<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 000-20799
EARTHLINK NETWORK, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4481766
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
3100 NEW YORK DRIVE, PASADENA, CALIFORNIA 91107
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(626) 296-2400
(REGISTRANT'S TELEPHONE, INCLUDING AREA CODE)
____________________
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
____________________
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
--- ---
There were 11,223,238 shares of Common Stock outstanding
as of September 30, 1997.
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<PAGE>
EARTHLINK NETWORK, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1997
TABLE OF CONTENTS
PART I
Item 1. Financial Statements and Supplementary Data...................... 1
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 6
Item 3. Quantitative and Qualitative Disclosures About Market Risk....... 11
Item 4. Submission of Matters to a Vote of Security Holders.............. 11
PART II
Item 6. Exhibits and Reports on Form 8-K................................. 11
<PAGE>
PART I
ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
EARTHLINK NETWORK, INC.
BALANCE SHEET
ASSETS
DECEMBER 31, 1996 SEPTEMBER 30, 1997
----------------- ------------------
(AUDITED) (UNAUDITED)
(in thousands)
Current assets:
Cash and cash equivalents $ 3,993 $ 17,089
Restricted short-term investment 1,087 1,250
Accounts receivable, net 1,725 3,067
Prepaid expenses 885 1,215
Other assets 1,383 938
-------- --------
Total current assets 9,073 23,559
Other long-term assets 329 425
Property and equipment, net 17,401 22,772
Intangibles, net 316 1,350
-------- --------
$ 27,119 $ 48,106
-------- --------
-------- --------
LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Trade accounts payable $ 11,207 $ 5,657
Accrued payroll and related expenses 1,469 2,168
Other accounts payable and
accrued liabilities 2,061 3,813
Current portion of capital lease
obligations 3,582 6,303
Notes payable 7,950 7,252
Deferred revenue 2,010 3,049
-------- --------
Total current liabilities 28,279 28,242
Long-term portion of capital lease
obligations 6,088 7,851
-------- --------
Total liabilities 34,367 36,093
-------- --------
Mandatorily redeemable convertible
preferred stock 14,013 -
Stockholders' equity (deficit):
Common stock 60 112
Additional paid-in capital 14,236 70,784
Warrants to purchase common stock 599 599
Accumulated deficit (36,156) (59,482)
-------- --------
Total stockholders' equity (deficit) (21,261) 12,013
-------- --------
$ 27,119 $ 48,106
-------- --------
-------- --------
The accompanying notes are an integral part of these financial statements
1
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EARTHLINK NETWORK, INC.
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
1996 1997 1996 1997
--------- --------- --------- ---------
(UNAUDITED)
(in thousands, except per share data)
<S> <C> <C> <C> <C>
Revenues:
Recurring revenues $ 8,272 $ 19,044 $ 15,914 $ 50,609
Other revenues 1,744 1,559 4,248 4,558
--------- --------- --------- ---------
Total Revenues 10,016 20,603 20,162 55,167
Operating costs and expenses:
Cost of recurring revenues 6,173 9,543 11,736 26,685
Cost of other revenues 693 741 2,020 2,460
Sales and marketing 4,395 5,636 9,867 15,653
General and administrative 3,783 3,511 7,838 10,462
Operations and member support 4,749 7,970 9,941 22,183
--------- --------- --------- ---------
19,793 27,401 41,402 77,443
--------- --------- --------- ---------
Loss from operations (9,777) (6,798) (21,240) (22,276)
Interest expense (422) (516) (683) (1,467)
Interest income 94 116 114 416
--------- --------- --------- ---------
Net loss $ (10,105) $ (7,198) $ (21,809) $ (23,327)
--------- --------- --------- ---------
--------- --------- --------- ---------
Net loss per share $ (1.44) $ (0.72) $ (3.32) $ (2.43)
--------- --------- --------- ---------
--------- --------- --------- ---------
Weighted average shares 7,006 9,932 6,568 9,593
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements
2
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EARTHLINK NETWORK, INC.
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- -----------------------
1996 1997 1996 1997
---------- ---------- ----------- ----------
(UNAUDITED)
(in thousands)
<S> <C> <C> <C> <C>
Net cash used in operating activities $ (3,989) $ (4,048) $ (11,070) $ (20,252)
-------- -------- --------- ---------
Cash flows from investing activities:
Purchases of property and equipment (4,007) (2,522) (13,596) (11,490)
Purchase of member base - (48) - (1,404)
Purchase of restricted short-term
investment (296) (200) (296) (200)
Liquidation of restricted short-term
investment 454 - 1,500 38
-------- -------- --------- ---------
Net cash used in investing
activities (3,849) (2,770) (12,392) (13,056)
-------- -------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of notes payable - 981 2,950 2,252
Repayment of notes payable - - - (2,225)
Repayment of line of credit - - (1,494) -
Proceeds from capital lease
obligations 2,174 2,512 9,220 7,837
Principal payments under capital
lease obligations (861) (1,274) (1,489) (3,354)
Proceeds from issuance of Mandatorily
Redeemable Convertible
Preferred Stock, net 14,013 14,013
Proceeds from issuance of Common
Stock, net - 15,523 8,660 41,894
-------- -------- --------- ---------
Net cash provided by financing
activities 15,326 17,742 31,860 46,404
-------- -------- --------- ---------
Net increase in cash and cash
equivalents 7,488 10,924 8,398 13,096
Cash and cash equivalents, beginning
of period 1,200 6,165 290 3,993
-------- -------- --------- ---------
Cash and cash equivalents, end
of period $ 8,688 $ 17,089 $ 8,688 $ 17,089
-------- -------- --------- ---------
-------- -------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements
3
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The condensed financial statements of EarthLink Network, Inc.
("EarthLink" or the "Company") for the three month and nine month periods
ended September 30, 1997 and the related footnote information are unaudited
and have been prepared on a basis substantially consistent with the Company's
audited financial statements as of December 31, 1996 contained in the
Company's Annual Report on Form 10-K as filed with the Securities and
Exchange Commission (the "Annual Report"). These financial statements should
be read in conjunction with the audited financial statements and the related
notes thereto contained in the Company's Annual Report. In the opinion of
management, the accompanying unaudited financial statements contain all
adjustments (consisting of normal recurring adjustments) which management
considers necessary to present fairly the financial position of the Company
at September 30, 1997 and the results of operations and the cash flows for
the three month and nine month periods ended September 30, 1996 and 1997.
The results of operations for the three month and nine month periods ended
September 30, 1997 are not necessarily indicative of the results for the
entire year ending December 31, 1997.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements.
Actual results may differ from those estimates.
2. RECLASSIFICATION
Certain amounts in the prior year financial statements have been
reclassified to conform to the current year presentation.
3. NET LOSS PER SHARE
For the three month and nine month periods ended September 30, 1997,
options to purchase shares of Common Stock, warrants to purchase shares of
Common Stock and debt instruments convertible into shares of Common Stock are
excluded from the calculation as their effect is antidilutive. Pursuant to
Securities and Exchange Commission Staff Accounting Bulletins, Common Stock
and Common Stock equivalent shares issued by the Company at prices below the
Company's initial public offering price during the twelve month period prior
to the Company's initial public offering, which was effective on January 22,
1997, have been included in the calculation for the three month and nine
month periods ended September 30, 1996 as if they were outstanding for all
periods prior to the initial public offering, regardless of whether they are
dilutive using the treasury stock method. Accordingly, all common stock
equivalents are included in the earnings per share calculations for the three
month and nine month periods ended September 30, 1996, even though the effect
on net loss is antidilutive. The Series A Convertible Preferred Stock shares
have been included for the respective weighted average periods for which such
shares were outstanding, even though their effect is antidilutive.
4. INCENTIVE STOCK OPTION GRANTS
On July 29, 1997 the Company granted incentive stock options to purchase
47,250 shares of Common Stock at $10.75 per share. The options were granted
pursuant to the Company's 1995 Stock Option Plan.
4
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS
5. AMENDMENT OF AGREEMENT WITH UUNET
In October 1997, the Company's Network Service agreement with UUNET
Technologies, Inc. ("UUNET") was amended. Among other terms, UUNET agreed to
waive certain minimum monthly revenue requirements and excess hours fees
through December 31, 1997. The parties further agreed to make reasonable and
good faith efforts to negotiate a new five year agreement to be entered into
no later than December 31, 1997 and EarthLink agreed not to exercise its
early termination clause prior to September 1, 1998. In conjunction with this
amendment, the parties also amended their Note Purchase Agreement and $5
million Convertible Note to extend the term of the Note one year to October
31, 1998. However, the Note will become due and payable immediately if the
monthly amounts payable under the amended Network Service Agreement are less
$1.5 million during any consecutive three months. The Note is convertible
into a maximum of 391,500 shares of Common Stock at a conversion price of
$12.88 per share.
6. PRIVATE PLACEMENT
On September 19, 1997, the Company closed a private placement of
1,459,759 shares of its unregistered restricted Common Stock. Net proceeds
from the offering were approximately $15.5 million. The financing was
offered and sold solely to accredited investors. The Company intends to use
these proceeds for general working capital purposes.
7. RETURN OF NATIONAL MEDIA WARRANTS
In May 1996, the Company entered into an agreement with National Media
Corporation ("NMC") pursuant to which NMC was to produce two television
direct advertisements. For the production and airing of the advertisements,
EarthLink issued warrants to NMC to purchase 50,000 shares of Common Stock at
$9.76 per share, and was to issue warrants to purchase one share of Common
Stock for each two members generated by this relationship, up to 300,000
shares of Common Stock. In September 1997, the parties agreed to rescind the
agreement. The rescission includes the return of the 50,000 warrants and the
cancellation of any future obligations of either party.
5
<PAGE>
This report contains certain forward-looking statements with respect to
the Company's operations, industry, financial condition and liquidity. These
statements, which are typically introduced by phrases such as "the Company
believes", "anticipates", "estimates" or "expects" certain conditions to
exist, reflect management's best current assessment of a number of risks and
uncertainties. The Company's actual results could differ materially from the
results anticipated in these forward-looking financial statements as a result
of certain factors described in this report.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE ACCOMPANYING
UNAUDITED CONDENSED FINANCIAL STATEMENTS AND RELATED NOTES THERETO AND THE
AUDITED FINANCIAL STATEMENTS AND THE NOTES THERETO.
OVERVIEW
EarthLink Network, Inc. ("EarthLink" or the "Company") is an Internet
service provider ("ISP") formed to help its members derive meaningful
benefits from the extensive resources of the Internet. The Company focuses on
providing access, information, assistance and services to its members to
encourage their introduction to the Internet and to help them have a
satisfying user experience.
The Company has experienced net losses in each quarter since it commenced
operations. The Company expects that it is likely to continue to incur net
losses as it continues to expend substantial resources to build its
infrastructure, develop new service and product offerings and build its sales
and marketing and administrative organizations. The Company's operating
results have fluctuated significantly in the past and will likely continue to
fluctuate significantly in the future as a result of a variety of factors.
EarthLink's principal strategy is to rapidly expand its member base and
increase its market share. To realize this strategy, the Company is
continuing to invest in sales and marketing, increase its member support
capabilities, enhance its network operations capacity to meet member demand
and add administrative infrastructure. This strategy requires substantial
cash outlays.
The Company believes that its long-term success largely depends on
maintaining member satisfaction with its services. EarthLink continues to
devote significant resources to enhancing its network operations capability,
World Wide Web site and service offerings. In addition, the Company
continues to expand its technical support staff and enhance the staff's
effectiveness by providing software tools that can assist the staff in
identifying and solving member problems.
The Company provides Internet access service to a large number of
consumers and small businesses. The Company has recently expanded its
consumer service offerings, adding a Personal Start Page-TM-, integrated an
"plug-and-play" Web site software package, the Arena-TM- which features
pay-per-play multi-player Internet games, international roaming service,
56kbps modem access, and high-speed cable access in certain parts of
California. In addition, the Company provides a variety of services for
business members, including business Web sites, high-speed LAN ISDN
communications capability, and frame relay connections, each of which involve
a monthly service charge plus set-up fees.
In order to maintain its focus on member needs, the Company has leveraged
the infrastructure and software development efforts of others by leasing POP
capacity from UUNET Technologies, Inc. ("UUNET") and PSINet, Inc. ("PSINet")
and licensing software from developers such as Netscape Communications
Corporation and Microsoft Corporation. The Company believes that this
approach gives it flexibility to rapidly expand its service coverage without
the need for substantial capital expenditures. The Company will continue to
pursue this strategy so that, in addition to its sales and marketing efforts,
it can devote its principal resources to improving its members' experience
with the Internet.
6
<PAGE>
RESULTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------------------ -----------------------------------------------
PERCENT PERCENT PERCENT PERCENT
OF TOTAL OF TOTAL OF TOTAL OF TOTAL
1996 REVENUE 1997 REVENUE 1996 REVENUE 1997 REVENUE
---------- -------- ---------- -------- ---------- -------- --------- ---------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total Revenues $ 10,016 100% $ 20,603 100% $ 20,162 100% $ 55,167 100%
Total Cost of Revenues 6,866 69% 10,284 50% 13,756 68% 29,145 53%
Gross Profit 3,150 31% 10,319 50% 6,406 32% 26,022 47%
Loss from Operations (9,777) 98% (6,798) 33% (21,240) 105% (22,276) 40%
Net Loss (10,105) 101% (7,198) 35% (21,809) 108% (23,327) 42%
EBITDA (1) $ (8,213) 82% $ (4,285) 21% $ (18,467) 92% $ (15,705) 28%
</TABLE>
(1) Represents earnings before depreciation and amortization, interest income
and expense and income tax expense. EBITDA is not determined in
accordance with generally accepted accounting principals, is not
indicative of cash used by operating activities and should not be
considered in isolation or as an alternative to or more meaningful than
measures of performance determined in accordance with generally accepted
accounting principals.
Revenues increased 106% and 174% during the respective three month and
nine month periods ended September 30, 1997 due to increases in the Company's
member base. The member base increased from 28,000 to 186,000 and from
227,000 to 362,000 during the nine months ended September 30, 1996 and 1997,
respectively. Continued improvement in gross margins is a direct result of
management's ongoing efforts to control telecommunications costs and renew
contracts under more favorable terms, combined with the economies of scale
achieved with membership growth. The Company noted improvement in net loss
and losses before interest, taxes, depreciation and amortization (EBITDA) for
both the three month and nine month periods ending September 30, 1996 and
1997, respectively, due to member growth and the Company's ability to control
costs and expenses. EBITDA loss decreased by 48% and 15% and net loss
decreased 29% and increased 7% for the three month and nine months ended
September 30, 1996 and 1997, respectively.
REVENUES.
Recurring revenues consists of monthly fees charged to members for
Internet access and other ongoing services. Other revenues generally
represent one-time set-up fees. Recurring revenues are recognized over the
period in which the services are performed. The Company experienced
substantial growth in revenues for the three month and nine month periods
ended September 30, 1997 as compared to the corresponding periods of 1996.
This growth is primarily attributable to an increase in the number of members
who use the Company's services, from approximately 186,000 at September 30,
1996 to 362,000 at September 30, 1997.
OTHER REVENUES.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------------------- -----------------------------------------
PERCENT PERCENT PERCENT PERCENT
OF OTHER OF OTHER OF OTHER OF OTHER
1996 REVENUE 1997 REVENUE 1996 REVENUE 1997 REVENUE
-------- -------- ------- ------- -------- -------- -------- --------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Dial-up Set up fees $ 1,478 85% $ 822 53% $ 3,582 84% $ 2,736 60%
Other Set up Fees and Revenue 266 15% 737 47% 666 16% 1,822 40%
-------- ------- -------- --------
Total Other Revenues $ 1,744 100% $ 1,559 100% $ 4,248 100% $ 4,558 100%
-------- ------- -------- --------
-------- ------- -------- --------
</TABLE>
Other revenues decreased 11% and increased 7% for the three month and nine
month periods ending September 30, 1997, respectively, compared to the
corresponding periods of 1996. Due to market pressures, the Company waives
set up fees for dial-up members acquired through certain affinity marketing
partnerships. This has caused a decrease in dial-up set up fees collected in
the three month and nine month periods ended September 30, 1997 as compared
to the corresponding periods of 1996. This trend is expected to continue for
dial-up set up revenue. During the nine months ended September 30, 1997, the
Company began to aggressively promote its web hosting and high speed access
and related hardware products. The
7
<PAGE>
decline in the dial-up set up fees was offset by increases in other set up
fees and revenues. These increases were attributable to the expansion of the
Company's nationwide service to include Web hosting and high-speed access and
sales of related hardware products.
COST OF RECURRING REVENUES.
Cost of recurring revenues principally includes telecommunications costs
and depreciation expense on equipment used in network operations for ongoing
member services. Included in telecommunications costs are fees paid to UUNET
and PSINet for local access to their respective nationwide systems of POPs.
Cost of recurring revenues increased 55% and 127% during three month and
nine month periods ended September 30, 1997, respectively, as compared to the
corresponding periods of 1996. The increase in the cost of recurring
revenues is primarily due to the increase in the Company's member base. Cost
of recurring revenues was 75% and 50% of recurring revenues for the three
months ended September 30, 1996 and 1997, respectively, and 74% and 53% of
recurring revenues for the respective nine month periods then ended. The
decrease in the cost of recurring revenues as a percentage of recurring
revenue is primarily due to the Company's ability to effectively manage
communications costs and to exploit economies of scale to reduce per member
costs as the total member base expands.
COST OF OTHER REVENUES.
Cost of other revenues principally includes costs related to the
registration of new members. These costs include licensing fees for software,
software duplication costs and commissions paid to third parties (bounties).
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------- ------------------------------------------
PERCENT PERCENT PERCENT PERCENT
OF OTHER OF OTHER OF OTHER OF OTHER
1996 REVENUE 1997 REVENUE 1996 REVENUE 1997 REVENUE
------ -------- ------ -------- -------- -------- ------- --------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Royalties $ 494 28% $ 192 12% $ 1,519 36% $ 873 19%
Bounties 138 8% 389 25% 234 6% 1,134 25%
Other 61 4% 160 10% 267 6% 453 10%
------ ------ -------- -------
Total Cost of Other Revenues $ 693 40% $ 741 47% $ 2,020 48% $ 2,460 54%
------ ------ -------- -------
------ ------ -------- -------
</TABLE>
Cost of other revenues increased 7% and 22% for the three month and nine
month periods ended September 30, 1997, respectively, as compared to the
corresponding periods of the previous year. The increase was due to growth
in affinity marketing partnerships and payment of the related bounties. The
growth in bounties was partially offset by a decrease in royalty expense due
to the renewal of various contracts under more favorable terms. The
increase in the cost of other revenues as a percentage of other revenues is
attributable to the decrease in other revenue, specifically, dial-up set up
fees.
Substantially all of the Company's members access the EarthLink Network
and the Internet by dialing into local POPs. Access in the Company's
Southern California base is provided through POPs owned by the Company. The
Company provides nationwide service to members through POP access leased from
UUNET and PSINet. (Access to the UUNET and PSINet POPs is on a non-exclusive
basis.)
Under the Company's amended agreement with UUNET, the Company pays UUNET
a monthly fee based primarily on peak member usage. If the usage becomes
more concentrated during peak times, the fees paid by the Company to UUNET
would increase, which would adversely affect the Company's operating margins.
8
<PAGE>
SALES AND MARKETING.
Sales and marketing expenses were 44% and 27% of total revenues for the
three months ended September 30, 1996 and 1997, respectively, and 49% and 28%
of total revenues for the respective nine month periods then ended. Sales
and marketing expenses consist primarily of sales commissions, salaries,
costs of promotional material, advertising, travel and trade shows. The
Company experienced an increase of 28% and 59% in sales and marketing
expenses for the three month and nine month periods ended September 30, 1997,
respectively, as compared to the corresponding periods of the previous year,
primarily as a result of EarthLink's efforts to expand its member base and
increase brand awareness in the market place through advertising and
promotions.
GENERAL AND ADMINISTRATIVE.
General and administrative expenses were 38% and 17% of total revenues
for the three months ended September 30, 1996 and 1997, respectively, and 39%
and 19% of total revenues for the respective nine month periods then ended.
General and administrative expenses consist primarily of costs associated
with the finance and human resources departments, professional expenses, rent
and other expenses, compensation earned by certain executive officers,
depreciation associated with office equipment, and bad debts. General and
administrative expenses increased 33% for the nine month period ended
September 30, 1997 as compared to the corresponding period of 1996. This
growth was primarily due to increases in bad debt, payroll, rent,
depreciation expenses and credit card fees. The rise in payroll costs is
primarily due to a growth in headcount. Rent expense increased as the Company
occupied a new 55,000 square foot facility adjacent to its corporate
headquarters. Monthly rent for the property is $66,000. The rise in
depreciation expense is due to the acquisition of office equipment and
leasehold improvements. The increase in credit card processing fees was
primarily due to the increase in member count from approximately 186,000 at
September 30, 1996 to 362,000 at September 30, 1997. General and
administrative expenses decreased 7% for the three month period ended
September 30, 1997 as compared to the corresponding period of the previous
year. The decrease was primarily due to a reduction in bad debt expense.
Bad debt was $1.5 million and $865,000 for the three month periods ended
September 30, 1996 and 1997, respectively. The decrease in bad debt was
sufficient to offset the effect of increases in rent, payroll, depreciation
and other expenses.
OPERATIONS AND MEMBER SUPPORT.
Operations and member support expenses were 47% and 39% of total revenues
for the three months ended September 30, 1996 and 1997, respectively, and 49%
and 40% of total revenues for the respective nine month periods then ended.
Operations and member support expenses consist primarily of costs associated
with technical support and other services to register and maintain member
accounts. These expenses have increased significantly since the Company's
inception. This trend reflects the costs associated with building a member
service organization to support the Company's member base and anticipated
member growth. Management continues to make significant investments in
technical and member support capabilities and to reduce member wait time for
assistance. Consequently, operations and member support expenses have not
significantly decreased as a percentage of revenue.
9
<PAGE>
POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS
The Company's operating results may fluctuate significantly in the future
as a result of a variety of factors, many of which are beyond the Company's
control. These factors include the rates of, and costs associated with, new
member acquisition, member retention, capital expenditures and other costs
relating to the expansion of operations, including upgrading the Company's
systems and infrastructure, the timing and market acceptance of new and
upgraded service introductions, changes in the pricing policies of the
Company and its competitors, changes in operating expenses (including
telecommunications costs), personnel changes, the introduction of alternative
technologies, the effect of potential acquisitions, increased competition in
the Company's markets and other general economic factors. In addition, a
significant portion of the Company's expenses are fixed; therefore, the
Company's operating margins are particularly sensitive to fluctuations in
revenues.
LIQUIDITY AND CAPITAL RESOURCES
The Company has not generated net cash from operations since its
inception. The Company has funded its operations primarily through public and
private sales of equity securities, borrowings from third parties and capital
leases of equipment. The Company's operating activities used net cash of
approximately $4.0 million and $20.3 million for the three month and nine
month periods ended September 30, 1997, respectively, and $4.0 million and
$11.1 million for the respective periods of 1996. During the three month and
nine month periods ended September 30, 1997 and 1996, net cash used in
operations resulted primarily from net losses partially offset by increases
in liabilities and non-cash expenses. Non cash expenses in the third quarter
of 1997 include $351,000 in the amortization of rights to member lists
acquired from Internet In a Mall Inc., in the second quarter.
Cash used in investing activities consists primarily of equipment
purchases for POP and network expansion. Cash used in investing activities
was $2.8 million and $13.1 million, for the three month and nine month
periods ended September 30, 1997, respectively, and $3.8 million and $12.4
million for the respective periods of 1996. The Company estimates that
remaining capital expenditures for 1997 will be approximately $3.1 million
including network enhancements, data center expansion, leasehold
improvements, and procurement of telecommunication and office equipment and
furniture and fixtures. Where feasible, the Company will seek to finance
certain of these expenditures through capital leases.
Cash provided by financing activities was $17.7 million and $46.4 million
for the three month and nine month periods September 30, 1997, respectively,
and $15.3 million and $31.9 million for the respective periods of 1996. The
Company's financing activities consisted of the private sale of convertible
preferred stock, debt and capital lease transactions, primarily for
equipment. The Company closed sale leaseback transactions of approximately
$2.5 million and $7.8 million during the three month and nine month periods
ended September 30, 1997, respectively, and $2.2 million and $9.2 million
during the respective periods of 1996. The sale leaseback transactions were
recorded at cost, which approximates the fair market value of the property
and, therefore, no gains or losses were recorded. The property remains on
the books and continues to be depreciated. A financing obligation
representing the proceeds is recorded and reduced based upon payments under
the lease agreement. Under an agreement with one of its vendors, EarthLink
obtained a $5 million credit facility for member access. EarthLink
accumulates member access charges, applies them against the credit facility
and is charged interest at a rate of prime plus 4% on the balance. The
outstanding balance due under the credit facility at September 30, 1997 was
$2.3 million leaving $2.7 million unused and available. The line of credit
is due on the earlier of termination or July 31, 1998. The Company maintains
a $5 million Convertible Promissory Note payable to UUNET and due on October
31, 1998. The Note is convertible into a maximum of approximately 391,500
shares of Common Stock at $12.88 per share. UUNET is a provider of network
services to the Company and has a designate on the Company's board of
directors.
10
<PAGE>
As of September 30, 1996 and 1997, the Company had cash and cash
equivalents of approximately $8.7 million and $17.1 million, respectively,
and negative working capital of approximately $6.4 million and $4.7 million,
respectively.
The Company believes that available cash will be sufficient to meet the
Company's operating expenses and capital requirements through the next year.
The Company's capital requirements depend on numerous factors including the
rate of market acceptance of the Company's services, the Company's ability to
maintain and expand its member base, the rate of expansion of the Company's
network infrastructure, the level of resources required to expand the
Company's marketing and sales organization, information systems and research
and development activities, the availability of hardware and software
provided by third-party vendors and other factors. The timing and amount of
all of these capital requirements cannot accurately be predicted; however,
many of these factors are within the control of management, and to that
extent management has control over the Company's liquidity position. If
capital requirements vary materially from those currently planned, the
Company may require additional financing sooner than anticipated. However,
the Company believes that financing alternatives are available to address the
Company's current liquidity requirements should the need arise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
PART II
ITEM 6. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Exhibits. The following exhibits are filed as part of this report:
Exhibit No. Description
----------- -----------
10.1 Letter Agreement Amending Network Services Agreement
between the Company and UUNET Technologies, Inc., dated
September 26, 1997.
10.2 Amendment No. 2 to Amended and Restated Note Purchase
Agreement and Convertible Note between the Company and
UUNET Technologies, Inc., dated October 27, 1997.
11.1 Statement of computation of earnings per share.
27 Financial Data Schedule.
(b) On September 19, 1997, the Company filed a Current Report on Form 8-K (the
"Form 8-K"). The Form 8-K reported that, on September 19, 1997 the
Company closed a private placement of 1,459,759 shares of its unregistered
restricted Common Stock for an aggregate purchase price of approximately
$15.7 million. The financing was offered and sold solely to accredited
investors. The Company intends to use the proceeds of the financing for
general working capital purposes.
11
<PAGE>
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.
EARTHLINK NETWORK, INC.
Date: November 14, 1997 /s/ CHARLES G. BETTY
------------------------------------
Charles G. Betty, President, Chief
Executive Officer, Acting Chief
Financial Officer and Director
Date: November 14, 1997 /s/ RICHARD A. QUIROGA
------------------------------------
Richard A. Quiroga, Vice President,
Corporate Controller.
12
<PAGE>
EXHIBIT 10.1
[LETTERHEAD]
September 26, 1997
Garry Betty
President & CEO
EarthLink Network
Dear Garry,
This letter is to formalize the interim arrangements, detailed below, which
were agreed upon in the recent interchanges between EarthLink and UUNET.
Please sign below showing your concurrence and return.
1. EarthLink and UUNET will make reasonable and good faith efforts to
negotiate a new five-year agreement to be entered into no later than
12/31/97.
2. EarthLink will not invoke the early termination clause in the current
agreement between EarthLink and UUNET prior to 9/1/98.
3. All new EarthLink subscribers between now and 12/31/97 will be on the
UUNET network. Exceptions to this include (a) those EarthLink members
in Southern California, or (b) those EarthLink members who are
(1) negatively impacted by UUNET's Access Control Server (ACS) and
(2) located where no UUNET Dial Access Network (DAN) alternative
exists.
4. UUNET will waive the revenue monthly minimums, the excess hours fees,
and PSU targets in the current agreement for 7/1/97 through 12/31/97.
5. The price per Peak Simultaneous User will be $180.00 through 12/31/97.
6. EarthLink will make reasonable efforts to move all existing
subscribers to the new UUNET dial access network by 12/31/97.
7. UUNET will issue a credit to EarthLink in the amount of $150,000 for
that portion of the June 1997 billing that is the result of the missed
Target PSU's.
8. Each of these terms is dependent upon agreement with respect to all
other terms.
Best regards,
/s/ CLINT HEIDEN
------------------------------
Clint Heiden
Vice President, U.S. Sales
UUNET
/s/ CHARLES G. BETTY
------------------------------
Garry Betty
President & CEO
EarthLink Network
<PAGE>
EXHIBIT 10.2
EXECUTION COPY
AMENDMENT NO. 2
TO
AMENDED AND RESTATED NOTE PURCHASE AGREEMENT
AND CONVERTIBLE NOTE
This AMENDMENT No. 2 to that certain Convertible Note (the "Note") in the
original principal amount of $5,000,000 dated October 31, 1996, issued by
EarthLink Network, Inc. (the "Company"), to UUNET Technologies, Inc.
("UUNET") and amended on January 1, 1997, is entered into this 27th day of
October, 1997. This Amendment is hereby incorporated into and made a part of
the Note.
Capitalized terms used but not defined herein shall have the meanings
given such terms in the Note and the Amended and Restated Note Purchase
Agreement, dated as of October 31, 1996, between the Company and UUNET (the
"Note Purchase Agreement").
For value received, the parties to this Amendment hereby agree to the
terms and conditions set forth in this Amendment.
1. PAYMENT. The Due Date set forth in the Note is hereby amended by
extending such date from October 31, 1997 to October 31, 1998. However, in
the event that the amount payable by the Company to UUNET under the Network
Services Agreement dated May 31, 1996, as amended on October 31, 1996 (and as
it may be amended from time to time), is less than $1.5 million per month
during any consecutive three months, all amounts owing under the Note shall
accelerate and become immediately due and payable.
2. RATIFICATION AND CONFIRMATION. Except as specifically modified in
this Amendment, the terms and conditions set forth in the Note shall remain
in full force and effect without change, and the Note, as modified by this
Amendment, and the Note Purchase Agreement are hereby ratified and affirmed
by the parties.
IN WITNESS WHEREOF, the parties have caused this Amendment to be signed in
their corporate names by their respective authorized officers.
UUNET TECHNOLOGIES, INC. EARTHLINK NETWORK, INC.
By: /s/ JOHN W. SIDGMORE By: /s/ CHARLES G. BETTY
-------------------------- --------------------------
John W. Sidgmore Charles G. Betty
Chief Executive Officer President
<PAGE>
EXHIBIT 11.1
EARTHLINK NETWORK, INC.
COMPUTATION OF EARNINGS PER COMMON SHARE
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
----------------------------- ----------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1996 1997 1996 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net loss............................................... $ (10,105) $ (7,198) $ (21,809) $ (23,327)
--------- -------- --------- ---------
Weighted average shares outstanding pursuant to
SAB 83................................................ 6,237 5,658
Weighted average shares outstanding pursuant to
APB 15................................................ 9,932 9,593
Purchase of shares of Common Stock below the
expected IPO price during fiscal 1996............... 171 312
Assumed exchange of warrants for Common Stock........ 235 - 235 -
Assumed exchange of options for Common Stock......... 363 - 363 -
--------- -------- --------- ---------
Weighted average shares outstanding.................... 7,006 9,932 6,568 9,593
--------- -------- --------- ---------
--------- -------- --------- ---------
Net loss per share..................................... $ (1.44) $ (0.72) $ (3.32) $ (2.43)
--------- -------- --------- ---------
--------- -------- --------- ---------
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) THE SECURITIES EXCHANGE
OF 1934 FOR QUARTERLY PERIOD SEPTEMBER 30, 1997 AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 9-MOS
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1997
<PERIOD-START> JAN-01-1997 JUL-01-1997
<PERIOD-END> SEP-30-1997 SEP-30-1997
<CASH> 17,089 0
<SECURITIES> 0 0
<RECEIVABLES> 3,227 0
<ALLOWANCES> 160 0
<INVENTORY> 413 0
<CURRENT-ASSETS> 23,559 0
<PP&E> 33,127 0
<DEPRECIATION> 10,335 0
<TOTAL-ASSETS> 48,106 0
<CURRENT-LIABILITIES> 28,242 0
<BONDS> 0 0
0 0
0 0
<COMMON> 112 0
<OTHER-SE> 71,383 0
<TOTAL-LIABILITY-AND-EQUITY> 48,106 0
<SALES> 0 0
<TOTAL-REVENUES> 20,603 55,167
<CGS> 0 0
<TOTAL-COSTS> 10,284 29,145
<OTHER-EXPENSES> 17,117 48,298
<LOSS-PROVISION> 840 2,814
<INTEREST-EXPENSE> 516 1,467
<INCOME-PRETAX> (7,198) (23,327)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> (6,798) (22,276)
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 7,198 23,327
<EPS-PRIMARY> (0.72) (2.43)
<EPS-DILUTED> 0 0
</TABLE>
