<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
-----------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number 0-23795
------------------------------------
EXODUS COMMUNICATIONS, INC.
--------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 77-0403076
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2650 San Tomas Expressway, Santa Clara, CA 95051
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(Address of principal executive offices)
(Zip Code)
(408) 346-2200
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
-------- --------
The number of shares outstanding of the issuer's common stock, par value $0.001,
as of November 11, 1998 was 19,901,263 shares.
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EXODUS COMMUNICATIONS, INC.
INDEX
-----
PART I. Financial Information Page No.
--------------------- --------
Item 1. Financial Statements
Condensed Balance Sheets - September 30, 1998 and
December 31, 1997 2
Condensed Statements of Operations - Three and
Nine Month Periods ended September 30, 1998 and 1997 3
Condensed Statements of Cash Flows - Nine Month
Periods ended September 30, 1998 and 1997 4
Notes to Condensed Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 27
PART II. Other Information
-----------------
Item 1. Legal Proceedings 27
Item 2. Changes in Securities and Use of Proceeds 28
Item 3. Defaults Upon Senior Securities 28
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information 28
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
<PAGE>
I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
EXODUS COMMUNICATIONS, INC.
CONDENSED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
-------------------- --------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents...................................................... $ 191,047 $ 10,270
Accounts receivable............................................................ 8,954 1,837
Prepaid expenses and other current assets...................................... 4,603 1,377
---------- ----------
Total current assets......................................................... 204,604 13,484
Property and equipment, net...................................................... 49,615 25,170
Restricted cash equivalents...................................................... 45,895 1,753
Other assets..................................................................... 7,035 566
---------- ----------
$ 307,149 $ 40,973
========== ==========
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Bank borrowings................................................................ $ -- $ 3,000
Current portion of equipment loans and line of credit facilities............... 14,076 3,777
Current portion of capital lease obligations................................... 3,730 1,143
Accounts payable............................................................... 11,233 6,252
Accrued expenses............................................................... 12,559 3,019
---------- ----------
Total current liabilities.................................................... 41,598 17,191
Equipment loans and line of credit facilities, less current portion.............. 17,537 12,693
Capital lease obligations, less current portion.................................. 8,938 2,442
11-1/4% Senior Notes due 2008.................................................... 200,000 --
---------- ----------
Total liabilities............................................................ 268,073 32,326
---------- ----------
Redeemable convertible preferred stock and warrants.............................. -- 39,247
---------- ----------
Stockholders' equity (deficit):
Common stock, $0.001 par value: 50,000,000 and 53,281,579 authorized as of
September 30, 1998 and December 31, 1997, respectively; 19,795,870 and
2,067,253 shares issued and outstanding as of September 30, 1998 and as of
December 31, 1997, respectively................................................ 19 2
Additional paid-in capital...................................................... 116,053 2,508
Notes receivable from stockholders.............................................. (50) (140)
Deferred stock compensation..................................................... (1,312) (2,393)
Accumulated deficit............................................................. (75,634) (30,577)
---------- ----------
Total stockholders' equity (deficit)............................................. 39,076 (30,600)
---------- ----------
$ 307,149 $ 40,973
========== ==========
</TABLE>
See accompanying notes to condensed financial statements.
2
<PAGE>
EXODUS COMMUNICATIONS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1998 1997
------------------------------------ -------------------------------------
<S> <C> <C> <C> <C>
Revenues $ 14,462 $ 3,443 $ 31,638 $ 7,505
---------- ---------- ---------- ----------
Costs and expenses:
Cost of revenues 16,427 4,644 39,291 9,542
Marketing and sales 6,887 3,291 20,467 7,667
General and administrative 3,861 1,447 9,518 3,526
Product development 935 512 2,299 1,100
---------- ---------- ---------- ----------
Total costs and expenses 28,110 9,894 71,575 21,835
---------- ---------- ---------- ----------
Operating loss (13,648) (6,451) (39,937) (14,330)
Net interest expense 4,012 105 5,120 242
---------- ---------- ---------- ----------
Net loss (17,660) (6,556) (45,057) (14,572)
Cumulative dividends and accretion on
redeemable convertible preferred stock -- (823) (2,014) (823)
---------- ---------- ---------- ----------
Net loss attributable to common stockholders $ (17,660) $ (7,379) $ (47,071) $ (15,395)
========== ========== ========== ==========
Basic and diluted net loss per share $ (0.90) $ (3.86) $ (3.32) $ (8.01)
========== ========== ========== ==========
Shares used in computing basic and diluted net
loss per share 19,592 1,911 14,198 1,921
========== ========== ========== ==========
</TABLE>
See accompanying notes to condensed financial statements.
3
<PAGE>
EXODUS COMMUNICATIONS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
-----------------
SEPTEMBER 30, SEPTEMBER 30,
1998 1997
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (45,057) $ (14,572)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization 8,568 1,762
Loss on disposal of property and equipment 248 --
Noncash warrant expense 786 --
Amortization of deferred stock compensation 1,081 85
Amortization of debt issuance costs 274 --
Interest accretion on restricted cash equivalents (580) --
Changes in operating assets and liabilities:
Accounts receivable (7,117) (1,230)
Prepaid expenses and other assets (3,970) (671)
Accounts payable 4,981 4,063
Accrued expenses 9,540 1,092
------------- -------------
Net cash used for operating activities (31,246) (9,471)
------------- -------------
Cash flows from investing activities:
Purchases of property and equipment (26,523) (14,775)
------------- -------------
Net cash used for investing activities (26,523) (14,775)
------------- -------------
Cash flows from financing activities:
Proceeds from issuance of redeemable convertible preferred stock and
warrants 2,176 14,541
Proceeds from issuance of common stock 71,353 1,189
Proceeds from issuance of bridge financing convertible notes -- 3,975
Notes receivable from stockholders, net 90 35
Repayment of bank borrowings (3,000) --
Proceeds from sale-leaseback transactions 4,035 932
Payment on capital lease obligations (1,689) (368)
Proceeds from debt 18,611 5,501
Repayment of debt (3,468) (716)
Proceeds from 11-1/4% Senior Notes, net 194,000 --
Restricted cash equivalents (43,562) (675)
------------- -------------
Net cash provided by financing activities 238,546 24,414
------------- -------------
Net increase in cash and cash equivalents 180,777 168
Cash and cash equivalents at beginning of year 10,270 3,715
------------- -------------
Cash and cash equivalents at end of period $ 191,047 $ 3,883
============= =============
Supplemental disclosure of cash flow information:
Cash paid-interest $ 2,921 $ 340
============= =============
Noncash investing and financing activities:
Assets recorded under capital lease $ 6,691 $ 829
============= =============
Cumulative dividends and accretion on Series C and D
redeemable convertible preferred stock and warrants $ 2,014 $ 823
============= =============
Conversion of redeemable convertible preferred stock to
common stock $ 43,437 $ --
============= =============
Conversion of bridge financing convertible notes to
redeemable convertible preferred stock $ -- $ 3,975
============= =============
</TABLE>
See accompanying notes to condensed financial statements.
4
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EXODUS COMMUNICATIONS, INC.
---------------------------
NOTES TO CONDENSED FINANCIAL STATEMENTS
---------------------------------------
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited condensed financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information, the instructions to Form 10Q and Article 10 of Regulation
S-X. Accordingly, they do not contain all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, the accompanying unaudited condensed
financial statements include all adjustments, consisting only of normal
recurring adjustments, necessary for the fair presentation of the Company's
financial position as of September 30, 1998 and the results of its operations
for the three and nine month periods ended September 30, 1998 and 1997 and its
cash flows for the nine months ended September 30, 1998 and 1997. These
financial statements should be read in conjunction with the Company's audited
financial statements as of December 31, 1997 and 1996 and for each of the three
years in the period ended December 31, 1997, including notes thereto, included
in the Company's final prospectus filed pursuant to Rule 424(b) under the
Securities Act of 1933, as amended, in connection with the Company's
Registration Statement on Form S-1 (File No. 333-44469). Operating results for
the nine month period ended September 30, 1998 are not necessarily indicative of
the results that may be expected for the year ending December 31, 1998.
NOTE 2 - NET LOSS PER SHARE
Basic and diluted net loss per share has been computed by dividing the net
loss attributable to common stockholders by the weighted average number of
shares of common stock outstanding. Diluted net loss per share for the nine
month periods ended September 30, 1998 and 1997 does not include the effect of
(i) 3,345,000 and 1,092,000 options outstanding as of September 30, 1998 and
September 30, 1997, respectively, (ii) 267,000 warrants to purchase common stock
and 961,000 warrants to purchase common and redeemable convertible preferred
stock, as of September 30, 1998 and September 30, 1997, respectively, and (iii)
11,987,000 shares (up to the date of the initial public offering) and 10,444,000
shares of redeemable convertible preferred stock on an "as if converted" basis
for the nine month periods ended September 30, 1998 and 1997, respectively, as
the effect of their inclusion is antidilutive during each period.
NOTE 3 - INITIAL PUBLIC OFFERING AND SENIOR NOTES
On March 24, 1998, the Company completed its initial public offering of
5,125,000 shares of its Common Stock (the "IPO"). Net proceeds to the Company,
after deducting underwriting discounts and commissions and offering expenses,
aggregated approximately $69,700,000. At the closing of the IPO, all redeemable
convertible preferred stock was converted to Common Stock on a one-for-three
basis. In connection with the IPO, certain warrant holders exercised their
warrants to purchase preferred stock (which converted into Common Stock), which
resulted in additional proceeds of $1,842,000.
On July 1, 1998, the Company issued $200 million of 11-1/4% Senior Notes due
2008 for aggregate net proceeds of approximately $194,000,000. Included in
restricted cash equivalents is approximately $42,900,000 which has been
deposited with an escrow agent that will pay, when due, the first four semi-
annual interest payments on the Senior Notes.
5
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NOTE 4 - REVENUE RECOGNITION
Revenues consist of monthly fees for server hosting, Internet connectivity,
collaborative systems management and Internet technology services, equipment
sales to customers and one-time fees for installation. Revenues (other than
installation fees and equipment sales to customers) are generally billed and
recognized ratably over the term of the contract, generally one year.
Installation fees are typically recognized at the time the installation occurs,
and equipment sales are typically recognized when the equipment is delivered to
the customer.
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment consisted of the following (in thousands):
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
-------- --------
<S> <C> <C>
Data centers and related equipment........................... $ 40,774 $ 16,316
Furniture, fixtures, computer equipment and other............ 21,181 12,815
--------- ---------
61,955 29,131
Less accumulated depreciation and amortization............... 12,340 3,961
--------- ---------
$ 49,615 $ 25,170
========= =========
</TABLE>
Computer equipment and certain data center equipment recorded under capital
leases aggregated $15,145,000 and $4,419,000 as of September 30, 1998 and
December 31, 1997, respectively. Accumulated amortization for the assets
recorded under capital leases aggregated $2,393,000 and $722,000 as of September
30, 1998 and December 31, 1997, respectively.
6
<PAGE>
NOTE 6 - BANK BORROWINGS, EQUIPMENT LOANS AND LINE OF CREDIT FACILITIES
The Company has a $7,000,000 bank line of credit bearing interest at the
bank's prime rate, which is collateralized by all of the Company's assets. The
bank line of credit expires in December 1998. No amount was outstanding under
the bank line of credit as of September 30, 1998.
A summary of equipment loans and line of credit facilities follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
---- ----
<S> <C> <C>
(IN THOUSANDS)
$850,000 equipment term loan with a financial institution;
prime rate plus 2.5% (11.0% as of June 30, 1998); principal
and interest due monthly for 42 months............................ $ -- $ 178
$1,800,000 equipment line of credit facility; effective interest
rate of approximately 16.4%; principal and interest due
monthly through September 2000; collateralized by
equipment......................................................... 1,094 1,393
$3,000,000 equipment line of credit facility; effective interest
rate of approximately 12.9%; principal and interest due
monthly through July 2001; collateralized by
equipment......................................................... 2,379 2,756
$6,500,000 equipment line of credit facility; effective interest
rate of approximately 15.9%; principal and interest due
monthly through July 2001; collateralized by
equipment......................................................... 5,194 6,312
$3,000,000 equipment line of credit facility; effective interest
rate of approximately 16.2%; principal and interest due
monthly through May 2001; collateralized by
equipment......................................................... 2,257 2,787
$5,000,000 equipment line of credit facility; effective interest
rate of approximately 16.2%; principal and interest due
monthly through September 2001; collateralized by
equipment......................................................... 3,371 3,044
$10,000,000 equipment line of credit facility; effective interest
rate of approximately 13.8%; principal and interest due
monthly through July 2002; collateralized by
equipment......................................................... 9,318 --
$8,000,000 line of credit facility; effective interest
rate of approximately 12.8%; principal and interest due
monthly through January 2000; collateralized by all of the
Company's assets.................................................. 8,000 --
-------------- ---------
31,613 16,470
Less current portion 14,076 3,777
-------------- ---------
Debt, less current portion $ 17,537 $ 12,693
============== =========
</TABLE>
7
<PAGE>
NOTE 7 - COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted the provisions of Statement
of Financial Accounting Standards (SFAS) No. 130, Reporting of Comprehensive
Income. SFAS No. 130 establishes standards for the reporting and display of
comprehensive income and its components in a full set of financial statements.
Comprehensive income includes all changes in equity during a period except those
resulting from the issuance of shares of stock and distributions to
stockholders. There were no material differences between net loss and
comprehensive loss during the three and nine months ended September 30, 1998 and
1997.
NOTE 8 - SUBSEQUENT EVENT
On October 2, 1998, the Company entered into an Asset Purchase Agreement with
CyberGuard Corporation under which it purchased substantially all of the assets,
including customer agreements, and assumed certain liabilities of Arca Systems,
Inc. ("Arca"), a wholly-owned subsidiary of CyberGuard Corporation. Arca is a
provider of advanced network and system security consulting services and designs
and develops security technology solutions for complex and sensitive information
systems. The Company also hired Arca's 43 employees. Arca will operate as a
wholly-owned subsidiary of the Company. The consideration paid to CyberGuard
Corporation in connection with the purchase of assets, together with amounts
paid to Arca employees in connection with their initial employment by the
Company and expenses associated with these transactions, amounted to an
aggregate of less than $8 million.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A
of the Securities Act of 1933, as amended. These forward-looking statements
involve a number of risks and uncertainties, including the timely expansion of
the Company's network and opening of additional Internet Centers and the ability
of the Company to execute its current business plan, retain customers, meet the
increasing requirements of existing customers and attract new customers and
other factors described throughout this Form 10-Q, including under "Revenues"
and "Other Factors That May Affect Future Operating Results," (referred to
herein as "Other Factors") and in the Company's final prospectus filed pursuant
to Rule 424(b) under the Securities Act of 1933, as amended, in connection with
the Company's Registration Statement on Form S-1 (File No. 333-44469) (the
"Final Prospectus"). The actual results that the Company achieves may differ
materially from any forward-looking statements due to such risks and
uncertainties. The forward-looking statements within this Form 10-Q are
identified by words such as "believes," "anticipates," "expects," "intends,"
"will," "may" and other similar expressions. In addition, any statements which
refer to expectations, projections or other characterizations of future events
or circumstances are forward-looking statements. In addition, the section
labeled "Other Factors That May Affect Future Operating Results" consists
primarily of forward-looking statements. The Company undertakes no obligation
to publicly release the results of any revisions to these forward-looking
statements which may be made to reflect events or circumstances occurring
subsequent to the filing of this Form 10-Q with the Securities and Exchange
Commission. Readers are urged to carefully review and consider the various
disclosures made by the Company in this report and in the Company's other
reports filed with the Securities and Exchange Commission, including its Final
Prospectus, that attempt to advise interested parties of the risks and factors
that may affect the Company's business.
8
<PAGE>
OVERVIEW
Exodus is a leading provider of Internet system and network management
solutions for enterprises with mission-critical Internet operations. The
Company's solutions include server hosting, Internet connectivity, collaborative
systems management and Internet technology services, which together provide the
high performance, scalability and expertise that enterprises need to optimize
Internet operations. The Company delivers its services from geographically
distributed, state-of-the-art Internet Data Centers that are connected through a
redundant high-performance national Internet backbone ring.
The Company is the successor to a Maryland Corporation that was formed in
August 1992 to provide computer consulting services. The Company began to offer
Internet connectivity services to enterprises in October 1994 and server hosting
services in late 1995. In August 1996, the Company opened its first dedicated
Internet Data Center and refocused its business strategy on providing Internet
system and network management solutions for enterprises with mission-critical
Internet operations. Since refocusing its business strategy, the Company has
derived most of its revenues (and substantially all of its growth in revenues)
from customers for which it provides these services. Each of the Company's
Internet Data Center customers initially purchases a subset of the Company's
service offerings to address specific departmental or enterprise Internet
computing needs, and some of these customers purchase additional services as the
scale and complexity of their Internet operations increase. The Company sells
its services under contracts that typically have terms of one year. Customers
pay monthly fees for the services utilized, as well as one-time fees for
installation and for any equipment that they choose to purchase from the
Company. Equipment revenue has represented less than 10% of total revenues for
each quarterly period beginning in 1997, and the Company expects equipment
revenues to remain less than 10% of total revenues going forward. However, the
foregoing forward-looking statement is subject to risks and uncertainties, such
as the level of customer equipment demands, which could cause actual results to
differ materially.
The Company opened its first Internet Data Center in the San Francisco
metropolitan area in August 1996. Since that time, the Company has opened seven
additional domestic Internet Data Centers in the metropolitan areas of New York
(March 1997), San Francisco (August 1997 and June 1998), Seattle (September
1997), Los Angeles (October 1997), Washington, D.C. (December 1997) and Boston
(July 1998) and has a server hosting facility in London. Additionally, the
Company plans to open Internet Data Centers in the Chicago metropolitan area in
the first quarter of 1999 and the London metropolitan area in the second quarter
of 1999 as well as additional Internet Data Centers in the Washington, D.C. and
Seattle metropolitan areas. See "Other Factors--Risks Associated with
Accelerated Business Expansion" for risks related to the foregoing forward-
looking statements. These facilities serve as a base for the array of solutions
offered by the Company, including server hosting, Internet connectivity,
collaborative systems management and Internet technology services. The building
of these Internet Data Centers has required the Company to obtain substantial
equity and debt financing. See "Other Factors--Substantial Leverage and Debt
Service" and "--Liquidity and Capital Resources" below.
Prior to building an Internet Data Center in a new a geographic region, the
Company employs various means to evaluate the market opportunity in a given
location, including the use of focus groups and market research on Internet
usage statistics, the pre-selling of services into the proposed market and
analysis of specific financial criteria. The Company typically requires at least
six months to select the appropriate location for an Internet Data Center,
construct the necessary facilities, install equipment and telecommunications
infrastructure, and hire the operations and sales personnel needed to conduct
business at that site. Expenditures related to an Internet Data Center commence
well before the Internet Data Center opens, and it takes an extended period to
approach break-even capacity utilization at each site. As a result, the Company
expects that individual Internet Data Centers will experience losses in excess
of one year from the time they are opened. The Company experiences further
losses from sales personnel hired to test market the Company's services in
markets where there is no, and may never be an, Internet Data Center. As a
result, the Company expects to make investments in expanding the Company's
business rapidly into new geographic regions which, while potentially increasing
the Company's revenues in the long term, will lead to
9
<PAGE>
significant losses for the foreseeable future. See "Other Factors--Risks
Associated with Accelerated Business Expansion" for risks related to the
foregoing forward-looking statements.
Since the Company began to offer server hosting services in 1995, it has
experienced operating losses and negative cash flows from operations in each
quarterly and annual period. As of September 30, 1998, the Company had an
accumulated deficit of approximately $75.6 million. The revenue and income
potential of the Company's business and market is unproven, and the Company's
limited operating history makes an evaluation of the Company and its prospects
difficult. Currently, the Company anticipates making significant investments in
new Internet Data Centers, product development and sales and marketing programs
and personnel and therefore believes that it will continue to experience net
losses on a quarterly and annual basis for the foreseeable future. The Company
and its prospects must be considered in light of the risks, expenses and
difficulties encountered by companies in the new and rapidly evolving market for
Internet system and network management solutions. See "Other Factors--Limited
Operating History; History of Losses" for risks related to the foregoing
forward-looking statements.
RESULTS OF OPERATIONS
The following table sets forth certain statement of operations data as a
percentage of total revenues for the three month and six month periods ended
September 30, 1998 and September 30, 1997. This information has been derived
from the Company's unaudited financial statements, which, in management's
opinion, have been prepared on substantially the same basis as the audited
financial statements and include all adjustments, consisting only of normal
recurring adjustments, necessary for a fair presentation of the financial
information for the quarters presented. This information should be read in
conjunction with the Financial Statements and Notes thereto included in the
Company's Final Prospectus. The operating results in any quarter are not
necessarily indicative of the results to be expected for any future period.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
------------------------------------ -------------------------------------
September 30, September 30, September 30, September 30,
1998 1997 1998 1997
------------------ ---------------- ----------------- ------------------
<S> <C> <C> <C> <C>
Revenues 100.0 % 100.0 % 100.0 % 100.0%
Costs and expenses:
Cost of revenues 113.6 134.9 124.2 127.1
Marketing and sales 47.6 95.6 64.7 102.1
General and administrative 26.7 42.0 30.1 47.0
Product development 6.5 14.9 7.2 14.7
---------- ---------- ---------- ----------
Total costs and expenses 194.4 287.4 226.2 290.9
---------- ---------- ---------- ----------
Operating loss (94.4) (187.4) (126.2) (190.9)
Net interest expense 27.7 3.0 16.2 3.2
---------- ---------- ---------- ----------
Net loss (122.1)% (190.4)% (142.4)% (194.1)%
</TABLE>
REVENUES
Revenues consist of (i) monthly fees for server hosting, Internet
connectivity, collaborative systems management and Internet technology services,
(ii) revenues from sales of third-party equipment to customers and (iii) one-
time fees for installation. Currently, substantially all of the Company's
revenue is derived from services fees. Revenues (other than installation fees
and equipment sales to customers) are generally billed and recognized ratably
over the term of the contract, generally one year. Installation fees are
typically recognized at the time the installation occurs, and equipment revenues
are typically recognized
10
<PAGE>
when the equipment is delivered to the customer or placed into service at an
Internet Data Center. The Company sells third-party equipment to its customers
as an accommodation to facilitate their purchase of services.
The Company's revenues increased 320% to $14.5 million for the three months
ended September 30, 1998 from $3.4 million in the same period of the prior year.
Revenues increased 322% to $31.6 million for the nine months ended September 30,
1998 from $7.5 in the same period of the prior year. This growth in revenues
resulted primarily from increases in the number of customers, increases in
revenues from existing customers and the opening of new Internet Data Centers.
COST OF REVENUES
The Company's cost of revenues is comprised primarily of the Company's
costs for its nationwide backbone network and local telco loops, salaries and
benefits for the Company's customer service and operations personnel (including
its network engineers, backbone engineers, network management and systems
personnel and installers), depreciation, rent, repairs and utilities related to
the Company's Internet Data Centers and costs of third-party equipment sold to
customers.
The Company's cost of revenues increased 254% to $16.4 million for the
three months ended September 30, 1998 from $4.6 million in the same period of
the prior year. Cost of revenues increased 312% to $39.3 million for the nine
months ended September 30, 1998 from $9.5 million in the same period of the
prior year. Cost of revenues as a percentage of revenues decreased to 114% and
124% for the three month and nine month periods ended September 30, 1998, from
135% and 127% for the same respective periods of the prior year. These declines
were due to the Company's significant increase in revenues between the
comparison periods. The Company expects that cost of revenues will continue to
increase in absolute dollars but will continue to decline as a percentage of
total revenue as existing fixed costs are spread over more substantial
operations and as the Company realizes operating efficiencies associated with
its increased levels of operations. The increases in cost of revenues in
absolute dollars were primarily the result of costs associated with the opening
of additional Internet Data Centers, including the hiring of additional
employees, and the Company's expansion and increased capacity of its nationwide
backbone network. The Company expects that its cost of revenues as a percentage
of revenues may remain above 100% through most of the first half of 1999.
MARKETING AND SALES
The Company's marketing and sales expenses are comprised primarily of
salaries and benefits for the Company's marketing and sales personnel, printing
and advertising costs, public relations costs, consultants' fees and travel and
entertainment expenses. The Company's marketing and sales expenses increased
109% and 167% to $6.9 million and $20.5 million (including a one-time non-cash
charge of $525,000 related to a warrant issued to At Home Corporation in the
first quarter of 1998 in connection with a distribution alliance) for the three
month and nine month periods ended September 30, 1998 from $3.3 million and $7.7
million in the same respective periods of the prior year. Marketing and sales
expenses increased as a result of increased marketing and sales personnel,
increased training, travel and entertainment expenses for sales personnel,
increased costs for marketing collateral, and increased public relations
expenses. Marketing and sales expenses as a percentage of revenues decreased to
48% and 65% for the three month and nine month periods ended September 30, 1998,
compared to 96% and 102% for the same respective periods of the prior year.
These declines were due primarily to increased recurring revenues from existing
customers, which tend to have lower marketing and sales associated with them, as
well as the Company's general significant increase in revenues between the
comparison periods. The Company expects that marketing and sales expenses will
continue to increase in absolute dollars but will continue to decline as a
percentage of total revenues as recurring revenues from the existing customers,
which tend to have lower marketing and sales expenses associated with them,
become a more significant percentage of total revenues. However, the foregoing
forward-looking statement is subject to risks and uncertainties, which may cause
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actual results to differ, such as risks associated with the Company's
achievement of anticipated levels of revenues and expenses, and the impact of
competition. See "Other Factors--Competition"; "--Dependence on New Market;
Uncertainty of Acceptance of Services."
GENERAL AND ADMINISTRATIVE
The Company's general and administrative expenses are comprised primarily
of salaries and benefits for the Company's administrative and management
information systems personnel and fees paid for professional services and
recruiting. The Company's general and administrative expenses increased 167% and
170% to $3.9 million and $9.5 million for the for the three month and nine month
periods ended September 30, 1998, respectively, from $1.4 million and $3.5
million in the same respective periods of the prior year. General and
administrative expenses increased in absolute dollars as a result of additional
personnel and increased professional and recruiting services. General and
administrative expenses as a percentage of revenues decreased to 27% and 30% for
the three months and nine months ended September 30, 1998, respectively, from
42% and 47% in the same respective periods of the prior year. These declines
were due to the Company's significant increase in revenues between the
comparison periods. The Company expects that general and administrative
expenses will continue to increase in absolute dollars but will continue to
decline as a percentage of total revenues as existing overhead is spread over
more substantial operations. However, the foregoing forward-looking statement
is subject to risks and uncertainties, which may cause actual results to differ
materially, such as risks associated with the Company's achievement of
anticipated levels of revenues and expenses. See "Other Factors--Potential
Fluctuations in Operating Results."
PRODUCT DEVELOPMENT
The Company's product development expenses are comprised primarily of
salaries and benefits for the Company's product development personnel and fees
paid to consultants, all of whom focus their efforts primarily on the
integration of best-of-breed products and services developed by leading
technology vendors with the Company's services and the development of the
Company's proprietary technologies. The Company's product development expenses
increased 83% and 109% to $935,000 and $2.3 million for the three month and nine
month periods ended September 30, 1998, respectively, from $512,000 and $1.1
million in the same respective periods of the prior year. Product development
expenses increased in absolute dollars as a result of additional personnel and
the increase in fees paid to consultants. Product development expenses as a
percentage of revenues decreased to 6% and 7% for the three month and nine
month periods ended September 30, 1998, respectively, from 15% in the same
respective periods of the prior year. These declines were due to the Company's
significant increase in revenues between the comparison periods. The Company
expects that product development expenses will continue to increase in
absolute dollars as the Company makes additional investments in developing
proprietary technology, particularly related to its collaborative systems
management services, but will decline as a percentage of total revenues as
existing costs are spread over a larger revenue base. However, the foregoing
forward-looking statement is subject to risks and uncertainties that may cause
actual results to differ materially, such as risks associated with the
Company's achievement of anticipated levels of revenues and expenses. See
"Other Factors-Potential Fluctuations in Operating Results."
NET INTEREST EXPENSE
The Company's net interest expense increased to $4.0 million and $ 5.1
million for the three month and nine month periods ended September 30, 1998,
respectively, from $105,000 and $242,000 in the same periods of the prior year.
The increases in net interest expense between the comparison periods was
primarily the result of interest expenses associated with the Company's $200
million 11 1/4% Senior Notes (the "Senior Notes") which were issued July 1,
1998, substantially increased borrowings as the Company entered into equipment
loans and lease agreements to finance the construction of its Internet Data
Centers, and working capital lines of credit to finance working capital for its
operations. The Company expects that
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net interest expense will continue to increase as the Company enters into
additional equipment leases and loans and obtains additional borrowings and as
interest income is reduced resulting from the decline in the Company's cash
reserves to fund working capital and other uses.
DEFERRED COMPENSATION EXPENSE
The Company's deferred compensation expense increased to $329,000 and $1.3
million for the three month and nine month periods ended September 30, 1998 from
$85,000 in the same periods of the prior year. The Company has recorded deferred
stock compensation in connection with the grant of certain stock options and
stock from March 1997 through May 1998. Deferred compensation expense associated
with the grant of stock options is generally being amortized over the 50 month
vesting period of such options. This amortization is being recorded in a manner
consistent with FASB Interpretation No. 28. These amortization amounts are
allocated among the expense categories discussed above.
EBITDA
The Company's loss before interest, taxes, depreciation, amortization and
other non-cash charges ("EBITDA") increased to $9.4 million and $29.5 million
for the three month and nine month periods ended September 30, 1998,
respectively, from a loss of $5.6 million and $12.5 million in the same
respective periods of the prior year. The increase in the level of EDITDA
losses between the comparison periods was primarily due to increased
expenditures needed to support the Company's growth in operations, including
salaries and benefits for additional employees, network costs, rent, utilities
and other costs related to the increase in the number of Company's Internet Data
Centers as well as increased marketing and sales expenses, consulting fees and
professional services. Although EBITDA should not be used as an alternative to
operating loss or net cash provided by (used for) operating activities,
investing activities or financing activities, each as measured under generally
accepted accounting principles, the Company's management believes that EBITDA is
an additional meaningful measure of performance and liquidity.
LIQUIDITY AND CAPITAL RESOURCES
Since inception and through September 30, 1998, the Company has financed its
operations primarily through private sales of preferred stock, its initial
public offering in March 1998, its Senior Notes and through various types of
equipment loans and lease lines and working capital lines of credit. At
September 30, 1998, the principal sources of liquidity for the Company was $191
million of cash and cash equivalents. As of that date, the Company also had
equipment loans and lease lines and working capital lines of credit under which
it could borrow up to an additional aggregate of $6.2 million for purchases of
equipment and for working capital. As of September 30, 1998, the Company's total
bank borrowings, equipment loans and lines of credit facilities, capital lease
obligations and Senior Notes were $244.3 million. See Notes 2 and 6 of Notes to
Financial Statements. In addition, the Company expects to enter into a credit
facility with Goldman Sachs Credit Partners L.P. (the "Credit Facility"), under
which the Company will be permitted to borrow up to approximately $25.0 million
or up to approximately $50.0 million upon meeting certain financial tests. The
Credit Facility is expected to be secured by a first priority lien on
substantially all of the Company's assets (subject to certain exceptions) and
the assets and stock of any future subsidiaries. The Credit Facility is subject
to the satisfaction of certain material conditions precedent and the specific
terms of the Credit Facility are subject to change pursuant to final loan
documentation. There can be no assurance as to whether, or on what terms, the
Company will enter into the Credit Facility.
Since the Company began to offer server hosting services in 1995, the
Company has had significant negative cash flows from operating activities. Net
cash used for operating activities for the nine months ended September 30, 1998
was $31.2 million, primarily due to net losses, offset in part by increases in
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accrued expenses and accounts payable and depreciation and amortization. This
compares to net cash used for operating activities for the nine months ended
September 30, 1997 of $9.5 million, primarily due to net losses, offset in part
by increases in accounts payable.
Net cash used for investing activities for the nine months ended September
30, 1998 was $26.5 million compared to $14.8 million for the nine months ended
September 30, 1997. Net cash used for investing activities was due to capital
expenditures for the continued construction of Internet Data Centers, leasehold
improvements, furniture and fixtures, and computers and other equipment. Cash
provided by financing activities for the nine months ended September 30, 1998
was $238.5 million, primarily due to the proceeds from the Company's issuance of
$200 million Senior Notes and its initial public offering. This compares to net
cash provided by financing activities for the nine months ended September 30,
1997 of $24.4 million due primarily to the proceeds of the issuance of preferred
stock and warrants.
As of September 30, 1998, the Company had commitments under capital leases
and under noncancellable operating leases of $12.7 million and $92.5 million,
respectively, through 2010. The Company intends to make significant expenditures
during the next 12 months primarily for property and equipment, in particular
equipment needed for existing and future Internet Data Centers, as well as
office equipment, computers and telephones. The Company expects to finance such
capital expenditures primarily through existing and future equipment loans and
lease lines, net proceeds from the Senior Notes and borrowings under the
expected Credit Facility. The Company expects to meet its working capital and
capital expenditure requirements over the next 12 months with existing cash and
cash equivalents and short-term investments, the proceeds from the Senior Notes,
borrowings under the expected Credit Facility, cash from sales of services and
proceeds from existing and future working capital lines of credit. The Company
may enter into additional equipment loans and capital leases. The Company may
also seek to raise additional funds through public or private financing,
strategic relationships or other arrangements. There can be no assurance that
the Company will be successful generating sufficient cash flows from operations
or raising capital in sufficient amounts on terms acceptable to it. See "Risk
Factors--Risks Associated with Accelerated Business Expansion."
OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
As referenced in the first paragraph of this Item 2, this section consists
primarily of forward-looking statements and accompanying risks. In addition to
the factors set forth above, the following additional factors may affect the
Company's future operating results.
LIMITED OPERATING HISTORY; HISTORY OF LOSSES. While the Company began
operations in 1992, it did not offer server hosting services until 1995 and did
not open its first dedicated Internet Data Center until August 1996, at which
time it refocused its business strategy on providing Internet system and network
management solutions for enterprises' mission-critical Internet operations. As a
result, the Company's business model is still in an emerging state. Since it
began to offer server hosting services in 1995, the Company has experienced
operating losses and negative cash flows from operations in each quarterly and
annual period. The revenue and income potential of the Company's business and
market is unproven, and the Company's limited operating history makes an
evaluation of the Company and its prospects difficult. Currently, the Company
anticipates making significant investments in new Internet Data Centers and
product development and sales and marketing programs and personnel and therefore
believes that it will continue to experience net losses on a quarterly and
annual basis for the foreseeable future. The Company and its prospects must be
considered in light of the risks, expenses and difficulties encountered by
companies in the new and rapidly evolving market for Internet system and network
management solutions. To address these risks, among other things, the Company
must market its brand name effectively, provide scaleable, reliable and cost-
effective services, ensure and enhance customer satisfaction, continue to grow
its infrastructure to accommodate new Internet Data Centers and increased
bandwidth use of its network, expand its channels of distribution, retain and
motivate qualified personnel and continue to respond to competitive
developments. Failure of the Company's services to achieve market acceptance
would have a
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material adverse effect on the Company's business, results of operations and
financial condition. Although the Company has experienced significant growth in
revenues in recent periods, the Company does not believe that this growth rate
necessarily is indicative of future operating results, and there can be no
assurance that the Company will ever achieve profitability on a quarterly or an
annual basis or will sustain profitability if achieved.
POTENTIAL FLUCTUATIONS IN OPERATING RESULTS. The Company has experienced
significant fluctuations in its results of operations on a quarterly and an
annual basis. The Company expects to continue to experience significant
fluctuations in its future quarterly and annual results of operations due to a
variety of factors, many of which are outside the Company's control, including:
demand for and market acceptance of the Company's services and enhancements;
introductions of services or enhancements by the Company and its competitors;
capacity utilization of its Internet Data Centers; reliable continuity of
service and network availability; the ability to increase bandwidth as
necessary, both on the Company's network and at its interconnection points with
other networks; the costs associated with increasing bandwidth on the Company's
network and at its interconnection points with other networks; the timing of
customer installations; providing customer discounts and credits; the mix of
services sold by the Company; customer retention and satisfaction; the timing
and success of marketing efforts and service introductions by the Company; the
timing and magnitude of capital expenditures, including construction costs
relating to the expansion of operations; the timely expansion of existing
Internet Data Centers and completion of new Internet Data Centers; costs related
to the acquisition of backbone capacity; the introduction by third parties of
new Internet and networking technologies; increased competition in the Company's
markets; changes in the pricing policies of the Company and its competitors;
fluctuations in bandwidth used by customers; the retention of key personnel;
economic conditions specific to the Internet industry; and other general
economic factors. In addition, a relatively large portion of the Company's
expenses are fixed in the short-term, particularly with respect to
telecommunications, depreciation, certain substantial interest expenses, real
estate and interest expenses and personnel, and therefore the Company's
operating results are particularly sensitive to fluctuations in revenues. Also,
if the Company's agreement with Computer Associates International, Inc.
("Computer Associates") were to terminate and the Company continued to require
Computer Associates' software, the license fees paid by the Company could
increase fixed costs significantly. Furthermore, if the Company were to become
unable to continue leveraging third party products in the Company's services
offerings, the Company's product development costs could increase significantly.
Although the Company has not encountered significant difficulties in collecting
upon accounts receivable in the past, many of the Company's customers are in an
emerging stage, and there can be no assurance that the Company will be able to
collect receivables on a timely basis. For these and other reasons, in some
future quarters, the Company's results of operations may fall below the
expectations of securities analysts or investors, which could have a material
adverse effect on the market price of the Company's Common Stock.
RISKS ASSOCIATED WITH ACCELERATED BUSINESS EXPANSION. A key element of the
Company's business strategy is the expansion of the Company's network through
the opening of additional Internet Data Centers in geographically diverse
locations. The Company currently has eight Internet Data Centers located in six
metropolitan areas: San Francisco (3), New York, Los Angeles, Seattle,
Washington, D.C. and Boston and has a server hosting facility in the London
metropolitan area. The Company intends to expand domestically and
internationally, including the expected addition of Internet Data Centers in
Chicago metropolitan area in the first quarter of 1999 and the London
metropolitan area in the second quarter of 1999 as well as additional Internet
Data Centers in the Washington, D.C. and Seattle metropolitan areas. The
Company's continued expansion and development of its network will depend on,
among other things, the Company's ability to assess markets, identify Internet
Data Center sites, install facilities and establish local peering
interconnections with Internet service providers ("ISPs"), all in a timely
manner, at reasonable costs and on terms and conditions acceptable to the
Company. The Company's ability to manage this expansion effectively will require
it to continue to implement and improve its operational and financial systems
and to expand, train and manage its employee base. The Company's inability to
establish additional Internet Data
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Centers or manage effectively its expansion would have a material adverse effect
upon the Company's business, results of operations and financial condition.
The establishment of each additional Internet Data Center will require the
Company to expend substantial resources for leases of real estate, significant
improvements of such facilities, purchase of equipment, implementation of
multiple telecommunications connections and hiring of network, administrative,
customer support and sales and marketing personnel. The failure to generate
sufficient cash flows from sales of services or to raise sufficient funds from
outside sources may require the Company to delay or abandon some or all of its
development and expansion plans or otherwise forego market opportunities and may
make it difficult for the Company to respond to competitive pressures, any of
which could have a material adverse effect on the Company's business, results of
operations and financial condition. See "--Liquidity and Capital Resources."
The Company expects to make investments in expanding the Company's business
rapidly into new geographic regions which, while potentially increasing the
Company's revenues in the long term, will lead to significant losses for the
foreseeable future. See "Overview." There can be no assurance that the Company
will be able to anticipate accurately the customer demand for such additional
Internet Data Centers or that the Company will be able to attract a sufficient
number of customers to such facilities. The Company's inability to attract
customers to new Internet Data Centers in a timely manner, or at all, would have
a material adverse effect on the Company's business, results of operations and
financial condition.
UNPROVEN NETWORK SCALABILITY. The Company must continue to expand and
adapt its network infrastructure (both its network and its interconnections to
other networks) as the number of users and the amount of information they wish
to transport increase and to meet changing customer requirements. The expansion
and adaptation of the Company's telecommunications infrastructure will require
substantial financial, operational and management resources as the Company
negotiates telecommunications capacity with its existing and other network
infrastructure suppliers and interconnection capacities with other ISPs. The
Company is expanding significantly and rapidly its network infrastructure due to
increased usage, and as a result additional stress is being placed upon the
Company's network hardware and traffic management systems as well as the
capacity of the networks of the ISPs with which it interconnects. Due to the
limited deployment of the Company's services to date, the ability of the
Company's network to connect and manage a substantially larger number of
customers at high transmission speeds is as yet unknown, and the Company faces
risks related to the network's ability to be scaled up to its expected customer
levels while maintaining superior performance. As customers' usage of bandwidth
increases, the Company will need to make additional investments in its
infrastructure, including interconnections, to maintain adequate downstream data
transmission speeds, the availability of which may be limited or the cost of
which may be significant. The ability of the Company to increase its
interconnections depends largely on the ability and willingness of other ISPs,
which are outside of the control of the Company. In addition, as the Company
adds new customers that have significant bandwidth needs, it may be required to
increase quickly its network capacity which may be difficult in light of current
lead times within the industry for adding capacity and interconnections. There
can be no assurance that additional network capacity and interconnections will
be available from third-party suppliers and ISPs as it is needed by the Company.
As a result, there can be no assurance that the Company's network will be able
to achieve or maintain a sufficiently high capacity of data transmission,
especially if the usage of the Company's customers increases. The Company's
failure to achieve or maintain high capacity data transmission circuits and
sufficient interconnections could significantly reduce consumer demand for its
services, because of possible degradation of service, and have a material
adverse effect on its business, results of operations and financial condition.
In addition, as the Company upgrades its telecommunications infrastructure to
increase bandwidth available to its customers, it is likely to encounter a
certain level of equipment or software incompatibility, which may cause delays
in implementation. There can be no assurance that the Company will be able to
expand or adapt its telecommunications infrastructure to meet additional demand
or its customers' changing requirements, including its plans to add OC-12
circuits, on a timely basis and at a commercially reasonable cost, or at all.
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DEPENDENCE UPON NETWORK INFRASTRUCTURE. The Company's success will depend
upon the capacity, scalability, reliability and security of its network
infrastructure, including the capacity leased from its telecommunications
network suppliers. In particular, the Company is dependent on WorldCom and Qwest
and certain other telecommunications providers for its backbone capacity
(including the Company's dedicated clear channel network and transit access to
ISPs) and is therefore dependent on such companies to maintain the operational
integrity of its backbone and interconnections. In addition, the Company relies
on a number of public and private peering interconnections to deliver its
services. If the carriers that operate the Internet exchange points ("IXPs")
were to discontinue their support of the peering points and no alternative
providers were to emerge, or such alternative providers were to increase the
cost of utilizing the IXPs, the distribution of content through the IXPs,
including content distributed by the Company, would be significantly
constrained. Furthermore, as traffic through the IXPs increases, if commensurate
increases in bandwidth are not added, the Company's ability to distribute
content rapidly and reliably through these networks will be adversely affected.
Many of the companies with which the Company maintains private interconnections
are competitors of the Company and may not be cooperative in responding to the
Company's requests to increase interconnection points and capacities. If these
organizations were to refuse to continue to interconnect directly with the
Company, or begin to impose additional costs (including fees) on the Company to
maintain and/or increase these interconnections, the Company might be required
to purchase transit access services to these ISPs in order to allow the
Company's customers to reach the customers of these ISPs, which would increase
the Company's costs and as a result the Company's business, results of
operations and financial condition could be materially adversely affected.
SUBSTANTIAL LEVERAGE AND DEBT SERVICE. The Company has significant amounts
of outstanding indebtedness and interest cost. The Company's level of
indebtedness presents various risks, including the possibility that the Company
may be unable to generate cash sufficient to pay the principal of and interest
on the indebtedness when due. At September 30, 1998, the Company's total bank
borrowings, debt and capital lease obligations were approximately $244.3 million
and its borrowings available under existing equipment loans and working capital
lines of credit was approximately $6.2 million, subject to the borrowing
conditions contained therein. In addition, the Company will have the right to
issue additional Notes on or prior to July 1, 1999 in an aggregate principal
amount not to exceed $75.0 million. Furthermore, the Company expects to enter
into a new secured Credit Facility, and the Notes would be effectively
subordinated to any borrowings under the Credit Facility. The Company expects
to incur additional equipment loans and lease lines to finance capital
expenditures for its Internet Data Centers and may obtain additional working
capital lines of credit and lease lines.
The Company's ability to make principal and interest payments on the Senior
Notes, and service other existing and future indebtedness, will be dependent on
the Company's future operating performance, which is itself dependent on a
number of factors, many of which are outside of the Company's control. These
factors include prevailing economic conditions and financial, competitive,
legislative, regulatory and other factors affecting the Company's business and
operations, and may be dependent on the availability of borrowings under the
expected Credit Facility or other borrowings. Although the Company believes,
based on current levels of operations, that its cash flow from operations,
together with other sources of liquidity, will be adequate to make required
payments of principal and interest on its debt (including the Senior Notes),
whether at or prior to maturity, finance anticipated capital expenditures and
fund working capital requirements, there is no assurance in this regard. If the
Company is unable to generate sufficient cash flow from operations, or obtain
additional equipment loans or equipment and working capital lines of credit, in
the future to service its debt, it may be required to sell assets, reduce
capital expenditures, refinance all or a portion of its existing indebtedness or
obtain other sources of financing. There can be no assurance that any such
refinancing would be available on commercially reasonable terms, or at all, or
that any other financing could be obtained, particularly in view of the
Company's high level of indebtedness and the fact that substantially all of the
Company's assets have been pledged to secure obligations under certain existing
indebtedness.
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The degree to which the Company is leveraged could have important
consequences to the Company's future operations, including but not limited to:
(i) increasing the Company's vulnerability to general adverse economic and
industry conditions; (ii) limiting the Company's ability to obtain additional
financing to fund future working capital, capital expenditures, acquisitions and
other general corporate requirements; (iii) requiring the dedication of a
substantial portion of the Company's cash flow from operations to the payment of
principal of, and interest on, its indebtedness, thereby reducing the
availability of such cash flow to fund working capital, capital expenditures or
other general corporate requirements; (iv) limiting the Company's flexibility in
planning for, or reacting to, changes in its business and the industry in which
it competes; and (v) placing the Company at a competitive disadvantage vis-a-vis
less leveraged or better capitalized competitors. Certain of the Company's
indebtedness are secured by the Company's assets. A default under such
indebtedness could result in the foreclosure on such collateral, which would
have a material adverse effect on the Company's business, results of operations
and financial condition.
RISKS ASSOCIATED WITH FINANCING ARRANGEMENTS. Certain of the Company's
existing financing arrangements are secured by substantially all of the
Company's assets. These financing arrangements require that the Company satisfy
certain financial covenants and currently prohibit the payment of dividends and
the repurchase of capital stock of the Company without, in each case, the
lender's consent. The Company's secured lenders would be entitled to foreclose
upon those assets in the event of a default under the financing arrangements and
to be repaid from the proceeds of the liquidation of those assets before the
assets would be available for distribution to the holders of the Senior Notes or
equity securities in the event that the Company is liquidated. In addition, the
collateral security arrangements under the Company's existing financing
arrangements may adversely affect the Company's ability to obtain additional
borrowings.
COMPETITION. The market served by the Company is intensely competitive,
and such competition is increasing. There are few substantial barriers to entry,
and the Company expects that it will face additional competition from existing
competitors and new market entrants in the future. The principal competitive
factors in this market include Internet system engineering expertise, customer
service, network capability and connectivity to other networks, reliability,
quality of service and scalability, broad geographic presence, brand name,
technical expertise and functionality, the variety of services offered, the
ability to maintain and expand distribution channels, customer support, price,
the timing of introductions of new services, network security, financial
resources and conformity with industry standards.
The Company's current and potential competitors in the market include: (i)
providers of server hosting services; (ii) national and regional ISPs; (iii)
global, regional and local telecommunications companies and Regional Bell
Operating Companies ("RBOCs"); and (iv) large IT outsourcing firms. Many of the
Company's competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than the
Company. As a result, certain of these competitors may be able to develop and
expand their network infrastructures and service offerings more quickly, adapt
to new or emerging technologies and changes in customer requirements more
quickly, take advantage of acquisition and other opportunities more readily,
devote greater resources to the marketing and sale of their products and adopt
more aggressive pricing policies than can the Company.
Certain of the Company's competitors may be able to provide customers with
additional benefits in connection with their Internet system and network
management solutions, including reduced communications costs, which could reduce
the overall costs of their services relative to the Company's. There can be no
assurance that the Company will be able to offset the effects of any such price
reductions. In addition, the Company believes that the businesses with which
the Company competes are likely to
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encounter consolidation in the near future, which could result in increased
price and other competition that could have a material adverse effect on the
Company's business, results of operations and financial condition.
DEPENDENCE ON NEW MARKET; UNCERTAINTY OF ACCEPTANCE OF SERVICES. The
market for Internet system and network management solutions has only recently
begun to develop, is evolving rapidly and likely will be characterized by an
increasing number of market entrants. There is significant uncertainty
regarding whether this market ultimately will prove to be viable or, if it
becomes viable, that it will grow. The Company's future growth, if any, will be
dependent on the willingness of enterprises to outsource the system and network
management of their mission-critical Internet operations and the Company's
ability to market its services in a cost-effective manner to a sufficiently
large number of customers. In addition, in order to be successful in this
emerging market, the Company must be able to differentiate itself from its
competition through its service offerings, such as its collaborative systems
management and Internet technology services and through quality of service.
There can be no assurance that the Company will be successful in differentiating
itself or achieving market acceptance of its services, or that it will not
experience difficulties that could delay or prevent the successful development,
introduction or marketing of these services. If the Company incurs increased
costs or is unable, for technical or other reasons, to develop and introduce new
services or enhancements of existing services in a timely manner, or if new
products or services do not achieve market acceptance in a timely manner or at
all, the Company's business, results of operations and financial condition could
be materially adversely affected.
RISK OF SYSTEM FAILURE. The Company's operations are dependent upon its
ability to protect its network infrastructure and customers' equipment against
damage from human error, fire, earthquakes, floods, power loss,
telecommunications failures, sabotage, intentional acts of vandalism and similar
events. Despite precautions taken by, and planned to be taken by the Company,
the occurrence of a natural disaster or other unanticipated problems at one or
more of the Company's Internet Data Centers could result in interruptions in the
services provided by the Company or significant damage to customer equipment.
In addition, failure of any of the Company's telecommunications providers, such
as WorldCom and Qwest Communications Corporation ("Qwest"), to provide the data
communications capacity required by the Company, as a result of human error, a
natural disaster or other operational disruption, could result in interruptions
in the Company's services. Any damage to or failure of the systems of the
Company or its service providers could result in reductions in, or terminations
of, services supplied to the Company's customers, which could have a material
adverse effect on the Company's business, results of operations and financial
condition. In addition, the Company's reputation could be materially adversely
affected. The Company has from time to time experienced interruptions in
specific circuits within its network resulting from events outside the Company's
control, which interruptions have caused short-term degradation in the level of
performance of the Company's network. Should the Company incur significant
obligations in connection with system downtime in the future, there can be no
assurance that the Company's liability insurance would be adequate to cover such
expenses.
DEPENDENCE ON THE INTERNET AND INTERNET INFRASTRUCTURE DEVELOPMENT. The
increased use of the Internet for retrieving, sharing and transferring
information among businesses, consumers, suppliers and partners has only
recently begun to develop, and the Company's success will depend in large part
on continued growth in the use of the Internet. Critical issues concerning the
commercial use of the Internet, including security, reliability, cost, ease of
access, quality of service and necessary increases in bandwidth availability,
remain unresolved and are likely to affect the development of the market for the
Company's services. If the Internet as a commercial or business medium fails to
develop or develops more slowly than expected, the Company's business, results
of operations and financial condition could be materially adversely affected.
The recent growth in the use of the Internet has caused frequent periods of
performance degradation, requiring the upgrade of routers and switches,
telecommunications links and other components forming the infrastructure of the
Internet by ISPs and other organizations with links to the Internet. Any
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perceived degradation in the performance of the Internet as a whole could
undermine the benefits of the Company's services.
RAPID TECHNOLOGICAL CHANGE; EVOLVING INDUSTRY STANDARDS. The Company's
future success will depend, in part, on its ability to offer services that
incorporate leading technology, address the increasingly sophisticated and
varied needs of its current and prospective customers and respond to
technological advances and emerging industry standards and practices on a timely
and cost-effective basis. The market for the Company's services is characterized
by rapidly changing and unproven technology, evolving industry standards,
changes in customer needs, emerging competition and frequent new service
introductions. There can be no assurance that future advances in technology will
be beneficial to, or compatible with, the Company's business or that the Company
will be able to incorporate such advances on a cost-effective and timely basis
into its business. Moreover, technological advances may have the effect of
encouraging certain of the Company's current or future customers to rely on in-
house personnel and equipment to furnish the services currently provided by the
Company. In addition, keeping pace with technological advances in the Company's
industry may require substantial expenditures and lead time.
The Company believes that its ability to compete successfully is also
dependent upon the continued compatibility and interoperability of its services
with products, services and architectures offered by various vendors. Although
the Company often works with various vendors in testing newly developed
products, there can be no assurance that such products will be compatible with
the Company's infrastructure or that such products will adequately address
changing customer needs. Although the Company currently intends to support
emerging standards, there can be no assurance that industry standards will be
established or, that if they become established, the Company will be able to
conform to these new standards in a timely fashion and maintain a competitive
position in the market. In addition, there can be no assurance that products,
services or technologies developed by others will not render the Company's
services uncompetitive or obsolete.
SYSTEM SECURITY RISKS. A significant barrier to electronic commerce and
communications is the secure transmission of confidential information over
public networks. Certain of the Company's services rely on encryption and
authentication technology licensed from third parties to provide the security
and authentication necessary to effect secure transmission of confidential
information. Despite the Company's design and implementation of a variety of
network security measures, there can be no assurance that unauthorized access,
computer viruses, accidental or intentional actions and other disruptions will
not occur. The Company's Internet Data Centers have in the past experienced and
may in the future experience delays or interruptions in service as a result of
the accidental or intentional actions of Internet users, current and former
employees or others. Furthermore, such inappropriate use of the network by
third parties could also potentially jeopardize the security of confidential
information, such as credit card, bank account numbers and other information,
that is electronically transmitted between the Company and its customers or
stored in the computer systems of the Company and its customers, which could
result in liability to the Company and the loss of existing customers or the
deterrence of potential customers. Although the Company intends to continue to
implement industry-standard security measures as well as other security
measures, such measures have been circumvented in the past, and there can be
no assurance that any such measures implemented by the Company will not be
circumvented in the future. The costs required to eliminate computer viruses
and alleviate other security problems could be prohibitively expensive and the
efforts to address such problems could result in interruptions, delays or
cessation of service to the Company's customers, which could have a material
adverse effect on the Company's business, results of operations and financial
condition.
DEPENDENCE ON THIRD-PARTY SUPPLIERS. The Company is dependent on other
companies to supply certain key components of its telecommunications
infrastructure and system and network management solutions, including
telecommunications services and networking equipment that, in the quantities and
quality demanded by the Company, are available only from sole or limited
sources. See "--Dependence Upon Network Infrastructure." The routers, switches
and modems used in the Company's telecommunications infrastructure are currently
supplied primarily by Cisco Systems Inc. ("Cisco"). The Company
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purchases these components pursuant to purchase orders placed from time to time,
does not carry significant inventories of these components and has no guaranteed
supply arrangements with these vendors. Any failure to obtain required products
or services on a timely basis and at an acceptable cost would have a material
adverse effect on the Company's business, results of operations and financial
condition. In addition, any failure of the Company's sole or limited source
suppliers to provide products or components that comply with evolving Internet
and telecommunications standards or that interoperate with other products or
components used by the Company in its communications infrastructure could have a
material adverse effect on the Company's business, results of operations and
financial condition. In addition, the Company expects to be dependent for a time
on third parties to deliver its services from and manage its international
operations, including its site in London.
The Company has also licensed certain software from Computer Associates
which allows the Company to monitor its customers' Internet operations and
assist in resolving performance issues that arise from time to time. Under the
agreement with Computer Associates, if the Company desires to offer a service
that has a substantially similar functionality to that provided by Computer
Associates' Unicenter(R) TNG(TM) family of software, or its ARCserve or InocuLAN
products (the "CA Products"), the Company must generally utilize the CA
Products, as long as they meet the Company's requirements. In addition, the
Company is a beta test site for new versions of the CA Products and must, upon
commercial deployment, replace existing software with new CA Products if they
are substantially similar in functionality. During the term of the agreement,
the Company is obligated to pay Computer Associates a royalty equal to one
percent of the Company's gross revenues. Either party may terminate this
agreement upon 60 days' prior written notice with no penalties. Should Computer
Associates or the Company decide to terminate this agreement, the Company has
the right to continue licensing software from Computer Associates at a forty
percent discount from Computer Associates' prevailing standard prices for five
years and the Company will no longer be obligated to pay a royalty to Computer
Associates.
MANAGEMENT OF GROWTH. The Company is currently experiencing a period of
rapid growth with respect to the building of its Internet Data Centers,
expansion of its customer base and increase in the number of Company employees.
This growth has placed, and if it continues, will place, a significant strain on
the Company's financial, management, operational and other resources, including
its ability to ensure customer satisfaction. In addition, the Company may be
required to manage multiple relationships with a growing number of third parties
as it seeks to complement its service offerings. There can be no assurance that
the Company's management, personnel, systems, procedures and controls will be
adequate to support the Company's existing and future operations. The Company's
ability to manage its growth effectively will require it to continue to expand
its operating and financial procedures and controls, to replace or upgrade its
operational, financial and management information systems and to attract, train,
motivate, manage and retain key employees. The Company has recently hired many
key employees and officers, including its President and Chief Executive Officer,
its Vice President, Marketing and Strategy and its Vice President, Engineering,
and as a result, the Company's entire management team has worked together for
only a brief time. If the Company's executives are unable to manage growth
effectively, the Company's business, results of operations and financial
condition could be materially adversely affected.
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES. The Company is not
currently subject to direct federal, state or local government regulation, other
than regulations applicable to businesses generally. There is currently only a
small body of laws and regulations directly applicable to access to or commerce
on the Internet. However, due to the increasing popularity and use of the
Internet, it is possible that a number of laws and regulations may be adopted at
the federal, state and local levels with respect to the Internet, covering
issues such as user privacy, freedom of expression, pricing, characteristics and
quality of products and services, taxation, advertising, intellectual property
rights, information security and the convergence of traditional
telecommunications services with Internet communications. In addition,
applicability to the Internet of existing laws governing issues such as property
ownership, copyrights and other intellectual property issues, taxation, libel,
obscenity and personal privacy is uncertain. The vast majority of such laws
were adopted prior to the advent of the Internet and related technologies and,
as a result, do not contemplate
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or address the unique issues of the Internet and related technologies. Changes
to such laws intended to address these issues, including some recently proposed
changes, could create uncertainty in the marketplace which could reduce demand
for the services of the Company or increase the cost of doing business as a
result of costs of litigation or increased service delivery costs, or could in
some other manner have a material adverse effect on the Company's business,
results of operations and financial condition. In addition, as the Company's
services are available over the Internet in multiple states and foreign
countries, and as the Company facilitates sales by its customers to end users
located in such states and foreign countries, such jurisdictions may claim that
the Company is required to qualify to do business as a foreign corporation in
each such state or foreign country. Any such new legislation or regulation, or
the application of laws or regulations from jurisdictions whose laws do not
currently apply to the Company's business, could have a material adverse effect
on the Company's business, results of operations and financial condition.
RISKS ASSOCIATED WITH INFORMATION DISSEMINATED THROUGH THE COMPANY'S
NETWORK. The law relating to the liability of online services companies and
Internet access providers for information carried on or disseminated through
their networks is currently unsettled. It is possible that claims could be made
against online services companies and Internet access providers under both
United States and foreign law for defamation, negligence, copyright or trademark
infringement, or other theories based on the nature and content of the materials
disseminated through their networks. Also, certain businesses, organizations
and individuals have in the past sent unsolicited commercial e-mails from
servers hosted at the Company's facilities to massive numbers of people,
typically to advertise products or services. This practice, known as
"spamming," can lead to complaints against service providers that enable such
activities, particularly where recipients view the materials received as
offensive. In addition, certain ISPs and other online services companies could
deny network access to companies that allow undesired content or spamming to be
transmitted through their networks. The Company has in the past received, and
may in the future receive, letters from recipients of information transmitted by
the Company's customers objecting to such transmission. Although the Company
prohibits its customers by contract from spamming, there can be no assurance
that its customers will not engage in this practice, which could have a material
adverse effect on the Company's business, results of operations and financial
condition.
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS. A component of the
Company's long-term strategy is to expand into international markets, and the
Company recently opened a site in the London metropolitan area. If revenue
generated by any current or future international Internet Data Center is not
adequate to offset the expense of establishing and maintaining any such
international operation, the Company's business, results of operations and
financial condition could be materially adversely affected. There can be no
assurance that the Company will be able to market, sell and deliver successfully
its services outside the United States. In order to expand its international
operations, the Company may, among other things, enter into joint ventures or
outsourcing agreements with third parties, acquire rights to high-bandwidth
transmission capability, acquire complementary businesses or operations, or
establish and maintain new operations outside of the United States. In addition,
the rate of development and adoption of the Internet has been slower outside of
the United States, and the cost of bandwidth has been higher, which may
adversely affect the Company's ability to expand its operations and may increase
its cost of operations internationally. In addition to the uncertainty as to
the Company's ability to expand into international markets, there are certain
risks inherent in conducting business internationally, such as unexpected
changes in regulatory requirements, export restrictions, tariffs and other trade
barriers, challenges in staffing and managing foreign operations, differing
technology standards, employment laws and practices in foreign countries, longer
payment cycles, problems in collecting accounts receivable, political
instability, fluctuations in currency exchange rates, imposition of currency
exchange controls, seasonal reductions in business activity and potentially
adverse tax consequences, any of which could adversely affect the Company's
international operations. Furthermore, certain foreign governments, such as
Germany, have enforced laws and regulations related to content distributed over
the Internet that are more strict than those currently in place in the United
States.
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DEPENDENCE ON KEY PERSONNEL. The Company's success depends in significant
part upon the continued services of its key technical, sales and senior
management personnel, including the Company's Chairman of the Board of
Directors, K.B. Chandrasekhar. The Company's future success will also depend on
its ability to attract, train, retain and motivate highly qualified technical,
marketing, sales and management personnel. There can be no assurance that the
Company will be able to attract and retain key personnel. The loss of the
services of one or more of the Company's key employees or the Company's failure
to attract additional qualified personnel could have a material adverse effect
on the Company's business, results of operations and financial condition.
RISKS ASSOCIATED WITH ACQUISITIONS. The Company believes that its future
growth depends, in part, upon the acquisition of complementary businesses,
products, services or technologies. There can be no
assurance that the Company will successfully identify, acquire on favorable
terms or integrate such businesses, products, services or technologies. The
Company may face competition for acquisition opportunities, which may inhibit
the Company's ability to consummate suitable acquisitions and increase the
costs of completing and the time required to complete such acquisitions. Any
such acquisitions, including its recent acquisition of Arca Systems, will
require the Company to manage and integrate such acquired businesses, products,
services or technologies, coordinate (and possibly change) the diverse operating
structures, policies and practices of the acquired entities and to integrate new
employees into the Company's organization and culture. Failure to integrate and
manage acquired businesses, products, services and technologies successfully
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, acquisitions by the Company
may result in the incurrence of additional debt, large one-time write-offs and
the creation of goodwill or other intangible assets that could result in
amortization expenses. These factors could have a material adverse effect on the
Company's business, results of operations and financial condition.
RISKS ASSOCIATED WITH LEGAL PROCEEDINGS. From time to time the Company has
been, and expects to continue to be, subject to legal proceedings and claims in
the ordinary course of its business, including, among others, contractual
disputes with vendors and customers, claims by employees and claims of alleged
infringement of the trademarks and other intellectual property rights of third
parties by the Company. Such claims, even if not meritorious, could result in
the expenditure of significant financial and managerial resources.
PROTECTION AND ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS. The Company
relies on a combination of copyright, trademark, service mark and trade secret
laws and contractual restrictions to establish and protect certain proprietary
rights in its products and services, but there can be no assurance that the
measures taken by the Company will be sufficient to prevent misappropriation of
its technology. The Company currently has no patented technology that would
preclude or inhibit competitors from entering the Company's market. The laws of
certain foreign countries may not protect the Company's products, services or
intellectual property rights to the same extent as do the laws of the United
States. The Company also relies on certain technologies that it licenses from
third parties, such as Computer Associates. There can be no assurance that
these third-party technology licenses will continue to be available to the
Company on commercially reasonable terms. The loss of such technology could
require the Company to obtain substitute technology of lower quality or
performance standards or at greater cost, which could materially adversely
affect the Company's business, results of operations and financial condition.
The Company has determined increasingly to develop or acquire additional
proprietary intellectual property in addition to licensing technologies from
third parties. The Company may from time to time receive notices from third
parties suggesting or claiming infringement by the Company with respect to
current or future products, particularly if such products or services include
one or more of the Company's own proprietary technologies. The Company expects
that participants in its markets will be increasingly subject to infringement
claims as the number of products and services and competitors in the Company's
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industry segment grows. Any such claim, whether meritorious or not, could be
time-consuming, result in costly litigation, cause product installation delays
or require the Company to enter into royalty or licensing agreements.
YEAR 2000 RISKS. The Year 2000 problem stems from the use of a two digit
date field to represent the year (e.g., 85=1985) in computer software and
firmware. As a result, many currently installed computer systems are not
capable of distinguishing dates beginning with the year 2000 from dates prior to
the year 2000. Software so created may be unable to properly address dates
after 1999. As a result, computer systems or applications used by many
companies in a wide variety of industries may experience operating difficulties
unless the systems or applications are modified to process information related
to the date change adequately. Significant uncertainty exists in the software
and other industries concerning the scope and magnitude of problems associated
with the century change. To the extent Year 2000 issues cause significant delay
in, or cancellation of decisions to purchase the Company's products or product
support, due to the reallocation of resources to address Year 2000 issues or
otherwise, the Company's business, results of operations and financial condition
could be materially adversely affected. In addition, any costs of defending and
resolving any Year 2000 related disputes, and any liability of the Company for
Year 2000-related damages, including consequential damages, could have a
material adverse effect on the Company's business, results of operations and
financial condition.
Exodus' Year 2000 Risk Management Initiative. The Company recognizes the
need to ensure its operations will not be adversely impacted by Year 2000
issues. As such, the Company has put into place a comprehensive Year 2000 Risk
Management initiative that is adequately funded, staffed and managed. This
initiative's scope covers both the Company's information technology (IT) systems
and non-IT systems and addresses all areas of the Year 2000 issues as defined by
the Information Technology Association of America (ITAA). The program has
several phases that overlap, all of which will be completed with issues
identified to be resolved by the end of the third quarter of 1999. The
Company's internal assessment of the Year 2000 issues is expected to be
complete by December 1998. At the conclusion of the assessment, the Company
plans to remedy any identified Year 2000 issues and test the solutions adopted
during the first quarter of 1999. In the second quarter of 1999, the Company
plans to have an independent review completed of its Year 2000 assessment with
final Year 2000 compliance expected in the third quarter of 1999.
The Company has established procedures for evaluating and managing the risks
and costs associated with this problem. Funding and execution for this
initiative is within the Company's existing business units and operating budgets
and is not viewed as material. Based on its current assessment, the Company
estimates that its costs (excluding employee personnel time and effort) to
resolve its Year 2000 issues (other than unanticipated liabilities) should not
exceed $500,000. The Company further estimates that the time and effort required
of Company personnel to resolve Year 2000 issues will not be material.
The Company's Year 2000 initiative specifically addresses processes and methods
in eleven focused areas:
. Assess Situation
.. Understand the scope and magnitude of Year 2000 problems to the
Company's organizational systems and operations.
.. Define the Company's objective for Year 2000 compliance, develop
an inventory of the Company's systems, assess the impact of Year
2000 on these systems, and identify candidate solutions for
addressing Year 2000 problems.
. Analyze Candidate Solutions
.. Perform studies and analyses resulting in the selection of a
solution to meet the Year 2000 problem and its defined
constraints.
.. Define approach and evaluation criteria for the analysis, select
the candidate solutions, and implementation.
. Plan Technical Effort
.. Establish plans that provide the basis for scheduling, costing,
controlling, tracking and negotiation the nature and scope of
technical work involved in transitioning a system to Year 2000
compliance.
.. Develop estimates for the work to be performed, obtain necessary
commitments from interfacing groups, and define plan to perform
the work.
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. Monitor and Control Technical Effort
.. Provide adequate visibility into actual progress and risks.
.. Involves directing, tracking, and reviewing the project's
accomplishments, results and risks against its documented
estimates, commitments and plans.
. Ensure Quality
.. Address not only the quality of Year 2000 compliant systems but
also the quality of the process used to produce those systems.
.. Involves objective verification of a project's activities with
respect to its plans and work products (e.g. code) to the
Company's standards.
. Manage Configurations
.. Maintain data on identified configuration units and analyze and
control changes to the systems and its configuration units.
.. Provide accurate and current configuration data to internal
Company personnel and external vendors for all work products
placed under configuration management.
. (Re)Engineer Products/Data
.. Consistently perform a well-defined engineering process that
integrates all engineering activities involved in
developing/converting products/services meeting the requirements
for Year 2000 compliance as defined by the Company.
.. Specify change requirements for Year 2000 compliant systems,
develop designs to accommodate those requirements, implement the
corresponding designs in software and perform testing of those
implementations.
. Integrate Systems
.. Ensure that system elements, and the system as a whole will
function in accordance with requirements when the elements operate
in conjunction with each other and with other external systems.
.. Identify, define and control interfaces.
.. Verify system functions whose successful operation involves more
than one system element throughout the entire product life cycle.
. Verify and Validate Systems
.. Ensure that the development/supplier team performs increasingly
comprehensive evaluations to ensure evolving work products meet
all requirements.
.. Scope covers development of the full system/service, as well as
its production, operation, delivery and support.
.. Measures customer loyalty on the basis of the customer's
operational needs and continues throughout product/service life.
. Oversee and Manage Subcontracts
.. Ensure that acquisition (outsourcing) of services for development
of Year 2000 compliant software keeps risks to an acceptable
minimum.
.. Ensure that both the operation of the software resulting from such
contracts and the data processing by the products under such
contracts meets the Company's requirements for Year 2000
compliance.
. Oversee and Manage Acquisitions
.. Ensure that acquisitions of commercial off-the-shelf tools and/or
software for Year 2000 compliance keeps risks to an acceptable
minimum.
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.. Ensure that both operation of the software resulting from such
contracts and the data processed by the products under such
contracts meets the Company's requirements for Year 2000
compliance.
The above eleven focus areas provide an instrument for analyzing the
Company's organizational process to assure the Company's preparedness for Year
2000 business operations. It also reviews both technical and managerial
practices to ensure effective management of the Year 2000 conversion or
compliant-product development process. Lastly, the Company sees this as an
effective process for identifying the Company's strengths and weaknesses with
respect to Year 2000 practices. Results of the Company's YEAR 2000 initiative
to date in specific target area is as follows.
Company Services and Products. The Company has determined that its
Internet Data Center equipment is either currently Year 2000 compliant or that a
funded replacement/upgrade plan is in place to resolve known issues. Likewise,
based on the on-going assessment relative to its current software service
offerings, the Company believes that the current versions of these products are
either "Year 2000 compliant" or will not require substantial effort or cost to
make them Year 2000 compliant by the end of the third quarter of 1999. The
Company is also in the process of a complete asset inventory and final asset
analysis assessment. This review is being conducted to re-validate previous Year
2000 assessments conducted by the management of the Company's individual
departments. These departmental programs and assessments are now part of a
coordinated unified company-wide Year 2000 initiative.
Company Vendor Relations. The Company's Year 2000 initiative also
addresses its vendor relationships (both IT and non-IT) and their
readiness/preparedness relating to Year 2000 issues. IT vendors include
software providers, hardware providers, service providers, off the shelf
software publishers and IT consultants. Non-IT providers include but are not
limited to electric power suppliers, vendors of uninterruptable power supplies
and generators, telcommunications service providers, business partners,
facilities maintainers and other non-IT service contractors. The Company
recognizes that it faces additional risk to the extent that suppliers of
products, services and systems purchased by the Company and others with whom the
Company transacts business are not Year 2000 compliant. In the event that any
such third parties cannot provide the Company with products, services or systems
that are Year 2000 compliant on a timely basis (or in the event that Year 2000
issues prevent such third parties from delivering products, services or systems
required by the Company on a timely basis), the Company's business, results of
operations and financial condition could be materially adversely affected.
To date, the Company has not discovered nor does it anticipate any material
issues with its vendors and service providers. Evaluation of vendor Year 2000
preparedness is an on-going process. As the Company's Year 2000 evaluation does
not evaluate our vendors' vendors nor our vendors' customer base viability
issues, the Company will be developing contingency plans as it deems necessary
to address specific vendor/service provider concerns.
Internal Operations. The Company has reviewed, and continues to review,
its internal management information and other systems in order to identify and
modify those products, services or systems that may not be Year 2000 compliant.
Based on its assessment to date, the Company believes that its internal
management information and other systems are either Year 2000 compliant or will
not require substantial effort or cost to make them Year 2000 compliant. The
Company does not foresee any issues with its internal IT and internal non-IT
systems being Year 2000 compliant by the end of the third quarter of 1999.
Company Customer Risks. Many of the Company's customers maintain their
Internet operations on servers which may be impacted by Year 2000 complications.
The failure of the Company's customers to ensure that their servers are Year
2000 compliant could have a material adverse effect on the Company's customers,
which in turn could have a material adverse effect on the Company's business,
results of operations and financial condition if its customers are forced to
cease or interrupt Internet operations or if its customers experience
malfunctions related to their equipment which in turn affect the overall
operations of the Company.
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Year 2000 Risk Summary. While the Company believes its Year 2000 initiative
to be prudent, properly funded and staffed and well-managed, there can be no
assurance that the Company will identify and remedy all Year 2000 problems in a
timely fashion, that any remedial efforts in this regard will not involve
significant time and expense, or that such problems will not have a material
adverse effect on the Company's business, results of operations and financial
condition.
VOLATILITY OF STOCK PRICE. The market price of the shares of Common Stock
is highly volatile and is subject to wide fluctuations in response to factors
such as actual or anticipated variations in the Company's results of operations,
announcements of technological innovations or new Internet Data Centers, new
products or services introduced by the Company or its competitors, changes in
financial estimates by securities analysts, conditions and trends in the
Internet, general market conditions and other factors. Further, the stock
markets, and in particular the Nasdaq National Market, have experienced extreme
price and volume fluctuations that have particularly affected the market prices
of equity securities of many technology companies and that often have been
unrelated or disproportionate to the operating performance of such companies.
The trading prices of many technology companies' stocks are at or near
historical highs and reflect price to earnings ratios substantially above
historical levels. There can be no assurance that these trading prices and
price to earnings ratios will be sustained. These market fluctuations, as well
as general economic, political and market conditions such as recessions,
interest rates or international currency fluctuations, may adversely affect the
market price of the Common Stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable.
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ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company's initial public offering of Common Stock was effected through
a Registration Statement on Form S-1 (File No. 333-44469) that was declared
effective by the SEC on March 18, 1998 and pursuant to which the Company sold an
aggregate of 5,125,000 shares of its Common Stock.
As of September 30, 1998, the Company had used the estimated aggregate net
proceeds of $69,743,750 from its initial public offering as follows:
Construction of plant, building and facilities: $1.0 million
Purchase and installation of machinery and equipment: $1.7 million
Purchases of real estate: $ 0
Acquisition of other businesses: $ 0
Repayment of indebtedness: $3.5 million
Working capital: $23.3 million
Temporary investments (short term, interest bearing
treasury securities): $40.2 million
Other purposes: $ 0
The foregoing amounts represent the Company's best estimate of its use of
proceeds for the period indicated. No such payments were made to directors or
officers of the Company or their associates, holders of 10% or more of any class
of equity securities of the Company or to affiliates of the Company.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
On October 2, 1998, the Company entered into an Asset Purchase Agreement
with CyberGuard Corporation under which it purchased substantially all of the
assets, including customer agreements, and assumed certain liabilities of Arca
Systems, Inc. ("Arca"), a wholly-owned subsidiary of CyberGuard Corporation.
Arca is a provider of advanced network and system security consulting services
and designs and develops security technology solutions for complex and sensitive
information systems. The Company also hired Arca's 43 employees. Arca will
operate as a wholly-owned subsidiary of the Company. The consideration paid to
CyberGuard Corporation in connection with the purchase of assets, together with
amounts paid to Arca employees in connection with their initial employment by
the Company and expenses associated with these transactions, amounted to an
aggregate of less than $8 million.
On September 1, 1998, K.B. Chandrasekhar resigned as the Company's Chief
Executive Officer and Ellen M. Hancock was appointed to serve in that position.
K.B. Chandrasekhar continues to serve as the Company's Chairman of the Board of
Directors.
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On October 26, 1998, B.V. Jagadeesh, the Company's Vice President,
Engineering, resigned from that position and was appointed as the Company's
Chief Technology Officer. On October 26, 1998, James McInerney was appointed to
the position of Vice President, Engineering.
On November 2, 1998, Susan Farber was appointed to the position of Vice
President, Marketing and Strategy. Effective November 2, 1998, Ellen M. Hancock
ceased serving in the role of acting Vice President, Marketing.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8K
a. Exhibits
Exhibit No. Description of Exhibit
----------- ----------------------
10.38* Lease Agreement dated August 1998 between Reynolds Metals
Development Company and Registrant.
10.39* Building Lease dated September 1998 between Centerpoint
Properties Trust and Registrant.
10.40* Sublease Agreement dated September 4, 1998 between S3,
Incorporated and Registrant.
27.1 Financial Data Schedule
__________________
* Incorporated by reference from the exhibit bearing the same number in
the Company's Registration Statement on Form S-4 (File No. 333-62413).
b. Reports on Form 8-K
Not applicable.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
EXODUS COMMUNICATIONS, INC.
November 13, 1998 /s/ Ellen M. Hancock
- ----------------------------- --------------------------------------
Date Ellen M. Hancock
President, Chief Executive Officer
and Director
November 13, 1998 /s/ Richard S. Stoltz
- ----------------------------- --------------------------------------
Date Richard S. Stoltz
Chief Financial Officer and
Chief Operating Officer
(Duly Authorized Officer and Chief
Accounting Officer)
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Exhibit Index
-------------
Exhibit No. Description of Exhibit
----------- ----------------------
10.38* Lease Agreement dated August 1998 between Reynolds Metals
Development Company and Registrant.
10.39* Building Lease dated September 1998 between Centerpoint
Properties Trust and Registrant.
10.40* Sublease Agreement dated September 4, 1998 between S3,
Incorporated and Registrant.
27.1 Financial Data Schedule
__________________
* Incorporated by reference from the exhibit bearing the same number in
the Company's Registration Statement on Form S-4 (File No. 333-62413).
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
BALANCE SHEET, STATEMENT OF OPERATIONS AND STATEMENT OF CASH FLOWS INCLUDED IN
THE COMPANY'S FORM 10-Q FOR THE NINE MONTH PERIOD ENDED SEPTEMBER 30, 1998, AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 191,047
<SECURITIES> 0
<RECEIVABLES> 9,371
<ALLOWANCES> (409)
<INVENTORY> 165
<CURRENT-ASSETS> 204,604
<PP&E> 61,955
<DEPRECIATION> (12,339)
<TOTAL-ASSETS> 307,149
<CURRENT-LIABILITIES> 41,598
<BONDS> 0
0
0
<COMMON> 19
<OTHER-SE> 39,057
<TOTAL-LIABILITY-AND-EQUITY> 307,149
<SALES> 1,459
<TOTAL-REVENUES> 31,638
<CGS> 1,107
<TOTAL-COSTS> 39,291
<OTHER-EXPENSES> 32,285
<LOSS-PROVISION> 500
<INTEREST-EXPENSE> 5,120
<INCOME-PRETAX> (45,057)
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (45,057)
<EPS-PRIMARY> (3.32)
<EPS-DILUTED> (3.32)
</TABLE>
