<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
----------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999
Commission File Number 333-59393
RHYTHMS NETCONNECTIONS INC.
State of Incorporation: Delaware I.R.S. Employer ID #: 33-0747515
Address: 6933 South Revere Parkway Telephone #: (303) 476-4200
Englewood, Colorado 80112
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 May 14, 1999, a total of 71,955,625 shares of the Registrant's Common
Stock, $0.001 par value, were issued and outstanding.
<PAGE>
RHYTHMS NETCONNECTIONS INC.
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The following are three-month quarterly consolidated financial statements of the
Registrant as of and through March 31, 1999.
2
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(Unaudited)
December 31 March 31
ASSETS: 1998 1999
------------- -------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 21,315,000 $ 33,752,000
Short-term investments 115,497,000 115,556,000
Accounts, loans, and other receivables, net 2,376,000 2,470,000
Inventory 340,000 1,020,000
Prepaid expenses and other current assets 230,000 147,000
------------- -------------
Total current assets 139,758,000 152,945,000
Equipment and furniture, net 11,510,000 48,912,000
Collocation fees, net 13,804,000 25,828,000
Deferred business acquisitions costs, net - 10,119,000
Deferred debt issue costs, net 6,304,000 7,386,000
Other assets 350,000 357,000
------------- -------------
$ 171,726,000 $ 245,547,000
------------- -------------
------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Current portion of long-term debt $ 333,000 $ 333,000
Accounts payable 10,601,000 29,622,000
Accrued expenses and other current liabilities 2,855,000 3,846,000
------------- -------------
Total current liabilities 13,789,000 33,801,000
Long-term debt 472,000 361,000
13.5% senior discount notes, net 157,465,000 162,990,000
Other liabilities 180,000 217,000
------------- -------------
Total liabilities 171,906,000 197,369,000
------------- -------------
Mandatorily redeemable Common Stock warrants 6,567,000 6,567,000
------------- -------------
Stockholders' equity:
Series A Convertible Preferred Stock, $0.001 par value; 12,900,000 shares
authorized in 1998 and 1999; 12,855,094 shares issued
and outstanding in 1998 and 1999 13,000 13,000
Series B Convertible Preferred Stock, $0.001 par value; 4,044,943
shares authorized in 1998 and 1999; 4,044,943 shares issued
and outstanding in 1998 and 1999 4,000 4,000
Series C Convertible Preferred Stock, $0.001 par value; no shares
authorized in 1998, 7,462,819 shares in 1999; no shares issued
and outstanding in 1998, 7,462,819 shares in 1999 - 7,000
Common Stock, $0.001 par value; 80,049,892 shares authorized in
1998, 89,005,274 shares in 1999; 8,042,530 shares issued in
1998, 9,619,720 shares in 1999 8,000 10,000
Treasury Stock, at cost; 438,115 shares (18,000) (18,000)
Additional paid-in capital 37,212,000 107,543,000
Warrants - 4,714,000
Deferred compensation (5,210,000) (8,007,000)
Accumulated deficit (38,756,000) (62,655,000)
------------- -------------
Total stockholders' equity (deficit) (6,747,000) 41,611,000
------------- -------------
$ 171,726,000 $ 245,547,000
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
(Unaudited)
Three Months Ended
---------------------------
March 31 March 31
1998 1999
------------ ------------
<S> <C> <C>
REVENUE:
Service and installation, net $ 10,000 $ 660,000
------------ ------------
OPERATING EXPENSES:
Network and service costs 198,000 6,138,000
Selling and marketing 284,000 1,685,000
General and administrative 2,038,000 12,111,000
Depreciation and amortization 16,000 782,000
------------ ------------
Total operating expenses 2,536,000 20,716,000
------------ ------------
LOSS FROM OPERATIONS (2,526,000) (20,056,000)
------------ ------------
OTHER INCOME AND EXPENSE:
Interest income 158,000 1,749,000
Interest expense (including amortized debt discount and issue costs) (12,000) (5,627,000)
Other - 35,000
------------ ------------
NET LOSS $ (2,380,000) $ (23,899,000)
------------ ------------
------------ ------------
NET LOSS PER SHARE:
Basic $ (1.10) $ (5.38)
------------ ------------
------------ ------------
Diluted $ (1.10) $ (5.38)
------------ ------------
------------ ------------
SHARES USED IN COMPUTING NET LOSS PER SHARE:
Basic 2,161,764 4,440,052
------------ ------------
------------ ------------
Diluted 2,161,764 4,440,052
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
4
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
(Unaudited)
Three Months Ended
----------------------------
March 31 March 31
1998 1999
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (2,380,000) $(23,899,000)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation of equipment and furniture 12,000 564,000
Amortization of collocation fees 4,000 87,000
Amortization of deferred business acquisition costs - 131,000
Amortization of debt discount and deferred debt issue costs - 5,612,000
Amortization of deferred compensation 94,000 601,000
Gain on sale of equipment to leasing company - (35,000)
Changes in assets and liabilities:
Increase in accounts, loans, and other receivables, net (214,000) (94,000)
Increase in inventory (226,000) (680,000)
Decrease in prepaid expenses and other current assets 2,000 83,000
Decrease (increase) in other assets 4,000 (7,000)
Increase (decrease) in accounts payable 1,261,000 (869,000)
Increase (decrease) in accrued expenses and other current liabilities (65,000) 991,000
Increase in other liabilities - 37,000
------------ ------------
Net cash used for operating activities (1,508,000) (17,478,000)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments - (34,048,000)
Maturities of short-term investments - 33,989,000
Purchases of equipment and furniture (183,000) (19,796,000)
Payment of collocation fees (475,000) (12,111,000)
------------ ------------
Net cash used for investing activities (658,000) (31,966,000)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from leasing company for equipment - 1,755,000
Repayments on long-term debt - (111,000)
Payment of debt issue costs - (1,169,000)
Proceeds from issuance of Common Stock 227,000 1,406,000
Proceeds from issuance of Preferred Stock and Warrants 18,292,000 60,000,000
------------ ------------
Net cash provided by financing activities 18,519,000 61,881,000
------------ ------------
Net increase in cash and cash equivalents 16,353,000 12,437,000
Cash and cash equivalents at beginning of period 10,166,000 21,315,000
------------ ------------
Cash and cash equivalents at end of period $ 26,519,000 $ 33,752,000
------------ ------------
------------ ------------
Supplemental schedule of cash flow information:
Cash paid for interest $ 8,000 $ 16,000
------------ ------------
------------ ------------
Supplemental schedule of non-cash financing activities:
Equipment purchases payable, to be financed through operating leases $ 1,576,000 $ 9,541,000
------------ ------------
------------ ------------
Equipment and furniture purchases payable $ - $ 10,349,000
------------ ------------
------------ ------------
Intangible business acquisition costs arising from issuance of preferred stock and warrants $ - $ 10,250,000
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
5
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Series A Convertible Series B Convertible Series C Convertible
Preferred Stock Preferred Stock Preferred Stock
$0.001 par value $0.001 par value $0.001 par value
---------------------- --------------------- --------------------
# Shares Amount # Shares Amount # SHARES AMOUNT
----------- -------- ---------- -------- ---------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998 12,855,094 $13,000 4,044,943 $ 4,000 - $ -
Issuance of Common Stock upon
exercise of options ($0.04 to $3.33
per share exercise price) (unaudited) - - - - - -
Issuance of Series C Preferred Stock
and Warrants for cash ($8.04 per
share) in March 1999 (unaudited) - - - - 7,462,819 7,000
Business relationship value arising
from issuance of Series C Preferred
Stock in March 1999 (unaudited) - - - - - -
Issuance of Warrants to leasing
company in March 1999 (unaudited) - - - - - -
Deferred compensation from grant of
options to purchase Common Stock
(unaudited) - - - - - -
Amortization of deferred compensation
(unaudited) - - - - - -
Reversal of deferred compensation
from cancellation of grants to
purchase Common Stock
(unaudited) - - - - - -
Net loss through March 31, 1999
(unaudited) - - - - - -
----------- -------- ---------- -------- ---------- --------
Balance at March 31, 1999 (unaudited) 12,855,094 $13,000 4,044,943 $ 4,000 7,462,819 $ 7,000
----------- -------- ---------- -------- ---------- --------
----------- -------- ---------- -------- ---------- --------
<CAPTION>
Common Stock Treasury Stock
$0.001 par value at cost Additional
-------------------- -------------------- Paid-In
# Shares Amount # Shares Amount Capital Warrants
---------- -------- -------- ---------- -------------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998 8,042,530 $ 8,000 438,115 $ (18,000) $ 37,212,000 $ -
Issuance of Common Stock upon
exercise of options ($0.04 to $3.33
per share exercise price) (unaudited) 1,577,190 2,000 - - 1,404,000 -
Issuance of Series C Preferred Stock
and Warrants for cash ($8.04 per
share) in March 1999 (unaudited) - - - - 55,529,000 4,464,000
Business relationship value arising
from issuance of Series C Preferred
Stock in March 1999 (unaudited) - - - - 10,000,000 -
Issuance of Warrants to leasing
company in March 1999 (unaudited) - - - - - 250,000
Deferred compensation from grant of
options to purchase Common Stock
(unaudited) - - - - 3,897,000 -
Amortization of deferred compensation
(unaudited) - - - - - -
Reversal of deferred compensation
from cancellation of grants to
purchase Common Stock
(unaudited) - - - - (499,000) -
Net loss through March 31, 1999
(unaudited) - - - - - -
---------- -------- -------- ---------- -------------- -----------
Balance at March 31, 1999 (unaudited) 9,619,720 $10,000 438,115 $ (18,000) $ 107,543,000 $4,714,000
---------- -------- -------- ---------- -------------- -----------
---------- -------- -------- ---------- -------------- -----------
<CAPTION>
Total
Deferred Accumulated Stockholders'
Compensation Deficit Equity
------------- ------------- ------------
<S> <C> <C> <C>
Balance at December 31, 1998 $ (5,210,000) $(38,756,000) $ (6,747,000)
Issuance of Common Stock upon
exercise of options ($0.04 to $3.33
per share exercise price) (unaudited) - - 1,406,000
Issuance of Series C Preferred Stock
and Warrants for cash ($8.04 per
share) in March 1999 (unaudited) - - 60,000,000
Business relationship value arising
from issuance of Series C Preferred
Stock in March 1999 (unaudited) - - 10,000,000
Issuance of Warrants to leasing
company in March 1999 (unaudited) - - 250,000
Deferred compensation from grant of
options to purchase Common Stock
(unaudited) (3,897,000) - -
Amortization of deferred compensation
(unaudited) 601,000 - 601,000
Reversal of deferred compensation
from cancellation of grants to
purchase Common Stock
(unaudited) 499,000 - -
Net loss through March 31, 1999
(unaudited) - (23,899,000) (23,899,000)
------------- ------------- ------------
Balance at March 31, 1999 (unaudited) $ (8,007,000) $(62,655,000) $ 41,611,000
------------- ------------- ------------
------------- ------------- ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
6
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION:
THE COMPANY: RHYTHMS NetConnections Inc. (the "Company"), a Delaware
corporation, was organized under the name Accelerated Connections Inc. in
February 1997. The Company's name was changed to RHYTHMS NetConnections Inc.
in August 1997. The Company is in the business of providing high-speed data
communications services on an end-to-end basis to business customers and end
users. The Company began service trials in the San Diego, California, market
in December 1997 and began commercial operations in San Diego effective April
1, 1998.
The Company's ultimate success depends upon, among other factors, rapidly
expanding the geographic coverage of its network services; entering into
interconnection agreements with incumbent local exchange carriers, some of
which are competitors or potential competitors of the Company; deploying
network infrastructure; attracting and retaining customers; accurately
assessing potential markets; continuing to develop and integrate its
operational support system and other back office systems; obtaining any
required governmental authorizations; responding to competitive developments;
continuing to attract, retain, and motivate qualified personnel; and
continuing to upgrade its technologies and commercialize its network services
incorporating such technologies. There can be no assurance that the Company
will be successful in addressing these matters and failure to do so could
have a material adverse effect on the Company's business, prospects,
operating results, and financial condition. As the Company continues the
development of its business, it will seek additional sources of financing to
fund its development. If unsuccessful in obtaining such financing, the
Company will continue expansion of its operations on a reduced scale based on
its existing capital resources.
INTERIM RESULTS (UNAUDITED): The accompanying consolidated financial
statements (unaudited), which include the transactions and balances of
Rhythms NetConnections Inc. and its wholly owned subsidiaries ACI Corp and
ACI Corp.-Virginia, have been prepared in accordance with generally accepted
accounting principles for interim financial information and, therefore, do
not include all the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of
management, these statements have been prepared on the same basis as the
audited financial statements and include all adjustments, consisting only of
normal recurring accruals, that are necessary for the fair statement of
results for the unaudited interim periods. The data disclosed in these notes
to consolidated financial statements is also unaudited. The preparation of
financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the financial statement date, as well as
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. The operating results for
the interim period are not necessarily indicative of the results to be
expected for a full fiscal year or for any future periods. All material
intercompany transactions and balances have been eliminated.
NOTE 2 - NET LOSS PER SHARE:
Basic earnings per share ("EPS") is calculated by dividing the income or loss
available to common stockholders by the weighted average number of common
shares outstanding for the period, without consideration for common stock
equivalents. Diluted EPS is computed by dividing the income or loss available
to common stockholders by the weighted average number of common shares
outstanding for the period in addition to the weighted average number of
common stock equivalents outstanding for the period. Shares subject to
repurchase by the Company are considered Common Stock equivalents for
purposes of this calculation. Shares issuable upon conversion of Preferred
Stock, upon the exercise of outstanding stock options and warrants, and
shares subject to repurchase by the Company totaling 61,281,828 and
46,325,054 at March 31, 1999 and 1998, respectively, have been excluded from
the computation since their effect would be antidilutive.
7
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED):
NOTE 3 - STOCKHOLDERS' EQUITY:
During the first quarter of 1999, the Company granted options to employees to
purchase a total 2,886,616 shares of Common Stock pursuant to its Stock
Option/Stock Issuance Plan. During this same time, employees exercised
previously granted options to purchase a total of 1,577,190 shares of Common
Stock for total proceeds to the Company of $1,406,000.
Effective March 2, 1999, the Company amended its Certificate of Incorporation
to increase the number of authorized Common shares to 84,527,584 and to
authorize 3,731,410 shares of Series C Preferred Stock.
On March 4, 1999, the Company issued Series C Preferred Stock and Warrants to
MCI WorldCom's investment fund for $30,000,000. A total of 3,731,410 shares
of Series C Preferred Stock and Warrants to purchase 720,000 shares of Common
Stock at a price of $6.70 per share were issued in this transaction. Of the
proceeds received, the Company allocated $29,496,000 to the Preferred Stock
and $504,000 to the Warrants. The terms of the transaction also provide for
the Company and MCI WorldCom to enter into various business relationships,
including MCI WorldCom's commitment to sell 100,000 of the Company's DSL
lines over a period of five years, subject to penalties for failure to reach
target commitments.
Effective March 15, 1999, the Company amended its Certificate of
Incorporation to increase the number of authorized Common shares to
74,171,062 and to authroize an additional 3,731,409 shares of Series C
Preferred Stock.
On March 16, 1999, the Company issued Series C Preferred Stock and Warrants
to Microsoft Corporation for $30,000,000. A total of 3,731,409 shares of
Series C Preferred Stock and Warrants to purchase 720,000 shares of Common
Stock at a price of $6.70 per share were issued in this transaction. Of the
proceeds received, the Company allocated $26,544,000 to the Preferred Stock
and $3,456,000 to the Warrants. The terms of the transaction also provide for
the Company and Microsoft to enter into various business relationships. In
connection with these business relationships, the Company capitalized
$10,000,000 in business acquisition costs that will be amortized to operating
expense over a three-year period beginning March 1999.
On March 16, 1999 the Company's Board of Directors approved the 1999 Stock
Incentive Plan and the 1999 Employee Stock Purchase Plan, each plan subject
to shareholder approval. The 1999 Stock Incentive Plan serves as the
successor equity incentive program to the 1997 Stock Option/Stock Issuance
Plan and became effective April 6, 1999. An initial reserve of 8,161,944
shares of Common Stock has been authorized for issuance under the 1999 Stock
Incentive Plan. The 1999 Employee Stock Purchase Plan has an initial reserve
of 1,200,000 shares of Common Stock and became effective April 6, 1999.
Effective March 19, 1999, the Company completed a six-for-five split of its
Common Stock. The accompanying consolidated financial statements have been
restated for all periods presented to reflect the stock split.
On March 31, 1999, the Company entered into a 36-month lease line that
provides for $24,000,000 in equipment on an operating lease basis. In
connection with this lease agreement, the Company issued 45,498 Warrants to
purchase Common Stock at a price of $10.55 per share, exercisable
immediately. The value of these Warrants, estimated to be $250,000, is being
amortized over the life of the lease.
NOTE 4 - SUBSEQUENT EVENTS:
Effective April 5, 1999, the Company restated its Certificate of Incorporation
to increase the number of authorized Common shares to 81,000,000, to authorize
an additional 932,836 shares of Series C Preferred Stock, to authorize 441,176
shares of Series D Preferred Stock, and to designate 1,000,000 shares as Series
1 Junior Participating Preferred Stock.
8
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED):
NOTE 4 - SUBSEQUENT EVENTS (CONTINUED):
On April 6, 1999, the Company issued 932,836 shares of its Series C Preferred
Stock at a price of $8.04 per share and 441,176 shares of its Series D
Preferred Stock at a price of $17.00 per share to a wholly owned subsidiary
of Qwest Communications Corporation for total proceeds of $15,000,000. In
connections with this investment, Qwest also received warrants to purchase
180,000 shares of Common Stock at a price of $6.70 per share and MCI WorldCom
received an additional warrant to purchase 136,996 shares of Common Stock at
a price of $21.00 per share. In accordance with provisions of the agreement
underlying this investment, the Company and Qwest have entered into certain
business relationships. Although a value has not been finalized for this
business relationship, the Company estimates that approximately $10,500,000
will be capitalized with respect to the relationship and that the amount
capitalized with be amortized to operating expense over a five-year period.
On April 5, 1999, the Company entered into a 36-month lease line that
provides for $20,000,000 in equipment on an operating lease basis. In
connection with this lease agreement, the Company issued 75,000 warrants to
purchase Common Stock at a price of $10.55 per share, exercisable immediately.
Effective April 12, the Company restated its Certificate of Incorporation to
increase the number of authorized Common shares to 250,000,000 and to
decrease the number of authorized Preferred Shares to 5,000,000.
Effective April 12, 1999, the Company completed an initial public offering of
its Common Stock. A total of 10,781,250 shares were issued at $21.00 per
share; net proceeds to the Company were approximately $211,407,000, after
payment of underwriting fees but before payment of related issue expenses.
Upon completion of the offering, all classes of Preferred Stock automatically
converted to Common Stock, resulting in an additional 51,076,051 shares of
Common Stock being issued and a resulting zero shares of Preferred Stock
being issued and outstanding.
On April 23, 1999, the Company issued 12.75 percent Senior Notes due 2009 in
the principal amount of $325,000,000, due at maturity. Cash proceeds from the
issuance, after payment of underwriting fees but before payment of related
issue expenses, were $315,250,000. Of these proceeds, approximately
$113,675,000 was used to purchase a portfolio of U.S. government securities
and will be used for the first three years' interest payments.
9
<PAGE>
RHYTHMS NETCONNECTIONS INC.
PART I
FINANCIAL INFORMATION (CONTINUED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis is based on the consolidated financial
statements of Rhythms NetConnections Inc. (the "Company" or "Rhythms") and
the notes thereto and should be read in conjunction with such consolidated
financial statements and related notes thereto presented previously. Certain
statements set forth below constitute "forward-looking statements." Such
forward-looking statements involve known and unknown risks, uncertainties,
and other factors that may cause the actual results, performance or
achievements of the Company, or industry results to be materially different
from any future results, performance, or achievements expressed or implied by
such forward-looking statements. Given these uncertainties, investors and
prospective investors are cautioned not to place undue reliance on such
forward-looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in the "Risks
and Uncertainties" below. The Company disclaims any obligation to update
information contained in any forward-looking statement.
RESULTS OF OPERATIONS:
During the first three months of fiscal year 1999, we continued the
development of our business operations, entering one new market, adding 155
central office locations, and adding service to approximately 735 DSL lines.
In accordance with our plan to rapidly expand our infrastructure and network
services, we intend to offer service in an additional 22 markets by the end
of this year and a further 17 markets by the end of year 2000.
During the first quarter of 1999, we received $60.0 million from selling
Series C Preferred Stock and Warrants. Also during the first quarter, we entered
into a 36-month lease line that provides for an additional $24.0 million in
equipment leasing.
THREE MONTHS ENDED MARCH 31, 1999
During the first quarter of 1999, we continued the development of our
business operations in our existing markets and additionally commenced
service in Philadelphia. We recorded $660,000 in revenues during the quarter,
compared to $10,000 in the same quarter of 1998, which comprise primarily DSL
service and installation charges, net of discounts given to customers upon
service establishment. Network service costs for the quarter also reflect the
increases in commercial service and include customer installation costs, line
and backbone expenses, the cost of customer premise equipment, equipment
operating leases, and repair and support costs. Since we did not offer
commercial services until April 1, 1998, revenues and network service costs
for the first quarter of 1998 were minimal.
Our selling, general, and administrative expenses for the quarter were
$13.8 million. These expenses reflect our continuing increase in staffing
levels, increased marketing efforts coinciding with the launch of commercial
services, and increased legal fees associated with development of additional
markets.
We recorded depreciation and amortization of $782,000 during the quarter, a
significant increase over the $16,000 recorded for the same period in 1998.
This increase is primarily attributable depreciation on our operating
equipment, which we began to use commercially on April 1, 1998.
During the first quarter of 1999, we recorded interest income of $1.7 million,
which was generated from our invested cash balances. These investment
balances include the proceeds from the issuance of the Series C Preferred
Stock and Warrants during the quarter in the amount of $60.0 million. We
recorded $5.5 million in amortized debt discount during the quarter, which
arose from issuing our 13.5 percent Senior Discount Notes in May 1998.
10
<PAGE>
RESULTS OF OPERATIONS (CONTINUED):
We continue to be in a net operating loss tax position through March 31,
1999; consequently, we have not recorded a provision for income taxes through
the first quarter.
CHANGES IN FINANCIAL POSITION:
We had $136.8 million in cash and investments at the beginning of our first
quarter 1999. During the quarter, we received $60.0 million from selling
Series C Preferred Stock and Warrants and we received $3.2 million from the
sale of Common Stock and the sale/leaseback of operating equipment. Of our
available cash and investments, we used approximately $50.7 million for
operations and capital purchases during the quarter, leaving $149.3 million
in cash and investments at the end of the quarter. Also during the first
quarter, we entered into a 36-month lease line that provides for an
additional $24.0 million in equipment leasing, which we will begin utilizing
during the second quarter.
As discussed above in "Results of Operations," the Company continued its
market build-out and development efforts. The result on financial condition
was increased operating losses, increased accounts payable and accrued
expenses, increased collocation expenditures, and smaller increases in
accounts receivable, inventory, and other assets.
LIQUIDITY AND CAPITAL RESOURCES:
The development and expansion of our business requires significant capital
expenditures. These capital expenditures primarily include build-out costs
such as the procurement, design, and construction of our connections points
and one or two metro service center locations in each market, as well as
other costs that support our network design.
The number of targeted central offices in each market varies, as does the
average capital cost to build our connection points in the given market.
Capital expenditures, including payments for collocation fees, were $42.3
million during the first quarter of 1999. We expect our capital expenditures
to be substantially higher in future periods, arising primarily from payments
of collocation fees and the purchase of infrastructure equipment necessary
for the development and expansion of our network.
Our capital requirements may vary based upon the timing and success of our
rollout and as a result of regulatory, technological, and competitive
developments or if
- demand for our services or our anticipated cash flow from operations
is less or more than expected;
- our development plans or projections change or prove to be inaccurate;
- we engage in any acquisitions; or
- we accelerate deployment of our network services or otherwise alter
the schedule or targets of our rollout plan.
Since our primary activities since inception have focused on building our
network and building a customer base, we have operated at a loss since
inception. We intend to continue to expand our operations at a rapid pace and
expect to continue to operate at a loss for the foreseeable future. The
nature of expenses contributing to our future losses will include network and
service costs in existing and new markets; legal, marketing, and selling
expenses as we enter each new market; payroll-related expenses as we continue
to add employees; general overhead to support the operational increases; and
interest expense arising from financing our expenditures.
We have not paid any dividends to our shareholders and will not pay dividends
for the foreseeable future. Our senior discount notes contain covenants that
restrict our ability to make certain payments, including dividend payments.
Through March 31, 1999, we have financed our operations and market build-outs
primarily through the issuance of senior discount notes in May 1998 for
$144.0 million in net proceeds and the private placements of equity totaling
$90.8 million, of which we received $60.0 million during the first quarter of
1999. We have also utilized operating leases totaling $26.5 million for the
acquisition of a large portion of our operating equipment. As of March 31,
1999, we had $149.3 million in cash and investments and we had an accumulated
deficit of $62.7 million.
Subsequent to the end of the first quarter we completed several significant
financings. On April 6, 1999, we received $15.0 million from the private
placement of preferred stock and warrants. On April 12, 1999, we completed
our initial public offering of common stock, from which we received $211.4
million in net proceeds. Effective April 23, 1999, we issued senior notes and
received $315.2 million in net proceeds, of which $113.7 million is
restricted and may be used to pay interest on the notes only. We additionally
entered into a 36-month lease line that provides for $20.0 million in
equipment on an operating lease basis.
We believe that our existing cash and investment balances as of March 31,
1999, together with the net proceeds from the April 1999 financing activities
and the anticipated future revenue generated from operations, will be
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sufficient to fund our operating losses, capital expenditures, lease
payments, and interest payments through approximately June 2001. We expect
our operating losses and capital expenditures to increase substantially in
the near-term, primarily due to our network expansion. We expect that
additional financing will be required in the future. We may attempt to raise
financing through some combination of commercial bank borrowings, leasing,
vendor financings, or the private or public sale of equity or debt
securities. Future equity or debt financings may not be available to us at
all, or, if available, may not be on favorable terms. If we are unable to
obtain financing in the future, we will continue the expansion of our
operations on a reduced scale based on our existing capital resources.
IMPACT OF THE YEAR 2000 ISSUE:
Many computer programs have been written using two digits rather than four to
define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year
1900 rather than the year 2000. This, in turn, could result in major system
failures or miscalculations, and is generally referred to as the "Year 2000
issue." We have formulated and, to a large extent, effected a plan to
address our Year 2000 issues. Our Year 2000 plan applies to two areas:
internal business systems and compliance by external customers and providers.
We have completed our Year 2000 compliance testing for all of our internal
systems and believe that they are Year 2000 compliant. Because we are a young
company, we believe we have been able to build our business systems with the
Year 2000 issue in mind in a more effective manner than many older companies.
Therefore, there have been few Year 2000 changes required to our existing
systems and applications. We have substantially completed a compliance check
of our external customers and providers, except for the incumbent carriers.
Based on responses from these third parties, other than the incumbent
carriers, we believe that they will not experience Year 2000 problems that
would materially and adversely affect our business. We have not been able to
conduct a compliance check of incumbent carriers nor assess the incumbent
carriers' Year 2000 compliance. To the extent that one or more incumbent
carriers or other third parties experience Year 2000 problems, our network
and services could be adversely affected. Furthermore, the purchasing
patterns of our customers may be affected by Year 2000 issues as companies
expend significant resources to correct their current systems for Year 2000
compliance. These expenditures may result in reduced funds available for our
services. Any of these developments could have a material and adverse effect
on our business, prospects, operating results and ability to repay our debt,
including the notes. We have not fully determined the risks associated with
the reasonably worst-case scenario and have not formulated a contingency plan
to address Year 2000 issues. We do not expect to have a specific contingency
plan in place in the future.
RISKS AND UNCERTAINTIES
IN ADDITION TO THE OTHER INFORMATION CONTAINED HEREIN, YOU SHOULD
CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS IN EVALUATING OUR COMPANY.
WE CANNOT PREDICT OUR SUCCESS BECAUSE WE HAVE A SHORT OPERATING HISTORY
We formed our company in February 1997, and we have a short operating
history for you to review in evaluating our business. We have limited
historical financial and operating data upon which you can evaluate our
business and prospects. We entered into our first interconnection agreement
with an incumbent carrier in July 1997 and began to offer commercial services
in San Diego in April 1998. We have limited commercial operations and have
recognized limited revenues since our inception. In addition, our senior
management team and our other employees have worked together at our company
for only a short period of time.
BECAUSE OUR MARKET IS NEW AND EVOLVING, WE CANNOT PREDICT ITS FUTURE
GROWTH OR ULTIMATE SIZE, AND WE MAY BE UNABLE TO COMPETE EFFECTIVELY
The market for packet-based high-speed digital communication services
using telephone lines is in the early stages of development. Since this
market is new and evolving and because our current and future competitors are
likely to introduce competing services, we cannot accurately predict the rate
at which this market will grow, if at all, or whether new or increased
competition will result in market saturation. Various providers of
high-speed digital communication services are testing products from various
suppliers for various applications, and suppliers have not broadly adopted an
industry standard. Certain critical issues concerning commercial use of DSL
for Internet and local area network access, including security, reliability,
ease and cost of access and quality of service, remain unresolved and may
impact the growth of these services. If the markets for our services fail to
develop, grow more slowly than anticipated or become saturated with
competitors, these events could materially and adversely affect our business,
prospects, operating results and financial condition.
Our success will depend on the development of this new and rapidly
evolving market and our ability to compete effectively in this market. To
address these risks, we must, among other things:
- rapidly expand the geographic coverage of our network services;
- raise additional capital;
- enter into interconnection agreements and working arrangements with
additional incumbent carriers, substantially all of which we expect to
be our competitors;
- deploy an effective network infrastructure;
- attract and retain customers;
- successfully develop relationships and activities with our partners and
distributors, including MCI WorldCom, Microsoft, Qwest and Cisco;
- continue to attract, retain and motivate qualified personnel;
- accurately assess potential markets and effectively respond to
competitive developments;
- continue to develop and integrate our operational support system and
other back office systems;
- obtain any required governmental authorizations;
- comply with evolving governmental regulatory requirements;
- increase awareness of our services;
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- continue to upgrade our technologies; and
- effectively manage our expanding operations.
We may not be successful in addressing these and other risks, and our
failure to address risks would materially and adversely affect our business,
prospects, operating results and financial condition.
WE CANNOT PREDICT OUR SUCCESS BECAUSE OUR BUSINESS MODEL IS UNPROVEN
We have not validated our business model and strategy in the market.
We believe that the combination of our unproven business model and the highly
competitive and fast changing market in which we compete makes it impossible
to predict the extent to which our network service will achieve market
acceptance and our overall success. To be successful, we must develop and
market network services that are widely accepted by businesses at profitable
prices. We may never be able to deploy our network as planned, achieve
significant market acceptance, favorable operating results or profitability
or generate sufficient cash flow to repay our debt. Of the 9,800 lines that
we have committed to deliver to date, we committed approximately 8,700 to
only two customers. None of our enterprise customers has rolled out our
services broadly to its employees, and we cannot be certain when or if these
rollouts will occur. We will not receive significant revenue from our large
customers unless these rollouts occur. Any continued or ongoing failure for
any reason of enterprise customers to roll out our services, failure to
validate our business model in the market, including failure to build out our
network, achieve widespread market acceptance or sustain desired pricing
would materially and adversely affect our business, prospects, operating
results and financial condition.
WE EXPECT OUR LOSSES TO CONTINUE
We have incurred losses and experienced negative operating cash flow
for each month since our formation. As of March 31, 1999, we had an
accumulated deficit of approximately $62.7 million. We intend to rapidly and
substantially increase our expenditures and operating expenses in an effort
to expand our network services. We expect to have annual interest and
amortization expense relating to our senior discount notes issued in May 1998
and our senior notes issued in April 1999 of approximately $52.2 million in
1999 and increasing to $80.6 million in 2003. In addition, we may incur more
debt in the future. Furthermore, as a result of recent preferred stock
issuances and stock option grants, we anticipate that there will be
significant charges to earnings in future periods. As a result of these
factors, we expect to incur substantial operating and net losses and negative
operating cash flow for the foreseeable future. We will need to obtain
additional financing to pay our expenses and to make payments on our debt.
We cannot give you any assurance about whether or when we will have
sufficient revenues to satisfy our funding requirements or pay our debt
service obligations.
OUR OPERATING RESULTS IN ONE OR MORE FUTURE PERIODS ARE LIKELY TO
FLUCTUATE SIGNIFICANTLY AND MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF
SECURITIES ANALYSTS OR INVESTORS
Our annual and quarterly operating results are likely to fluctuate
significantly in the future due to numerous factors, many of which are
outside of our control. These factors include:
- the rate of customer acquisition and turnover;
- the prices our customers are willing to pay;
- the amount and timing of expenditures relating to the expansion of our
services and infrastructure;
- the timing and availability of incumbent carrier central office
collocation facilities and transport facilities;
- the success of our relationships with our partners and distributors,
including MCI WorldCom, Microsoft, Qwest and Cisco;
- our ability to deploy our network on a timely basis;
- introduction of new services or technologies by our competitors;
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- price competition;
- the ability of our equipment and service suppliers to meet our needs;
- regulatory developments, including interpretations of the 1996
Telecommunications Act;
- technical difficulties or network downtime;
- the success of our strategic alliances; and
- the condition of the telecommunication and network service industries
and general economic conditions.
Because of these factors, our operating results in one or more future
periods could fail to meet or exceed the expectations of securities analysts
or investors.
IF SALES FORECASTED FOR A PARTICULAR PERIOD ARE NOT REALIZED IN THAT
PERIOD DUE TO THE LENGTHY SALES CYCLE OF OUR SERVICES, OUR OPERATING RESULTS
FOR THAT PERIOD WILL BE HARMED
The sales cycle of our network services can be very lengthy,
particularly for large businesses. The sales cycle for large businesses
typically involves:
- a significant technical evaluation;
- an initial trial rollout to a relatively small number of end users;
- a commitment of capital and other resources by the customer;
- delays associated with the customer's internal procedures to approve
large capital expenditures;
- time required to engineer the deployment of our services;
- coordination of the activation of multiple access lines with incumbent
carriers; and
- testing and acceptance of our services.
For these and other reasons, our sales cycle for enterprise customers
lasts at least six months. During this lengthy sales cycle, we will incur
significant expenses in advance of the receipt of revenues. If sales that we
forecast for a particular period do not occur because of our lengthy sales
cycle, this event could materially and adversely affect our business,
prospects, operating results and financial condition.
WE DEPEND ON INCUMBENT CARRIERS FOR COLLOCATION AND TRANSMISSION
FACILITIES
We must use copper telephone lines controlled by the incumbent
carriers to provide DSL connections to customers. We also depend on the
incumbent carriers for collocation and for a substantial portion of the
transmission facilities we use to connect our equipment in incumbent carrier
central offices to our Metro Service Centers. In addition, we depend on the
incumbent carriers to test and maintain the quality of the copper lines that
we use. We have not established a history of obtaining access to collocation
and transmission facilities from incumbent carriers in large volumes. In
many cases, we may be unable to obtain access to collocation and transmission
facilities from the incumbent carriers, or to gain access at acceptable
rates, terms and conditions, including timeliness. We have experienced, and
expect to experience in the future, lengthy periods between our request for
and the actual provision of the collocation space and telephone lines. An
inability to obtain adequate and timely access to collocation space or
transmission facilities on acceptable terms and conditions from incumbent
carriers could have a material and adverse effect on our business, prospects,
operating results and financial condition.
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Because we compete with incumbent carriers in our markets, they may be
reluctant to cooperate with us. The incumbent carriers may experience, or claim
to experience, a shortage of collocation space or transmission capacity. If
this occurs, we may not have alternate means of connecting our DSL equipment
with the copper lines or connecting our equipment in central offices to Metro
Service Centers. We have experienced rejections of some of our collocation
applications on the grounds that no space is available. We may receive
additional rejections in the future. The number of other competitive local
exchange carriers that request collocation space will also affect the
availability of collocation space and transmission capacity. If we are unable
to obtain physical collocation space or transmission capacity from our targeted
incumbent carriers, we may face delays, additional costs or an inability to
provide services in certain locations. In many cases where our application for
physical collocation is rejected, we expect to have the option of adjacent
location--where we install our equipment in a building that is very close to the
incumbent carrier central office--or virtual collocation--where the incumbent
carrier manages and operates our equipment. While we have used adjacent and
virtual collocation in our network, those alternatives reduce our control over
our equipment, and therefore may reduce the level of quality and service we
provide to our customers. We are currently in an arbitration proceeding with
SBC Communications Inc. concerning the availability of DSL-enabled copper lines,
as well as other operational issues. Delays in obtaining access to collocation
space and telephone lines or the rejection of our applications for collocation
could result in delays in, and increased expenses associated with, the rollout
of our services, which in turn could have a material and adverse effect on our
business, prospects, operating results and financial condition.
WE ARE UNABLE TO CONTROL THE TERMS AND CONDITIONS UNDER WHICH WE GAIN
ACCESS TO INCUMBENT CARRIER COLLOCATION AND TRANSMISSION FACILITIES
We cannot control the terms under which we collocate our equipment,
connect to copper lines or gain the use of an incumbent carrier's
transmission facilities. State tariffs, state public utility commissions and
interconnection agreements with the incumbent carriers determine the price,
terms and conditions under which collocation space is made available, and
they make these administrative determinations in ongoing hearings.
Interconnection agreements and state public utility commissions also
determine the terms and conditions of access to copper lines and other
components of an incumbent carrier's network. We may be unable to negotiate
or enter into interconnection agreements on acceptable terms or at all. In
addition, we cannot be sure that incumbent carriers will abide by their
obligations under those agreements. Delays in obtaining interconnection
agreements would delay our entry into certain markets. In addition, disputes
may arise between us and the incumbent carriers with respect to
interconnection agreements, and we may be unable to resolve disputes in our
favor. If we are unable to enter into, or experience a delay in obtaining,
interconnection agreements, this inability or delay could adversely affect
our business, prospects, operating results and financial condition. Further,
the interconnection agreements are generally short term, and we may be unable
to renew the interconnection agreements on acceptable terms or at all. The
state commissions, the Federal Communications Commission and the courts
oversee, in varying degrees, interconnection arrangements as well as the
terms and conditions under which we gain access to incumbent carrier copper
lines and transmission facilities. These government entities may modify the
terms or prices of our interconnection agreements and our access to incumbent
carrier copper lines and transmission facilities in ways that would be
adverse to our business. State regulatory commissions establish the price
rates for DSL-capable copper lines as well as other rates, terms and
conditions of our dealings with the incumbent carriers in ongoing public
hearings. Participation in these hearings will involve significant
management time and expense. Incumbent carriers may from time to time propose
new rates, and the outcomes of hearings and rulings could have a material and
adverse effect on our business, prospects, operating results and financial
condition.
WE DEPEND ON THIRD PARTIES, PARTICULARLY MCI WORLDCOM, MICROSOFT,
QWEST AND CISCO, FOR THE MARKETING AND SALES OF OUR NETWORK SERVICES
We will rely significantly on indirect sales channels for the
marketing and sales of our network services. We will seek to establish
relationships with numerous service providers, including Internet Service
Providers, interexchange carriers, other competitive carriers and value-added
resellers, to gain access to customers. Our agreements to date with service
providers are non-exclusive, and we anticipate that future agreements will
also be on a non-exclusive basis, allowing service providers to resell
services offered by our competitors. These agreements are generally short
term, and can be cancelled by the service provider without significant
financial consequence. We cannot control how these service providers perform
and cannot be certain that their performance will be satisfactory to us or
our customers. Many of these companies also compete with us. If the number
of customers we obtain through indirect sales channels is significantly lower
than our forecast for any reason, or if the service providers with
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which we have contracted are unsuccessful in competing in their own intensely
competitive markets, these events would have a material and adverse effect on
our business, prospects, operating results and financial condition.
We expect to rely particularly on the sales and marketing efforts of
our strategic partners, including MCI WorldCom, Microsoft, Cisco and Qwest.
While our agreement with MCI WorldCom calls for it to sell 100,000 DSL lines,
the agreement also enables MCI WorldCom to terminate the agreement under
certain circumstances and to receive offsets and credits under other
circumstances. Therefore, MCI WorldCom might sell significantly fewer than
100,000 DSL lines, or we might receive significantly lower revenues than we
otherwise would.
THE MARKET IN WHICH WE OPERATE IS HIGHLY COMPETITIVE, AND WE MAY NOT
BE ABLE TO COMPETE EFFECTIVELY, ESPECIALLY AGAINST ESTABLISHED INDUSTRY
COMPETITORS WITH SIGNIFICANTLY GREATER FINANCIAL RESOURCES
We will face competition from many competitors with significantly
greater financial resources, well-established brand names and large, existing
installed customer bases. We expect the level of competition to intensify in
the future. We expect significant competition from incumbent carriers,
traditional and new long distance carriers, cable modem service providers,
Internet Service Providers, wireless and satellite data service providers and
other competitive carriers. Incumbent carriers have existing metropolitan
area networks and circuit-switched local access networks. In addition, most
incumbent carriers are establishing their own Internet Service Provider
businesses and are in some stage of market trials and retail sales of
DSL-based access services. Some incumbent carriers have announced that they
intend to aggressively market these services to their residential customers
at attractive prices. We believe that incumbent carriers have the potential
to quickly overcome many of the issues that have delayed widespread
deployment of DSL services in the past. In addition, we may experience
substantial customer turnover in the future. Many providers of
telecommunications and networking services experience high rates of customer
turnover.
Many of the leading traditional long distance carriers, including AT&T
Corporation, MCI WorldCom and Sprint, are expanding their capabilities to
support high-speed, end-to-end networking services. The newer long distance
carriers, including Williams Companies Inc., Qwest Communications
International, Inc. and Level 3 Communications, Inc., are building and
managing high bandwidth, nationwide packet networks and partnering with
Internet Service Providers to offer services directly to the public. Cable
modem service providers, like @Home Networks, are offering or preparing to
offer high-speed Internet access over hybrid fiber networks to consumers, and
@Work positioned itself to do the same for businesses. Several new companies
are emerging as wireless, including satellite-based, data service providers.
Internet Service Providers, including some with significant and even
nationwide presences, provide Internet access to residential and business
customers, generally over the incumbent carriers' circuit switched networks,
although some have begun offering DSL-based access. Certain competitive
carriers, including Covad Communications Group, Inc. and NorthPoint
Communications, Inc., have begun offering DSL-based access services, and,
like us, have attracted strategic equity investors, marketing allies and
product development partners. Others are likely to do the same in the
future.
Many of these competitors are offering, or may soon offer,
technologies and services that will directly compete with some or all of our
service offerings. Some of the technologies used by these competitors for
local access connections include integrated services digital network (ISDN),
DSL, wireless data and cable modems. Some of the competitive factors in our
markets include transmission speed, reliability of service, breadth of
service availability, price performance, network security, ease of access and
use, content bundling, customer support, brand recognition, operating
experience, capital availability and exclusive contracts. We believe that we
compare unfavorably with many of our competitors with regard to, among other
things, brand recognition, existing relationships with end users, available
pricing discounts, central office access, capital availability and exclusive
contracts. Substantially all of our competitors and potential competitors
have substantially greater resources than us. We may not be able to compete
effectively in our target markets. Our failure to compete effectively would
have a material and adverse effect on our business, prospects, operating
results and financial condition. Please see "Management's Discussion and
Analysis of Financial Condition and Results of Options--Liquidity and Capital
Resources."
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OUR NETWORK SERVICES MAY NOT ACHIEVE SIGNIFICANT MARKET ACCEPTANCE
BECAUSE OUR PRICES ARE OFTEN HIGHER THAN THOSE CHARGED FOR COMPETING SERVICES
Our prices are in some cases higher than those that our competitors
charge for some of their services. Prices for digital communications
services have fallen historically, and we expect prices in the industry in
general, and for the services we offer now and plan to offer in the future,
to continue to fall. We may be required to reduce prices periodically to
respond to competition and to generate increased sales volume. Our prices
may not permit our network services to gain a desirable level of commercial
acceptance, and we may be unable to sustain any current or future pricing
levels. Due to these factors, we cannot accurately forecast our revenues or
the rate at which we will add new customers.
WE WILL NEED SIGNIFICANT ADDITIONAL FUNDS, WHICH WE MAY NOT BE ABLE TO
OBTAIN
The expansion and development of our business will require significant
additional capital. We intend to seek substantial additional financing in
the future to fund the growth of our operations, including funding the
significant capital expenditures and working capital requirements necessary
for us to provide service in our targeted markets. We believe that our
current capital resources will be sufficient to fund our aggregate capital
expenditures and working capital requirements, including operating losses,
approximately until June 2001. We will not have completed our network
rollout by this date and will need additional capital, whether or not our
estimate on how long current capital resources will last is accurate. In
addition, our actual funding requirements may differ materially if our
assumptions underlying this estimate turn out to be incorrect. Therefore,
you should consider our estimate in light of the following facts:
- we have no meaningful history of operations or revenues;
- our estimated funding requirements do not reflect any contingency
amounts and may increase, perhaps substantially, if we are unable to
generate revenues in the amount and within the time frame we expect or
if we have unexpected cost increases; and
- we face many challenges and risks, including those discussed elsewhere
in "Risks and Uncertainties."
We may be unable to obtain any future equity or debt financing on
acceptable terms or at all. Recently the financial markets have experienced
extreme price fluctuations. A market downturn or general market uncertainty
may adversely affect our ability to secure additional financing. The
indentures that govern our senior discount notes issued in May 1998 and our
senior notes issued in April 1999 restrict our ability to obtain additional
debt financing. Any future borrowing instruments, such as credit facilities
and lease agreements, are likely to contain similar or more restrictive
covenants and could require us to pledge assets as security for the
borrowings. If we are unable to obtain additional capital or are required to
obtain it on terms less satisfactory than what we desire, we will need to
delay deployment of our network services or take other actions that could
adversely affect our business, prospects, operating results and financial
condition. If we are unable to generate sufficient cash flow or obtain funds
necessary to meet required payments of our debt, then we will be in default
on our debt instruments. To date, our cash flow from operations has been
insufficient to cover our expenses and capital needs. Please see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN
CURRENT OR FUTURE LAWS OR REGULATIONS COULD RESTRICT THE WAY WE OPERATE OUR
BUSINESS
A significant portion of the services that we offer through our
subsidiaries is subject to regulation at the federal, state and/or local
levels. Future federal or state regulations and legislation may be less
favorable to us than current regulation and legislation and therefore have an
adverse impact on our business, prospects, operating results and financial
condition. In addition, we may expend significant financial and managerial
resources to participate in rule-setting proceedings at either the federal or
state level, without achieving a favorable result. The Federal
Communications Commission prescribes rules applicable to interstate
communications, including rules implementing the 1996 Telecommunications Act,
a responsibility it shares with the state regulatory commissions. In
particular, we believe that incumbent carriers will work aggressively to
modify or restrict the operation of many provisions of the 1996
Telecommunications Act. We expect incumbent carriers will pursue litigation
in courts, institute administrative proceedings with the Federal
Communications Commission and other regulatory agencies
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and lobby the United States Congress, all in an effort to affect laws and
regulations in a manner favorable to the incumbent carriers and against the
interest of competitive carriers such as us. If the incumbent carriers
succeed in any of their efforts, if these laws and regulations change or if
the administrative implementation of laws develops in an adverse manner,
these events could have a material and adverse effect on our business,
prospects, operating results and financial condition.
OUR FAILURE TO MANAGE GROWTH COULD ADVERSELY AFFECT US
We have rapidly and significantly expanded our operations. We
anticipate further significant expansion of our operations in an effort to
achieve our network rollout and deployment objectives. Our expansion to date
has strained our management, financial controls, operations systems,
personnel and other resources. Any future rapid expansion would increase
these strains. If our marketing strategy is successful, we may experience
difficulties responding to customer demand for services and technical support
in a timely manner and in accordance with their expectations. As a result,
rapid growth of our business would make it difficult to implement
successfully our strategy to provide superior customer service. To manage
any growth of our operations, we must:
- improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
- hire, train and manage additional qualified personnel;
- expand and upgrade our core technologies; and
- effectively manage multiple relationships with our customers, suppliers
and other third parties.
We may not be able to install management information and control
systems in an efficient and timely manner, and our current or planned
personnel, systems, procedures and controls may not be adequate to support
our future operations. Failure to manage our future growth effectively could
adversely affect the expansion of our customer base and service offerings.
Any failure to successfully address these issues could materially and
adversely affect our business, prospects, operating results and financial
condition.
OUR SUBSTANTIAL DEBT CREATES FINANCIAL AND OPERATING RISK
We are highly leveraged, and we intend to seek additional debt funding
in the future. As of March 31, 1999, we had approximately $163.7 million of
outstanding debt, and our debt made up 77.3% of our capitalization. During
April 1999, we issued an additional $325 million in debt. We are not
generating any meaningful revenue to fund our operations or to repay our
debt. Our substantial leverage poses the risks that:
- we may be unable to repay our debt due to one or more events discussed
in "Risks and Uncertainties;"
- we may be unable to obtain additional financing;
- we must dedicate a substantial portion of our cash flow from operations
to servicing our debt once our debt requires us to make cash interest
payments, and any remaining cash flow may not be adequate to fund our
planned operations; and
- we may be more vulnerable during economic downturns, less able to
withstand competitive pressures and less flexible in responding to
changing business and economic conditions.
THE TELECOMMUNICATIONS INDUSTRY IS UNDERGOING RAPID TECHNOLOGICAL
CHANGE, AND NEW TECHNOLOGIES MAY BE SUPERIOR TO THE TECHNOLOGY WE USE
The telecommunications industry is subject to rapid and significant
technological changes, such as continuing developments in DSL technology and
alternative technologies for providing high-speed data communications. We
cannot predict the effect of technological changes on our business. We will
rely in part on third parties, including certain of our competitors and
potential competitors, for the development of and access to communications
and networking technology. We expect that new products and technologies
applicable to our
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market will emerge. New products and technologies may be superior and/or
render obsolete the products and technologies that we currently use. Our
future success will depend, in part, on our ability to anticipate and adapt
to technological changes and evolving industry standards. We may be unable
to obtain access to new technology on acceptable terms or at all, and we may
be unable to adapt to new technologies and offer services in a competitive
manner. Our joint development projects with Cisco and MCI WorldCom and our
strategic arrangement with Microsoft may not produce useful technologies or
services for us. Further, new technologies and products may not be
compatible with our technologies and business plan. We believe that the
telecommunications industry must set standards to allow for the compatibility
of various products and technologies. However, the industry may not set
standards on a timely basis or at all. In addition, many of the products and
technologies that we intend to use in our network services are relatively new
and unproven and may be unreliable.
WE MAY BE UNABLE TO EFFECTIVELY EXPAND OUR NETWORK SERVICES AND
PROVIDE HIGH PERFORMANCE TO A SUBSTANTIAL NUMBER OF END USERS
Due to the limited deployment of our network services, we cannot
guarantee that our network will be able to connect and manage a substantial
number of end users at high transmission speeds. We may be unable to scale
our network to service a substantial number of end users while achieving high
performance. Further, our network may be unable to achieve and maintain
competitive digital transmission speeds. While digital transmission speeds
of up to 7.1 Mbps are possible on certain portions of our network, that speed
is not available over a majority of our network. Actual transmission speeds
on our network will depend on a variety of factors and many of these factors
are beyond our control, including the type of DSL technology deployed, the
distance an end user is located from a central office, the quality of the
telephone lines, the presence of interfering transmissions on nearby lines
and other factors. As a result, we may not be able to achieve and maintain
digital transmission speeds that are attractive in the market.
OUR SERVICES MAY SUFFER BECAUSE THE TELEPHONE LINES WE REQUIRE MAY BE
UNAVAILABLE OR IN POOR CONDITION
Our ability to provide DSL-based services to potential customers
depends on the quality, physical condition, availability and maintenance of
telephone lines within the control of the incumbent carriers. We believe
that the current condition of telephone lines in many cases will be
inadequate to permit us to fully implement our network services. In
addition, the incumbent carriers may not maintain the telephone lines in a
condition that will allow us to implement our network effectively. The
telephone lines may not be of sufficient quality or the incumbent carriers
may claim they are not of sufficient quality to allow us to fully implement
or operate our network services. Further, some customers use technologies
other than copper lines to provide telephone services, and DSL might not be
available to these customers.
OUR SUCCESS DEPENDS ON OUR RETENTION OF CERTAIN KEY PERSONNEL AND ON
THE PERFORMANCE OF THOSE PERSONNEL
Our success depends on the performance of our officers and key
employees, especially our Chief Executive Officer. Members of our senior
management team have worked together for only a short period of time. We do
not have "key person" life insurance policies on any of our employees nor do
we have employment agreements for fixed terms with any of our employees. Any
of our employees, including any member of our senior management team, may
terminate his or her employment with us at any time. Given our early stage
of development, we depend on our ability to retain and motivate high quality
personnel, especially our management. Our future success also depends on our
continuing ability to identify, hire, train and retain highly qualified
technical, sales, marketing and customer service personnel. Moreover, the
industry in which we compete has a high level of employee mobility and
aggressive recruiting of skilled personnel. We may be unable to continue to
employ our key personnel or to attract and retain qualified personnel in the
future. We face intense competition for qualified personnel, particularly in
software development, network engineering and product management.
WE DEPEND ON THIRD PARTIES FOR EQUIPMENT, INSTALLATION AND PROVISION
OF FIELD SERVICE
We currently plan to purchase all of our equipment from many vendors
and outsource the majority of the installation and field service of our
networks to third parties. Our reliance on third party vendors involves a
number of risks, including the absence of guaranteed capacity and reduced
control over delivery schedules, quality assurance, production yields and
costs. If any of our suppliers reduces or interrupts its supply, or if any
significant installer or field service provider interrupts its service to us,
this reduction or interruption could disrupt our business.
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<PAGE>
Although multiple manufacturers currently produce or are developing equipment
that will meet our current and anticipated requirements, our suppliers may be
unable to manufacture and deliver the amount of equipment we order, or the
available supply may be insufficient to meet our demand. Currently, almost
all of the DSL modem and DSL multiplexing equipment we use for a single
connection over a copper line must come from the same vendor since there are
no existing interoperability standards for the equipment used in our higher
speed services. If our suppliers or licensors enter into competition with
us, or if our competitors enter into exclusive or restrictive arrangements
with the suppliers or licensors, then these events may materially and
adversely affect the availability and pricing of the equipment we purchase
and the technology we license.
A SYSTEM FAILURE OR BREACH OF NETWORK SECURITY COULD CAUSE DELAYS OR
INTERRUPTIONS OF SERVICE TO OUR CUSTOMERS
Our operations depend on our ability to avoid damages from fires,
earthquakes, floods, power losses, excessive sustained or peak user demand,
telecommunications failures, network software flaws, transmission cable cuts
and similar events. A natural disaster or other unanticipated problem at our
owned or leased facilities could interrupt our services. Additionally, if an
incumbent carrier, competitive carrier or other service provider fails to
provide the communications capacity we require, as a result of a natural
disaster, operational disruption or any other reason, then this failure could
interrupt our services.
Despite the implementation of security measures, our network may be
vulnerable to unauthorized access, computer viruses and other disruptive
problems. Corporate networks and Internet Service Providers have in the past
experienced, and may in the future experience, interruptions in service as a
result of accidental or intentional actions of Internet users, current and
former employees and others. Unauthorized access could also potentially
jeopardize the security of confidential information stored in the computer
systems of our customers, which might cause us to be liable to our customers,
and also might deter potential customers. Eliminating computer viruses and
alleviating other security problems may require interruptions, delays or
cessation of service to our customers and our customers' end users.
INTERFERENCE OR CLAIMS OF INTERFERENCE COULD DELAY OUR ROLLOUT OR HARM
OUR SERVICES
All transport technologies deployed on copper telephone lines have the
potential to interfere with, or to be interfered with by, other transport
technologies on the copper telephone lines. We believe that our DSL
technologies, like other transport technologies, do not interfere with
existing voice services. We believe that a workable plan that takes into
account all technologies could be implemented in a scalable way across all
incumbent carriers using existing plant engineering principles. There are
several initiatives underway to establish national standards and principles
for the deployment of DSL technologies. We believe that our technologies can
be deployed consistently with these evolving standards. Nevertheless,
incumbent carriers may claim that the potential for interference permits them
to restrict or delay our deployment of DSL services. Interference could
degrade the performance of our services or make us unable to provide service
on selected lines. The procedures to resolve interference issues between
competitive carriers and incumbent carriers are still being developed, and
these procedures may not be effective. We may be unable to successfully
negotiate interference resolution procedures with incumbent carriers.
Moreover, incumbent carriers may make claims regarding interference or
unilaterally take action to resolve interference issues to the detriment of
our services. State or federal regulators could also institute responsive
actions. Interference, or claims of interference, if widespread, would
adversely affect our speed of deployment, reputation, brand image, service
quality and customer satisfaction and retention.
WE DEPEND ON THIRD PARTIES FOR FIBER OPTIC TRANSPORT FACILITIES
We depend on the availability of fiber optic transmission facilities
from third parties to connect our equipment within and between metropolitan
areas. These third party fiber optic carriers include long distance
carriers, incumbent carriers and other competitive carriers. Many of these
entities are, or may become, our competitors. This approach includes a
number of risks. For instance, we may be unable to negotiate and renew
favorable supply agreements. Further, we depend on the timeliness of these
companies to process our orders for customers who seek to use our services.
We have in the past experienced supply problems with certain of our fiber
optic suppliers, and they may not be able to meet our needs on a timely basis
in the future. Moreover, the fiber optic transport providers whose networks
we lease may be unable to obtain or maintain permits and rights-of-way
necessary to develop and operate existing and future networks.
20
<PAGE>
UNCERTAIN FEDERAL AND STATE TAX AND OTHER SURCHARGES ON OUR SERVICES
MAY INCREASE OUR PAYMENT OBLIGATIONS
Telecommunications providers pay a variety of surcharges and fees on
their gross revenues from interstate and intrastate services. The division
of our services between interstate and intrastate services is a matter of
interpretation, and in the future the Federal Communications Commission or
relevant state commission authorities may contest this division. A change in
the characterization of the jurisdiction of our services could cause our
payment obligations to increase. In addition, pursuant to periodic revisions
by state and federal regulators of the applicable surcharges, we may be
subject to increases in the surcharges and fees currently paid.
OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS
We rely on a combination of licenses, confidentiality agreements and
other contracts to establish and protect our technology and other
intellectual property rights. We have applied for trademarks and
servicemarks on certain terms and symbols that we believe are important for
our business. We currently have no patents or patent applications pending.
The steps we have taken may be inadequate to protect our technology or other
intellectual property. Moreover, our competitors may independently develop
technologies that are substantially equivalent or superior to ours. Third
parties may assert infringement claims against us and, in the event of an
unfavorable ruling on any claim, we may be unable to obtain a license or
similar agreement to use technology we rely upon to conduct our business. We
also rely on unpatented trade secrets and know-how to maintain our
competitive positions, which we seek to protect, in part, by confidentiality
agreements with employees, consultants and others. However, these agreements
may be breached or terminated, and we may not have adequate remedies for any
breach. In addition, our competitors may otherwise learn or discover our
trade secrets. Our management personnel were previously employees of other
telecommunications companies. In many cases, these individuals are
conducting activities for us in areas similar to those in which they were
involved prior to joining us. As a result, we or our employees could be
subject to allegations of violation of trade secrets and other similar
claims.
RISKS ASSOCIATED WITH POTENTIAL GENERAL ECONOMIC DOWNTURN
In the last few years the general health of the economy, particularly
the economy of California where we have conducted a significant portion of
our operations to date, has been relatively strong and growing, a consequence
of which has been increasing capital spending by individuals and growing
companies to keep pace with rapid technological advances. To the extent the
general economic health of the United States or of California declines from
recent historically high levels, or to the extent individuals or companies
fear a decline is imminent, these individuals and companies may reduce
expenditures such as those for our services. Any decline or concern about an
imminent decline could delay decisions among certain of our customers to roll
out our services or could delay decisions by prospective customers to make
initial evaluations of our services. Any delays would have a material and
adverse effect on our business, prospects, operating results and financial
condition.
WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE
COVENANTS IN OUR EXISTING DEBT SECURITIES
The indentures for our senior discount notes issued in May 1998 and
our senior notes issued in April 1999 impose significant restrictions on how
we can conduct our business. For example, the restrictions prohibit or limit
our ability to incur additional debt, make dividend payments and engage in
certain business activities. The restrictions may materially and adversely
affect our ability to finance future operations or capital needs or conduct
additional business activities. Any future senior debt that we may incur
will likely impose additional restrictions on us. If we fail to comply with
any existing or future restrictions, we could default under the terms of the
applicable debt and be unable to meet our debt obligations. If we default,
the holders of the applicable debt could demand that we pay the debt,
including interest, immediately. We may be unable to make the required
payments or raise sufficient funds from alternative sources to make the
payments. Even if additional financing is available in the event that we
default, it may not be on acceptable terms.
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<PAGE>
OUR PRINCIPAL STOCKHOLDERS AND MANAGEMENT OWN A SIGNIFICANT PERCENTAGE
OF OUR COMPANY, AND WILL BE ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR
COMPANY
Our executive officers and directors and principal stockholders
together beneficially own over 81% of the total voting power of our company.
Accordingly, these stockholders will be able to determine the composition of
our Board of Directors, will retain the voting power to approve all matters
requiring stockholder approval and will continue to have significant
influence over our affairs. This concentration of ownership could have the
effect of delaying or preventing a change in our control or otherwise
discouraging a potential acquirer from attempting to obtain control of us,
which in turn could have a material and adverse effect on the market price of
the common stock or prevent our stockholders from realizing a premium over
the market prices for their shares of common stock.
OUR FAILURE AND THE FAILURE OF THIRD PARTIES TO BE YEAR 2000 COMPLIANT
COULD NEGATIVELY IMPACT OUR BUSINESS
Many computer programs have been written using two digits rather than
four to define the applicable year. This poses a problem at the end of the
century because these computer programs may recognize a date using "00" as
the year 1900 rather than the year 2000. This, in turn, could result in
major system failures or miscalculations, and is generally referred to as the
"Year 2000 issue." We have formulated and, to a large extent, effected a
plan to address our Year 2000 issues.
Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year
2000 compliance testing for all of our internal systems and believe that they
are Year 2000 compliant. Because we are a young company, we believe we have
been able to build our business systems with the Year 2000 issue in mind in a
more effective manner than many older companies. Therefore, there have been
few Year 2000 changes required to our existing systems and applications. We
have substantially completed a compliance check of our external customers and
providers, except for the incumbent carriers. Based on responses from these
third parties, other than the incumbent carriers, we believe that they will
not experience Year 2000 problems that would materially and adversely affect
our business. We have not been able to conduct a compliance check of
incumbent carriers nor assess the incumbent carriers' Year 2000 compliance.
To the extent that one or more incumbent carriers or other third parties
experience Year 2000 problems, our network and services could be adversely
affected. Furthermore, the purchasing patterns of our customers may be
affected by Year 2000 issues as companies expend significant resources to
correct their current systems for Year 2000 compliance. These expenditures
may result in reduced funds available for our services. Any of these
developments could have a material and adverse effect on our business,
prospects, operating results and financial condition. We have not fully
determined the risks associated with the reasonably worst-case scenario and
have not formulated a contingency plan to address Year 2000 issues. We do not
expect to have a specific contingency plan in place in the future.
IF WE ARE REQUIRED TO REGISTER AS AN INVESTMENT COMPANY, WE WOULD
BECOME SUBJECT TO SUBSTANTIAL REGULATION WHICH WOULD INTERFERE WITH OUR
ABILITY TO CONDUCT OUR BUSINESS ACCORDING TO OUR BUSINESS PLAN
As a result of our previous financings, we have substantial cash, cash
equivalents and short-term investments. We plan to continue investing the
excess proceeds of these financings in short-term instruments consistent with
prudent cash management and not primarily for the purpose of achieving
investment returns. Investment in securities primarily for the purpose of
achieving investment returns could result in our being treated as an
"investment company" under the Investment Company Act of 1940. The
Investment Company Act requires the registration of companies that are
primarily in the business of investing, reinvesting or trading securities or
that fail to meet certain statistical tests regarding their composition of
assets and sources of income even though they consider themselves not to be
primarily engaged in investing, reinvesting or trading securities.
We believe that we are primarily engaged in a business other than
investing in or trading securities and, therefore, are not an investment
company within the meaning of the Investment Company Act. If the Investment
Company Act required us to register as an investment company, we would become
subject to substantial regulation with respect to our capital structure,
management, operations, transactions with affiliated persons and other
matters. Application of the provisions of the Investment Company Act to us
would materially and adversely affect our business, prospects, operating
results and financial condition.
22
<PAGE>
WE HAVE NOT PAID AND DO NOT INTEND TO PAY DIVIDENDS
We have not paid any dividends, and we do not intend to pay cash
dividends in the foreseeable future. Our current financing documents contain
provisions which restrict our ability to pay dividends.
THE TERMS OF OUR EXISTING DEBT MAY LIMIT OUR ABILITY TO ENTER INTO A
CHANGE OF CONTROL TRANSACTION
The indentures governing our senior discount notes issued in May 1998
and our senior notes issued in April 1999 require us to offer to repurchase
all such notes for 101% of their principal amount or accreted value, plus any
accrued interest due, within 30 days after a change of control. We might not
have sufficient funds available at the time of any change of control to make
any required payment, as well as any payment that may be required pursuant to
any other outstanding indebtedness at the time, including our indebtedness to
equipment financing lenders. These covenants may also deter third parties
from entering into a change of control transaction with us. Furthermore,
following the occurrence of certain change-of-control events, we must offer
to repurchase for cash all of the outstanding warrants issued in connection
with our senior discount notes issued in May 1998.
23
<PAGE>
RHYTHMS NETCONNECTIONS INC.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are currently a party to an arbitration proceeding between us and SBC
Communications regarding the terms of interconnection with Southwestern Bell
in Texas. This arbitration, instituted December 11, 1998, is pending before
the Public Utility Commission of Texas. The dispute involves the terms and
conditions of issues related to DSL-based services and loops in connection
with our interconnection agreement with Southwestern Bell. We are seeking to
compel Southwestern Bell to include in our interconnection agreement language
comparable to that in our other interconnection agreements, which gives us
the ability to obtain copper telephone lines on which we provide our chosen
variety of DSL technologies.
In addition, on March 12, 1999, our subsidiary ACI Corp. filed a complaint
with the Oregon Public Utilities Commission (the "Oregon PUC") against U S
West Communications regarding collocation matters. ACI has requested the
Oregon PUC to intervene in an on-going dispute between ACI and U S West
Communications regarding ACI's ability to collocate in three central offices
located in Portland, Oregon pursuant to Section 251(c)(6) of the 1996
Telecommunications Act. ACI has requested that the Oregon PUC make a
determination that U S West Communications can, in fact, accommodate ACI's
requests for collocation and, if such a determination is made, that the
Oregon PUC immediately order U S West Communications to make space available
to ACI on the terms and conditions set forth in the existing interconnection
agreement between the companies. ACI has also sought monetary damages in an
amount to be proven at a hearing to compensate for ACI's economic losses. No
hearing date or schedule has yet been set for this proceeding.
On February 18, 1999, we filed a complaint for declaratory relief in San
Diego County Superior Court (North County) against Thomas R. Lafleur. Mr.
Lafleur was a former employee who resigned and/or was terminated in 1998.
After he left, we sent him a check for the repurchase or buy-back of his
unvested shares; Mr. Lafleur refused to cash this check. The declaratory
relief action is to determine that his shares were unvested and thus properly
repurchased. On or about March 26, 1999, Mr. Lafleur filed an answer to the
complaint and also filed a cross-complaint against us for fraud, breach of
the covenant of good faith and fair dealing, conspiracy to inflict emotional
distress, intentional infliction of emotional distress, conversion and
declaratory relief. The cross-complaint seeks compensatory and punitive
damages according to proof, and 438,115 shares of common stock. Mr. Lafleur
alleges in his cross-complaint that since we failed to purchase his shares
within 60 days following his termination, the terms of his stock purchase
agreement prevent us from repurchasing his shares. We intend to vigorously
defend against such cross-claims, and have filed a demurrer to the
cross-complaint. We are currently accounting for these 438,115 shares as
treasury stock.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(c) The Registrant issued the following unregistered securities
during the quarter ended March 31, 1999:
(1) In March 1999 the Registrant issued to MCI WorldCom
Venture Fund, Inc. and to Microsoft Corporation 3,731,410 and
3,731,409 shares of Series C preferred stock, respectively, and issued
to each of them a warrant to purchase 720,000 shares of common stock for
an aggregate purchase price of $60.0 million.
24
<PAGE>
(2) In March 1999 the Registrant issued to GATX Capital
Corporation, warrants to purchase an aggregate of 45,498 shares of
common stock with an exercise price per share of $10.55 in connection
with an equipment lease financing.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
No defaults upon senior securities occurred during the quarter ended March 31,
1999.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matters were submitted to a vote of security holders during the
quarter ended March 31, 1999. All share numbers are on an as-converted to
common stock basis and give effect to the 6-for-5 forward stock split
effected in March 1999.
(1) Effective February 26, 1999, the stockholders approved by written
consent an amendment to the Registrant's certificate of incorporation
to, among other things, (i) set the conversion price of the Series A and
Series B Preferred Stock at their respective purchase prices as of the
date of an amendment to the Restated Certificate of Incorporation and
(ii) exclude from the definition of "Additional Stock" (with respect to
antidilution adjustments) the shares of securities issued or issuable
upon exercise of warrants issued in connection with a contemplated and
any future private placements pursuant to Rule 144A of the Securities
Act of 1933, as amended. A total of 39,328,313 shares were voted in
favor of this written consent. Votes were not received with respect to
the remaining 9,780,826 shares then outstanding.
(2) In connection with the sale of Series C preferred stock and a
warrant to purchase shares of common stock to MCI WorldCom, the
stockholders approved by written consent, effective March 1, 1999, a
restatement of the Registrant's certificate of incorporation to, among
other things, (i) authorize additional shares of preferred stock, (ii)
designate shares of Series C preferred stock and (iii) provide for the
rights, preferences and privileges of the Series C preferred stock. A
total of 37,849,193 shares were voted in favor of this written consent.
Votes were not received with respect to the remaining 11,259,946 shares
then outstanding.
(3) In connection with the sale of Series C preferred stock and a
warrant to purchase shares of common stock to Microsoft Corporation, the
stockholders approved by written consent, effective March 12, 1999, a
restatement of the Registrant's certificate of incorporation to, among
other things, (i) authorize additional shares of preferred stock and
(ii) designate shares of Series C preferred stock. A total of
42,326,885 shares were voted in favor of this written consent. Votes
were not received with respect to the remaining 11,259,946 shares then
outstanding.
(4) Effective March 16, 1999, the stockholders approved by written
consent the adoption of the Registrant's 1999 Stock Incentive Plan and
the reservation of 7,440,000 shares of common stock for issuance under
such plan. The stockholders also approved an automatic annual increase
in the number of shares reserved under such plan in an amount equal to
two percent (2%) of the total number of shares of common stock
outstanding on the last trading day in December of the immediately
preceding year, provided that no such annual increase shall exceed
1,440,000 shares. The stockholders also approved the adoption of the
Registrant's 1999 Employee Stock Purchase Plan and the reservation of
1,200,000 shares of common stock for issuance under such plan, with an
automatic annual increase in such number of reserved shares in an amount
equal to one percent (1%) of the total number of shares of common stock
outstanding on the last trading day in December of the immediately
preceding year, provided that no such annual increase shall exceed
780,000 shares. A total of 42,566,885 shares were voted in favor of
this written consent. Votes were not received with respect to the
remaining 16,124,727 shares then outstanding.
(5) Effective March 17, 1999, the stockholders approved by written
consent an amendment to the Registrant's certificate of incorporation to
effect a 6-for-5 forward stock split. A total of 42,566,885 shares
25
<PAGE>
were voted in favor of this written consent. Votes were not received
with respect to the remaining 16,124,727 shares then outstanding.
(6) Effective March 25, 1999, the stockholders approved by written
consent an amendment to the Registrant's bylaws to (i) implement a
staggered system of electing directors, pursuant to which the directors
were classified into three classes, with terms of offices of the first,
second and third classes of directors to expire in 2000, 2001 and 2002,
respectively, and with directors elected to each respective class
thereafter to serve three-year terms and (ii) to amend the provision
relating to the determination of the size of the board of directors such
that, within the range proscribed (between 7 and 10 directors and
initially set at 8), the size of the board can be fixed by resolution of
66-2/3% of the directors then in office or by the vote of 66-2/3% of the
stockholders at the annual meeting of stockholders. A total of
48,196,579 shares were voted in favor of this written consent. Votes
were not received with respect to the remaining 10,495,033 shares then
outstanding.
(7) Effective March 26, 1999, the stockholders approved by written
consent the form of Restated Certificate of Incorporation and form of
Restated Bylaws to become effective immediately prior to the closing of
the Registrant's initial public offering (which was consummated on April
12, 1999). A total of 48,196,576 shares were voted in favor of this
written consent. Votes were not received with respect to the remaining
10,932,616 shares then outstanding.
(8) Effective March 27, 1999, the stockholders approved by written
consent an amendment to the Registrant's 1997 Stock Option/Stock
Issuance Plan to increase the authorized number of shares for issuance
under such plan by 500,000. The stockholders also approved an increase
in the number of shares of common stock to be available for issuance
under the Restated Certificate of Incorporation to become effective
immediately prior to the closing of the Registrant's initial public
offering (which was consummated on April 12, 1999). A total of
47,044,576 shares were voted in favor of this written consent. Votes
were not received with respect to the remaining 12,084,616 shares then
outstanding.
(9) In connection with the sale of Series C preferred stock, Series D
preferred stock and a warrant to purchase shares of common stock to
Qwest Communications Corporation, the stockholders approved by written
consent, effective March 31, 1999, a restatement of the Registrant's
certificate of incorporation to, among other things, (i) authorize
additional shares of preferred stock, (ii) authorize additional shares
of Series C preferred stock (iii) designate shares of Series D preferred
stock and (iv) provide for the rights, preferences and privileges of the
Series D preferred stock. A total of 47,044,576 shares were voted in
favor of this written consent. Votes were not received with respect to
the remaining 12,090,616 shares then outstanding.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
27.1 Financial Data Schedule
(b) Reports on Form 8-K:
There have been no reports on Form 8-K filed during the quarter
ended March 31, 1999.
26
<PAGE>
RHYTHMS NETCONNECTIONS 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.
/s/ SCOTT C. CHANDLER
- ----------------------------------------------------
Scott C. Chandler
Chief Financial Officer and Executive Vice President
(Principal Financial and Accounting Officer)
May 17, 1999
27
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<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM
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FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
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<RECEIVABLES> 800
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<INVENTORY> 1,020
<CURRENT-ASSETS> 152,945
<PP&E> 49,822
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<BONDS> 162,990
0
24
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<INTEREST-EXPENSE> 5,627
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