeltaCom"), a related
party through relationships with ITC Holding. Long-distance charges from
ITC/\DeltaCom totaled approximately $3,672,000, $1,942,000 and $677,000 for the
years ended December 31, 1998, 1997 and 1996, respectively.
6. DEBT
The Company's only debt obligation for the periods presented is a
promissory note issued in connection with the PSINet transaction. The final
payment on this note was made in December 1998.
<TABLE>
<CAPTION>
1998 1997
---------------- ----------------
(In Thousands)
<S> <C> <C>
PSINet Note, due October, 1998 $ - $2,043
Less current maturities - (2,043)
---------------- ----------------
Long-term obligations $ - $ -
================ ================
</TABLE>
The carrying value of the PSINet Note approximated the market value as
of December 31, 1997.
F-14
<PAGE> 32
7. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases certain equipment under agreements, which are
classified as capital leases. These leases have original terms of three years
or less and contain bargain purchase options at the end of the original lease
terms. The Company also has operating leases, which relate to the lease of
office and equipment space. Rental expense attributable to these operating
leases was approximately $1,953,000, $1,420,000, and $519,000 for the year
ended December 31, 1998, 1997 and 1996, respectively.
At December 31, 1998, the Company's capital lease obligations and
minimum rental commitments under non-cancelable operating leases with initial
or remaining terms of more than one year were as follows:
<TABLE>
<CAPTION>
Capital Operating
Leases Leases
--------------- ----------------
(In Thousands)
<S> <C> <C>
1999 $3,103 $ 3,385
2000 2,595 3,392
2001 - 1,441
2002 - 829
2003 and thereafter - 963
--------------- ----------------
Total minimum lease payments 5,698 $10,010
================
Amounts representing interest (579)
---------------
Present value of net minimum
payments 5,119
Current portion (2,695)
---------------
Long-term capitalized lease
obligations $2,424
===============
</TABLE>
LEGAL PROCEEDINGS
The Company is subject to legal proceedings and claims that arise in
the ordinary course of business. As of December 31, 1998, management is not
aware of any asserted or pending litigation or claims against the Company that
would have a material adverse effect on the Company's financial condition,
results of operations, or liquidity.
8. INCOME TAXES
The provision for income taxes is attributable to:
<TABLE>
<CAPTION>
1998 1997 1996
-------------- -------------- --------------
(In Thousands)
<S> <C> <C> <C>
Current $ 3,000 $ - $ -
Deferred 654 (1,574) (2,915)
Increase in (reversal of) valuation allowance (5,198) 1,574 2,915
-------------- -------------- --------------
Income tax provision (benefit) $ (1,544) $ - $ -
============== ============== ==============
</TABLE>
F-15
<PAGE> 33
A reconciliation of the income tax provision (benefit) computed at
statutory tax rates to the income tax benefit for the year ended December 31,
1998, 1997 and 1996 is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Income tax benefit at statutory rate 34% (34)% (34)%
State income taxes, net of federal benefit 4 (4) (4)
Other 2 0 0
Valuation allowance (57) 38 38
---------- ---------- ----------
Total income tax provision (benefit) (17)% 0% 0%
========== ========== ==========
</TABLE>
Deferred income taxes reflect the net tax effect of temporary
differences between the carrying amount of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. The
significant components of the Company's deferred tax assets and liabilities as
of December 31, 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
1998 1997
------------ ------------
(In Thousands)
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards $ - $ 3,866
Acquired customer base 3,902 1,742
Deferred revenue 2,221 835
Allowance for doubtful accounts 465 285
Prepaid revenue 608 -
Accrued vacation 371 -
Other accrued liabilities - 126
------------ ------------
Total deferred tax assets 7,567 6,854
------------ ------------
Deferred tax liabilities:
Depreciation (2,779) (1,608)
Other (244) (48)
------------ ------------
Total deferred tax liabilities (3,023) (1,656)
------------ ------------
Net deferred tax asset 4,544 5,198
Valuation allowance for deferred tax assets - (5,198)
------------ ------------
Net deferred taxes $ 4,544 $ -
============ ============
</TABLE>
The Company's net operating loss carryforwards will expire between
2009 and 2012 unless utilized. Due to the fact that prior to 1998 the Company
incurred losses since inception, the Company did not recognize the income tax
benefit of the net operating loss carryforwards. Management provided a 100%
valuation reserve against its net deferred tax asset, consisting primarily of
net operating loss carryforwards. Management reviewed this position based on
the net income generated in 1998 as well as the projections of future income
and determined that it was more likely than not that the deferred tax assets
would be realized. Accordingly, the Company reversed its entire valuation
allowance in 1998. In addition, the Company's ability to recognize the benefit
from the net operating loss carryforwards could be limited under Section 382 of
the Internal Revenue Code if ownership of the Company changes by more than 50%,
as defined.
F-16
<PAGE> 34
9. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the unaudited quarterly results for
1998, 1997, and 1996:
(In Thousands Except Per Share Data)
<TABLE>
<CAPTION>
Operating Net Net Income
Quarter Ended Revenue Income (Loss) Income (Loss) (Loss) Per Share
- ------------------------ --------- --------------- ------------------------------------
Basic Diluted
<S> <C> <C> <C> <C> <C>
December 31, 1998 $39,534 $1,299 $3,679 $.14 $.13
September 30, 1998 28,695 3,440 3,985 .15 .15
June 30, 1998 25,060 1,994 2,020 .09 .08
March 31, 1998 21,384 1,053 860 .04 .04
December 31, 1997 $17,209 $646 $498 $.02 $.02
September 30, 1997 13,967 (465) (626) (.03) (.03)
June 30, 1997 11,600 (1,421) (1,430) (.06) (.06)
March 31, 1997 9,780 (2,505) (2,525) (.11) (.11)
December 31, 1996 $8,524 ($2,378) ($2,411) ($.11) ($.11)
September 30, 1996 5,301 (2,601) (2,702) (.18) (.18)
June 30, 1996 2,495 (1,577) (1,460) (.10) (.10)
March 31, 1996 1,812 (966) (1,039) (.10) (.10)
</TABLE>
See Note 1 for a discussion of earnings per share.
10. SUBSEQUENT EVENT
ACQUISITION
On February 17, 1999, MindSpring acquired certain tangible and
intangible assets and rights used in connection with the Internet services
business operated in the United States by NETCOM On-Line Communication
Services, Inc. ("NETCOM"), a Delaware corporation and an indirect wholly owned
subsidiary of ICG Communications, Inc. including, (i) approximately 400,000 of
NETCOM's individual Internet access accounts; (ii) approximately 3,000
dedicated Internet access accounts; (iii) approximately 18,000 Web hosting
accounts; and (iv) various assets used in serving those subscribers, including
leased operations facilities in San Jose, California and Dallas, Texas and all
of NETCOM's rights to the "NETCOM" name (except in Brazil, Canada and the United
Kingdom). The acquisition was effected pursuant to an Asset Purchase Agreement
dated January 5, 1999 between MindSpring and NETCOM. MindSpring paid NETCOM
approximately $245,000,000, including $215,000,000 in cash and $30,000,000 in
MindSpring stock.
The NETCOM operations outside the United States are not included in
this transaction. In addition, NETCOM (which will change its name in the near
future) will retain all of the assets used in connection with its network
operations. Under a separate network services agreement, NETCOM (operating
under a new corporate name) will sell MindSpring wholesale access to its
network. The agreement has an initial term of one year, with an option for a
second year on potentially different terms to be negotiated and accepted by both
parties.
The transaction will be accounted for as a purchase. The purchase
price will be allocated to the underlying assets purchased and liabilities
assumed based on their fair market values at the acquisition date.
F-17
<PAGE> 35
The following table summarizes the net assets purchased in connection
with the NETCOM and Spry acquisitions and the amount attributable to cost in
excess of net assets acquired in millions:
<TABLE>
<CAPTION>
NETCOM Spry
---------- ----------
<S> <C> <C>
Working capital $ (3.0) $ -
Property and equipment 17.2 -
Other assets 0.2 -
Acquired customer base 230.6 32.0
</TABLE>
The preliminary estimate of net assets represents management's best
estimate based on currently available information; however, such estimate may
be revised up to one year from the acquisition date. Acquired subscriber bases
are amortized over 3 years.
The following unaudited pro forma condensed statements of operations
(in millions) assumes the NETCOM and Spry acquisitions occurred on January 1,
1997. In the opinion of management, all adjustments necessary to present fairly
such unaudited pro forma condensed statements of operations have been made.
<TABLE>
<CAPTION>
1998 1997
-------- ----------
<S> <C> <C>
Revenue $ 294.9 $ 250.3
Net Loss (101.5) (101.0)
Net Loss per share (3.57) (3.58)
</TABLE>
CREDIT FACILITY
Subsequent to year end, the Company obtained a $100 million secured
revolving credit facility from First Union National Bank and certain other
lenders. The credit facility may be increased to $200 million with the
approval of 51% of the lenders. The credit facility has an interest rate of
either the bank rate plus 25 to 100 basis points (defined as the banks prime
rate or the overnight federal funds rate plus 50 basis points) or LIBOR plus
125-200 basis points depending upon the ratio of total debt to EBITDA. The
facility is available for 36 months and contains certain restrictive covenants
including certain financial ratios. Additionally, borrowings are secured by
all assets and properties. To complete the NETCOM acquisition, the Company
borrowed $80 million under this facility. The proceeds from any future debt
issuances and certain sales of assets and insurance proceeds must be used to
repay any outstanding borrowings.
F-18
<PAGE> 1
EXHIBIT 99.2
RISK FACTORS
Listed below are important risk factors relating to MindSpring's business,
operating results and financial condition.
We have a limited operating history during which we have incurred significant
annual operating losses.
We started our business on February 24, 1994 and began offering Internet
access in June 1994. Our limited historical operating data and rapid growth may
make it more difficult for you to evaluate our performance. Before 1998, we
had incurred annual operating losses in each year since we started our business.
Our annual net losses since 1995 and our accumulated deficit as of December 31,
1998 are as follows:
<TABLE>
<CAPTION>
Annual Accumulated Deficit
Net Loss as of December 31, 1998
-------- -----------------------
<S> <C> <C>
1995 $1,959,000
1996 $7,612,000
1997 $4,083,000
1998 N/A $3,185,000
</TABLE>
Our ability to maintain profitability and positive cash flow depends upon a
number of factors, including our ability to increase revenue while maintaining
or reducing per subscriber costs. We may not succeed in increasing revenue
while maintaining or reducing per subscriber costs or achieving or sustaining
positive cash flow in the future, and our failure to do so could have a
material adverse effect on our business, financial condition and results of
operations.
There are risks associated with our acquisitions of subscriber accounts,
including the Spry and NETCOM acquisitions.
As part of our business strategy, we have acquired subscriber accounts and
related assets from other companies. In October 1998, we acquired approximately
130,000 subscribers and related assets of Spry, Inc. from America On-Line, Inc.
In February 1999, we completed the acquisition of approximately 421,000
subscribers from NETCOM On-Line Communication Services, Inc., a wholly owned
subsidiary of ICG Communications, Inc. We will continue to evaluate strategic
acquisitions of businesses and subscriber accounts principally relating to our
current operations. These transactions commonly involve risks. These risks
include, among others, that:
- we may experience difficulty in assimilating the acquired
operations and personnel;
- the acquisition may disrupt our ongoing business;
- the acquisition may divert management's attention from our
ongoing business;
<PAGE> 2
- we may not be able to successfully incorporate acquired assets,
technology and rights into our service offerings;
- we may not be able to maintain uniform standards, controls,
procedures, and policies;
- we may lack the necessary experience to enter new markets and
add new services; and
- an acquisition may impair our relationships with employees and
subscribers as a result of changes in management.
We may not be successful in overcoming these risks or any other problems
encountered in connection with the Spry and NETCOM acquisitions or any future
transactions. In addition, a transaction could require us to (1) issue
additional equity securities, which would dilute our stockholders, (2) incur
additional debt, or (3) amortize acquisition or debt-related expenses for
goodwill and other intangible assets. We were required to take each of these
actions to complete the NETCOM acquisition. Any of these actions could have a
material adverse effect on our business, operating results and financial
condition.
We cannot assure you that we will effectively manage our growth.
We may not be successful in effectively managing our growth. Our rapid
growth has in the past placed, and may in the future place, a significant strain
on our business and financial resources. The rapid expansion of our subscriber
base, including through the Spry and NETCOM acquisitions, has placed increasing
demands on our customer service and technical support resources. Failure to
manage our recent and anticipated growth could have a material adverse effect on
our business, results of operations and financial condition.
For us to effectively (1) manage our rapidly growing operations, (2)
successfully integrate newly acquired assets, including those acquired in the
Spry and NETCOM acquisitions, and (3) continue to implement a nationwide
strategy and network, we must:
- continue to implement and improve our operational, financial,
and management information systems;
- closely monitor service quality, particularly through third-
party points-of-presence, or "POPs";
- integrate leased physical sites;
- acquire and install necessary equipment and telecommunications
facilities;
- implement marketing efforts in new and existing markets, which
may involve expanding our marketing strategy to include
telemarketing and other methods ;
- add new services such as dedicated Internet access services and
provide related customer and technical support;
- employ qualified personnel to provide technical and marketing
support for new sites;
<PAGE> 3
- identify, attract, train, integrate, and retain other qualified
personnel, including new management personnel;
- develop additional expertise; and
- continue to expand our operational and financial resources.
We have significant debt and we may be unable to service that debt.
On February 17, 1999, we entered into a credit agreement with First
Union National Bank and other lenders establishing a $100 million secured
revolving credit facility. Also on February 17, 1999, we borrowed
approximately $80 million under the credit facility to finance the NETCOM
acquisition. At December 31, 1998, giving effect to the NETCOM acquisition and
the borrowings under the credit facility as if they had occurred on January 1,
1998:
- we would have had $85.1 million of indebtedness;
- stockholders' equity would have been $237.1 million; and
- our earnings would have been insufficient to cover our fixed
charges for the year ended December 31, 1998 by $96.2 million.
We cannot assure you that we will be able to improve our earnings before
fixed charges or that we will be able to meet our debt service obligations under
our credit facility. We will be in default under the terms of our credit
facility if (1) we are unable to generate sufficient cash flow or otherwise
obtain funds necessary to make required payments, or (2) we otherwise fail to
comply with the various covenants in our debt obligations. A default would
permit the holders of the indebtedness to accelerate its maturity. This, in
turn, would have a material adverse effect on our business, financial condition
and results of operations. In addition, we are required under the terms of the
credit facility to obtain, within 90 days after February 17, 1999, landlord
consents under some of our operating leases. If we do not obtain these consents
by the required date, the lenders' commitment under the credit facility could be
reduced down to $20 million, which could have a material adverse effect on our
business, financial condition and results of operations.
Even if we are able to meet our debt service obligations, the amount of
debt we have could adversely affect us in a number of ways, including by:
- limiting our ability to obtain any necessary financing in the
future for working capital, capital expenditures, debt service
requirements or other purposes;
- limiting our flexibility in planning for, or reacting to,
changes in our business;
- placing us at a competitive disadvantage to those of our
competitors having lower levels of debt;
- making us more vulnerable to a downturn in our business or the
economy generally; and
- requiring us to use a substantial portion of our cash flow from
operations to pay principal and interest on our debt, instead
of contributing those funds to other purposes, such as working
capital and capital expenditures.
<PAGE> 4
To be able to meet our obligations under our credit facility, we must
successfully implement our business strategy, which includes:
- expanding our network;
- attracting or acquiring and retaining a significant number of
subscribers; and
- achieving significant and sustained growth in our cash flow.
We cannot assure you that we will successfully implement our business
strategy or that we will be able to generate sufficient cash flow from operating
activities to meet our debt service obligations and working capital
requirements. Our ability to meet our obligations will be dependent upon our
future performance, which will in turn depend upon prevailing economic
conditions and financial, business and other factors.
If the implementation of our business strategy is delayed or unsuccessful,
or if we do not generate sufficient cash flow to meet our debt service and
working capital requirements, we may need to seek additional financing. If we
are unable to obtain necessary financing on terms that are acceptable to us, we
could be forced to dispose of assets to make up for any shortfall in the
payments due on our indebtedness under circumstances that might not be favorable
to realizing the highest price for those assets. A substantial portion of our
assets consist of intangible assets, the value of which will depend upon a
variety of factors, including the success of our business. As a result, we
cannot assure you that our assets could be sold quickly enough, or for amounts
sufficient, to meet our obligations.
Various factors outside of our control may affect our operating results and
cause potential fluctuations in our quarterly results.
Our future success depends on a number of factors, many of which are beyond
our control. In particular, our revenue depends on our ability to attract and
keep subscribers. We normally offer our new subscribers a 30-day money-back
satisfaction guarantee. In addition, our subscribers, including the recently
acquired Spry and NETCOM subscribers, may discontinue their service at the end
of any month for any reason. We incur some expenses based on our expectations of
future revenue. If revenue is less than we expect, we may not be able to reduce
expenses proportionately. If we do not do so, our operating results, cash flows,
and liquidity will likely be adversely affected.
Our operating results, cash flows and liquidity may also fluctuate
significantly in the future due to other factors beyond our control which
include:
- how quickly we are able to acquire new subscribers;
- how expensive it will be to acquire new subscribers;
- the impact of increased depreciation and amortization from
acquisitions;
- how much money we have to spend to improve our business and
expand our operations;
- how quickly we are able to develop new products and services
that our subscribers require;
<PAGE> 5
- how our prices compare to those of our competitors;
- whether customers accept our new and enhanced products and
services;
- how much our operating expenses increase;
- the nature of changes in our strategy;
- whether we lose key employees;
- whether we experience business disruptions resulting from
third parties encountering "Year 2000" computer problems;
- whether and how quickly alternative technologies introduced by
our competitors gain market acceptance;
- whether our arrangements with third-party network providers
under various services agreements prove to be viable;
- changes in laws and regulations which affect our business;
- the extent to which we experience increased competition in our
markets; and
- other general economic factors.
Due to all of the foregoing factors, it is likely that in some future
periods, our operating results and/or our growth rate will be below what public
market analysts and investors expect. If that happens, the market price of our
common stock could decline materially.
Technology and industry standards relating to our business are constantly
evolving and our success depends on our ability to keep pace with these
developments.
The market for Internet access and Web hosting is characterized by rapidly
changing technology, evolving industry standards, changes in subscriber needs,
and frequent new service and product introductions. Our future success will
depend, in part, on our ability to use leading technologies effectively, to
continue to develop our technical expertise, and to enhance our existing
services and develop new services to meet changing subscriber needs on a timely
and cost-effective basis. We may not be successful in achieving these goals.
We believe that our ability to compete successfully will also depend upon
the continued compatibility and interoperability of our services with products
and architectures offered by various vendors. Although we intend to support
emerging standards in the market for Internet access, industry standards may not
be established or, if they are established, we may not be able to conform to
these new standards in a timely fashion and maintain a competitive position in
the market. In addition, others may develop services or technologies that will
render our services or technology noncompetitive or obsolete.
We are also at risk to fundamental changes in the way customers access the
Internet. Currently, customers access Internet services primarily through
computers connected by telephone lines. Several companies, however, have
developed cable television modems that transmit data at substantially faster
speeds than the modems that we and most of our subscribers currently use. As the
Internet becomes accessible through these cable
<PAGE> 6
television modems and by screen-based telephones, wireless products,
televisions, and other consumer electronic devices, or as subscriber
requirements change the way Internet access is provided, we must develop new
technology or modify our existing technology to accommodate these developments.
We will have to continue to modify and expand the means by which we deliver
our services. As discussed below, our ability to offer cable wire access to our
subscribers may depend on our ability to negotiate agreements with cable
companies and, therefore, may be very limited. Our pursuit of technological
advances, such as a new technology called Digital Subscriber Lines, or "DSL,"
that uses telephone lines for high-speed data transfers, may require substantial
time and expense. We may not succeed in adapting our Internet access business to
alternate access devices and conduits.
We may need additional capital to finance our growth and capital requirements.
We must continue to enhance and develop our network to maintain our
competitive position and continue to meet the increasing demands for service
quality, availability, and competitive pricing. Despite the availability of
additional network capacity from third-party network providers, we intend to
maintain the flexibility to expand or open MindSpring POPs or make other capital
investments as dictated by subscriber demand or strategic considerations. To
open new MindSpring POPs, we must spend significant amounts of money for new
equipment as well as for leased telecommunications facilities and advertising.
In addition, to further expand our subscriber base nationwide, we will probably
have to spend significant amounts of money on additional equipment to maintain
the high speed and reliability of our Internet access services. We may also need
to spend significant amounts of cash to:
- fund growth, operating losses and increases in expenses;
- take advantage of unanticipated opportunities, such as major
strategic alliances or other special marketing opportunities,
acquisitions of complementary businesses or assets, or the
development of new products; or
- otherwise respond to unanticipated developments or competitive
pressures.
If we do not have enough cash on hand, cash generated from our operations,
or cash available under our credit facility to meet these cash requirements, we
will need to seek alternative sources of financing to carry out our growth and
operating plans. We may not be able to raise needed cash on terms acceptable to
us or at all. Financings may be on terms that are dilutive or potentially
dilutive to our stockholders. If alternative sources of financing are required,
but are insufficient or unavailable, we will be required to modify our growth
and operating plans to the extent of available funding and attempt to
attain profitability in our existing operations.
<PAGE> 7
Our business depends on our network infrastructure, including our ability to
obtain sufficient network capacity.
The future success of our business will depend on the capacity,
reliability, and security of our network infrastructure, including the
third-party POPs. We will need to use substantial financial, operational, and
management resources to expand and adapt our network infrastructure to meet the
needs of an increasing number of subscribers and to accommodate the expanding
amount and type of information they wish to transfer. We may not be able to
expand or adapt our network infrastructure to meet additional demand or changing
subscriber requirements on a timely basis and at a commercially reasonable cost,
or at all.
In the past we have experienced shortages in bandwidth capacity, both at
the level of particular POPs, which affects only subscribers attempting to use
the particular POP, and in connection with system-wide services, such as e-mail
and news group services. If we do not maintain sufficient bandwidth capacity in
our network connections, subscribers will perceive a general slowdown of all
services on the Internet. We will sometimes temporarily delay adding new
subscribers in cities experiencing significant capacity constraints until the
capacity contraints can be alleviated. This is done to protect the service
levels for current subscribers. Similar problems can occur if we are unable to
expand the capacity of our information servers for e-mail, news, and the World
Wide Web fast enough to keep up with demand from our rapidly expanding
subscriber base. If the capacity of our servers is exceeded, subscribers will
experience delays when trying to use a particular service. While our objective
is to maintain excess capacity, our failure to expand or enhance our network
infrastructure on a timely basis or to adapt it to an expanding subscriber base,
changing subscriber requirements, or evolving industry standards could
materially adversely affect our business, financial condition, and results of
operations.
We are dependent on third-party network providers.
In a significant number of markets, we provide Internet access exclusively
through third-party POPs. Our ability to provide Internet access to our
subscribers will be limited if (1) third-parties are unable or unwilling to
provide POP access to our subscribers, (2) we are unable to secure alternative
POP arrangements upon partial or complete termination of third-party network
provider agreements or (3) there is a loss of access to third-party POPs for
other reasons. These events could also limit our ability to further expand
nationally, which could, in turn, have a material adverse effect on our
business. If we lose access to third-party POPs under our current arrangements,
we may not be able to make alternative arrangements on terms acceptable to us,
or at all. We do not currently have any plans or commitments with respect to
such alternative POP arrangements, although there are some geographic overlaps
among our current arrangements. Moreover, while our contracts with the
third-party providers require them to provide commercially reliable service to
MindSpring's subscribers with a significant assurance of accessibility to the
Internet, the performance of third-party providers may not meet our
requirements, which could materially adversely affect our business, financial
condition and results of operations.
In connection with the NETCOM acquisition, we entered into a network
services agreement with NETCOM, which will change its name. We expect to
provide service to
<PAGE> 8
the majority of subscribers we acquired from NETCOM under this agreement which
at least for the first year of the agreement, will be at favorable rates.
However, NETCOM is just beginning to offer network services as a third-party
provider for companies like MindSpring. We cannot be sure that this network
agreement will be adequate to provide the level of service we require for our
subscribers, and there may be operating inefficiencies, network reliability
issues or technical support difficulties that are outside of our control.
Our operations and services are vulnerable to natural disasters.
Our operations and services depend on the extent to which our computer
equipment and the computer equipment of our third-party network providers is
protected against damage from fire, earthquakes, power loss, telecommunications
failures, and similar events. A significant portion of our computer equipment,
including critical equipment dedicated to our Internet access services, is
located at a single facility in Atlanta, Georgia. Despite precautions taken by
us and our third-party network providers, over which we have no control, a
natural disaster or other unanticipated problems at our headquarters, network
hub, or a MindSpring or third-party network provider POP could cause
interruptions in the services that we provide. If disruptions occur, we may have
no means of replacing these network elements on a timely basis or at all. We do
not currently maintain fully redundant or back-up Internet services or backbone
facilities or other fully redundant computing and telecommunications facilities.
Any accident, incident, system failure, or discontinuance of operations
involving our network or a third-party network that causes interruptions in our
operations could have a material adverse effect on our ability to provide
Internet services to our subscribers and, in turn, on our business, financial
condition, and results of operations.
We are dependent on telecommunications carriers and other suppliers.
We rely on local telephone companies and other companies to provide data
communications capacity via local telecommunications lines and leased
long-distance lines. We may experience disruptions or capacity constraints in
these telecommunications services. If disruptions or capacity constraints occur,
we may have no means of replacing these services on a timely basis or at all.
In addition, local phone service is sometimes available only from the local
monopoly telephone company in each of the markets we serve. We believe that the
federal Telecommunications Act of 1996 generally will lead to increased
competition in the provision of local telephone service, but we cannot predict
when or to what extent this will occur or the effect of increased competition
on pricing or supply.
We depend on a few third-party suppliers of hardware components. We acquire
some components we use to provide our networking services currently from only
one source, including modems and terminal servers manufactured by 3Com, Inc. and
high-performance routers manufactured by Cisco Systems, Inc. The expansion of
our network infrastructure and the expansion of Internet services in general is
placing, and will continue to place, a significant demand on our suppliers, some
of which have limited resources and production capacity. From time to time, we
have experienced delayed delivery from suppliers of new telephone lines, modems,
terminal servers, and other equipment. If delays of this nature
<PAGE> 9
are severe, all incoming modem lines may become full during peak times,
resulting in busy signals for subscribers who are trying to connect to
MindSpring. If our suppliers cannot adjust to meet increasing demand, the higher
demand levels may prevent them from continuing to supply components and products
in the quantities, at the quality levels and at the times we require, or at all.
If we are unable to develop alternative sources of supply, if required, we could
experience delays and increased costs in expanding our network infrastructure.
Our suppliers and telecommunications carriers also sell or lease products
and services to our competitors and may be, or in the future may become,
competitors themselves. Our suppliers and telecommunications carriers may enter
into exclusive arrangements with our competitors or stop selling or leasing
their products or services to us at commercially reasonable prices, or at all.
Our network is vulnerable to security breaches and inappropriate use by
Internet users which could disrupt our service.
The future success of our business will depend on the security of our
network and, in part, on the security of the network infrastructures of our
third-party providers, over which we have no control. Despite the implementation
of security measures, our infrastructure and the infrastructures of our network
providers are vulnerable to computer viruses or similar disruptive problems
caused by our or their subscribers or other Internet users. Computer viruses or
problems caused by third parties, such as the sending of excessive volumes of
unsolicited bulk e-mail or "spam," could lead to interruptions, delays, or
cessation in service to our subscribers. Third parties could also potentially
jeopardize the security of confidential information stored in our computer
systems or our subscribers' computer systems by their inappropriate use of the
Internet, which could cause losses to us or our subscribers or deter persons
from subscribing to our services. Inappropriate use of the Internet includes
attempting to gain unauthorized access to information or systems, commonly known
as "cracking" or "hacking." Although we intend to continue to implement security
measures to prevent this, "hackers" have circumvented these security measures
in the past, and others may be able to circumvent our security measures or the
security measures of our third-party network providers in the future.
To alleviate problems caused by computer viruses or other inappropriate
uses or security breaches, we may have to interrupt, delay, or cease service to
our subscribers, which could have a material adverse effect on our business,
financial condition, and results of operations. In addition, we expect that our
subscribers will increasingly use the Internet for commercial transactions in
the future. Any network malfunction or security breach could cause these
transactions to be delayed, not completed at all, or completed with compromised
security. Subscribers or others may assert claims of liability against us as a
result of any failure by us to prevent these network malfunctions and security
breaches. Until more comprehensive security technologies are developed, the
security and privacy concerns of existing and potential subscribers may inhibit
the growth of the Internet service industry in general and our subscriber base
and revenue in particular.
<PAGE> 10
The Internet access and web hosting markets are very competitive.
The markets for the provision of Internet access and Web hosting services
to individuals and small businesses are extremely competitive and highly
fragmented. There are no substantial barriers to entry, and we expect that
competition will continue to intensify. We may not be able to compete
successfully against current or future competitors, many of whom may have
financial resources greater than ours. Increased competition could cause us to
increase our selling and marketing expenses and related subscriber acquisition
costs and could also result in increased subscriber attrition. We may not be
able to offset the effects of these increased costs through an increase in
the number of our subscribers or higher revenue from enhanced services and we
may not have the resources to continue to compete successfully. These
developments could adversely affect our business, financial condition and
results of operations.
Competitive Factors. We believe that the primary competitive factors
determining success in the Internet access and Web hosting markets are a
reputation for reliability and service, effective customer support, pricing,
easy-to-use software, and geographic coverage. Other important factors include
the timing of introductions of new products and services and industry and
general economic trends. Our current and prospective competitors include many
large companies that have substantially greater market presence and financial,
technical, marketing, and other resources. In addition, every local market that
we have entered or intend to enter is served by multiple local ISPs.
Our Competitors. We currently compete or expect to compete with the
following types of companies:
- established on-line commercial information service providers,
such as AOL;
- national long-distance carriers, such as AT&T Corp. and MCI
WorldCom, Inc.;
- national commercial ISPs, such as EarthLink Network, Inc.;
- computer hardware and software and other technology companies,
such as IBM Corp. and Microsoft Corporation;
- numerous regional and local commercial ISPs which vary widely
in quality, service offerings, and pricing;
- national and regional Web hosting companies that focus
primarily on providing Web hosting services;
- cable operators and on-line cable services;
- local telephone companies and regional Bell operating
companies; and
- nonprofit or educational Internet service providers.
We believe that new competitors, including large computer hardware and
software, media, and telecommunications companies, will continue to enter the
Internet access and Web hosting markets. As consumer awareness of the Internet
grows, existing competitors are likely to further increase their emphasis on
their Internet access and Web hosting services, resulting in even greater
competition for us. In addition, telecommunications companies may be able to
offer customers reduced communications costs in connection with
<PAGE> 11
these services, reducing the overall cost of their Internet access and Web
hosting solutions and significantly increasing pricing pressures on us. The
ability of our competitors to acquire other ISPs, to enter into strategic
alliances or joint ventures or to bundle other services and products with
Internet access or Web hosting could also put us at a significant competitive
disadvantage.
Broadband Technologies. We also face competition from companies that
provide broadband connections to consumers' homes, including local and
long-distance telephone companies, cable television companies, electric utility
companies, and wireless communications companies. These companies may include
Internet access or Web hosting using broadband technologies in their basic
bundle of services or may offer Internet access and Web-hosting services for a
nominal additional charge. Broadband technologies enable consumers to transmit
and receive print, video, voice and data in digital form at significantly
faster access speeds than existing dial-up modems.
The companies that own these broadband networks could prevent us from
delivering Internet access through the wire and cable connections that they own.
Cable television owners are not currently required to allow ISPs to access their
broadband facilities and the terms of ISP access to broadband local telephone
company networks are not certain. Therefore, our ability to compete with
telephone and cable television companies that are able to support broadband
transmission, and to provide better Internet services and products may depend on
future regulation to guarantee open access to the broadband networks. However,
in January 1999, the FCC declined to take any action to mandate or otherwise
regulate access by ISPs to broadband facilities at this time. It is unclear at
this time whether and to what extent local and state regulatory agencies will
take any initiatives to implement this type of regulation, and whether they will
be successful in establishing their authority to do so. If the owners of these
high-speed, broadband facilities increasingly use them to provide Internet
access and we are unable to gain access to these facilities on reasonable terms,
our business, financial condition and results of operations could be materially
adversely affected.
No International Operations. We do not currently compete internationally.
If the ability to provide Internet access internationally becomes a competitive
advantage in the Internet access industry, we may be at a competitive
disadvantage relative to our competitors.
We may not be successful in protecting our proprietary rights or avoiding claims
that we infringe the proprietary rights of others.
Our success depends in part upon our software and related documentation. We
principally rely upon copyright, trade secret, and contract laws to protect our
proprietary technology. We cannot be certain that we have taken adequate steps
to prevent misappropriation of our technology or that our competitors will not
independently develop technologies that are substantially equivalent or superior
to our technology.
We have permission and, in some cases, licenses from each manufacturer of
the software that we bundle in MindSpring's front-end software product for
subscribers. Although we do not believe that the software or the trademarks we
use or any of the other elements of our business infringe on the proprietary
rights of any third parties, third parties may assert
<PAGE> 12
claims against us for infringement of their proprietary rights and these claims
may be successful. We might also face third party claims as a result of our
acquisition of software, trademarks and other proprietary technology from Spry
and NETCOM.
We could incur substantial costs and diversion of management resources in
the defense of any claims relating to proprietary rights, which could materially
adversely affect our business, financial condition, and results of operations.
Parties making these claims could secure a judgment awarding substantial damages
as well as injunctive or other equitable relief that could effectively block our
ability to license our products in the United States or abroad. Such a judgment
could have a material adverse effect on our business, financial condition and
results of operations. If a third party asserts a claim relating to proprietary
technology or information against us, we may seek licenses to the intellectual
property from the third party. We cannot be certain, however, that third parties
will extend licenses to us on commercially reasonable terms, or at all. If we
fail to obtain the necessary licenses or other rights, it could materially
adversely affect our business, financial condition and results of operations.
Our success depends upon our ability to attract and retain key personnel.
Our success depends upon the continued efforts of our senior management
team and our technical, marketing, and sales personnel. These employees may
voluntarily terminate their employment with us at any time. Our success also
depends on our ability to attract and retain additional highly qualified
management, technical, marketing, and sales personnel. The process of hiring
employees with the combination of skills and attributes required to carry out
our strategy can be extremely competitive and time-consuming. We may not be able
to successfully retain or integrate existing personnel or identify and hire
additional personnel. If we lose the services of key personnel or are unable to
attract additional qualified personnel, our business, financial condition and
results of operations could be materially and adversely affected.
ITC Holding Company, Inc., one of our principal stockholders, and our management
can exercise significant influence over MindSpring.
ITC Holding Company, Inc. indirectly owns approximately 18.5% of our common
stock as of January 31, 1998. MindSpring's executive officers and directors own
an aggregate of approximately 10.4% of our common stock as of the same date. As
a result, if ITC Holding and management act together, they would be able to
exercise significant influence over most matters requiring stockholder approval,
including the election of directors and the approval of significant corporate
matters, such as some types of change-of-control transactions. The common stock
of MindSpring owned by ITC Holding is pledged to ITC Holding's lenders in
connection with a credit facility. If ITC Holding's subsidiaries default under
the credit facility, ITC Holding could lose ownership of all of its stock in
MindSpring and someone unknown to us would become a significant stockholder of
MindSpring.
Some of our directors have conflicts of interest involving ITC Holding.
ITC Holding, as a significant stockholder of MindSpring, and Campbell B.
Lanier, III, William H. Scott, III and O. Gene Gabbard, who are directors of
MindSpring and directors, stockholders and, in the case of Messrs. Lanier and
Scott, officers of
<PAGE> 13
ITC Holding, are in positions involving the possibility of conflicts of interest
with respect to transactions concerning MindSpring. Some decisions concerning
our operations or financial structure may present conflicts of interest between
us and ITC Holding and/or its affiliates. For example, if we are required to
raise additional capital from public or private sources to finance our
anticipated growth and contemplated capital expenditures, our interests might
conflict with those of ITC Holding and/or its affiliates with respect to the
particular type of financing sought. In addition, we may have an interest in
pursuing acquisitions, divestitures, financings, or other transactions that, in
our judgment, could be beneficial to us, even though the transactions might
conflict with the interests of ITC Holding and/or its affiliates. If these
conflicts do occur, ITC Holding and its affiliates may exercise their influence
in their own best interests.
We currently engage and expect in the future to engage in transactions with
ITC Holding and/or its affiliates. In addition, we provide Internet access to
various companies controlled by ITC Holding, although the revenue we derive from
these sources is not substantial. We have a policy that requires any material
transaction with our officers, directors, or principal stockholders, or their
affiliates, to be on terms no less favorable to MindSpring than we reasonably
could have obtained in arm's-length transactions with independent third parties.
We believe that each current transaction in which we are engaged with an
affiliate complies with this policy.
The ability of our stockholders to effect changes in control of MindSpring is
limited.
There are provisions in our Amended and Restated Certificate of
Incorporation, as amended, our Amended and Restated Bylaws , and the Delaware
General Corporation Law that could delay or impede the removal of incumbent
directors and could make more difficult a merger, tender offer, or proxy contest
involving MindSpring or could discourage a third-party from attempting to
acquire control of MindSpring, even if these events would be beneficial to the
interests of the stockholders. In particular, our board of directors could delay
a change in control of MindSpring. In addition, the Restated Certificate
authorizes the board of directors to provide for the issuance of shares of
preferred stock of MindSpring, in one or more series, which the board of
directors could issue without further stockholder approval and with terms and
conditions and rights, privileges, and preferences determined by the board of
directors. We have no current plans to issue any shares of preferred stock. We
are also governed by Section 203 of the Delaware Corporation Law. In general,
Section 203 prohibits a publicly held Delaware corporation from engaging in a
"business combination" with an "interested stockholder" for a period of three
years after the date of the transaction in which the person became an interested
stockholder, unless specified conditions are met. These factors could have the
effect of delaying, deferring, or preventing a change of control of MindSpring.
We may become regulated by the Federal Communications Commission or other
government agencies.
We provide Internet access, in part, through transmissions over public
telephone lines. These transmissions are governed by regulatory policies
establishing charges and terms for communications. As an Internet service
provider, we are not currently directly regulated
<PAGE> 14
by the Federal Communications Commission or any other agency, other than
regulations applicable to businesses generally. In a report to Congress adopted
on April 10, 1998, the FCC reaffirmed that Internet service providers should be
classified as unregulated "information service providers" rather than regulated
"telecommunications providers" under the terms of the Telecommunications Act of
1996.
This finding is important because it means that regulations that apply to
telephone companies and similar carriers do not apply to us. We also are not
required to contribute a percentage of our gross revenues to support "universal
service" subsidies for local telephone services and other public policy
objectives, such as enhanced communications systems for schools, libraries, and
some health care providers. The FCC action is also likely to discourage states
from regulating Internet service providers as telecommunications carriers or
imposing similar subsidy obligations.
Nevertheless, Internet-related regulatory policies are continuing to
develop, and it is possible that we could be exposed to regulation in the
future. For example, in the same report to Congress, the FCC stated its
intention to consider whether to regulate voice and fax telephony services
provided over the Internet as "telecommunications" even though Internet access
itself would not be regulated. The FCC is also considering whether the universal
service support obligations discussed above should apply to Internet-based
telephone services, or whether Internet-based telephone services should be
required to pay carrier access charges on the same basis as traditional
telecommunications companies. Local telephone companies assess access charges to
long distance companies for the use of the local telephone network to originate
and terminate long distance calls, generally on a per-minute basis. Access
charges have been a matter of continuing dispute, with long distance companies
complaining that the rates are substantially in excess of cost, and local
telephone companies arguing that access rates are justified to subsidize lower
local rates for end users and other purposes. Both local and long distance
companies, however, contend that these charges should apply to Internet-based
telephony. We have no current plans to install gateway equipment and offer
telephony, and so we do not believe we would be directly affected by these
developments. However, we cannot predict whether these debates will cause the
FCC to reconsider its current policy of not regulating Internet service
providers.
The law relating to the liability of Internet service providers and on-line
services companies for information carried on, stored on, or disseminated
through their network is unsettled, even with the recent enactment of the
Digital Millennium Copyright Act. While no one has ever filed a claim against us
relating to information carried on, stored on, or disseminated through our
network, someone may file a claim of that type in the future and may be
successful in imposing liability on us. If that happens, we may have to spend
significant amounts of money to defend ourselves against these claims and, if we
are not successful in our defense, the amount of damages that we will have to
pay may be significant. Any costs that we incur as a result of defending these
claims or the amount of liability that we may suffer if our defense is not
successful could materially adversely affect our business, financial condition
and results of operations.
If, as the law in this area develops, we become liable for information
carried on, stored on, or disseminated through our network, we may decide to
spend significant amounts of money to reduce our exposure to this type of
liability. This may require us to spend
<PAGE> 15
significant amounts of money for new equipment and may also require us to
discontinue offering some of our products or services.
Due to the increasing popularity and use of the Internet, it is possible
that additional laws and regulations may be adopted with respect to the
Internet, covering issues such as content, privacy, access to some types of
content by minors, pricing, bulk e-mail or "spam," encryption standards,
consumer protection, electronic commerce, taxation, copyright infringement, and
other intellectual property issues. We cannot predict the impact, if any, that
any future regulatory changes or developments may have on our business,
financial condition, and results of operations. Changes in the regulatory
environment relating to the Internet access industry, including regulatory
changes that directly or indirectly affect telecommunication costs or increase
the likelihood or scope of competition from regional telephone companies or
others, could have a material adverse effect on our business, financial
condition and results of operations.
Failure to achieve Year 2000 compliance may have adverse effects on MindSpring.
Most of the world's computer hardware and software have historically used
only two digits to identify the year in a date, often meaning that the computer
will fail to distinguish dates in the 21st century from dates in the 20th
century. As a result, various problems may arise from the improper processing of
dates and date-sensitive calculations by computers and other machinery as the
Year 2000 is approached and reached.
Our failure, or the failure of third parties on which we rely, to
adequately address Year 2000 readiness issues could result in an interruption,
or a failure, of some normal business activities or operations. Presently, we
believe that the primary risks that we face with regard to the Year 2000 are
those arising from third party services or products.
In particular, MindSpring depends heavily on a significant number of third
party vendors to provide both network services and equipment. A significant Year
2000-related disruption of these network services or equipment could cause our
customers to consider seeking alternate providers or cause an unmanageable
burden on customer service and technical support. This in turn could materially
and adversely affect MindSpring's results of operations, liquidity and financial
condition.
Furthermore, our business depends on the continued operation of, and
widespread access to, the Internet. To the extent that the normal operation of
the Internet is disrupted by the Year 2000 issue, or if a large portion of our
customers are unable to access the Internet due to Year-2000 related issues in
connection with their own systems, MindSpring's results of operations, liquidity
and financial condition could be materially and adversely affected.
We also face Year 2000 risks related to the acquisitions we make. If we
fail to identify and address Year 2000 issues in connection with our
acquisitions, our results of operations, liquidity and financial condition could
be materially and adversely affected.
<PAGE> 16
We have established a Year 2000 readiness program to coordinate appropriate
activity to be taken to address the Year 2000 issue. As of December 31, 1998, we
had incurred approximately $75,000 in connection with the implementation of the
program. We expect to incur an additional $250,000 to $300,000 of expenses to
implement the remainder of the Year 2000 readiness program. These estimates do
not include additional costs which may be incurred in connection with expanding
the program to include the systems and products acquired in the Spry and NETCOM
transactions. These are our best estimates, and we do not believe that the total
costs will have a material affect on our business. However, if the actual costs
resulting from implementation of the Year 2000 readiness program significantly
exceed our estimates, they may have a material adverse effect on our results of
operations, liquidity and financial condition.
Our credit facility contains restrictive covenants.
Our credit facility contains restrictions on MindSpring and any of
our future subsidiaries that affect, and in some cases prohibit or
significantly limit, our ability and the ability of our future subsidiaries, if
any, to:
- incur additional indebtedness;
- create liens;
- make investments;
- declare and pay cash dividends;
- issue some types of convertible and redeemable stock; and
- sell assets.
Our credit facility also requires us to maintain specified financial
ratios and satisfy financial condition tests. Our ability to meet those
financial ratios and tests can be affected by events beyond our control. We can
offer no assurance that we will meet those tests. In addition, these
restrictive covenants may adversely affect our ability to finance our future
operations or capital needs, or to engage in other business activities that may
be in our interest. A breach of any of these covenants could result in a
default under the credit facility. Upon the occurrence of an event of default
under the credit facility, our lenders could elect to declare all amounts
outstanding under the credit facility, together with any accrued interest, to
be immediately due and payable. If we were unable to repay those amounts, our
lenders could proceed against the collateral granted to them to secure that
indebtedness. Substantially all of our assets are pledged as collateral under
the credit facility. If the credit facility were to be accelerated, we can
offer no assurance that our assets would be sufficient to repay in full that
indebtedness. An event of default or acceleration of the credit facility could
have a material adverse effect on our business, financial condition and results
of operations.
Our stock price will fluctuate, and could fluctuate significantly.
Since our common stock has been publicly traded, the market price of our
common stock has fluctuated over a wide range and may continue to do so in the
future. Significant fluctuations in the market price of our common stock may
occur in response to various factors and events, including, among other things:
<PAGE> 17
- the depth and liquidity of the trading market for our common
stock;
- quarterly variations in actual or anticipated operating
results;
- growth rates;
- changes in estimates by analysts;
- market conditions in the industry, including demand for
Internet access;
- announcements by competitors;
- regulatory actions; and
- general economic conditions.
In addition, the stock market has from time to time experienced
significant price and volume fluctuations, which have particularly affected the
market prices of the stocks of high-technology companies and which may be
unrelated to the operating performance of particular companies. Furthermore, our
operating results and prospects from time to time may be below the expectations
of public market analysts and investors. The occurrence of any of these events
could result in a material decline in the price of our common stock.
We do not anticipate that we will pay cash dividends.
We have never declared or paid any cash dividends on our capital
stock and do not anticipate paying cash dividends in the foreseeable future. In
addition, our credit facility contains limits on our ability to declare and pay
cash dividends.
<PAGE> 1
EXHIBIT 99.3
DESCRIPTION OF SECURED CREDIT FACILITY
We have a credit agreement, dated as of February 17, 1999, with First Union
National Bank as lender and as administrative agent for the other lenders, which
agreement provides for a $100,000,000 secured revolving credit facility. The
credit facility will mature on February 17, 2002. The credit facility may be
increased at our option to $200,000,000 with the approval of lenders holding at
least 51% of the aggregate unpaid principal amount of the notes thereunder or,
if no such amounts are outstanding, lenders holding at least 51% of the
aggregate commitment of the lenders. We are obligated under the credit agreement
to deliver to the lenders specific consents and related documents in connection
with eleven of our leased properties within 90 days after February 17, 1999. If
we fail to do so, then on the 91st day after February 17, 1999, (1) our option
to increase the commitment to $200,000,000 will terminate, (2) the commitment
will be automatically and permanently reduced to $20,000,000 plus an incremental
amount based upon the extent of our compliance with the requirement concerning
consents and related documents (with the exception that if we do not deliver the
consents and related documents for our Atlanta, Georgia leased property, no
incremental amount will be added to the $20,000,000 amount); and (3) the
applicable margin will be increased between .375% and 1.00% for both Base Rate
borrowings and LIBOR rate borrowings. While at present we do not anticipate
difficulties in obtaining the described consents and related documents by the
specified deadline, there can be no assurance that we will be able to do so.
The credit facility is to be used to finance the acquisition of some of the
assets of NETCOM, to finance permitted acquisitions and for working capital and
general corporate requirements. The following summary of the material provisions
of the credit agreement does not purport to be complete and is subject to, and
qualified in its entirety by reference to, the credit agreement. Some of the
capitalized terms used in this description of the credit facility are defined at
the end of this section.
Amounts drawn under the credit facility will bear interest, at our option,
at either the Base Rate or the reserve adjusted LIBOR rate, plus an applicable
margin. The applicable margin will be an annual rate which will fluctuate based
on
1
<PAGE> 2
our ratio of total debt to EBITDA and which will be between 0.25% and 1.00%
for Base Rate borrowings and between 1.25% and 2.00% for LIBOR rate borrowings.
The credit agreement requires us to repay indebtedness outstanding under
the credit facility with the net cash proceeds from all debt issuances, from
some types of sales of our assets and from some types of insurance proceeds. In
addition, the total loan commitment will be reduced by the amount of net cash
proceeds from debt issuances and, to the extent not reinvested in similar assets
or used to finance the repair or replacement of damaged assets, as the case may
be, by the amount of net cash proceeds from some types of asset sales and from
some types of insurance proceeds.
Our obligations under the credit facility will be guaranteed by all of our
future subsidiaries. Our obligations are secured by a first priority lien on all
of our current and future assets and properties and will be secured by a first
priority pledge of the capital stock of any subsidiary that we organize or
acquire.
The credit agreement contains negative covenants limiting our ability and
that of our future subsidiaries to:
- incur debt;
- guaranty obligations;
- create liens;
- make loans, advances, investments and acquisitions;
- engage in mergers and liquidations;
- sell assets;
- pay dividends and make distributions;
- exchange and issue some types of convertible or redeemable capital stock;
- engage in transactions with affiliates;
- amend subordinated debt; and
- enter into restrictive agreements and change our fiscal year or
accounting method.
In addition, the credit agreement contains affirmative covenants, including
covenants requiring:
- compliance with laws and material contracts;
- maintenance of corporate existence, properties and insurance;
- payment of taxes and all other obligations;
- year 2000 compatibility; and
- the delivery of financial and other information.
The credit agreement also requires us to comply with specific financial
tests and to maintain specific financial ratios. We must maintain (1) as of the
end of any fiscal quarter, a ratio of EBITDA to interest expense for the
immediately preceding four consecutive fiscal quarters of no less than 3.0:1.0;
(2) a maximum total debt to EBITDA ratio no greater than 3.0:1.0; and (3) a net
worth not less than $175,000,000 plus 50% of net income (to the extent positive)
plus 75% of the net cash proceeds of equity issuances.
Failure to satisfy any of the financial covenants constitutes an event of
default under the credit facility, notwithstanding our ability to meet our debt
service obligations. The credit agreement also includes other customary events
of default, including, without limitation, cross default to other debt
and
2
<PAGE> 3
material contracts; insolvency or bankruptcy; occurrence of certain ERISA
events; material undischarged judgments and change in control.
"Base Rate" means the greater of First Union National Bank's prime lending
rate or the overnight federal funds rate plus 0.50%.
"EBITDA" means, for any period, the sum of the following on a consolidated
basis, without duplication, for MindSpring and our Subsidiaries (as defined in
the credit agreement) in accordance with generally accepted accounting
principles: (A) net income for such period plus (B) the sum of the following to
the extent deducted in determining net income: (1) income and franchise taxes,
(2) interest expense, (3) amortization, depreciation and other non-cash charges
less (C) interest income and any extraordinary gains. EBITDA will be adjusted in
a manner reasonably satisfactory to First Union National Bank to include on a
pro forma basis as of the first day of any calculation period any acquisition
consummated during that period as permitted by the credit agreement and exclude
on a pro forma basis as of the first day of any calculation any Subsidiary or
assets sold during that period as permitted by the credit agreement.
"LIBOR" means the rate of interest per annum determined on the basis of the
rate for deposits in dollars in minimum amounts of at least $5,000,000 for a
period equal to the applicable Interest Period (as defined in the credit
agreement) which appears on the Telerate Page 3750 at approximately 11:00 a.m.
(London time) two business days prior to the first day of the applicable
Interest Period. If, for any reason, the rate does not appear on Telerate Page
3750, then "LIBOR" will be determined by First Union National Bank to be the
arithmetic average of the rate per annum at which deposits in dollars would be
offered by first class banks in the London interbank market to First Union
National Bank at approximately 11:00 a.m. (London time) two business days prior
to the first day of the applicable Interest Period for a period equal to that
Interest Period and in an amount substantially equal to the amount of the
applicable loan.
3
