<PAGE>
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 June 30, 2000.
or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number: 0-24507
PILOT NETWORK SERVICES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-3305774
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
1080 MARINA VILLAGE PARKWAY
ALAMEDA, CA 94501
(Address of principal executive offices, including zip code)
(510) 433-7800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
---- ----
At June 30, 2000, there were 15,080,927 shares of the Registrant's Common Stock
outstanding.
Page 1 of 17
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PILOT NETWORK SERVICES, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
<TABLE>
<CAPTION>
Page Number
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements........................................... 3
Condensed Consolidated Balance Sheets as of
March 31, 2000 and June 30, 2000............................... 3
Condensed Consolidated Statements of Operations for
the three months ended June 30, 1999 and 2000.................. 4
Condensed Consolidated Statements of Cash Flows for the
three months ended June 30, 1999 and 2000...................... 5
Notes to Condensed Consolidated Financial Statements........... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................... 7
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 16
PART II. OTHER INFORMATION.............................................. 16
Item 6. Exhibits and Reports on Form 8-K............................... 16
SIGNATURES................................................................... 16
INDEX TO EXHIBITS............................................................. 17
</TABLE>
Page 2 of 16
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PILOT NETWORK SERVICES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)
<TABLE>
<CAPTION>
March 31, June 30,
2000 2000
--------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................................... $ 7,920 $ 19,617
Short-term investments...................................................... 898 891
Trade receivables, less allowance for doubtful accounts of $389 and $500 as
of March 31, 2000, and June 30, 2000, respectively......................... 7,233 8,767
Prepaid and other current assets............................................ 843 2,107
--------- ---------
Total current assets....................................................... 16,894 31,382
Property and equipment, net.................................................. 24,624 28,388
Other assets................................................................. 1,639 1,050
--------- ---------
$ 43,157 $ 60,820
========= =========
LIABILITIES, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................ $ 5,352 $ 10,420
Accrued expenses............................................................ 2,067 2,521
Line of credit.............................................................. 4,652 4,293
Term loan................................................................... 3,000 3,000
Current portion of capital lease obligation................................. 2,275 2,380
Deferred revenue............................................................ 1,200 1,826
--------- ---------
Total current liabilities.................................................. 18,546 24,440
Capital lease obligations, net of current portion............................ 3,561 6,700
--------- ---------
Total liabilities.......................................................... 22,107 31,140
--------- ---------
Convertible preferred stock, net of related warrant and issuance costs,
$0.01 par value; 15,000 shares authorized; 15,000 shares issued and
outstanding as of June 30, 2000............................................. - 11,450
--------- ---------
Stockholders' equity:
Common stock, $0.001 par value; 40,000,000 shares authorized; 15,487,063
and 15,531,863 shares issued and outstanding as of March 31, 2000, and
June 30, 2000, respectively................................................ 15 15
Additional paid-in capital.................................................. 77,035 79,952
Accumulated other comprehensive income...................................... 39 16
Deferred stock compensation................................................. (326) (286)
Accumulated deficit......................................................... (53,019) (58,773)
Treasury stock, 450,936 shares of common stock at cost
as of March 31, 2000 and June 30, 2000, respectively................. (2,694) (2,694)
--------- ---------
Total stockholders' equity................................................. 21,050 18,230
--------- ---------
$ 43,157 $ 60,820
========= =========
</TABLE>
See accompanying notes to condensed financial statements.
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PILOT NETWORK SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
Three months ended
June 30,
1999 2000
---- ----
<S> <C> <C>
Service revenues............................... $ 5,816 $11,112
Technology access revenues..................... - 425
------- -------
Total revenues................................. 5,816 11,537
Cost of revenues............................... 6,430 9,690
------- -------
Gross margin................................... (614) 1,847
------- -------
Operating expenses:
Sales and marketing........................... 2,938 4,234
Engineering and development................... 635 1,503
General and administrative.................... 760 1,416
------- -------
Total operating expenses...................... 4,333 7,153
------- -------
Operating loss................................. (4,947) (5,306)
Interest expense, net.......................... (250) (448)
------- -------
Net loss....................................... (5,197) (5,754)
======= =======
Basic and diluted net loss per common share.... $(0.38) $(0.38)
======= =======
Weighted average common shares used in
computing basic and diluted net loss
per share..................................... 13,557 15,064
======= =======
</TABLE>
See accompanying notes to condensed financial statements.
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PILOT NETWORK SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Three months ended
June 30,
1999 2000
<S> <C> <C>
Cash flows from operating activities:
Net loss........................................................ $(5,197) $(5,754)
Adjustments to reconcile net loss to net cash used in operating
activities:
Foreign currency translation loss.............................. (8) -
Depreciation and amortization.................................. 1,599 2,545
Amortization of deferred compensation.......................... 193 40
Amortization of loan fees...................................... 150 250
Provision for doubtful accounts................................ 97 111
Changes in operating assets and liabilities:
Trade receivables............................................. 612 (1,645)
Prepaid and other assets...................................... 139 (925)
Accounts payable.............................................. 1,268 5,068
Accrued expenses.............................................. (336) 454
Deferred revenue.............................................. (567) 626
------- -------
Net cash provided by (used in) operating activities........... (2,050) 770
------- -------
Cash flows used in investing activities:
Purchases of property and equipment............................. (4,840) (2,309)
Purchases of short-term investments............................. - (16)
Proceeds from short-term investments............................ 2,827 -
------- -------
Net cash used in investing activities......................... (2,013) (2,325)
------- -------
Cash flows from financing activities:
Proceeds from issuance of common stock.......................... 387 367
Proceeds from issuance of convertible preferred stock and
related warrant, net of issuance costs......................... - 14,000
Payments on working capital line of credit...................... (1,083) (359)
Principal payments of obligations under capital leases.......... (526) (756)
------- -------
Net cash provided by (used in) financing activities........... (1,222) 13,252
------- -------
Net increase (decrease) in cash and cash equivalents............. (5,285) 11,697
Cash and cash equivalents, beginning of period................... 10,660 7,920
------- -------
Cash and cash equivalents, end of period......................... $ 5,375 $19,617
======= =======
Supplemental disclosure of cash flow information:
Cash paid during the period for interest........................ $ 385 $ 407
======= =======
Noncash financing activities:
Assets acquired under capital lease obligations................ $ 493 $ 4,000
======= =======
</TABLE>
See accompanying notes to condensed financial statements.
Page 5 of 17
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of presentation
The consolidated financial statements included herein for Pilot Network
Services, Inc. and subsidiary (the "Company") have been prepared by the Company,
without audit, pursuant to the rules and regulations for Form 10-Q of the
Securities and Exchange Commission. In management's opinion, the interim
financial data presented includes all adjustments (which include only normal and
recurring adjustments) necessary for a fair presentation. Certain information
and footnote disclosures normally included in the financial statements prepared
in accordance with generally accepted accounting principles have been condensed
or omitted pursuant to such rules and regulations. The results of operations for
the three months ended June 30, 2000 are not necessarily indicative of the
operating results expected for the entire year. The financial statements
included herein should be read in conjunction with other documents the Company
files from time to time with the Securities and Exchange Commission, including
the Company's Annual Report on Form 10-K for the fiscal year ended March 31,
2000, and its Report on Form 8-K filed June 28, 2000.
2. Basic and diluted net loss per share
Basic and diluted loss per share is computed using the weighted average
number of common shares outstanding during the period. The following options and
warrants to acquire shares of common stock were excluded from the computation of
diluted earnings per share because their effects would be anti-dilutive:
<TABLE>
<CAPTION>
June 30, 1999 June 30, 2000
------------------------------- -------------------------------
Shares Exercise Prices Shares Exercise Prices
------ --------------- ------ ---------------
<S> <C> <C> <C> <C>
Options 2,457,645 $0.090-$20.063 2,701,579 $0.090-$49.875
Warrants 255,374 $0.365-$2.000 675,453 $0.365-$25.000
--------- ---------
2,713,019 3,377,032
========= =========
</TABLE>
Common shares that would result from the conversion of the Company's convertible
preferred stock are also excluded from the computation of diluted earnings per
share.
3. Recent accounting pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement establishes standards for
accounting for derivative instruments and hedging activities. The Company is
required to adopt SFAS No. 133, as amended by SFAS No. 137, in the first quarter
of fiscal year 2002. The Company does not anticipate that SFAS No. 133 will have
a material impact on its financial statements.
In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101 SAB 101, "Revenue Recognition in Financial
Statements." SAB 101 summarized certain of the SEC's view in applying generally
accepted accounting principles to revenue recognition. The Company is required
to adopt SAB 101 in the fourth quarter of fiscal 2001. The SEC has recently
indicated it intends to issue further guidance with respect to adoption of
specific issues addressed by SAB 101. Until such time as this additional
guidance is issued, the Company is unable to assess the impact, if any, it may
have on its financial position or results of operations.
4. Comprehensive loss
Total comprehensive loss for the quarter ended June 30,1999 and 2000, was
$5,242,000 and $5,777,000, respectively.
<PAGE>
Total comprehensive loss for the quarter ended June 30, 1999 and 2000, was
$5,242,000 and $5,777,000, respectively.
5. Convertible preferred stock
In June 2000, the Company sold 15,000 shares of convertible preferred stock
directly to an investor at a price of $1,000 per share. The gross proceeds were
$15.0 million. After transaction fees and costs estimated at $1.0 million, the
net proceeds to the Company were approximately $14.0 million. At the investor's
option, the convertible preferred stock may be converted into shares of common
stock at the lower of 125% of the average market price immediately prior to the
transaction, specifically $18.266 per share, or 101% of the average market price
immediately prior to conversion. The convertible preferred stock pays a dividend
of 3% per annum which can be paid in cash or common stock of the Company, at the
Company's option. The convertible preferred stock matures in two years. The
convertible preferred stock may be redeemed at maturity in either cash or common
stock at the option of the Company or, under certain circumstances, the
convertible preferred stock may be redeemed in cash at the option of the holder
prior to maturity. Prior to maturity, the preferred stock cannot be converted
into more than 3,014,199 of Pilot's outstanding shares of common stock. This
maximum number of shares of common stock upon conversion includes shares of
common stock that may be issued as dividends. At maturity, the convertible
preferred stock may be converted into more than 3,014,199 of the Company's
outstanding shares of common stock only upon prior approval of the Company's
shareholders. As additional consideration, the Company issued a warrant to
purchase 256,621 shares of common stock at 120% of the average market price
immediately prior to the transaction, specifically $17.536 per share. The
Company calculated a fair value of the warrant of $2.55 million which amount was
capitalized and is included as a component of additional paid-in capital. The
fair value of the warrant was calculated using the Black-Scholes option pricing
using the following assumptions: dividend yield-none; contractual life-5 years;
risk free interest rate-5.5%; volatility-85%.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION
Forward-looking statements made in this report or in the documents
incorporated by reference herein that are not statements of historical fact are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended (the "Securities Act"), and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"). A number of
risks and uncertainties, including those discussed under the caption "Risk
Factors" below and the documents incorporated by reference herein could affect
such forward-looking statements and could cause actual results to differ
materially from the statements made.
COMPANY OVERVIEW
We provide a wide range of secure Internet services that incorporate high-
bandwidth connectivity and enable secure electronic business over the Internet.
Our services are offered for a fixed monthly fee on an annual subscription basis
and include secure hosting and Internet connectivity services that enable secure
connectivity between a corporate network and the Internet and secure virtual
private networking services that enable remote users and wide-area networks to
securely communicate enterprise-wide and over the Internet.
Our Internet services allow our customers to avoid the risks associated with
traditional approaches to Internet security. Customers can also avoid extensive
costs associated with implementing an in-house solution, including set-up costs
for security and systems design, hardware, software, Internet access
Page 7 of 17
<PAGE>
services provided by Internet Service Providers, as well as labor and ongoing
costs for telecommunications, staffing, maintenance and upgrades.
The foundation of our solution is our Heuristic Defense Infrastructure, an
Internet security approach we developed to continuously manage and monitor
Internet traffic to and from customer networks in order to respond in real-time
to security threats. The Heuristic Defense Infrastructure consists of a multi-
layered defensive architecture and around-the-clock security operations
delivered through geographically dispersed customer centers called Network
Security Centers that are connected to customer networks via dedicated, high-
speed data lines. Our solution aggregates the experience gained from protecting
each customer against attacks and leverages such experience for the collective
benefit of all customers. The Heuristic Defense Infrastructure offers benefits
over other security approaches by eliminating single points of failure,
enhancing attack detection, delivering real-time defenses, and adapting
continuously to external conditions. Customers can concentrate on their core
business because the secure infrastructure for electronic commerce is provided
by Pilot.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 1999 AND 2000
Service revenues. Service revenues consist of monthly fees for installation,
recurring services and, to a lesser extent, one-time fees for management and
consulting services such as security audits. We had service revenues of $11.1
million in the quarter ended June 30, 2000, an increase of 91% from $5.8 million
in the same period last year. The growth in our service revenues over this
period resulted primarily from an increase in the number of customers and to a
lesser extent from increases in the number of service offerings and in service
revenues per customer.
Technology access revenues. We generate technology access revenues when we
sell access to our technologies and methodologies to enable other companies to
sell or deliver our Heuristic Defense Infrastructure services. Technology access
revenue is recognized upon a signed agreement and delivery of the technology
unless there are related services that are considered to be essential to the
utility of the technology. In the quarter ended June 30, 2000, we sold
technology and methodologies for a total of $425,000. We did not have any
technology access revenues in the same period last year.
Cost of revenues. Our cost of revenues is comprised primarily of our cost for
network bandwidth, equipment costs and salaries and benefits for our customer
service and operations personnel, including our network engineers, backbone
engineers, network management and systems and installation personnel. Network
bandwidth consists of costs for access to and use of third-party communications
networks. Cost of revenues increased from $6.4 million, or 111% of revenue, in
fiscal 2000 to $9.7 million in fiscal 2001, or 84% of revenue. The increase in
cost of revenues in absolute dollars was due to increased costs associated with
the build-out and operation of our Network Security Centers, including increased
costs for network bandwidth, equipment costs and salaries and benefits for our
customer service, engineering and operations personnel. The reduction in cost of
revenues as a percentage of revenues came from better capacity utilization and,
to a lesser extent, higher margins on certain services. We expect the cost of
revenues to increase on an absolute basis at least through fiscal 2001 as a
result of expected customer expansion in our Network Security Centers. As of
June 30, 2000, we employed 114 people in this area, up from 77 as of June 30,
1999.
Sales and marketing. Our sales and marketing expenses are comprised primarily
of salaries, commissions and benefits for our sales and marketing personnel and
marketing expenses for items such as tradeshows and product literature. Our
sales and marketing expenses increased from $2.9 million in fiscal 2000 to $4.2
million in fiscal 2001. The increase was primarily the result of hiring
additional sales and marketing personnel in connection with our expansion of our
operations. We expect that sales and marketing expenses will continue to
increase in absolute dollars. As of June 30, 2000, we employed 68 people in this
area, up from 42 as of June 30, 1999.
Page 8 of 17
<PAGE>
Engineering and development. Our engineering and development expenses are
comprised primarily of salaries and benefits for our engineering and development
personnel and fees paid to consultants. These individuals work on researching
changes in security threats and technology, development of new processes and
methodologies, and integration of best-of-breed components into our secure
operating environment. Our engineering and development expenses increased from
$635,000 in fiscal 2000 to $1.5 million in fiscal 2001. Our security and
services development expenses grew from fiscal 2000 to fiscal 2001 primarily due
to the addition of engineering personnel required to create and enhance our
expanded service offerings. We expect that engineering and development expenses
will continue to increase in absolute dollars as we make additional investments
in developing our secure electronic commerce services. As of June 30, 2000, we
employed 39 people in this area, up from 18 as of June 30, 1999.
General and administrative. Our general and administrative expenses are
comprised primarily of salaries and benefits for our general management and
administrative personnel as well as fees paid for professional services. Our
general and administrative expenses increased from $760,000 in fiscal 2000 to
$1.4 million in fiscal 2001. The increase was primarily the result of increased
recruiting, travel as well as costs for consultants and professional services
providers. Over the course of fiscal 2001, we expect to see some increase in
absolute dollars to the extent we expand our operations. As of June 30, 2000, we
employed 16 people in this area, compared to 17 as of June 30, 1999.
Interest expense, net. We had an increase in net interest expense from
$250,000 in fiscal 2000 to $448,000 in fiscal 2001. The increase in net interest
expense was due to a reduction in interest income due to lower average cash
balances as well as an increase in the amortization of loan fees associated with
warrants issued in connection with debt financing.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2000, we had $9.1 million in outstanding equipment lease
facilities that financed equipment purchases bearing interest rates of
approximately 15%. Borrowings under the facilities are repayable in monthly
installments of principal and interest over periods ranging from 36 to 48 months
and are secured by a lien on the financed equipment. As of June 30, 2000, we had
fully utilized these lease facilities. We intend to secure additional equipment
lease facilities to fund growth in capital equipment purchases.
Cash used in operating activities was $2.0 million for the quarter ended June
30, 1999, while our operating activities provided $770,000 in cash in the
quarter ended June 30, 2000. The primary source of cash in operating activities
for fiscal 2001 was the expansion of accounts payable associated with equipment
purchased for customer use. In the quarter ended June 30, 2000, the primary use
of cash in investing activities was for purchases of capital equipment and
leasehold improvements to support increased capacity and services provided to
customers. In the quarter ended June 30, 2000, the major source of cash provided
by financing activities was from the issuance of preferred stock which provided
$14.0 million, net of issuance costs.
In June 2000, we sold 15,000 shares of convertible preferred stock directly
to an investor at a price of $1,000 per share. The gross proceeds were $15.0
million. After transaction fees and costs estimated at $1.0 million, our net
proceeds were approximately $14.0 million. At the investor's option, the
convertible preferred stock may be converted into shares of common stock at the
lower of 125% of the average market price immediately prior to the transaction,
specifically $18.266 per share, or 101% of the average market price immediately
prior to conversion. The convertible preferred stock pays a dividend of 3% per
annum which can be paid in cash or in shares of our common stock at our option.
The convertible preferred stock matures in two years. The convertible preferred
stock may be redeemed at maturity in either cash or common stock at our option
or, under certain circumstances, the convertible preferred stock may be redeemed
in cash at the option of the holder prior to maturity. Prior to maturity, the
preferred stock cannot be converted into more than 3,014,199 of our outstanding
shares of common stock. This maximum number of shares of common stock upon
Page 9 of 17
<PAGE>
conversion includes shares of common stock that may be issued as dividends. At
maturity, the convertible preferred stock may be converted into more than
3,014,199 of our outstanding shares of common stock only upon prior approval of
our shareholders. As additional consideration, we issued a warrant to purchase
256,621 shares of common stock at 120% of the average market price immediately
prior to the transaction, specifically $17.536 per share. We calculated a fair
value of the warrant of $2.55 million which amount was capitalized and is
included as a component of additional paid-in capital. The fair value of the
warrant was calculated using the Black-Scholes option pricing using the
following assumptions: dividend yield-none; contractual life-5 years; risk free
interest rate-5.5%; volatility-85%.
In the quarter ended June 30, 2000, we received funding of an additional $4
million in capital equipment lease facilities from two lessors on terms
substantially similar to previously existing equipment leases.
On December 28, 1999, we entered into an agreement with Primus
Telecommunications Group, Inc. that included the purchase by Primus of 919,540
shares of our common stock for $16.3125 per share for a total purchase price of
$15.0 million. The $16.3125 per share price was the closing price of our common
stock on December 27, 1999. Additionally, we issued to Primus a warrant to
purchase 200,000 shares of common stock at $25 per share. The warrant is
exercisable for three years following its issuance. On January 5, 2000, we
received the full amount of the purchase price in cash, and the shares and
warrant were released to Primus.
On November 10, 1999, we completed an $8.0 million credit facility with a
financial institution consisting of a $5.0 million revolving line of credit and
a $3.0 million term loan. The line of credit is renewable in successive one-year
terms and the term loan matures one year from the effective date. Both loans
currently bear interest of 11% per annum. Additionally, the term loan must be
pre-paid, without penalty, if the we raise more than $15 million in equity. For
each of our two subsequent $15 million equity transactions, the lender waived
the pre-payment provision. The credit facility is secured by our general assets.
As additional consideration, we issued a warrant to purchase 121,212 shares of
common stock at $8.25 per share. We calculated a fair value of the warrants of
$1.0 million which amount was capitalized and is being amortized over the
expected terms of the loans. At June 30, 2000, $707,000 of the revolving line of
credit remained available.
On October 19, 1998, we announced an open-market common stock repurchase
program under which we would repurchase up to 1.5 million shares of our Common
Stock. As of June 30, 2000, 450,936 shares had been repurchased, at an aggregate
cost of approximately $2.7 million. We do not anticipate making any additional
repurchases under this program.
If we are unable to generate sufficient cash flow from operations, or are
unable to obtain additional equity or equipment lease financing, we may be
required to sell assets, scale down our operations and expansion plans,
refinance all or a portion of our existing indebtedness or obtain other sources
of financing earlier than planned, any of which could have a material adverse
impact on our financial condition and ability to continue operations. Our
working capital requirements depend upon several factors, including:
- plans to incur substantial additional capital expenditures
primarily for additions to and expansions of our Network Security
Centers;
- developing, acquiring or licensing new applications and
technologies; and
- the level of resources that we devote to our sales and marketing
activities.
In addition to the $30.0 million in aggregate equity investment in June 2000
and December 1999 and $8.0 million credit facility completed in November 1999,
we believe that we will require additional
Page 10 of 17
<PAGE>
equity financing. However, we may not be successful in generating sufficient
levels of cash from operations or in obtaining financing on commercially
reasonable terms, or at all.
RISK FACTORS
You should carefully consider the following and other information contained
in this Form 10-Q before making an investment decision. If any of the events or
circumstances described in the following risk factors actually occurs, our
business, financial condition, or results of operations could be materially
harmed. In that case, the trading price of our common stock could decline, and
you may lose all or part of your investment.
You should consider carefully whether an investment in Pilot is an
appropriate investment for you. We do not intend to issue any dividends in the
foreseeable future, so the only purpose of investment in Pilot's shares is in
expectation of a potential increase in the shares' value. Because of the risks
mentioned here, and other risks not mentioned specifically here, it is possible
that Pilot's shares will decline in value in the future. If you cannot afford to
lose the full value of your investment, in either the short or long term,
purchasing Pilot shares is not appropriate for you.
If our existing financing sources or other sources of financing are not
available, we may not have sufficient cash to satisfy our working capital
requirements.
If we are unable to generate sufficient cash flow from operations, or are
unable to obtain additional equity or equipment lease financing, we may be
required to sell assets, scale down our operations and expansion plans,
refinance all or a portion of our existing indebtedness or obtain other sources
of financing earlier than planned, any of which could have a material adverse
impact on our financial condition and ability to continue operations. Our
working capital requirements depend upon several factors, including:
- plans to incur substantial additional capital expenditures primarily
for additions to and expansions of our Network Security Centers;
- developing, acquiring or licensing new applications and
technologies; and
- the level of resources that we devote to our sales and marketing
activities.
In addition to the $30.0 million in aggregate equity investment in June 2000
and December 1999 and $8.0 million credit facility completed in November 1999,
we believe that we will require additional equity financing. However, we may not
be successful in generating sufficient levels of cash from operations or in
obtaining financing on commercially reasonable terms, or at all.
We are experiencing operating losses and may not achieve profitability.
We have experienced operating losses and negative cash flows from operations
in each quarterly and annual period since we began operations in 1993 and expect
to continue to experience losses for the foreseeable future. As of June 30,
2000, we had an accumulated deficit of approximately $58.8 million. We
experienced an increase in net loss in fiscal 1998, 1999 and 2000. The revenue
and income potential of our business and market is unproven, and our limited
operating history makes an evaluation of our prospects difficult.
Failure of our services to achieve market acceptance would have a material
adverse effect on our revenues and results of operations. We cannot assure you
that we will ever achieve profitability.
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<PAGE>
Our stock price and our quarterly operating results are highly volatile, which
may impair our ability to raise money and cause our investors to lose money.
Our results of operations may not meet the expectations of securities
analysts or investors, which could cause the market price of our common stock to
decline. For example, a relatively large portion of our expenditures are fixed
in the short-term, and our success is substantially dependent on the continued
growth in our customer base and the retention of our customers for sufficient
periods to provide returns on our investment. We derive revenue from our
customers primarily through initial setup fees and ongoing monthly service
charges. For each new customer, we incur costs in anticipation of the customer's
decision to use our services and in advance of the receipt of sufficient
revenues to repay these costs and provide a return on our investment. Our
customers may decide not to maintain or renew their commitments to use our
services.
In addition, we typically experience a lengthy sales cycle for our services,
particularly given the importance to customers of adequately securing Internet
connectivity for electronic commerce and the need to educate them regarding the
requirements for effective network security. Changes in the rate of growth in
our customer base, customer renewal rates and the sales cycle for our services,
have caused, and we expect will continue to cause for the foreseeable future,
significant fluctuations in our results of operations on a quarterly and an
annual basis.
The conversion of our Series A convertible preferred stock may have a dilutive
impact on our security holders.
The number of shares of common stock that may ultimately be issued upon
conversion of shares of our Series A preferred stock is presently undeterminable
because the conversion price of the Series A preferred stock is based in part on
the price of the common stock at the time of the conversion. The conversion
price of the Series A preferred stock is initially fixed at $18.266 per share.
The conversion of all of the 15,000 shares of Series A preferred stock
outstanding would result in the issuance of approximately 821,198 shares of
common stock. This represents about 5.5% of our outstanding common stock based
on the number of shares outstanding as of June 28, 2000.
The terms of the Series A preferred stock provide that the number of shares
issuable upon conversion of the Series A preferred stock will increase as the
price of our common stock drops. For example, if the price of our common stock
declines and the conversion price falls to $10.00 per share, assuming all 15,000
shares of Series A preferred stock were converted, we would issue approximately
1,500,000 shares of common stock. This would represent approximately 9.9% of our
outstanding common stock based on the number of shares outstanding as of June
28, 2000. Any increased issuance of our common stock resulting from a lowered
conversion price could place additional downward pressure on the price of our
common stock generally. A downward movement in the price of our common stock
could result in the loss of substantially all of your investment.
We rely on third parties to deliver our Heuristic Defense Infrastructure and
generate revenues.
In fiscal 2000, we sold technology and consulting services to enable two
telecommunications carriers to embed our Heuristic Defense Infrastructure in
several of their security centers. As part of the relationship with these
carriers, we will receive a recurring fee based on the total revenue generated
through the Heuristic Defense Infrastructure. In exchange, we will provide
security monitoring for network traffic using the Heuristic Defense
Infrastructure. While the telecommunications carriers have committed capital and
operational resources to these projects, as of July 24, 2000, none of these
third-party centers are operational. There are no guarantees that these centers
will ever be operational or that they will generate material revenues or
earnings for us. To the extent one or both of the carriers elect not to proceed
with using the Heuristic Defense Infrastructure or if the implementation is
materially delayed, there could be a material adverse effect on our ability to
expand operations and improve our operating results and financial condition.
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<PAGE>
We may not be able to prevent unauthorized access to our customers' networks.
Despite our focus on Internet security, we may not be able to stop
unauthorized attempts, whether made unintentionally or by computer "attackers,"
to gain access to or disrupt the network operations of our customers.
Accordingly, our success is substantially dependent on the continued confidence
of our current and potential customers that we provide superior network security
protection. Any failure by us to stop unauthorized access from the Internet or
disruptions to related Internet operations of our customers could materially
harm such customers and us.
Although we generally limit warranties and liabilities relating to security
in our customer contracts, our customers may seek to hold us responsible for any
losses suffered as a result of unauthorized access to customers' network systems
from the Internet. This could result in liability to us, which could have a
material adverse effect upon our business. Moreover, computer attackers from the
Internet could infiltrate our network and sabotage our network or services by
creating bugs or viruses. Any adverse publicity resulting from unauthorized
access could deter future customers from using our services and could cause
current customers to cease using our services, which could have a material
adverse effect upon our business.
We may not be able to effectively manage our growth.
Any inability on our part to manage effectively our expansion, including any
disruption of service to current customers, may have a material adverse effect
upon our business. Our current plans are to expand domestically and
internationally by adding, or partnering with third parties that add, Network
Security Centers in new locations and expanding Network Security Centers in
existing locations. This expansion will require us or our partners to expend
substantial resources for leases and improvements of facilities, purchases of
equipment, implementation of multiple telecommunications connections and hiring
of network, administrative, customer support, and sales and marketing personnel.
Furthermore, it may cause the interruption of service to current customers.
In addition, we have recently hired large numbers of new employees. This
growth has placed, and may continue to place, a significant strain on our
financial, management, operational and other resources.
The market we serve is highly competitive and we may lose market share to
current or future competitors.
We may not have the resources or expertise to compete successfully in the
market we serve. The market we serve is new, rapidly evolving, highly
competitive and largely undefined. There are few barriers to entry, and we
expect that we will face increasing competition from existing competitors and
new market entrants in the future.
We compete with a broad range of products and services. Many of our
competitors have substantially greater financial, technical and marketing
resources, larger customer bases, longer operating histories, greater name
recognition and more established relationships in the industry than we do. As a
result, certain of these competitors may be able to develop and expand their
network infrastructures and service offerings more quickly, adapt to new or
emerging technologies and changes in customer requirements more quickly, take
advantage of acquisition and other opportunities more readily, devote greater
resources to the marketing and sale of their products and adopt more aggressive
pricing policies than us.
In addition, we believe that the businesses with which we compete are likely
to encounter consolidation in the near future, which could result in increased
price and other competition that could have a material adverse effect on our
ability to compete in our market.
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<PAGE>
If our systems fail, our business will suffer.
Despite existing and planned precautions by us, the occurrence of a natural
disaster or other unanticipated problems at one or more of our Network Security
Centers could result in interruptions in the services we provide. Our success
depends on the excellence of security protection and uninterrupted operation of
our network infrastructure. Any damage to or failure of our systems or those of
our service providers could result in reductions in, or terminations of,
services supplied to our customers. These reductions or terminations in service
could materially and adversely impact our customers, which could cause our
customers to elect not to use our services.
The expansion of our international operations exposes us to risks.
A key component of our long-term strategy is to expand into international
markets. If the revenue we generate from any international Network Security
Center is not adequate to offset the expense of establishing and maintaining any
such international operation, our financial condition could be materially
adversely affected.
If our growth exceeds our capacity to transmit data, our business will suffer.
If we fail to achieve or maintain high capacity data transmission, customer
demand for our services could decline significantly. We must continue to expand
and adapt our network infrastructure as the number of customers and the amount
of information they wish to transmit increases, and as customer requirements
change. The expansion and adaptation of our telecommunications infrastructure
will require substantial financial, operational and management resources.
Because the deployment of our services to date has been limited, the ability of
our network to connect and manage a substantially larger number of customers at
high transmission speeds is as yet unknown and our network's ability to operate
with higher customer levels while maintaining superior performance is unproven,
we may not be able to expand or adapt our telecommunications infrastructure to
meet additional demand or our customers' changing requirements.
We depend on third party network infrastructure providers to deliver our
services.
Our business relies on Internet exchange points, or IXPs, to transmit our
customers' traffic to and from the Internet. If the carriers that operate these
IXPs discontinue their support of the peering points or refuse to offer services
to us and no alternative providers emerge, or such alternative providers
increase the cost of utilizing the IXPs, our ability to transmit network traffic
will be significantly constrained. Our success depends upon these Internet
infrastructure providers.
In addition, we rely on a number of private peering interconnections (i.e.,
arrangements among access providers to carry traffic of each other) to deliver
our services. If we are unable to access alternative networks on a cost-
effective basis to distribute our customers' content or pass through any
additional costs of utilizing these networks to our customers, our business will
be materially harmed.
Our ability to deliver our services will suffer if we are unable to obtain
components available in limited quantities or from single source.
If we fail to obtain hardware or software components that we require on a
timely basis and at an acceptable cost, our ability to provide our services will
suffer. We are dependent on other companies to supply certain key components of
our telecommunications infrastructure and system and network management
solutions that, in the quantities and quality demanded by us, are available only
from sole or limited sources.
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<PAGE>
We also intend to develop alternative distribution and lead generation
channel partners for our services, such as systems integration firms and
bandwidth providers. If we fail to develop these channel partners, our ability
to generate increased revenues will be materially and adversely affected.
If we are not able to enhance our services to adapt to rapid technological
change, our services may not achieve market acceptance.
Our success depends, in part, on our ability to offer services that
incorporate leading technology, address the increasingly sophisticated and
varied needs of our current and prospective customers and respond to
technological advances and emerging industry standards and practices on a timely
and cost-effective basis. The market for our services is characterized by
rapidly changing and unproven technology, evolving industry standards, changes
in customer needs, emerging competition and frequent new service introductions.
Future advances in technology may not be beneficial to, or compatible with, our
business or we may not be able to incorporate such advances on a cost-effective
and timely basis into our business. We believe that our ability to compete
successfully is also dependent upon the continued compatibility and
interoperability of our services with products, services and architectures
offered by various vendors as part of our services. These products may not be
compatible with our infrastructure or these products may not adequately address
changing customer needs. In addition, products, services or technologies
developed by others may render our services uncompetitive or obsolete, which
would materially harm our business.
If we are not able to attract and retain qualified personnel, our business will
not be able to grow.
Our success depends in significant part upon the continued services of our
key technical, sales and senior management personnel, including our President
and Chief Executive Officer, Marketta Silvera, and our Chief Technology Officer,
Thomas Wadlow. Any officer or employee of ours can terminate his or her
relationship with us at any time. The loss of the services of one or more of our
key employees or our failure to attract additional qualified personnel could
have a material adverse effect on our business.
The law governing the liability of on-line service providers is unsettled and
exposes us to risks.
The law relating to the liability of on-line service companies such as Pilot
and Internet access providers for information carried on or disseminated through
their networks is currently unsettled. It is possible that claims could be made
against us under both United States and foreign law for defamation, negligence,
copyright or trademark infringement, or other theories based on the nature and
content of the materials disseminated through our networks. The imposition of
liability upon us for information carried on or disseminated through our systems
could require us to implement measures to reduce our exposure to such liability,
which may require the expenditure of substantial resources, or to discontinue
certain service or product offerings.
Our proprietary rights may be inadequately protected and infringement claims
could harm our competitive position.
We rely on a combination of copyright, trademark, patent, service mark and
trade secret laws and contractual restrictions to establish and protect the
proprietary rights in technology underlying our services. We may fail to obtain
patents or trademarks from currently pending or any future applications, and any
patents or trademarks that may be issued or granted may not be sufficient in
scope or strength to provide meaningful protection or any commercial advantage
to us. In addition, the laws of certain foreign countries may not protect our
products, services or intellectual property rights to the same extent as do the
laws of the United States.
The contractual arrangements and other steps we take to protect our
intellectual property may not prove sufficient to prevent infringement of or
misappropriation of our technology or may not deter
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<PAGE>
independent third-party development of similar technologies. Any such
infringement or misappropriation, should it occur, could have a material adverse
effect on our ability to deliver our services.
To date, we have not been notified that our products infringe the proprietary
rights of third parties, but we cannot assure you that third parties will not
claim infringement or indemnification by us with respect to current or future
products. Any such claim, whether meritorious or not, is likely to be time-
consuming, result in costly litigation, cause product installation delays,
prevent us from using important technologies or methods, subject us to
substantial damages, or require us to enter into royalty or licensing
agreements. As a result, any such claim could have a material adverse effect
upon our business.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
We have limited exposure to financial market risks, including changes in
interest rates. The fair value of our investment portfolio or related income
would not be significantly impacted by a 100 basis point increase or decrease in
interest rates due mainly to the short-term nature of the major portion of our
investment portfolio. An increase or decrease in interest rates would not
significantly increase or decrease interest expense on debt obligations due to
the fixed nature of our debt obligations. Our foreign operations are limited in
scope and thus we are not materially exposed to foreign currency fluctuations.
PART II. OTHER INFORMATION.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibits
Exhibit Number Description of Exhibit
27.1 Financial Data Schedule.
B. Reports on Form 8-K
On June 30, 2000, we filed a Report on Form 8-K with the Securities and Exchange
Commission describing our sale of Series A convertible preferred stock to
Marshall Capital Management, Inc.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
August 14, 2000 /s/ William C. Leetham
--------------- ----------------------
William C. Leetham
Senior Vice President, Finance and Administration
Chief Financial Officer, Treasurer and Secretary
(Principal Financial and Accounting Officer)
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EXHIBIT INDEX
Exhibit Number Description of Exhibit
27.1 Financial Data Schedule
Page 17 of 17
