<PAGE> 1
- - --------------------------------------------------------------------------------
- - --------------------------------------------------------------------------------
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: 0-22967
NETWORK SOLUTIONS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C>
DELAWARE 52-1146119
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR IDENTIFICATION NO.)
ORGANIZATION)
</TABLE>
505 HUNTMAR PARK DRIVE
HERNDON, VIRGINIA 20170
(703)742-0400
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER,
INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
As of November 6, 1998, the Registrant had 4,168,202 shares of Class A
common stock, $0.001 par value per share, issued and outstanding, and 11,925,000
shares of Class B common stock, $0.001 par value per share, issued and
outstanding.
- - --------------------------------------------------------------------------------
- - --------------------------------------------------------------------------------
<PAGE> 2
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Statements of Financial Position as of December
31, 1997 and September 30, 1998 (unaudited)............... 3
Unaudited Condensed Statements of Operations for the three
and nine months ended September 30, 1997 and 1998......... 4
Unaudited Condensed Statements of Changes in Stockholders'
Equity for the nine months ended September 30, 1998....... 5
Unaudited Condensed Statements of Cash Flows for the nine
months ended September 30, 1997 and 1998.................. 6
Notes to Condensed Financial Statements..................... 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of
Operations................................................ 9
Item 3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 27
PART II OTHER INFORMATION
Item 1. Legal Proceedings........................................... 28
Item 2. Changes in Securities and Use of Proceeds................... 29
Item 6. Exhibits and Reports on Form 8-K............................ 30
Signature ............................................................ 31
Index to Exhibits..................................................... 32
</TABLE>
2
<PAGE> 3
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
NETWORK SOLUTIONS, INC.
CONDENSED STATEMENTS OF FINANCIAL POSITION
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1997 1998
------------ -------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 41,146,000 $ 9,124,000
Short-term investments, marketable securities............. 40,200,000 107,876,000
Accounts receivable, net.................................. 5,792,000 13,922,000
Prepaids and other assets................................. 1,005,000 1,512,000
Deferred tax asset........................................ 20,153,000 30,941,000
Restricted assets......................................... 25,873,000 627,000
------------ ------------
Total current assets........................................ 134,169,000 164,002,000
Furniture and equipment, net................................ 6,146,000 9,579,000
Long-term investments, marketable securities................ -- 6,272,000
Deferred tax asset.......................................... 8,128,000 11,292,000
Goodwill, net............................................... 1,177,000 770,000
------------ ------------
Total Assets................................................ $149,620,000 $191,915,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities.................. $ 6,426,000 $ 15,565,000
Due to parent............................................. 1,250,000 2,587,000
Income taxes payable...................................... 5,042,000 3,090,000
Current portion of capital lease obligations.............. 842,000 861,000
Deferred revenue, net..................................... 43,789,000 77,766,000
Internet fund liability................................... 25,873,000 627,000
------------ ------------
Total current liabilities................................... 83,222,000 100,496,000
Capital lease obligations................................... 1,081,000 436,000
Long-term deferred revenue, net............................. 17,662,000 28,964,000
------------ ------------
Total liabilities........................................... 101,965,000 129,896,000
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value, authorized 10,000,000
shares; none issued and outstanding in 1997 and 1998... -- --
Class A common stock, $.001 par value; authorized
100,000,000 shares;
3,795,000 and 4,139,838 issued and outstanding in 1997
and 1998............................................... 4,000 4,000
Class B common stock, $.001 par value; authorized
30,000,000 shares;
11,925,000 issued and outstanding in 1997 and 1998..... 12,000 12,000
Additional paid-in capital................................ 56,451,000 63,147,000
Accumulated deficit....................................... (8,812,000) (1,295,000)
Accumulated other comprehensive income.................... -- 151,000
------------ ------------
Total stockholders' equity.................................. 47,655,000 62,019,000
------------ ------------
Total Liabilities and Stockholders' Equity.................. $149,620,000 $191,915,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE> 4
NETWORK SOLUTIONS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
1997 1998 1997 1998
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net revenue............................... $12,172,000 $25,427,000 $30,896,000 $62,395,000
Cost of revenue........................... 7,033,000 10,312,000 18,468,000 26,451,000
----------- ----------- ----------- -----------
Gross profit.............................. 5,139,000 15,115,000 12,428,000 35,944,000
Research and development expenses......... 377,000 1,353,000 1,095,000 2,893,000
Selling, general and administrative
expenses................................ 3,105,000 10,248,000 7,893,000 24,438,000
Interest income........................... (570,000) (1,680,000) (1,054,000) (4,423,000)
Other expenses............................ -- 26,000 -- 93,000
----------- ----------- ----------- -----------
Income before income taxes................ 2,227,000 5,168,000 4,494,000 12,943,000
Provision for income taxes................ 995,000 2,163,000 2,006,000 5,426,000
----------- ----------- ----------- -----------
Net income................................ $ 1,232,000 $ 3,005,000 $ 2,488,000 $ 7,517,000
=========== =========== =========== ===========
Earnings per common share:
Basic................................... $ 0.10 $ 0.19 $ 0.20 $ 0.47
=========== =========== =========== ===========
Diluted................................. $ 0.10 $ 0.18 $ 0.20 $ 0.45
=========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE> 5
NETWORK SOLUTIONS, INC.
CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED)
<TABLE>
<CAPTION>
CLASS A CLASS B ACCUMULATED
COMMON STOCK COMMON STOCK ADDITIONAL OTHER RETAINED TOTAL
------------------ -------------------- PAID-IN COMPREHENSIVE EARNINGS STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL INCOME (DEFICIT) EQUITY
--------- ------ ---------- ------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31,
1997.................... 3,795,000 $4,000 11,925,000 $12,000 $56,451,000 $(8,812,000) $47,655,000
Issuance of common stock
pursuant to stock
plans................... 344,838 4,456,000 4,456,000
Tax benefit associated
with
stock plans............. 2,240,000 2,240,000
Unrealized gain on
securities.............. $151,000 151,000
Net income for the nine
months ended September
30, 1998................ 7,517,000 7,517,000
--------- ------ ---------- ------- ----------- -------- ----------- -----------
Balance, September 30,
1998.................... 4,139,838 $4,000 11,925,000 $12,000 $63,147,000 $151,000 $(1,295,000) $62,019,000
========= ====== ========== ======= =========== ======== =========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE> 6
NETWORK SOLUTIONS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------
1997 1998
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................ $ 2,488,000 $ 7,517,000
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 1,635,000 2,613,000
Provision for uncollectible accounts receivable........ 5,577,000 2,168,000
Deferred income taxes.................................. (9,649,000) (14,061,000)
Tax benefit associated with stock plans................ -- 2,240,000
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable........... 348,000 (10,298,000)
Increase in prepaids and other assets................ (896,000) (507,000)
Increase in accounts payable and accrued
liabilities....................................... 1,811,000 9,139,000
Decrease in income taxes payable..................... -- (1,952,000)
Increase in deferred revenue......................... 25,156,000 45,279,000
------------ ------------
Net cash provided by operating activities............ 26,470,000 42,138,000
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of furniture and equipment....................... (1,254,000) (5,639,000)
Purchase of short-term investments, net................... (28,321,000) (67,676,000)
Purchase of long-term investments......................... -- (6,012,000)
------------ ------------
Net cash used in investing activities................ (29,575,000) (79,327,000)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net transactions with SAIC................................ 6,627,000 1,337,000
Repayment of capital lease obligations.................... -- (626,000)
Issuance of common stock pursuant to stock plans.......... -- 4,456,000
------------ ------------
Net cash provided by financing activities............ 6,627,000 5,167,000
------------ ------------
Net increase (decrease) in cash and cash equivalents........ 3,522,000 (32,022,000)
Cash and cash equivalents, beginning of period.............. 15,540,000 41,146,000
------------ ------------
Cash and cash equivalents, end of period.................... $ 19,062,000 $ 9,124,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE> 7
NETWORK SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
NOTE 1 -- ORGANIZATION AND BUSINESS
Since 1993, Network Solutions, Inc. ("the Company") has acted as the
exclusive registrar and registry of Internet domain names within the .com, .org,
.net and .edu top level domains ("TLDs") under a cooperative agreement (as
amended, the "Cooperative Agreement") with the National Science Foundation
("NSF") and, currently, the Department of Commerce's National Telecommunications
and Information Administration ("NTIA"). Domain names are used to identify a
unique site or presence on the Internet. As registrar and registry for these
TLDs, the Company registers new domain names and is responsible for the
maintenance and dissemination of the master file of domain names through daily
updates to the Internet. The Company also provides enterprise network consulting
services to large companies, focusing on network engineering, network and
systems security and network management.
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES
INTERIM FINANCIAL STATEMENTS
The interim financial statements have been prepared by the Company, without
audit, pursuant to the rules and regulations of the Securities and Exchange
Commission ("SEC"). In the opinion of management, financial statements included
in this report reflect all normal recurring adjustments which the Company
considers necessary for fair presentation of the results of operations for the
interim periods covered and of the financial position of the Company at the date
of the interim balance sheet. Certain information and footnote disclosures
normally included in the annual financial statements prepared in accordance with
generally accepted accounting principles have been condensed or omitted pursuant
to such rules and regulations. However, the Company believes that the
disclosures are adequate for understanding the information presented. The
operating results for interim periods are not necessarily indicative of the
operating results for the entire year. These interim financial statements should
be read in conjunction with the Company's December 31, 1997 audited financial
statements and notes thereto included in the Company's Form 10-K annual report
for the year ended December 31, 1997. Prior periods have been restated for
comparative purposes.
NOTE 3 -- COMPUTATION OF EARNINGS PER SHARE
The following is a reconciliation of the numerator and denominator used in
the basic and diluted earnings per share computations:
<TABLE>
<CAPTION>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ---------
<S> <C> <C> <C>
THREE MONTHS ENDED SEPTEMBER 30, 1998
Basic.................................. $3,005,000 16,041,000 $0.19
=====
Dilutive securities:
Outstanding options.................. -- 705,000
---------- ----------
Diluted................................ $3,005,000 16,746,000 $0.18
========== ========== =====
THREE MONTHS ENDED SEPTEMBER 30, 1997
Basic.................................. $1,232,000 12,502,000 $0.10
=====
Dilutive securities:
Outstanding options.................. -- 118,000
---------- ----------
Diluted................................ $1,232,000 12,620,000 $0.10
========== ========== =====
</TABLE>
7
<PAGE> 8
<TABLE>
<CAPTION>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ---------
<S> <C> <C> <C>
NINE MONTHS ENDED SEPTEMBER 30, 1998
Basic.................................. $7,517,000 15,888,000 $0.47
=====
Dilutive securities:
Outstanding options.................. -- 656,000
---------- ----------
Diluted................................ $7,517,000 16,544,000 $0.45
========== ========== =====
NINE MONTHS ENDED SEPTEMBER 30, 1997
Basic.................................. $2,488,000 12,501,000 $0.20
=====
Dilutive securities:
Outstanding options.................. -- 99,000
---------- ----------
Diluted................................ $2,488,000 12,600,000 $0.20
========== ========== =====
</TABLE>
Common shares issued are weighted for the period the shares were
outstanding and incremental shares assumed issued under the treasury stock
method for diluted earnings per share are weighted for the period the underlying
options were outstanding.
NOTE 4 -- ACCUMULATED OTHER COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income," which established standards for reporting and displaying
comprehensive income and its components in a financial statement that is
displayed with the same prominence as other financial statements. The changes in
the components of accumulated other comprehensive income are reported net of
income taxes for the nine months ended September 30, 1998 as follows:
<TABLE>
<CAPTION>
ACCUMULATED
OTHER
UNREALIZED GAINS COMPREHENSIVE
ON SECURITIES INCOME
---------------- -------------
<S> <C> <C>
Pre-tax amount.......................... $260,000 $260,000
Income tax.............................. 109,000 109,000
-------- --------
Net of tax amount....................... $151,000 $151,000
======== ========
</TABLE>
NOTE 5 -- RESTRICTED ASSETS
Under the terms of the September 14, 1995 amendment to the Cooperative
Agreement, 30% of the registration fees collected by the Company is required to
be set aside for the enhancement of the intellectual infrastructure of the
Internet ("set aside funds") and, as such, is not recognized as revenue by the
Company. The Company has reflected these set aside funds, along with the
appropriate percentage of net accounts receivable as restricted assets, and has
recorded an equivalent, related current liability. The Company maintains the
cash received relating to the set aside funds in a separate interest bearing
account. The set aside funds, plus any interest earned, are intended to be
disbursed at the direction of the NSF. In September 1998, the Company disbursed
$39.2 million out of this fund to the NSF at its direction, bringing cumulative
disbursements since September 14, 1995 to $62.2 million.
On March 12, 1998, the NSF and the Company amended the Cooperative
Agreement to eliminate the 30% set aside requirement effective April 1, 1998.
Future disbursement of these set aside funds will have no significant effect on
the Company's business, financial condition or results of operations. For
purposes of the Company's statements of cash flows, amounts relating to these
restricted assets and the Internet fund liability have been excluded in their
entirety.
8
<PAGE> 9
NOTE 6 -- COMMITMENTS AND CONTINGENCIES
INTERNET GOVERNANCE
Within the U.S. Government, leadership for the continued privatization of
Internet administration is currently provided by the NTIA. After a series of
draft proposals and public comment periods, on June 10, 1998, the NTIA published
in the Federal Register a plan referred to as the Statement of Policy or "White
Paper," calling for the formation of a not-for-profit corporation to assume
responsibility for administration of the domain name system ("DNS"), but which
is not expected to perform actual registration of domain names either as a
registrar or registry. The Statement of Policy invites private sector Internet
stakeholders to work together to form a new private, not-for-profit corporation
to oversee policy for the Internet name and address system. The Statement of
Policy calls for a separation of the registry and registrar functions of the
DNS, both of which functions are currently performed exclusively by the Company
in the .com, .org, .net and .edu TLDs.
As part of the process initiated by the Statement of Policy, several
proposals were put forward to the NTIA on the establishment and governance of
the not-for-profit corporation. A newly-formed U.S. based private not-for-profit
corporation denoted the Internet Corporation for Assigned Names and Numbers
("ICANN") has submitted a series of proposals which is forming the basis of
public discussion at a series of meetings one of which was held on November 14,
1998.
As a result of these and other meetings and private negotiations, the
process initiated by the Statement of Policy may result in U.S. Government
recognition of ICANN as the not-for-profit corporation under the Statement of
Policy. The NTIA plan calls for a phased transition of its responsibilities for
the DNS to the not-for-profit corporation over the period ending on September
30, 2000. Despite the significant efforts undertaken to date, it is impossible
to predict at this time whether or when the process initiated by the Statement
of Policy will result in the transition of DNS administration and, if it does,
the effect on the Company of such transition.
In October 1998, the Cooperative Agreement was amended (the "October 1998
Amendment") to extend its term through September 30, 2000. As the U.S.
Government transitions its authority over the DNS to the not-for-profit
corporation, corresponding obligations under the Cooperative Agreement may be
terminated and, as appropriate, covered in a contract between the not-for-profit
corporation and the Company. In the October 1998 Amendment, the Company and the
NTIA agreed to a plan for the transition to a shared registration system, in
which multiple registrars may register domain names with the single registry for
each TLD, in a phased approach, the first phase of which is scheduled to be
completed by March 31, 1999.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
This quarterly report on Form 10-Q contains forward-looking statements. For
this purpose, any statements contained herein that are not statements of
historical fact may be deemed to be forward-looking statements. Statements
regarding the intent, belief or current expectations of the Company are intended
to be forward-looking statements which may involve risk and uncertainty. There
are a number of factors that could cause the Company's actual results to differ
materially from those indicated by such forward-looking statements, including,
but not limited to, those discussed in "Part I -- Item 1 -- Business -- Risk
Factors" and "Part II -- Item 7 -- Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Factors Affecting Operating
Results" contained in the Company's 1997 Form 10-K, as filed with the SEC on
March 31, 1998. In addition, set forth below under the heading "Factors
Affecting Operating Results" is a further discussion of certain of those risks
as they relate to the period covered by this report, the Company's near term
outlook with respect thereto, and the forward-looking statements set forth
herein; however, the absence in this quarterly report of a complete recitation
of or update to all risk factors identified in the 1997 Form 10-K should not be
interpreted as modifying or superseding any such risk factors, except to the
extent set forth below. Investors should review this quarterly report in
combination with the Company's 1997 Form 10-K in order to have a more complete
understanding of the principal risks associated with an investment in the
Company's common stock.
9
<PAGE> 10
OVERVIEW
The Company currently acts as the exclusive registrar and registry of
Internet domain names within the .com, .org, .net and .edu TLDs pursuant to the
Cooperative Agreement with the NTIA. Domain names are used to identify a unique
site or presence on the Internet. As registrar and registry for these TLDs, the
Company registers new domain names and is responsible for the maintenance and
dissemination of the master file of domain names through daily updates to the
Internet.
The Company also delivers enterprise network consulting services to large
companies that desire to establish or enhance their Internet presence or
re-engineer legacy network infrastructures to accommodate the integration of
both Internet connectivity and internal enterprise network ("Intranet"),
technology into their information technology base. The Company's consulting
services include network engineering, network and systems security and network
management.
Registration Services. In December 1992, the Company entered into the
Cooperative Agreement with the NSF under which the Company was to provide
Internet domain name registration services for five TLDs: .com, .org, .net, .edu
and .gov. These registration services include domain name registration and
annual re-registration, and, throughout the registration term, maintenance of,
and unlimited modifications to, individual domain name records and updates to
the master file of domain names. The Cooperative Agreement became effective
January 1, 1993. It includes a three-month phase-in period, a five-year
operational period (commencing April 1, 1993 and ending March 31, 1998), and a
six-month flexibility period through September 30, 1998. Effective September 9,
1998, the NTIA took over the administration of the Cooperative Agreement from
the NSF. In October 1998, the Cooperative Agreement was amended and extended
until September 30, 2000.
The original terms of the Cooperative Agreement provided for a cost
reimbursement plus fixed-fee contract (with an initial fee of 8%). Effective
September 14, 1995, the NSF and the Company amended the Cooperative Agreement to
require the Company to begin charging end users a services fee of $50 per year
for each domain name in the .com, .org and .net TLDs. Prior to April 1, 1998,
registrants paid a services fee of $100 for two years of domain name services
upon each initial registration and an annual re-registration fee of $50 per year
thereafter (collectively "registration fees"). The NSF paid the registration
fees for domain names within the .edu and .gov TLDs through March 31, 1997.
Commencing April 1, 1997, the Company agreed with the NSF to provide domain name
services within the .edu and .gov TLDs free of charge. As of October 1, 1997,
the Company no longer registers or administers domain names in the .gov TLD.
Under the terms of the September 14, 1995 amendment to the Cooperative
Agreement, 30% of the registration fees collected by the Company was required to
be set aside for the enhancement of the intellectual infrastructure of the
Internet and, as such, was not recognized as revenue by the Company. The Company
has reflected these funds, along with the appropriate percentage of net accounts
receivable, as restricted assets and has recorded an equivalent, related current
liability. The Company maintains the cash received relating to the set aside
funds in a separate interest bearing account. The set aside funds, plus any
interest earned, are disbursed at the direction of the NSF. To date, the Company
has disbursed $62.2 million to the NSF at their direction, and as of September
30, 1998, has a remaining restricted cash balance of approximately $627,000.
On March 12, 1998, the NSF and the Company amended the Cooperative
Agreement to eliminate the 30% set aside requirement effective April 1, 1998 and
to reduce the registration fees by a corresponding amount. Initial registrations
on and after April 1, 1998 are charged $70 for two years of registration
services and an annual re-registration fee of $35 per year thereafter. This
amendment has no effect on the revenue currently recognized on each registration
($70 for initial registrations and $35 for re-registrations), since the Company
previously did not recognize revenue on the 30% set aside funds. Accordingly,
while the revenue to the Company on a per registration basis does not change,
the amount charged to customers declined.
In order to provide prompt access to new domain names on the Internet, the
Company generally invoices customers and permits them to pay their registration
fees after their domain names are registered. The Company's experience has been
that, for the period from September 1995 through September 1998, approximately
30% of new registrations have ultimately been deactivated for non-payment. The
Company
10
<PAGE> 11
believes that this level of uncollectible receivables is due to, among other
factors, the large number of individuals and corporations that have registered
multiple domain names with the apparent intention of transferring registration
for such names at a profit. Such resellers have a greater tendency than other
customers to default on their registration fees. As a consequence, the Company
has recorded a comparable provision for uncollectible accounts in determining
net registration revenue. This 30% provision has been consistently applied for
the period from September 1995 through September 1998 and is considered adequate
by the Company.
Registration fees charged to customers for registration services are
recognized as revenue evenly over the registration term. For example, the
Company recognizes $70 on a straight-line basis over the two-year service period
for each $70 initial domain name registration, equivalent to $35 per year.
Annual re-registrations of domain names are recorded as revenue based upon $35
recognized on a straight-line basis over the one-year service period. This
subscription-based model defers revenue recognition until the Company provides
the registration services, including maintenance of and unlimited modifications
to individual domain name records, over the respective registration terms. At
September 30, 1998, the Company had net deferred revenue of $106.7 million.
Enterprise Network Consulting Services. Substantially all of the Company's
enterprise network consulting services revenue is derived from professional
services which are generally provided to clients on a time and expense basis and
is recognized as services are performed.
The majority of the Company's enterprise network consulting services are
provided to customers in the financial services industry. Bank America (formerly
NationsBanc) is currently the Company's largest consulting services client,
accounting for 49% of the Company's enterprise network consulting services
business net revenue and 3.7% of the Company's total net revenue in the nine
months ended September 30, 1998. NationsBanc originally contracted with the
Company in 1993 and the Company currently provides network design and
engineering services as well as a variety of project specific services under the
contract.
RESULTS OF OPERATIONS
Net Revenue. Net revenue increased 109% from $12.2 million for the three
months ended September 30, 1997 to $25.4 million for the three months ended
September 30, 1998. This increase in net revenue was primarily attributable to
the increase in the number of domain name registrations, principally in the .com
TLD. Net revenue from registration services increased 116% from $10.7 million
for the three months ended September 30, 1997 to $23.1 million for the three
months ended September 30, 1998. Net new registrations increased 89% from
269,000 for the three months ended September 30, 1997 to 507,000 for the three
months ended September 30, 1998. This also represents a 14% increase over the
443,000 net new registrations for the three months ended June 30, 1998. Growth
in net registrations continues to be driven by the widespread use and adoption
by businesses of the Internet and Intranets on a global basis. Cumulative net
registrations as of September 30, 1997 were 1,296,000 as compared to 2,777,000
as of September 30, 1998, for a 114% increase. In addition, this growth in
cumulative net registrations is a 21% increase in the Company's entire customer
base since June 30, 1998.
Net revenue from enterprise network consulting services increased 53% from
$1.5 million for the three months ended September 30, 1997 to $2.3 million for
the three months ended September 30, 1998. This also represents a 53% increase
over the $1.5 million in enterprise network consulting services revenue for the
three months ended June 30, 1998. NationsBanc accounted for $305,000 or 2.5% of
the Company's total net revenue for the three months ended September 30, 1997
and $1.2 million or 4.7% of the Company's total net revenue for the three months
ended September 30, 1998.
Net revenue increased 102% from $30.9 million for the nine months ended
September 30, 1997 to $62.4 million for the nine months ended September 30,
1998. This increase in net revenue was primarily attributable to the increase in
the number of domain name registrations, principally in the .com TLD. Net
revenue from registration services increased 123% from $25.9 million for the
nine months ended September 30, 1997 to $57.7 million for the nine months ended
September 30, 1998. Net new registrations increased 85% from 698,000 for the
nine months ended September 30, 1997 to 1,290,000 for the nine months ended
September 30,
11
<PAGE> 12
1998. The provision for uncollectible accounts used in determining net new
registration revenue for the nine months ended September 30, 1997 and 1998 was
consistently applied at a rate of 30%.
Net revenue from enterprise network consulting services decreased 6% from
$5.0 million for the nine months ended September 30, 1997 to $4.7 million for
the nine months ended September 30, 1998. NationsBanc accounted for $1.7 million
or 5.5% of the Company's total net revenue for the nine months ended September
30, 1997 and $2.3 million or 3.7% for the nine months ended September 30, 1998.
During the three and nine months ended September 30, 1998, the consulting
services division continued to add new leadership in sales and operations and
hired additional technical consultants. In addition, the division continued to
emphasize its efforts targeted at lead generation and regional sales and
marketing programs by opening offices in New York City and Atlanta, Georgia.
Cost of Revenue. Cost of revenue consists primarily of salaries and
employee benefits, fees paid to subcontractors for work performed in connection
with revenue producing projects, depreciation and equipment costs, lease costs
of the operations infrastructure and the associated operating overhead. Cost of
revenue increased from $7.0 million for the three months ended September 30,
1997 to $10.3 million for the three months ended September 30, 1998. This 47%
increase was primarily driven by the growth of the Company's registration
business which experienced additional outsourcing costs of $1.2 million in
support of the Company's invoicing, collection and processing activities and
additional direct labor charges of $795,000 related to systems engineering and
operations.
As a percentage of net revenue, cost of revenue decreased from 57.8% for
the three months ended September 30, 1997 to 40.6% for the three months ended
September 30, 1998. This decrease primarily reflects economies of scale that the
Company has continued to achieve due to the growth of its subscription-based
domain name registration business. In the near term, the continued need for back
office investments is expected to partially offset future margin improvements
arising from economies of scale.
Cost of revenue increased from $18.5 million for the nine months ended
September 30, 1997 to $26.5 million for the nine months ended September 30,
1998. This 43% increase was driven by a $1.8 million increase in labor, a $3.7
million increase in outsourcing costs and $2.6 million in additional
depreciation charges and equipment expenditures primarily associated with
supporting the growth of the Company's registration services business.
As a percentage of net revenue, cost of revenue decreased from 59.8% for
the nine months ended September 30, 1997 to 42.4% for the nine months ended
September 30, 1998 reflecting economies of scale achieved in the Company's
registration business.
Research and Development Expenses. Research and development expenses
consist primarily of compensation and consultant expenses to support the
creation, development and enhancement of the Company's products, services and
technologies. Research and development expenses increased 259% from $377,000 for
the three months ended September 30, 1997 to $1.4 million for the three months
ended September 30, 1998. To date, all research and development costs have been
expensed as incurred. The Company expects that the level of research and
development expenses will continue to increase in the near future in terms of
absolute dollars as the Company invests in developing new product and service
offerings. As a percentage of net revenue, research and development expenses
increased from 3.1% for the three months ended September 30, 1997 to 5.3% for
the three months ended September 30, 1998.
Research and development expenses increased 164% from $1.1 million for the
nine months ended September 30, 1997 to $2.9 million for the nine months ended
September 30, 1998. As a percentage of net revenue, research and development
expenses increased from 3.5% for the nine months ended September 30, 1997 to
4.6% for the nine months ended September 30, 1998.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist primarily of salaries of business development,
general management, administrative and financial personnel, marketing expenses,
corporate services from Science Applications International Corporation ("SAIC"),
legal and other professional costs and amortization of goodwill associated with
the Company's 1995 acquisition by
12
<PAGE> 13
SAIC. Selling, general and administrative expenses increased 230% from $3.1
million for the three months ended September 30, 1997 to $10.2 million for the
three months ended September 30, 1998. The increase is primarily attributable to
increases in marketing and business development expenses of $5.0 million
including television, Internet banner advertising and targeted direct mail
campaigns. The Company expects that the level of marketing and business
development expenses will increase in the near future as the Company continues
to promote the value of a .com Web address and other new Internet-based
value-added services. The Company also plans to continue to develop its
distribution channels, both domestically and internationally.
As a percentage of net revenue, selling, general and administrative
expenses increased from 25.5% for the three months ended September 30, 1997 to
40.3% for the three months ended September 30, 1998.
Selling, general and administrative expenses increased 210% from $7.9
million for the nine months ended September 30, 1997 to $24.4 million for the
nine months ended September 30, 1998. The increase was attributable to a $10.2
million increase in marketing and business development expenses, increased
staffing expenses of $1.5 million and an increase in legal and other
professional costs of $2.7 million.
As a percentage of net revenue, selling, general and administrative
expenses increased from 25.5% for the nine months ended September 30, 1997 to
39.2% for the nine months ended September 30, 1998.
Interest Income. The Company had interest income of $570,000 for the three
months ended September 30, 1997 as compared to $1.7 million for the three months
ended September 30, 1998.
The Company had interest income of $1.1 million for the nine months ended
September 30, 1997 as compared to $4.4 million for the nine months ended
September 30, 1998. The increase for both the three month and nine month
comparisons is attributable to the investment of the net proceeds of the
Company's initial public offering as well as positive cash flow resulting from
increasing domain name registrations.
Income Taxes. The provision for income taxes was 45% of pretax earnings,
or $995,000 for the three months ended September 30, 1997, and 42% or $2.2
million for the three months ended September 30, 1998.
The provision for income taxes was 45% of pretax earnings, or $2.0 million
for the nine months ended September 30, 1997, and 42%, or $5.4 million for the
nine months ended September 30, 1998. The difference between the effective rates
for both periods presented is principally attributable to the relative impact
that non-deductible goodwill had on pretax operating income. Goodwill is being
amortized by the Company over five years and is associated with the acquisition
of the Company by SAIC in 1995.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998, the Company's principal source of liquidity was its
cash and cash equivalents of $9.1 million and its short-term investments of
$107.9 million, which when combined represent an increase of $35.7 million from
the December 31, 1997 balance in those accounts. The Company also has $6.3
million of marketable securities held as long term investments as of September
30, 1998.
At September 30, 1998, the Company's cumulative net obligation to SAIC for
intercompany activity was $2.6 million, a net increase of $1.3 million from
December 31, 1997. Intercompany activity is primarily comprised of salaries and
benefits paid by SAIC on behalf of the Company. The Company currently reimburses
SAIC for intercompany activity on a monthly basis. Pursuant to the Tax Sharing
Agreement dated September 26, 1997, the Company now generally remits income tax
payments directly to tax authorities as it no longer is part of SAIC's
consolidated group for federal income tax purposes.
Cash provided by operations was $42.1 million for the nine months ended
September 30, 1998. This amount is principally attributed to net income plus the
increase in deferred revenue reflecting cash collected in advance of
registration services revenue recognition ratably over the two- and one-year
registration terms. Partially offsetting this amount is an increase in deferred
tax assets resulting from accelerated revenue recognition for tax purposes and
the subsequent tax liabilities.
13
<PAGE> 14
Investing activities totaled $79.3 million for the nine months ended
September 30, 1998, of which $67.7 million was net purchases of short-term
investments and $6.0 million of long-term investments. These investments are
primarily comprised of commercial investment grade securities.
The Company believes that its existing cash balance, investments and cash
flows expected from future operations will be sufficient to meet the Company's
capital requirements for at least the next 12 months.
FACTORS AFFECTING OPERATING RESULTS.
Ongoing Privatization of Internet Administration. The Internet is not
bound by geography, and neither the U.S. Government nor any single organization
or entity currently has formal authority over all aspects of the Internet. There
is, however, a need for central policy decisions surrounding the coordination of
the administrative services required for the registration, allocation and use of
TLDs and Internet Protocol ("IP") numbers, and for the effective global
operation of the Internet. This role has been filled through mutual cooperation
and interrelated informal agreements, historical leadership from an
unincorporated entity called the Internet Assigned Numbers Authority (the
"IANA") and growing involvement from the U.S. Government. With the onset of
increased commercial growth of the Internet, the U.S. Government has initiated
an activity directed at increased privatization of the policy making and central
administration of the Internet. Without authoritative policy making, it is
becoming increasingly more difficult to achieve consensus in the historical
manner. Failure to achieve consensus among the various groups who now informally
administer the Internet could disrupt Internet operations or delay
infrastructure improvements or changes in operations needed to maintain and
expand the Internet. The Company's business, financial condition and results of
operations could be materially and adversely affected by such a failure.
Within the U.S. Government, leadership for the further privatization of
Internet administration is currently provided by the NTIA. After a series of
draft proposals and public comment periods, on June 10, 1998, the NTIA published
in the Federal Register the Statement of Policy, calling for the formation of a
not-for-profit corporation to assume responsibility for administration of the
DNS, but which is not expected to perform actual registration of domain names
either as a registrar or registry. The Statement of Policy invites private
sector Internet stakeholders to work together to form a new private,
not-for-profit corporation to oversee policy for the Internet name and address
system. The Statement of Policy calls for a separation of the registry and
registrar functions of the DNS, both of which functions are currently performed
exclusively by the Company in the .com, .org .net, and .edu TLDs.
As part of the process initiated by the Statement of Policy, several
proposals were put forward to the NTIA on the establishment and governance of
the not-for-profit corporation. ICANN has submitted a series of proposals which
is forming the basis of public discussion at a series of meetings one of which
was held on November 14, 1998.
As a result of these and other meetings and private negotiations, the
process initiated by the Statement of Policy may result in U.S. Government
recognition of ICANN as the not-for-profit corporation under the Statement of
Policy. The NTIA plan calls for a phased transition of its responsibilities for
the DNS to the not-for-profit corporation over the period ending on September
30, 2000.
There are several risks associated with the recognition of private sector
DNS administration and the establishment of, and transfer of DNS administration
from the NTIA to, the not-for-profit corporation. Some of those risks include:
- failure to achieve consensus on the many issues relating to the
establishment and governance of the not-for-profit corporation could
prevent or delay the transition and thereby result in instability in DNS
administration,
- the not-for-profit corporation could fail to achieve consensus or gain
legitimacy resulting in instability in the operation of the Internet,
- the U.S. Government could refuse to transfer some responsibilities for
DNS administration to the not-for-profit corporation thereby resulting in
fragmentation or other instability in DNS administration,
14
<PAGE> 15
- the Company might not succeed in establishing an acceptable contractual
agreement with the not-for-profit corporation, and
- the not-for-profit corporation could adopt or promote policies,
procedures or programs that are unfavorable to the Company's role in the
registration of domain names or that are not consistent with, or
preclude, the Company's current or future plans.
Despite the significant efforts undertaken to date, it is impossible to
predict at this time whether or when the process initiated by the Statement of
Policy will result in the transition of DNS administration and, if it does, the
effect on the Company of such transition. The Company's business, financial
condition and results of operations could be materially and adversely affected
by any of these events and the uncertainty regarding authoritative sources for
domain name registration policies.
Status of Cooperative Agreement. On January 1, 1993, the Company initiated
phase-in of the Cooperative Agreement. The three-month phase-in was followed by
a five year operations period (commencing April 1, 1993 and ending March 31,
1998) and a six-month "flexibility period" through September 30, 1998. Effective
in September 1998, the responsibility for the Cooperative Agreement was
transferred to the NTIA. In October 1998, the Cooperative Agreement was amended
to extend its term through September 30, 2000. As the U.S. Government
transitions its responsibilities for the DNS to the not-for-profit corporation,
corresponding obligations under the Cooperative Agreement may be terminated and,
as appropriate, covered in a contract between the not-for-profit corporation and
the Company. In the October 1998 Amendment, the Company and the NTIA agreed to a
plan for the transition to a shared registration system, in which multiple
registrars may register domain names with the single registry for each TLD, in a
phased approach, the first phase of which is scheduled to be completed by March
31, 1999.
While the Cooperative Agreement by its terms expires in September 2000, it
may be terminated earlier by the NTIA. The Company's business, financial
condition and results of operations could be materially and adversely affected
by a termination or a change in the terms of the Cooperative Agreement. There is
also a risk that the U.S. Government's interpretation of certain provisions of
the Cooperative Agreement could differ from the Company's. Certain aspects of
implementation of the Cooperative Agreement also remain to be negotiated. If the
Company is unsuccessful in negotiating acceptable terms of implementation, the
costs of implementation of the Cooperative Agreement, the Company's relationship
with the not-for-profit corporation and other matters affecting the Company's
position in a more competitive DNS environment could all be materially and
adversely affected.
There is a risk that withdrawal of or challenges to the government's
sponsorship or authorization of certain functions that the Company performs
could create a public perception or result in a legal finding that the Company
lacks authority to continue in the Company's current role as registry or
registrar within the .com, .org, .net and .edu TLDs. The legal authority
underlying the roles of NTIA and the not-for-profit corporation with regard to
the DNS system also could be challenged. The impact, if any, of any such public
perception or finding is unknown but it could materially and adversely affect
the Company's business, financial condition and results of operations.
Increased Competition in Domain Name Registration Business. A principal
objective of the Statement of Policy is to introduce additional competition and
global participation in the management of Internet names and addresses,
including competition among registrars within a single TLD and competition among
existing and new TLDs. The October 1998 Amendment reflects this objective with
the transition to a shared registration system in a phased approach, the first
phase of which is scheduled to be completed by March 31, 1999. Many aspects of
how competition will work in the DNS, however, remain unsettled and could be
impacted by, among other things, actions of the not-for-profit corporation.
Although the Statement of Policy contemplates establishment of additional
competition, the Company currently faces competition in the domain name
registration business from registries for country codes, third level domain name
providers such as Internet access providers and registries of TLDs other than
those TLDs which the Company currently registers. A number of entities have
already begun to offer competing registration services using other TLDs and when
the shared registration system takes effect the Company will no longer be the
exclusive registrar in .com, .org and .net TLDs.
15
<PAGE> 16
Future competition in the Company's domain name registration business could
come from many different companies, including:
- domain name registration resellers,
- Internet access providers,
- major telecommunications firms, and
- cable companies.
Many of these entities have core capabilities to deliver registration
services, such as help desks, billing services and network management, along
with strong name recognition and Internet industry experience. The Company's
position as the leading registrar of domain names could be materially and
adversely affected by the emergence of any of these competitors and potential
competitors, many of which have longer operating histories and significantly
greater name recognition and greater financial, technical, marketing,
distribution and other resources than the Company. The Company's revenue from
registration fees could be reduced due to increased competition, pricing
pressures or a modification of billing practices. For example, other entities
may bundle domain name registrations with other products or services. The
introduction of additional competition into the domain name registration
business could have a material adverse effect on the Company's business,
financial condition and results of operations.
Limited Service Offerings to Date; Reliance on Domain Name Registration
Services for a Significant Portion of Revenues. The Company's domain name
registration services business generates over 90% of the Company's revenue and
is expected to continue to account for a very significant portion of the
Company's revenue in at least the near term. The Company's future success will
depend largely on:
- the continued increase in domain name registrations,
- re-registration rates of the Company's customers,
- the Company's ability to maintain its current position as a leading
registrar of domain names, and
- the successful development, introduction and market acceptance of new
services that address the demands of Internet users.
Although the Company has experienced revenue growth in recent periods, the
Company may not be able to sustain it and such growth may not be indicative of
future operating results. For example, the Company may not be able to maintain
its current position in providing domain name registration services or develop
or market additional services. The Company's failure to do so could materially
and adversely affect the Company's business, financial condition and results of
operations.
Limited Operating History. Prior to September 14, 1995, the Company was
paid directly by the NSF for providing registration services on a cost
reimbursement plus fixed fee basis. Accordingly, the Company has only a limited
operating history for its current domain name registration business upon which
to base an evaluation of the Company and its prospects. The Company's prospects
must be considered in light of the risks frequently encountered by companies in
their early stages of development, particularly companies in new and rapidly
evolving markets. To address these risks, the Company must, among other things:
- respond to competitive developments,
- increase its sales and marketing operations,
- continue to identify, attract, retain and motivate qualified persons, and
- continue to upgrade and integrate technologies, products and services.
Due to the rapidly evolving nature of Internet technologies, the Company's
enterprise network consulting services business faces similar risks. The Company
may not be successful in addressing such risks.
Evolving Sales and Marketing Organization and Distribution Channels. The
Company will need to effectively manage its growing sales and marketing
organization if the Company wants to achieve future
16
<PAGE> 17
revenue growth. The Company does not know if it will be able to identify,
attract and retain experienced sales and marketing personnel with relevant
experience. Further, the Company's sales and marketing organization may not be
able to successfully compete against the significantly more extensive and
well-funded sales and marketing operations of its current or potential
competitors.
In addition to establishing direct sales channels, the Company is also
developing multiple distribution channels. The Company's ability to achieve
future revenue growth will also depend on its establishing and maintaining
relationships with Internet access providers and other third parties and on
effective use of the Internet as a medium of distribution.
If the Company fails to manage and grow its new sales and marketing
organization, develop and expand its distribution channels or effectively use
the Internet as a medium of distribution, the Company's business, financial
condition and results of operations could be materially and adversely affected.
Reliance on Third Parties. The functioning of the DNS is facilitated
through a hierarchy of domain name servers (specialized software programs
resident in network computers). The top level of this hierarchy consists of 13
globally distributed servers (ten in the United States, two in Europe and one in
Asia), which together are referred to as the Root Server System. These root
servers function as the equivalent of master "white pages" of the Internet. The
Company administers and operates two of the 13 root servers (designated by the
letters A and J). Root Server A has special significance. Every night the
Company updates the Root Server A database by adding the newly registered second
level domain names and updating existing domain name records. The 12 other root
servers then copy the updated database.
All 13 root servers contain information with respect to all TLDs, including
country code TLDs. Also, nine of the 13 root servers currently are populated
with the domain names registered by the Company. When communication with a
particular host within a domain name is required and the IP address of that host
is not known locally, the root servers make that information available or
"point" to a direct or indirect source of the information. Multiple root servers
are required for purposes of load balancing and redundancy.
The location and control of these root servers historically has been
determined by consensus of various members of the Internet community. The eleven
root servers that the Company does not maintain and control are maintained and
controlled by independent operators on a volunteer basis. If these volunteer
operators at any time, for any reason, fail to properly maintain such servers or
abandon such servers, the Company's business, financial condition and results of
operations could be materially and adversely affected.
Further, as no single organization or entity currently has formal authority
over all aspects of the Internet, neither the U.S. Government nor any
organization or entity has clear legal authority to direct root server
operations including where the root servers are to be pointed. If any or all of
the root servers fail to include or provide accessibility to the Company's data,
the Internet and the Company's business, financial condition and results of
operations would be materially and adversely affected.
The Company's success and ability to compete also depend upon its
relationships with Internet service providers ("ISPs") worldwide. The Company's
business, financial condition and results of operations would be materially and
adversely affected if enough ISPs decided not to route Internet communications
to or from domain names registered by the Company or if enough ISPs decided to
provide routing to a set of accepted root servers which did not point to the
Company's TLD servers.
System Interruption and Security Risks. A failure in the operation of the
Company's registration system could result in deletion of one or more domain
names from the Internet for a period of time. A failure in the
17
<PAGE> 18
operation or update of Root Server A could result in deletion of one or more
TLDs from the Internet and the discontinuation of domain names in those TLDs for
a period of time.
The Company's operations depend on its ability to maintain its computer and
telecommunications equipment in effective working order and to reasonably
protect its systems against interruption. Such interruptions could result from:
- fire, natural disaster, sabotage, power loss, telecommunication failure,
human error or similar events,
- computer viruses, hackers or similar disruptive problems caused by
employees, customers or other Internet users, and
- systems strain caused by the growth of the Company's customer base and
the Company's inability to sufficiently maintain or upgrade its systems.
The Company's business, financial condition and results of operations could
be materially and adversely affected by any damage, failure or delay that causes
significant interruptions in the Company's systems.
Regulation. In the United States, apart from the Company's obligations
under the Cooperative Agreement, the Company is not currently subject to direct
regulation other than federal and state regulation applicable to businesses
generally. However, if there are changes in the regulatory environment, the
Company could become subject to direct regulation by U.S. regulatory agencies.
For example, the Company is aware that certain industry requests have been made
to the Federal Communications Commission (the "FCC") to review the impact of
Internet usage on the U.S. telecommunications service providers, in particular,
the generally lower cost for data transmission versus voice. In addition, as the
Internet becomes more widespread internationally, international regulation
becomes more likely. The Company cannot predict whether or to what extent any
such new regulation will occur; however, such regulation could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Additionally, the Company is not certain how existing laws governing issues
such as intellectual property ownership would be applied to it. The Company also
is not certain how courts will interpret the obligation of domain name
registration providers to prevent trademark infringement and other legal issues.
See "-- Legal Proceedings."
Legal Proceedings. The Company is involved in several legal proceedings.
As of November 1, 1998, the Company was named as a defendant in two active
lawsuits involving domain name disputes between trademark owners and domain name
holders. In addition, on March 20, 1997, PG Media, Inc., a New York-based
corporation, filed a lawsuit (the "PG Media suit"), alleging that the Company
had violated the Sherman Act by restricting access to the Internet by not adding
PG Media's requested TLDs to the Internet root zone system. In its complaint, PG
Media has, in addition to requesting damages, asked that the Company be ordered
to include reference to PG Media's TLDs and name servers in the root zone file
that the Company administers under the Cooperative Agreement. The Company
received written direction from the NSF not to take any action which would
create additional TLDs or to add any new TLDs to the Internet root zone until
the NSF provides further guidance. On September 17, 1997, PG Media filed a
Second Amended Complaint adding the NSF as a defendant. On May 14, 1998, PG
Media served the Company with a motion for a preliminary injunction against both
defendants. The motion sought a hearing before the court on June 8, 1998 to
compel both defendants to add PG Media's TLDs to the Internet root zone within
30 days. In response, both the Company and the NSF filed cross motions for
summary judgment against PG Media. On July 20, 1998, all motions were heard. The
basic issue before the court was the NSF's authority to control the Internet's
root zone system. The court has taken the issue under advisement and no date has
been indicated for the issuance of a decision.
18
<PAGE> 19
On October 17, 1997, a group of six plaintiffs filed a lawsuit (the "Thomas
suit") against the Company and the NSF. The lawsuit:
- challenged the legality of fees charged by the Company for domain name
registration services; and
- sought restitution of fees collected from domain name registrants in an
amount in excess of $100 million.
The plaintiffs alleged violations of the Administrative Procedures Act,
Independent Offices Appropriations Act, the Sherman Act and the U.S.
Constitution. In August 1998, the court dismissed all of the plaintiffs' claims
against the Company. In October 1998, however, the plaintiffs appealed the
court's dismissal of their claims.
While the Company cannot reasonably estimate the potential impact of the
claims advanced in the PG Media or Thomas suits, a successful claim against the
Company in either of these proceedings could have a material adverse effect on
the Company's business, financial condition and results of operations.
In addition, on June 27, 1997, SAIC received a Civil Investigative Demand
("CID") from the U.S. Department of Justice ("DOJ") issued in connection with an
investigation regarding possible antitrust violations under the Sherman Act
relating to Internet registration products and services. The Company cannot
reasonably estimate the potential impact of the investigation nor can the
Company predict whether a civil action will ultimately be filed by the DOJ or
the form of relief that might be sought. Any such relief could have a material
adverse effect on the Company's business, financial condition and results of
operations.
On August 17, 1998, the Company received notice from the Commission of the
European Communities (the "EC") of an investigation concerning the Company's
Premier Domain Registration Service Program ("Premier Program") in Europe. The
EC requested production of these agreements and related materials for review.
The Company cannot reasonably estimate the potential impact of the investigation
nor can the Company predict whether an action will ultimately be brought by the
EC or the form of relief that might be sought. Any such relief could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Legal proceedings in which the Company is involved have resulted and likely
will result in, and any future legal proceedings can be expected to result in,
substantial legal and other expenses to the Company and a diversion of the
efforts of the Company's personnel.
Technological Change and Additional Technology, Products and Services. The
Company's future financial success will depend upon its ability to develop,
integrate or commercialize in a timely manner new technology, products and
services that can be offered with the Company's current domain name registration
and enterprise network consulting services and that can meet the changing
requirements of the Company's current and future customers. The market for such
technology, products and services is characterized by rapidly changing
technology and evolving industry standards. Generally, the successful
development and commercialization of new technology, products and services
involves many risks, including:
- identifying opportunities for new products or services,
- identifying, hiring and retaining appropriate research and development
personnel,
- successfully completing the development process, and
- customer acceptance of the product or service.
Uncollectible Receivables; Modifications to Billing Practices. Currently,
the Company invoices a majority of its customers and permits them to pay their
services fee after the domain name is registered. The Company believes it has
experienced a high level of uncollectible receivables due to, among other
factors, the large number of individuals and corporations that have registered
multiple domain names with the apparent intention of reselling such names at a
profit. The Company's experience has been that such resellers have a greater
tendency than other customers to default on their services fees. The Company has
established a
19
<PAGE> 20
provision for uncollectible accounts which the Company believes to be adequate
to cover anticipated uncollectible receivables; however, actual results could
differ from the Company's estimates.
The Company continually reviews its billing practices for modification to
respond to market conditions and to implement operational improvements. These
modifications could have unanticipated consequences which could materially and
adversely affect the Company's business, financial condition and results of
operations.
Competition in Internet-Based Businesses and Enterprise Network Consulting
Services. In developing and distributing products and services for the
Internet-based services markets, the Company faces intense competition and
expects to have multiple competitors for each of the products or services the
Company develops or sells. Many of the Company's potential competitors for these
products have longer operating histories, greater name recognition and
significantly greater financial, technical, marketing, distribution and other
resources than the Company does. In addition, the Company's industry is
characterized by rapid changes and frequent product and service introductions.
To the extent a competitor introduces a competitive product or service before
the Company introduces the same or similar product or service, market acceptance
of the competitor's product or service may adversely affect the Company's
competitive position.
The Company's current and potential competitors in its enterprise network
consulting services business are companies with Internet expertise including
systems integrators and consulting firms, such as Andersen Consulting, IBM
Global Services and International Network Services. The Company also competes
with certain companies that have developed products that automate the management
of IP addresses and name maps throughout enterprise-wide networks and with
companies with internally-developed systems integration efforts. Many of these
competitors and potential competitors have longer operating histories, greater
name recognition and significantly greater financial, technical, marketing,
distribution and other resources than the Company does.
Management of Growth; Dependence on Key Personnel. The Company continues
to experience growth in the number of its employees and in the scope of its
operating and financial systems. This growth has increased the responsibilities
for both existing and new management personnel. To manage growth, the Company
will have to successfully integrate its management team, continue to implement
and improve its operational, financial and management information systems and to
train, motivate, manage and retain its employees. If the Company cannot manage
its growth, its business, financial condition and results of operations could be
materially and adversely affected. In addition, growth of the Company's customer
base may strain the capacity of its computers and telecommunications systems.
Therefore, the Company must maintain or upgrade its systems or risk degradation
in performance or system failure.
The Company's future success also depends on the continued service of its
key engineering, sales, marketing, executive and administrative personnel, and
its ability to identify, hire and retain additional personnel. On November 16,
1998, the Company announced the resignation of Gabriel A. Battista from his
positions as Chief Executive Officer and Director of the Company. While the
Company conducts a search for a new Chief Executive Officer, Michael A. Daniels,
Chairman of the Board, will assume the executive responsibilities previously
performed by Mr. Battista. In addition, Robert J. Korzeniewski, Chief Financial
Officer, will also be acting as the Company's Chief Operating Officer, assuming
responsibility for day-to-day operations. In addition, the future success of the
Company's enterprise network consulting services business depends in large part
on its ability to hire, train and retain engineers who have expertise in a wide
array of network and computer systems and a broad understanding of the
industries the Company serves. If the Company fails to hire, train and retain a
sufficient number of qualified engineers, the Company's ability to adequately
manage and complete its existing projects or to obtain new projects, as well as
expanding its business, could be impaired. Competition for engineering, sales,
marketing and executive personnel is intense. The Company cannot be certain that
it will be able to retain existing personnel or identify, hire or retain
additional qualified personnel. It is impossible to reasonably estimate the
potential financial impact of hiring a new Chief Executive Officer at this time.
Intellectual Property Rights. As required under the Cooperative Agreement,
on or before November 6, 1998, the Company submitted to the U.S. Government an
electronic copy of all software and data generated
20
<PAGE> 21
under the Cooperative Agreement through September 30, 1998. By December 6, 1998,
the Company must submit to the U.S. Government a copy of all existing
documentation for that software and data generated through September 30, 1998.
The U.S. Government is required to take appropriate measures to protect the
confidentiality of such data, software and documentation. The Company's
business, financial condition and results of operations could be materially and
adversely affected if:
- the Company's ownership rights in its data, software and documentation
were to be successfully challenged,
- the Company cannot protect such rights,
- the Company is required to share its data, software and documentation
with potential competitors, or
- the Company's potential competitors were otherwise able to obtain its
data, software or documentation.
The Company relies on a combination of nondisclosure and other contractual
arrangements with its employees and third parties, privacy and trade secret laws
to protect its proprietary rights and limit the distribution of its proprietary
information. Although these actions are considered reasonable and adequate, no
controls can guarantee the protection of the Company's proprietary rights.
Furthermore, even if these steps are successful, other companies may develop
technologies that are similar or superior to the Company's proprietary
technology. Although the Company believes that its services do not infringe on
the intellectual property rights of others and that the Company has all rights
needed to use the intellectual property employed in its business, it is possible
that the Company could become subject to claims alleging infringement of third
party intellectual property rights. Any claims could subject the Company to
costly litigation, and may require the Company to pay damages and develop
non-infringing intellectual property or acquire licenses to the intellectual
property that is the subject of the alleged infringement. If the Company fails
to adequately protect its proprietary rights or if the Company becomes involved
in litigation relating to intellectual property rights, the Company's business,
financial condition and results of operations could be materially and adversely
affected.
Dependence on Future Growth of the Internet and Internet
Infrastructure. The Company's future success substantially depends on the
continued growth in the use of the Internet. If the use of and interest in the
Internet does not continue to grow at its current pace, the Company's business,
financial condition and results of operations would be materially and adversely
affected. Continued growth of the Internet could be slowed by:
- inadequate infrastructure,
- lack of availability of cost-effective, high speed systems and service,
- failure to maintain a reliable network system,
- delays in developing or adopting new standards and protocols to handle
increased levels of Internet activity, or
- government regulation.
If the use of the Internet does not continue to grow, if the necessary
infrastructure or complementary products are not developed or do not effectively
support growth that may occur, or if the Internet does not become a viable
information medium or commercial marketplace, the Company's business, financial
condition and results of operations would be materially and adversely affected.
Uncertainty of Future Acquisitions and Investments. The Company evaluates
potential acquisitions and investments on an ongoing basis. The Company may not
be able to compete successfully for available acquisition candidates, complete
future acquisitions and investments or accurately estimate the financial effect
on the Company of any businesses the Company acquires or investments the Company
makes. Future acquisitions and investments may require the Company to spend
significant cash amounts or decrease operating income, either of which could
have a material adverse effect on the Company's business, financial
21
<PAGE> 22
condition and results of operations. The Company's failure to implement
successfully its acquisition and investment strategy could materially and
adversely affect the Company's business, financial condition and results of
operations. The Company may also make future acquisitions or investments in
companies which are in the early stages of development. To the extent that any
of these companies fail, it could have a material adverse effect on the
Company's financial condition.
Potential Fluctuations in Quarterly Results. The Company's quarterly
operating results may fluctuate significantly in the future due to a variety of
factors, many of which are beyond the Company's control. Such factors may
include, but are not limited to:
- developments in Internet governance including establishment of the
not-for-profit corporation and the effect of the October 1998 Amendment,
- increased competition, through the introduction of competing TLDs or
competing registrars in .com, .net or .org,
- variations in the number of requests for domain name registrations or
demand for the Company's services,
- introduction or enhancements of services by the Company or its
competitors,
- market acceptance of new service offerings,
- costs associated with developing or providing domain name registration or
other services,
- litigation costs,
- adverse results of litigation,
- termination or completion of contracts in the Company's enterprise
network consulting services business or failure to obtain additional
contracts in that business,
- patterns of growth in the use of and interest in the Internet, or
- general economic conditions.
In addition, the Company expects a significant increase in its operating
expenses as it:
- increases sales and marketing operations,
- updates systems and infrastructure,
- funds greater levels of product and services development,
- develops new distribution channels,
- broadens customer support capabilities, and
- expands facilities.
If the increase in the Company's expenses is not followed by an increase in
revenue, the Company's business, financial condition and results of operations
could be materially and adversely affected.
In addition, a majority of the Company's enterprise network consulting
services operating expenses, particularly personnel and related costs,
depreciation and rent, are substantially fixed before any particular quarter. As
a result, any under-utilization of engineers may cause the Company's operating
results to vary significantly in any particular quarter and could result in
losses for such quarter.
Control by SAIC. As of November 6, 1998, SAIC owned 100% of the Company's
outstanding Class B Common Stock, representing approximately 74.1% of the
Company's outstanding Common Stock and approximately 96.6% of the combined
voting power of the Company's outstanding Common Stock. The Class B Common Stock
is convertible into Class A Common Stock, subject to certain limitations set
forth in the Company's Second Amended and Restated Certificate of Incorporation
(the "Certificate of Incorporation"). As a result, SAIC effectively controls all
matters requiring approval by the Company's stockholders
22
<PAGE> 23
including the election of members of the Company's Board of Directors, changes
in the size and composition of the Board of Directors and a change in control.
The Company does not have an agreement with SAIC which restricts its rights to
convert, distribute or sell its shares of the Company's Common Stock and there
can be no assurance that SAIC will maintain its ownership of the Company's Class
B Common Stock.
Reliance on SAIC for Certain Corporate Services. The Company has entered
into certain intercompany agreements with SAIC, including an agreement pursuant
to which SAIC will provide various corporate services to the Company that may be
material to the conduct of the Company's business (the "Corporate Services
Agreement"). These services include certain routine and ordinary corporate
services, including business insurance, accounting systems, employee benefits,
payroll, tax and legal services as well as assistance in government relations
and corporate quality assurance services as described in the Corporate Services
Agreement. With respect to matters covered by the Corporate Services Agreement,
the Company's relationship with SAIC is intended to continue in a manner
generally consistent with past practices. If SAIC's ownership of the Company's
outstanding Common Stock drops below 50%, the Corporate Services Agreement will
be terminable by either party upon 180 days' prior written notice. Certain
individual services are also terminable by either party upon 180 days' prior
written notice, regardless of SAIC's ownership interests. Although neither the
Company nor SAIC currently intends to terminate the Corporate Services
Agreement, if SAIC did elect to terminate the Corporate Services Agreement, the
Company may not be able to secure alternative sources for such services within
180 days or such services may only be available at prices higher than those
charged by SAIC.
Certain Charter Provisions and Limitations on Liability. The Company's
Certificate of Incorporation includes provisions relating to competition by SAIC
with the Company, allocations of corporate opportunities, transactions with
interested parties and intercompany agreements and provisions limiting the
liability of certain people. It is unclear whether such provisions are
enforceable under Delaware corporate law. The Company's Certificate of
Incorporation provides that any person purchasing or acquiring an interest in
shares of the Company's capital stock shall be deemed to have consented to the
provisions in the Certificate of Incorporation relating to competition with
SAIC, conflicts of interest, corporate opportunities and intercompany
agreements, and such consent may restrict such person's ability to challenge
transactions carried out in compliance with such provisions. The corporate
charter of SAIC does not include similar provisions. Therefore, persons who are
directors and/or officers of the Company and who are also directors and/or
officers of SAIC may choose to take action in reliance on such provisions rather
than act in a manner that might be favorable to the Company but adverse to SAIC.
Under the Company's Certificate of Incorporation, the personal monetary
liability of the Company's directors for breach of their fiduciary duty of care,
including actions involving gross negligence, is eliminated to the fullest
extent permitted under Delaware law.
International Revenues. While substantially all of the Company's
operations, facilities, and personnel are located within the United States, the
Company's revenues from sources outside the U.S. have increased significantly
and may continue to increase in the future. As a result, the Company is subject
to the risks of conducting business internationally, including unexpected
changes in regulatory requirements, fluctuations in the U.S. dollar, tariffs and
other barriers and restrictions and the burdens of complying with a variety of
foreign laws. The Company does not know what the impact of such regulatory,
geopolitical and other factors will be on its business in the future or if the
Company will have to modify its business practice. In addition, the laws of
certain foreign countries may not protect the Company's proprietary rights to
the same extent as do the laws of the United States.
Possible Volatility of Stock Price. The market price of the Company's
Class A Common Stock has been and is likely to continue to be highly volatile
and may be significantly affected by factors such as actual or anticipated
fluctuations in the Company's quarterly operating results, announcements of
technological innovations, industry conditions and trends, changes in or the
Company's failure to meet the expectations of securities analysts and investors,
general market conditions and other factors. It is possible that in some future
quarter, the Company's operating results may be below the expectations of
securities analysts and investors. If this occurs, the price of the Company's
Class A Common Stock would likely decline, perhaps substantially. In
23
<PAGE> 24
addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the market prices of the stocks of
technology companies, including Internet-related companies. These broad market
fluctuations may adversely affect the market price of the Company's Class A
Common Stock. In the past, following periods of volatility in the market price
of a particular company's securities, securities class action litigation has
often been brought. Such litigation could result in substantial costs and a
diversion of management's attention and resources, which could have a material
adverse effect on the Company's business, financial condition and results of
operations.
YEAR 2000 COMPLIANCE
The Company is in the process of assessing the potential effects of the
Year 2000 millennium change on the Company's business systems and processes,
including the Internet root servers under the Company's control,
telecommunications systems, facilities, data-networking infrastructure,
commercial-off-the-shelf hardware, software and components used by its employees
and its outsourcing vendors. The Company's Year 2000 project is proceeding on
schedule. The project goal is to ensure that the Company's business is not
impacted by the date transitions associated with the Year 2000.
The Company's Year 2000 project plan is coordinated by a team that reports
directly to senior management. The project team is evaluating the Year 2000
compliance of the Company's business systems and processes, including the
Internet root servers under the Company's control, telecommunications systems,
facilities, data-networking infrastructure, commercial-off-the-shelf hardware,
software and components used by its employees and its outsourcing vendors whom
provide services relating to the Company's domain name registration business.
The Company's Year 2000 project is comprised of the following phases:
- Phase 1 -- Inventory all of the Company's business systems and processes,
including the Internet root servers under the Company's control,
telecommunications systems, facilities, data-networking infrastructure,
commercial-off-the-shelf hardware, software and components used by its
employees in order to assign priorities to potentially impacted systems
and services. This phase is expected to be completed in November 1998;
- Phase 2 -- Assess the Year 2000 compliance of all inventoried business
systems and processes, including the Internet root servers under the
Company's control, telecommunications systems, facilities,
data-networking infrastructure, commercial-off-the-shelf hardware,
software and components used by its employees and determine whether to
renovate or replace any non-Year 2000 compliant systems and services.
This phase is expected to be completed by December 1998;
- Phase 3 -- Complete remediation, if any is required, of any non-Year 2000
compliant business systems and processes, including the Internet root
servers under the Company's control, telecommunications systems,
facilities, data-networking infrastructure, commercial-off-the-shelf
hardware, software and components used by its employees. Conduct
procurements to replace any other non-Year 2000 compliant business
systems and processes, telecommunications systems, facilities,
data-networking infrastructure, commercial-off-the-shelf hardware,
software and components used by its employees that won't be remediated.
All remediation efforts, if any are required, are expected to be
completed by April 30, 1999;
- Phase 4 -- Test and validate remediated and replacement systems, if any
such remediation or replacement is required, to ensure inter-system
compliance and mission critical system functionality. The testing and
validation efforts, if any are required, are expected to be completed by
May 31, 1999;
- Phase 5 -- Deploy and implement remediated and replacement systems, if
any deployment or implementation is required, after the completion of
successful testing and validation. The deployment and implementation of
the remediated or replacement systems, if any is required, are expected
to be completed by October 31, 1999; and
- Phase 6 -- Design contingency and business continuation plans in the
event of the failure of business systems and processes,
telecommunications systems, facilities, data-networking infrastructure,
commercial-off-the-shelf hardware, software and components used by the
Company's employees due to the
24
<PAGE> 25
Year 2000 millennium change. The initial contingency and business
continuation plan is expected to be in place by December 31, 1998.
Based on its inventory and assessment to date, the Company believes that
its internal mission critical systems are Year 2000 compliant. The Company, in
its normal course of business, anticipates replacing or upgrading, prior to the
millennium change, portions of these systems with new systems which will also be
Year 2000 compliant. Currently, the Company is enhancing its back-office and
registration-related systems and the software relating to its core domain name
registration services business. When complete in 1999, this enhancement effort
will result in replacing portions of the existing registration-related systems
which will be procured from vendors as Year 2000 compliant and will be subjected
to both component and end-to-end testing and validation to ensure the Year 2000
compliance of such systems prior to acceptance and deployment in the Company's
business. This enhancement effort is a function of the Company's business growth
and not a Year 2000 remediation effort.
Based on its inventory and assessment to date, the Company believes that
its facilities and telecommunications systems are Year 2000 compliant. The
Company has conducted detailed assessments of the components of its
telecommunications infrastructure and is working to identify appropriate system
testing guidelines. In addition, the Company is seeking assurances from its
facilities' landlords and telecommunications equipment vendors and data circuit
providers regarding the Year 2000 compliance of their facilities and equipment.
In the event of electrical power interruption outside of the Company's control,
the Company has deployed back-up power systems capable of operating its core
business indefinitely.
At this time, the Company believes that its incremental remediation costs,
if any, needed to make its current business systems and processes, including the
Internet root servers under the Company's control, telecommunications systems,
facilities, data-networking infrastructure, commercial-off-the-shelf hardware,
software and components used by its employees Year 2000 compliant are not
material. While the Company is incurring some incremental costs directly
relating to staff augmentation for the Year 2000 program management and
technical assessment, the costs expended by the Company through October 31, 1998
are less than $100,000. The Company's expected total costs, including
remediation and replacement costs, if any, are estimated to be between $500,000
and $1,000,000 over the life of the Year 2000 project. Since portions of the
mission critical back office and domain name registration-related systems will
generally be replaced as a function of business growth, the labor and capital
costs associated with such replacement systems are not directly attributed to
achieving Year 2000 compliance.
The Company is contacting its other hardware and software vendors, other
significant suppliers, outsourcing service providers and other contracting
parties to determine the extent to which the Company is vulnerable to any such
third party's failure to achieve Year 2000 compliance for their own systems. At
the present time, the Company does not expect Year 2000 issues of any such third
parties to materially affect the Company's business. Furthermore, the Company's
business depends on the continued operation of, and widespread access to, the
Internet. This, in turn, depends to a large extent on third parties on which the
Company's systems rely or to which they are connected or of other
Internet-related companies, including Internet web hosting companies, Internet
access providers and Internet root server operators. The Company can give no
assurances that the systems of such companies will be Year 2000 compliant or
that the failure of such third parties to achieve Year 2000 compliance will not
have a material adverse effect on the Company. To the extent that the normal
operation of the Internet is disrupted by the Year 2000 millennium change, the
Company's business, financial condition or results of operations could be
materially and adversely affected.
Should the Company fail to solve a Year 2000 compliance problem to its
mission critical business systems and processes, including the Internet root
servers under the Company's control, telecommunications systems, facilities,
data-networking infrastructure, commercial-off-the-shelf hardware, software and
components used by its employees the result could be a failure or interruption
to normal business operations. The Company believes that, with the deployment of
the new back office and domain name registration related systems in 1999, the
potential for significant interruptions to normal operations should be
minimized. The
25
<PAGE> 26
Company's primary risks with regard to Year 2000 failures are those which impact
its domain name registration business. The reasonably likely worst case risks
inherent in the Company's business are as follows:
- Significant and protracted interruption of electrical power to data and
call-center operations in the Company's engineering facility could
materially and negatively impact the Company's ability to provide data
and call-center operations. To mitigate this risk, the Company has
deployed back-up power systems capable of operating indefinitely.
However, electrical power interruptions that impact Internet connectivity
providers could adversely impact the Company because of the Company's
reliance upon Internet-based operations for its day to day business.
- Significant and protracted interruption of telecommunications and data
network services in either of the Company's headquarters or engineering
facilities could materially and negatively impact the Company's ability
to provide data and call-center operations. The Company has conducted
detailed assessments of the components of its telecommunications
infrastructure and is working to identify appropriate system testing
guidelines. As part of the technical assessment scheduled for completion
by the end of 1998, the Company will have identified the compliance
status of its data networking infrastructure and developed plans for
remediation, if necessary. Finally, the Company has plans to seek
additional assurances and a better understanding of the compliance
programs of its telecommunications and data circuit providers.
- The failure of components of the Company's current back office and domain
name registration related systems could materially and negatively impact
the Company's business. However, as a function of business growth, these
systems are planned to be retired before the end of 1999. As a
contingency planning measure, the Company is conducting a technical
assessment of the current systems and their software applications in the
event that the deployment of the new systems is delayed beyond December
1999.
- Despite the assurances of the Company's third-party suppliers, hardware
and software vendors, and outsourcing service providers regarding the
Year 2000 compliance of their products and services, the potential exists
that a Year 2000 problem relating to such third-party suppliers, vendors
and outsourcing service providers products and services could have a
material impact on the Company's business. The Company is conducting
monthly discussions with its mission critical outsourcing service
providers to determine the progress of their Year 2000 compliance
programs.
Despite the Company's belief that its mission critical computer software
applications and systems are Year 2000 compliant and the expectation that its
enhancement effort will result in Year 2000 compliant back-office and
registration-related systems and software relating to its core domain name
registration services business, the Company is currently developing a business
continuation contingency plan and is performing a test on the existing core
registration-related systems that are being replaced. The Company expects to
finalize its initial contingency plan and to complete the testing of all
existing systems by December 31, 1998.
Although the Company is taking appropriate steps relative to ensuring that
the Company's business is not impacted by the date transitions associated with
the Year 2000, the Company has no responsibility for, nor control over other
Internet root server operators or tens of thousands of lower level domain name
system server operators that are critical to the efficient operation of the
Internet. The Company has no way of knowing whether such root server operators
or other server operators have hardware, software or firmware that is Year 2000
compliant. The Company is notifying various federal government authorities of
this issue and requesting that the necessary steps be taken to ensure the
uninterrupted and efficient operation of the Internet.
Forward-Looking Statements
The foregoing Year 2000 discussion contains "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements, including without limitation, anticipated costs and the dates by
which the Company expects to complete certain actions, are based on management's
best current estimates, which were derived utilizing numerous assumptions about
future events, including the continued availability of certain resources,
representations received from third parties and other factors.
26
<PAGE> 27
However, there can be no guarantee that these estimates will be achieved, and
actual results could differ materially from those anticipated. Specific factors
that might cause such material differences include, but are not limited to, the
ability to identify and remediate all relevant systems, results of Year 2000
testing, adequate resolution of Year 2000 issues by governmental agencies,
businesses and other third parties who are outsourcing service providers,
suppliers, and vendors of the Company, unanticipated system costs, the adequacy
of and ability to implement contingency plans and similar uncertainties. The
"forward-looking statements" made in the foregoing Year 2000 discussion speak
only as of the date on which such statements are made, and the Company
undertakes no obligation to update any forward-looking statement to reflect
events or circumstances after the date on which such statement is made or to
reflect the occurrence of unanticipated events.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not Applicable.
27
<PAGE> 28
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
As of November 1, 1998, the Company was a defendant in two active lawsuits
involving domain name disputes between trademark owners and domain name holders.
The Company is drawn into such disputes, in part, as a result of claims by
trademark owners that the Company is legally required, upon request by a
trademark owner, to terminate the right the Company granted to a domain name
holder to register a domain name which is alleged to be similar to the trademark
in question. The holders of the domain name registrations in dispute have, in
turn, questioned the Company's right, absent a court order, to take any action
which suspends their use of the domain names in question. Although 43 out of
approximately 4,000 of these situations have resulted in suits actually naming
the Company as a defendant, as of November 1, 1998, no adverse judgment has been
rendered and no award of damages has ever been made against the Company. The
Company believes that it has meritorious defenses and vigorously defends itself
against these claims.
On March 20, 1997, PG Media, Inc., a New York-based corporation ("PG
Media"), filed a lawsuit against the Company in the United States District
Court, Southern District of New York alleging that the Company had restricted
access to the Internet by not adding PG Media's requested TLDs to the Internet
root zone system in violation of the Sherman Act. In its complaint, PG Media
has, in addition to requesting damages, asked that the Company be ordered to
include reference to PG Media's TLDs and name servers in the root zone file
administered by the Company under the Cooperative Agreement. The Company
answered the complaint. In June 1997, the Company received written direction
from the NSF not to take any action which would create additional TLDs or to add
any new TLDs to the Internet root zone until the NSF provides further guidance.
On September 17, 1997, PG Media filed a Second Amended Complaint adding the NSF
as a defendant. On May 14, 1998, PG Media served the Company with a motion for a
preliminary injunction against both defendants. The motion sought a hearing
before the court on June 8, 1998 to compel both defendants to add PG Media's
TLDs to the Internet root zone within 30 days. On July 20, 1998, a hearing on
all parties' motions occurred. The basic issue before the court is the NSF's
authority to control the Internet's root zone system. The court has taken the
issue under advisement and no date has been indicated for the issuance of a
decision. Although the Company cannot reasonably estimate the potential impact
of such claims, a successful claim under the plaintiff's theory could have a
material adverse effect on the Company's business, financial condition and
results of operations.
On October 17, 1997, a group of six plaintiffs filed a lawsuit (the "Thomas
suit") against the Company and the NSF in the United States District Court,
District of Columbia, challenging the legality of fees defendants charge for the
registration of domain names on the Internet and seeking restitution of fees
collected from domain name registrants in an amount in excess of $100 million,
damages, and injunctive and other relief. Plaintiffs originally alleged
violations of the Competition in Contracting Act ("CICA"), the Sherman Act and
the U.S. Constitution. Following the filing of motions to dismiss by the
defendants, the plaintiffs filed an amended complaint on January 30, 1998,
dropping the cause of action based upon CICA, but adding alleged violations of
the Administrative Procedures Act and the Independent Offices Appropriations
Act. The plaintiffs also filed a motion for preliminary injunctive relief
against the NSF concerning the "Intellectual Infrastructure Fund." On February
2, 1998, the United States District Court, District of Columbia, issued an order
granting the plaintiffs' motion for a preliminary injunction, enjoining the NSF
from spending any of the money collected by the Company for the Intellectual
Infrastructure Fund. On February 10, 1998, the plaintiffs filed a motion for
preliminary injunction against the Company seeking several items of relief. On
February 24, 1998, the Company and the NSF filed motions to dismiss the amended
complaint. Also on February 24, the plaintiffs filed a motion for partial
summary judgment concerning the Intellectual Infrastructure Fund. The
plaintiffs' motion for preliminary injunction against the Company and partial
summary judgment against the NSF, and both motions to dismiss were heard before
the Court on March 17, 1998. On April 6, 1998, the Court issued its opinion
granting summary judgment in favor of the plaintiffs on the Intellectual
Infrastructure Fund, ruling it an "unlawful tax." The court also granted the
Company's motion to dismiss all other counts (II through X) and simultaneously
denied the plaintiffs' preliminary injunction motion against the Company.
Subsequently, the NSF appealed the February 2, 1998 preliminary injunction
against it. On April 30, 1998, Congress passed H.R. 3579 which was signed into
law by
28
<PAGE> 29
the President on May 1, 1998. Section 8003 of H.R. 3579 legalized, ratified and
confirmed the entire Intellectual Infrastructure Fund and authorized and
directed the NSF to deposit the entire fund into the U.S. Treasury. On May 5,
1998, the NSF filed a motion to vacate the preliminary injunction and to dismiss
the case. On June 4, 1998, the plaintiffs filed a notice of appeal on the
Court's dismissal of counts II through X and on the plaintiff's motion for
preliminary injunction against the Company. On June 27, 1998, the United States
Court of Appeals for the District of Columbia Circuit dismissed the plaintiffs'
appeal of the Court's dismissal of counts II through X at this juncture in the
case. On August 28, 1998, the District Court dismissed the entire case, issuing
a final judgment in the matter. Following that decision, the plaintiffs
dismissed all pending appeals in the Court of Appeals. The plaintiffs, however,
on October 23, 1998, filed a new notice of appeal from the final order filed by
the District Court on August 28, 1998.
On June 27, 1997, SAIC received a CID from the DOJ issued in connection
with an investigation to determine whether there is, has been, or may be any
antitrust violation under the Sherman Act relating to Internet registration
products and services. The CID seeks documents and information from SAIC and the
Company relating to their Internet registration business. The Company cannot
reasonably estimate the potential impact of the investigation nor can it predict
whether a civil action may ultimately be filed by the DOJ or the form of relief
that might be sought. Any such relief from such a suit could have a material
adverse effect on the Company's business, financial condition and results of
operations.
On August 17, 1998, the Company received notice from the Commission of the
European Communities of an investigation concerning the Company's Premier
Program agreements in Europe. The EC requested production of these agreements
and related materials for review. The Company cannot reasonably estimate the
potential impact of the investigation nor can the Company predict whether an
action will ultimately be brought by the EC or the form of relief that might be
sought. Any such relief could have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company is involved in various other investigations, claims and
lawsuits arising in the normal conduct of its business, none of which, in the
opinion of the Company's management, will have a material adverse effect on its
financial position, results of operations, cash flows or its ability to conduct
business.
Litigation in which the Company is involved has resulted and likely will
result in, and any future litigation can be expected to result in, substantial
legal and other expenses to the Company and a diversion of the efforts of the
Company's personnel.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
The Company's Registration Statement on Form S-1 (Registration No.
333-30705) was declared effective September 25, 1997 by the Securities and
Exchange Commission. The managing underwriters of the Class A common stock
offering commencing September 26, 1997 were Hambrecht & Quist, J.P. Morgan & Co.
and PaineWebber Incorporated. The Company registered and sold 3,220,000 shares
for its own account at an aggregate price of $57,960,000 and the selling
stockholder (SAIC) registered and sold 575,000 shares for its account at an
aggregate price of $10,350,000, for a combined total of 3,795,000 shares at an
aggregate price of $68,310,000. The offering has since terminated.
The total amount of expenses incurred for the Company's account in
connection with the offering were $5,555,200, which is comprised of $4,057,200
for underwriting discounts and commissions and $1,498,000 of other expenses. No
expenses were paid to directors, officers or persons owning more than ten
percent of any class of the Company's equity securities. The resultant Company's
net offering proceeds were $52,404,800. The net proceeds to SAIC for its account
were $9,625,500 after deducting the associated underwriting discounts and
commissions of $724,500.
On October 1, 1997, the Company received the offering proceeds from which a
$10,000,000 dividend was paid to SAIC. SAIC owns ten percent or more of a class
of the Company's equity securities and is an affiliate of the Company. The
remaining proceeds have been invested in investment grade government discount
notes, commercial paper and corporate bonds.
29
<PAGE> 30
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits -- See Exhibit Index
(b) The Company filed a report on Form 8-K on October 6, 1998 announcing
that it had entered into an amendment to its Cooperative Agreement with
the United States Department of Commerce (the "Amendment"). A copy of
the Amendment and a press release related thereto were filed as
exhibits to the Form 8-K.
30
<PAGE> 31
SIGNATURE
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.
NETWORK SOLUTIONS, INC.
By: /s/ ROBERT J. KORZENIEWSKI
Robert J. Korzeniewski
Chief Financial Officer, Acting
Chief Operating Officer and
Authorized Signatory
Date: November 16, 1998
31
<PAGE> 32
EXHIBIT INDEX
NETWORK SOLUTIONS, INC.
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION OF EXHIBITS
- - ------- -----------------------
<S> <C>
10.22 Amendment No. 10 to the Cooperative Agreement dated
September 29, 1998
27.1 Financial Data Schedule
</TABLE>
32
<PAGE> 1
<TABLE>
<CAPTION>
<S> <C> <C>
FORM CD-451 U.S. DEPARTMENT OF COMMERCE
(REV 10-93) [ ] GRANT [X] COOPERATIVE AGREEMENT
D&O 203-26 -----------------------------------------
AMENDMENT TO ACCOUNTING CODE
FINANCIAL ASSISTANCE AWARD N/A
-----------------------------------------
AWARD NUMBER
NCR 92-18742
- - -----------------------------------------------------------------------------------------------------------
RECIPIENT NAME AMENDMENT NUMBER
Network Solutions, Incorporated Ten (10)
- - -----------------------------------------------------------------------------------------------------------
STREET ADDRESS EFFECTIVE DATE
505 Huntmar Park Drive October 1, 1998
- - -----------------------------------------------------------------------------------------------------------
CITY, STATE, ZIP CODE EXTEND WORK COMPLETION TO
Herndon, Virginia 22070 October 7, 1998
- - -----------------------------------------------------------------------------------------------------------
DEPARTMENT OF COMMERCE OPERATING UNIT
National Telecommunications and Information Administration
- - -----------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C>
COSTS ARE REVISED AS FOLLOWS: PREVIOUS TOTAL
N/A ESTIMATED COST ADD DEDUCT ESTIMATED COST
- - -----------------------------------------------------------------------------------------------------------
FEDERAL SHARE OF COST
$ $ $ $
- - -----------------------------------------------------------------------------------------------------------
RECIPIENT SHARE OF COST
$ $ $ $
- - -----------------------------------------------------------------------------------------------------------
TOTAL ESTIMATED COST
$ $ $ $
- - -----------------------------------------------------------------------------------------------------------
</TABLE>
REASON(S) FOR AMENDMENT In accordance with the Memorandum of Agreement entered
into under the authority of the National Science Foundation Act of 1950, as
amended, 42 U.S.C. Sec. 1861-75, and specifically 42 U.S.C. Sec. 1870(c), (j),
and 42 U.S.C. 1862(a)(4), (h), the flexibility period of the Cooperative
Agreement is extended at no additional cost to the Government
- - --------------------------------------------------------------------------------
THIS AMENDMENT APPROVED BY THE GRANTS OFFICER IS ISSUED IN TRIPLICATE AND
CONSTITUTES AN OBLIGATION OF FEDERAL FUNDING. BY SIGNING THE THREE DOCUMENTS,
THE RECIPIENT AGREES TO COMPLY WITH THE AMENDMENT PROVISIONS CHECKED BELOW AND
ATTACHED, AS WELL AS PREVIOUS PROVISIONS INCORPORATED INTO THE AWARD. UPON
ACCEPTANCE BY THE RECIPIENT, TWO SIGNED AMENDMENT DOCUMENTS SHALL BE RETURNED
TO THE GRANTS OFFICER AND THE THIRD DOCUMENT SHALL BE RETAINED BY THE RECIPIENT.
IF NOT SIGNED AND RETURNED BY THE RECIPIENT WITHIN 15 DAYS OF RECEIPT, THE
GRANTS OFFICER MAY DECLARE THIS AMENDMENT NULL AND VOID.
[X] Special Award Conditions
[ ] Line Item Budget
[ ] Other(s):
- - --------------------------------------------------------------------------------
<TABLE>
<S> <C> <C>
SIGNATURE OF DEPARTMENT OF COMMERCE GRANTS OFFICER TITLE DATE
Joseph Levine /s/ Joseph Levine Acting Grants Officer Office of 9/29/98
Executive Assistance Management
- - ------------------------------------------------------------------------------------------------------------
TYPED NAME AND SIGNATURE OF AUTHORIZED RECIPIENT OFFICIAL TITLE DATE
/s/ D.M. GRAVES DAVID M. GRAVES 9/29/98
DIRECTOR, BUSINESS AFFAIRS
- - ------------------------------------------------------------------------------------------------------------
</TABLE>
<PAGE> 2
SPECIAL AWARD CONDITIONS
NCR 92-18742
Amendment Number Ten (10)
1. The Grants Officer's Name, address, and telephone number are:
Joseph Levine
Acting Grants Officer
U.S. Department of Commerce
Office of Executive Assistance Management
14th Street & Constitution Avenue, N.W., Room H6054
Washington, D.C. 20230
202 482-1370
2. The Grant/Cooperative Agreement Specialist's name, and telephone number
are:
Betty L. Cassidy
202 482-5381
3. The Federal Program Officer's name, address, and telephone number are:
J. Beckwith Burr
Acting Associate Administrator for International Affairs
National Telecommunications and Information Administration
U.S. Department of Commerce
14th Street & Constitution Avenue, N.W., Room H4712
Washington, D.C. 20230
202 482-1304
<PAGE> 3
MEMORANDUM OF AGREEMENT
BETWEEN
THE NATIONAL SCIENCE FOUNDATION
AND
THE U.S. DEPARTMENT OF COMMERCE
I. PURPOSE
This memorandum of agreement (MOA) provides for the transfer of authority from
the National Science Foundation (NSF) to authorize the U.S. Department of
Commerce (DOC) to administer Cooperative Agreement NCR 92-18742. It is in the
mutual interest of DOC and NSF to transfer this authority and to cooperate in
negotiating the terms of the ramp down of the Cooperative Agreement to ensure
the seamless and stable transition from the existing framework of Internet
administration to a private sector management governance structure as set forth
in the Statement of Policy entitled, "Management of Internet Names and
Addresses," 63 Fed. Reg. 31741 (1998) (hereinafter "Statement of Policy").
II. BACKGROUND
A. In the spring of 1992, NSF issued a competitive Program Solicitation
(NSF 92-24) for Information Services for NSFNET and the NREN (National
Research and Education Network) which included, among other activities,
registration services for the non-military Internet registration. As a
result of that solicitation, NSF awarded Cooperative Agreement NCR 92-18742
to Network Solutions, Inc. (NSI), which required, among other activities,
NSI to provide registration services for the non-military Internet
registration for the period January 1, 1993, through September 30, 1998,
including a 3-month phase-in period and a 6-month unfunded flexibility
period.
B. In July of 1997, the President directed the Secretary of Commerce to
support efforts to make the governance of the Internet domain name system
private and competitive and to transition the management of domain names
and addresses to the private sector. The principle purpose of this MOA is
to aid DOC with carrying out this mission. Further, all executive
departments and agencies were directed "to promote efforts domestically and
internationally to make the Internet a secure environment for commerce."
NSF and DOC agree that the transfer of the Cooperative Agreement to DOC is
necessary to further this objective. NSF and DOC have also determined that
DOC will initiate negotiations with NSI regarding the steps NSI will take
under the Cooperative Agreement and otherwise to facilitate the development
of a private, competitive domain name system as set forth in the Statement
of Policy.
III. RESPONSIBILITIES
A. The NSF agrees to:
1. Transfer immediately a copy of the official award file to DOC,
including all
<PAGE> 4
amendments, addenda, performance reports, financial reports, progress
reports, program plans, budget documents and related correspondence. This
material will be provided to Joseph Levine, Acting Grants Officer, Office
of Executive Assistance Management, U.S. Department of Commerce, 14th
Street and Constitution Avenue, N.W., Room 6054, Washington, D.C. 20230,
(202) 482-1370, "[email protected]".
2. On receipt of information about the DOC points of contact under section
B.2 below, notify NSI that DOC, as of the date of execution of this MOA,
shall assume responsibility for the administration of the Cooperative
Agreement. NSF will provide NSI with names, telephone numbers and E-mail
addresses of the DOC points of contact for the Cooperative Agreement in the
cognizant programmatic, business, and administrative areas.
3. Consult with DOC throughout the duration of this MOA and the Cooperative
Agreement, including the negotiations with NSI.
4. Continue to be responsible for the disposition of funds from the
Intellectual Infrastructure fund that have been or will be transferred to
NSF by NSI as authorized and directed by Sec 8003 of Public Law No.
105-174, 112 Stat. 58, 93-94 (1998).
5. Continue, in concert with the U.S. Department of Justice, to be
responsible for any litigation concerning the Intellectual Infrastructure
fund mentioned in the preceding paragraph and all other litigation arising
from actions of NSF or NSI prior to the effective date of this MOA.
6. Continue to be responsible for audit activities covering the period
between the award of the Cooperative Agreement and the date of execution of
this MOA. NSF agrees to provide the results of any such audit to DOC and to
transfer the original official award file after the completion of such
audit.
B. DOC agrees to:
1. Negotiate, prepare and execute any amendment or agreement, in
consultation with NSF and DOJ, regarding the terms and conditions of the
ramp down of the Cooperative Agreement with NSI and the other steps NSI
will take to facilitate the development of a private, competitive domain
name system.
2. Provide Karen L. Sandberg, Division of Grants and Agreements, Office of
Budget, Finance, and Award Management, National Science Foundation, Room
495N, 4201 Wilson Boulevard, Arlington, VA 22230, (703) 306-1212,
"[email protected]" with the names, telephone numbers and E-mail addresses
of the DOC points of contact in the cognizant programmatic, business,
and administrative areas for the Cooperative Agreement within three (3)
working days
2
<PAGE> 5
of the execution of this MOA.
IV. PERIOD AND TERMS OF AGREEMENT
A. This MOA will be effective from the date of the last signature and
continue in full force and effect through the expiration of the Cooperative
Agreement. This MOA may be renegotiated and amended, extended, or otherwise
modified through an exchange of correspondence with signatory approval of
authorized officials of DOC and NSF.
B. This MOA does not require DOC to obligate appropriated funds in excess
of funds available to DOC, or for items of expenditure agreed upon between
NSF and NSI prior to the date of this MOA.
C. This MOA may be terminated by authorized officials of either party
hereto with 30 days written notification to the other party.
V. AUTHORITY
This MOA is entered into under the authority of the National Science Foundation
Act of 1950, as amended, 42 U.S.C. Sections 1861-75, and specifically 42 U.S.C.
Sections 1870(c), (j), which authorizes NSF to transfer its legal authority to
DOC, and 42 U.S.C. Sections 1862(a)(4), (h), which authorizes the award of
Cooperative Agreement NCR 92-18742. This MOA is also authorized by the National
Telecommunications and Administration Organization Act, 47 U.S.C. Section 901 et
seq.
This MOA is effective upon signatures of both parties.
FOR THE NATIONAL SCIENCE FOUNDATION FOR THE U.S. DEPARTMENT OF COMMERCE
By: /s/ Aaron R. Asrael By: /s/ Joseph Levine
- - ------------------------------------ -----------------------------------
Name, Title Aaron R. Asrael Name, Title Joseph Levine,
Grants and Agreements Officer Acting Grants Officer
- - ------------------------------------ -----------------------------------
Date 8/27/98 Date Sept./9/1998
3
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 9,124
<SECURITIES> 107,876
<RECEIVABLES> 28,046
<ALLOWANCES> (14,124)
<INVENTORY> 0
<CURRENT-ASSETS> 164,002
<PP&E> 14,820
<DEPRECIATION> 5,241
<TOTAL-ASSETS> 191,915
<CURRENT-LIABILITIES> 100,496
<BONDS> 0
0
0
<COMMON> 16
<OTHER-SE> 62,003
<TOTAL-LIABILITY-AND-EQUITY> 191,915
<SALES> 0
<TOTAL-REVENUES> 62,395
<CGS> 0
<TOTAL-COSTS> 26,451
<OTHER-EXPENSES> 22,908
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 93
<INCOME-PRETAX> 12,943
<INCOME-TAX> 5,426
<INCOME-CONTINUING> 7,517
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 7,517
<EPS-PRIMARY> .47
<EPS-DILUTED> .45
</TABLE>
