<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 JUNE 30, 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 80112-3931
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 No X
----- -----
As of August 10, a total of 72,981,667 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 second quarter and six-month year-to-date, as
applicable, consolidated financial statements of the Registrant as of and
through June 30, 1999.
1
<PAGE>
RHYTHMS NetConnections INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(Unaudited)
December 31 June 30
ASSETS: 1998 1999
------------ -------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 21,315,000 $ 297,183,000
Short-term investments 115,497,000 218,842,000
Restricted cash - 34,963,000
Accounts, loans, interest, and other receivables, net 2,376,000 6,541,000
Inventory 340,000 1,417,000
Prepaid expenses and other current assets 230,000 628,000
------------ -------------
Total current assets 139,758,000 559,574,000
Equipment and furniture, net 11,510,000 73,243,000
Collocation fees, net 13,804,000 39,690,000
Restricted cash - 78,248,000
Deferred business acquisition costs, net - 21,388,000
Deferred debt issue costs, net 6,304,000 16,514,000
Other assets 350,000 658,000
------------ -------------
$171,726,000 $ 789,315,000
------------ -------------
------------ -------------
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Current portion of long-term debt $ 333,000 $ 333,000
Accounts payable 10,601,000 32,866,000
Interest payable 39,000 7,866,000
Accrued expenses and other current liabilities 2,816,000 8,426,000
------------ -------------
Total current liabilities 13,789,000 49,491,000
Long-term debt 472,000 278,000
13.50% senior discount notes due 2008, net 157,465,000 168,701,000
12.75% senior notes due 2009 - 325,000,000
Other liabilities 180,000 181,000
------------ -------------
Total liabilities 171,906,000 543,651,000
------------ -------------
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, no shares authorized in 1999; 12,855,094
shares issued and outstanding in 1998, no shares issued and
outstanding in 1999 13,000 -
Series B convertible preferred stock, $0.001 par value; 4,044,943 shares
authorized in 1998, no shares authorized in 1999; 4,044,943 shares issued
and outstanding in 1998, no shares issued and outstanding in 1999 4,000 -
Common stock, $0.001 par value; 80,049,892 shares authorized in 1998,
250,000,000 shares authorized in 1999; 8,042,530 shares issued in 1998,
72,708,777 shares issued in 1999 8,000 73,000
Treasury stock, at cost; 438,115 shares in 1998 and 486,595 shares in 1999 (18,000) (20,000)
Additional paid-in capital 37,212,000 344,394,000
Warrants - 10,247,000
Deferred compensation (5,210,000) (10,086,000)
Accumulated deficit (38,756,000) (105,511,000)
------------ -------------
Total stockholders' equity (deficit) (6,747,000) 239,097,000
------------ -------------
$171,726,000 $ 789,315,000
------------ -------------
------------ -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
2
<PAGE>
RHYTHMS NetConnections INC.
CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
(Unaudited) (Unaudited)
Three Months Ended Six Months Ended
------------------------------ -------------------------------
June 30 June 30 June 30 June 30
1998 1999 1998 1999
------------ ------------- ------------ -------------
<S> <C> <C> <C> <C>
REVENUE:
Service and installation, net $ 71,000 $ 1,641,000 $ 82,000 $ 2,300,000
------------ ------------- ------------ -------------
OPERATING EXPENSES:
Network and service costs 477,000 12,033,000 665,000 18,170,000
Selling and marketing 644,000 2,219,000 928,000 3,904,000
General and administrative 4,007,000 20,104,000 6,056,000 32,214,000
Depreciation and amortization 19,000 1,493,000 35,000 2,144,000
Amortized deferred business acquisition costs - 1,521,000 - 1,652,000
------------ ------------- ------------ -------------
Total operating expenses 5,147,000 37,370,000 7,684,000 58,084,000
------------ ------------- ------------ -------------
LOSS FROM OPERATIONS (5,076,000) (35,729,000) (7,602,000) (55,784,000)
------------ ------------- ------------ -------------
OTHER INCOME AND EXPENSE:
Interest income 1,516,000 6,579,000 1,674,000 8,329,000
Interest expense (including amortized debt discount and
issue costs) (3,209,000) (13,744,000) (3,221,000) (19,372,000)
Other - 37,000 - 72,000
------------ ------------- ------------ -------------
NET LOSS $ (6,769,000) $ (42,857,000) $ (9,149,000) $ (66,755,000)
------------ ------------- ------------ -------------
------------ ------------- ------------ -------------
NET LOSS PER SHARE:
Basic $ (2.84) $ (0.68) $ (4.02) $ (1.97)
------------ ------------- ------------ -------------
------------ ------------- ------------ -------------
Diluted $ (2.84) $ (0.68) $ (4.02) $ (1.97)
------------ ------------- ------------ -------------
------------ ------------- ------------ -------------
SHARES USED IN COMPUTING NET LOSS PER SHARE:
Basic 2,386,828 62,878,429 2,277,529 33,820,672
------------ ------------- ------------ -------------
------------ ------------- ------------ -------------
Diluted 2,386,828 62,878,429 2,277,529 33,820,672
------------ ------------- ------------ -------------
------------ ------------- ------------ -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
RHYTHMS NetConnections INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
(Unaudited)
Six Months Ended
--------------------------------
June 30 June 30
1998 1999
-------------- --------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (9,149,000) $ (66,755,000)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation of equipment and furniture 23,000 1,807,000
Amortization of collocation fees 12,000 337,000
Amortization of deferred business acquisition costs - 1,652,000
Amortization of deferred debt issue costs and debt discount 3,188,000 11,515,000
Amortization of deferred compensation 238,000 1,575,000
Amortization of gain on sale of equipment to leasing company - (70,000)
Changes in assets and liabilities:
Increase in accounts, loans, interest, and other receivables, net (260,000) (4,165,000)
Increase in inventory (364,000) (1,077,000)
Increase in prepaid expenses and other current assets (38,000) (398,000)
Increase in other assets (15,000) (308,000)
Increase (decrease) in accounts payable 298,000 (3,521,000)
Increase in interest payable - 7,827,000
Increase in accrued expenses and other current liabilities 538,000 5,610,000
Increase in other liabilities - 71,000
-------------- --------------
Net cash used for operating activities (5,529,000) (45,900,000)
-------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments - (168,839,000)
Maturities of short-term investments - 65,494,000
Purchases of government securities as restricted cash - (113,211,000)
Purchases of equipment and furniture (3,742,000) (61,509,000)
Payments of collocation fees (2,743,000) (26,223,000)
-------------- --------------
Net cash used for investing activities (6,485,000) (304,288,000)
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from leasing company for equipment 2,000,000 23,755,000
Proceeds from issuance of 13.50% senior discount notes and warrants 150,365,000 -
Proceeds from issuance of 12.75% senior notes - 325,000,000
Payments of debt issue costs (6,046,000) (10,489,000)
Proceeds from borrowings on long-term debt 432,000 -
Repayments of long-term debt (56,000) (194,000)
Proceeds from issuance of common stock 229,000 229,476,000
Proceeds from issuance of preferred stock and warrants 18,292,000 75,000,000
Payments of equity issue costs - (16,490,000)
Purchases of treasury stock - (2,000)
-------------- --------------
Net cash provided by financing activities 165,216,000 626,056,000
-------------- --------------
Net increase in cash and cash equivalents 153,202,000 275,868,000
Cash and cash equivalents at beginning of period 10,166,000 21,315,000
-------------- --------------
Cash and cash equivalents at end of period $ 163,368,000 $ 297,183,000
-------------- --------------
-------------- --------------
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Cash paid for interest $ 25,000 $ 30,000
-------------- --------------
-------------- --------------
SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:
Equipment purchases payable, to be financed through operating leases $ 2,299,000 $ -
-------------- --------------
-------------- --------------
Equipment and furniture purchases payable $ - $ 25,786,000
-------------- --------------
-------------- --------------
Intangible business acquisition costs arising from issuance of preferred
stock and warrants $ - $ 23,040,000
-------------- --------------
-------------- --------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<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 in initial public
offering in April 1999 (unaudited) - - - - - -
Issuance of common stock upon exercise
of options for cash ($0.04 to $6.37
per share) (unaudited) - - - - - -
Issuance of common stock upon cashless
exercise of warrants ($0.004 per share)
in May and June 1999 (unaudited) - - - - - -
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited) - - - - 8,395,655 8,000
Issuance of Series D preferred stock and
warrants for cash ($17.00 per share) in
April 1999 (unaudited) - - - - - -
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited) - - - - - -
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited) (12,855,094) (13,000) (4,044,943) (4,000) (8,395,655) (8,000)
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited) - - - - - -
Costs arising from initial public offering in
April 1999 (unaudited) - - - - - -
Purchase of treasury stock for cash ($0.04
to $0.25 per share) (unaudited) - - - - - -
Issuance of warrants to leasing companies
in March and April 1999 (unaudited) - - - - - -
Issuance of warrants to business partner
in April 1999 (unaudited) - - - - - -
Deferred compensation from grants 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 June 30, 1999 (unaudited) - - - - - -
----------- ------- ---------- ------ ---------- ------
Balance at June 30, 1999 (unaudited) - $ - - $ - - $ -
----------- ------- ---------- ------ ---------- ------
----------- ------- ---------- ------ ---------- ------
<CAPTION>
Series D Convertible
Preferred Stock Common Stock Treasury Stock
$0.001 Par Value $0.001 Par Value at cost
------------------- ---------------------- ---------------------
# Shares Amount # Shares Amount # Shares Amount
-------- ------ ---------- ------- -------- ---------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998 - $ - 8,042,530 $ 8,000 438,115 $(18,000)
Issuance of common stock in initial public
offering in April 1999 (unaudited) - - 10,781,250 11,000 - -
Issuance of common stock upon exercise
of options for cash ($0.04 to $6.37
per share) (unaudited) - - 2,556,834 3,000 - -
Issuance of common stock upon cashless
exercise of warrants ($0.004 per share)
in May and June 1999 (unaudited) - - 252,112 - - -
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited) - - - - - -
Issuance of Series D preferred stock and
warrants for cash ($17.00 per share) in
April 1999 (unaudited) 441,176 - - - - -
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited) - - - - - -
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited) (441,176) - 51,076,051 51,000 - -
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited) - - - - - -
Costs arising from initial public offering in
April 1999 (unaudited) - - - - - -
Purchase of treasury stock for cash ($0.04
to $0.25 per share) (unaudited) - - - - 48,480 (2,000)
Issuance of warrants to leasing companies
in March and April 1999 (unaudited) - - - - - -
Issuance of warrants to business partner
in April 1999 (unaudited) - - - - - -
Deferred compensation from grants 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 June 30, 1999 (unaudited) - - - - - -
-------- ------ ---------- ------- -------- ---------
Balance at June 30, 1999 (unaudited) - $ - 72,708,777 $73,000 486,595 $ (20,000)
-------- ------ ---------- ------- -------- ---------
-------- ------ ---------- ------- -------- ---------
<CAPTION>
Total
Additional Stockholders'
Paid-In Deferred Accumulated Equity
Capital Warrants Compensation Deficit (Deficit)
------------ ------------ ------------ ------------- -------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1998 $ 37,212,000 $ - $ (5,210,000) $ (38,756,000) $ (6,747,000)
Issuance of common stock in initial public
offering in April 1999 (unaudited) 226,395,000 - - - 226,406,000
Issuance of common stock upon exercise
of options for cash ($0.04 to $6.37
per share) (unaudited) 3,067,000 - - - 3,070,000
Issuance of common stock upon cashless
exercise of warrants ($0.004 per share)
in May and June 1999 (unaudited) - - - - -
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited) 60,368,000 7,124,000 - - 67,500,000
Issuance of Series D preferred stock and
warrants for cash ($17.00 per share) in
April 1999 (unaudited) 6,317,000 1,183,000 - - 7,500,000
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited) 21,100,000 - - - 21,100,000
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited) (26,000) - - - -
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited) (234,000) - - - (234,000)
Costs arising from initial public offering in
April 1999 (unaudited) (16,256,000) - - - (16,256,000)
Purchase of treasury stock for cash ($0.04
to $0.25 per share) (unaudited) - - - - (2,000)
Issuance of warrants to leasing companies
in March and April 1999 (unaudited) - 1,030,000 - - 1,030,000
Issuance of warrants to business partner
in April 1999 (unaudited) - 910,000 - - 910,000
Deferred compensation from grants of
options to purchase common stock
(unaudited) 7,009,000 - (7,009,000) - -
Amortization of deferred compensation
(unaudited) - - 1,575,000 - 1,575,000
Reversal of deferred compensation from
cancellation of grants to purchase
common stock (unaudited) (558,000) - 558,000 - -
Net loss through June 30, 1999 (unaudited) - - - (66,755,000) (66,755,000)
------------ ------------ ------------ ------------- -------------
Balance at June 30, 1999 (unaudited) $344,394,000 $ 10,247,000 $(10,086,000) $(105,511,000) $ 239,097,000
------------ ------------ ------------ ------------- -------------
------------ ------------ ------------ ------------- -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
RHYTHMS NetConnections INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION:
THE COMPANY: RHYTHMS NetConnections Inc. ("Rhythms" or 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 use
currently available funds and seek additional sources of financing. If
unsuccessful in obtaining additional 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 Rhythms Links Inc.
(formerly 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 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 and upon the exercise of outstanding
stock options and warrants, and shares subject to repurchase by the Company
totaling 20,915,262 and 15,931,733 at June 30, 1998 and 1999, respectively, have
been excluded from the computation since their effect would be antidilutive.
6
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED):
NOTE 3 - DEBT:
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. Interest on the notes is due
semi-annually. Cash proceeds from the issuance, after payment of underwriting
fees and other debt issue costs, were $314,511,000. Of these proceeds,
approximately $113,211,000 was used to purchase a portfolio of U.S. government
securities and will be used for the first three years' interest payments.
NOTE 4 - STOCKHOLDERS' EQUITY:
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.
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.
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 connection with
this investment, Qwest also received warrants to purchase 180,000 shares of
common stock at a price of $6.70 per shares 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. In connection with these business relationships, the Company
capitalized $11,100,000 in business acquisition costs that are being amortized
over a five-year period.
In March 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
was 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 April 12, 1999, 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 $210,150,000 after payment of
underwriting fees and related issue costs. 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.
During the second quarter of 1999, the Company granted options to employees to
purchase a total 1,667,347 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 979,644 shares of Common
Stock for total proceeds to the Company of $1,664,000.
7
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED):
NOTE 5 - SUBSEQUENT EVENTS:
On July 14, 1999, the Company filed a registration statement on Form S-1 with
the Securities and Exchange Commission for up to 4,732,800 shares of common
stock to be offered for sale by certain of the Company's stockholders. On
July 29, 1999, the Company filed an amendment to this registration statement
and reduced the amount of shares to be sold to 3,919,087. An underwriters'
over-allotment of 15 percent of the shares sold will also be registered with
this offering.
On July 30, 1999, the Company entered into a 36-month lease line that provides
for $26,000,000 in equipment on an operating lease basis. In connection with
this lease agreement, the Company issued 10,000 warrants to purchase common
stock at a price of $50.00 per share, exercisable immediately.
8
<PAGE>
RHYTHMS NetConnections INC.
PART I
FINANCIAL INFORMATION (CONTINUED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
We have based the following discussion and analysis on the consolidated
financial statements of our company and this should be read in conjunction
with our financial statements and the related footnotes presented previously.
Certain statements we have set forth below constitute forward-looking
statements. Forward-looking statements are based on our current expectations
and projections about future events. They involve known and unknown risks,
uncertainties, and other factors that may cause our actual results,
performance or achievements, or industry results, to be materially different
from any future results anticipated or implied by the forward-looking
statements. Given these uncertainties, we caution investors and prospective
investors not to place undue reliance on any forward-looking statements.
Factors discussed in the "Risk Factors" and "Business" sections contained in
the Company's Registration Statement on Form S-1 as filed with the Securities
and Exchange Commission on July 14, 1999 could, among other things, cause or
contribute to differences from the forward-looking statements. We disclaim
any obligation to publicly update or revise information contained in any
forward-looking statement, whether as a result of new information, future
events, or otherwise. In light of these risks, uncertainties, and
assumptions, the forward-looking events discussed in this Form 10-Q might not
occur.
RESULTS OF OPERATIONS:
We are a leading service provider of high-speed local access networking
solutions using DSL technology to businesses. We began offering commercial
services in our first market in April 1998 and currently offer service in a
total of 17 markets. We intend to continue our network rollout into an
additional 16 markets in 1999 and a further 17 markets by the end of year 2000.
Since our inception in February 1997, our primary activities have consisted of:
- obtaining required governmental authorizations;
- negotiating and executing interconnection agreements with incumbent
carriers;
- entering into strategic alliances;
- identifying collocation space and locations for our connection
points, metro service centers, and business offices;
- acquiring and deploying equipment and facilities;
- launching service trials;
- hiring management and other personnel;
- raising capital; and
- developing and integrating our operations support systems and other
back office systems.
During the first six-months of 1999, we continued the development of our
business operations as follows:
- entered one new market during the first quarter and six new markets
during the second quarter;
- added 155 central office locations during the first quarter and 153
during the second quarter;
- added service to 735 DSL lines during the first quarter and 2,105
during the second quarter; and
- increased headcount by 170 employees during the first quarter and
225 during the second quarter.
We have incurred operating losses, net losses and negative operating cash
flow for each month since our formation. As of June 30, 1999, we had an
accumulated deficit of approximately $105.5 million. We expect to
substantially increase our expenditures and operating expenses as we continue
our rapid expansion of our infrastructure and network services. We expect to
incur substantial operating losses, net losses, and negative cash flow during
the network build-out and the initial penetration of each new market we
enter. We expect to continue these losses for at least the next several years.
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RESULTS OF OPERATIONS (CONTINUED):
THREE MONTHS ENDED JUNE 30, 1999 COMPARED TO THREE MONTHS ENDED JUNE 30, 1998
For the three months ended June 30, 1999, we recorded revenues of $1.6
million and network and service costs of $12.0 million. This compares to
revenues of $71,000 and network and service costs of $477,000 during the same
period in the prior year. The substantial increases in both revenues and
costs in 1999 is a result of our continued rapid expansion. Each new market
we enter provides us with additional revenue opportunity, but also higher
costs until we have an established customer base in the market. As of June
30, 1999 we operated in 17 markets, compared to two markets at June 30, 1998.
Our revenues are derived primarily from DSL service and installation charges,
net of discounts given to customers upon service establishment. Network
service costs include customer installation costs, line and backbone
expenses, equipment operating leases, and repair and support costs.
Our selling, marketing, general, and administrative expenses for the second
quarter of 1999 were $22.3 million, which compares to $4.7 million in the prior
year. This increase between years reflects our continuing increases in staffing
levels, legal fees, and marketing efforts coinciding with the development and
launch of new markets.
We recorded depreciation and amortization of $1.5 million during the second
quarter of 1999, a significant increase over the $19,000 recorded during the
second quarter of 1998. This increase reflects the rapid expansion of our
network and includes amortization of collocation fees and depreciation on
operating equipment as we turn up service in each new location.
During the first and second quarters of 1999, we entered into strategic
arrangements with Microsoft Corporation and Qwest Communications Corporation. In
addition to their investments in our company totaling $45.0 million, the
strategic arrangements provide for certain other business relationships.
Combined, these business relationships are valued at $21.1 million and we have
capitalized these costs as deferred assets. We are amortizing these assets over
three- and five-year periods. Accordingly, during the second quarter of 1999 we
recorded $1.5 million in amortized deferred business acquisition costs that have
no corresponding amortization in the prior year.
During the second quarter of 1999 we recorded interest income of $6.6 million.
During the second quarter in 1998 we recorded interest income of $1.5 million.
The increase between years primarily resulted from a substantial increase in
invested cash balances. As of June 30, 1999, we had cash and investments
totaling $629.2 million, compared to cash and investments of $163.4 million at
June 30, 1998. The increase during 1999 resulted from a variety of financing
activities, including:
- issuing Series C and Series D preferred stock and warrants totaling
$75.0 million in March and April 1999;
- issuing common stock upon our initial public offering in April 1999
for cash proceeds of $210.1 million;
- issuing 12.75 percent senior debt in April 1999 for cash proceeds of
$314.5 million; and
- executing equipment lease lines totaling $44.0 million in March and
April 1999.
While we recorded increased interest income on the invested cash balances, we
also recorded higher interest expense during 1999 as compared to 1998. For the
quarter ended June 30, 1999 we had interest expense of $13.7 million which
compared to $3.2 million for the same period in the prior year. This increase
primarily resulted from the senior debt we issued in April 1999.
We continue to be in a net operating loss tax position through June 30, 1999;
consequently, we have not recorded a provision for income taxes for periods
through June 30, 1999.
SIX MONTHS ENDED JUNE 30, 1999 COMPARED TO SIX MONTHS ENDED JUNE 30, 1998
We recorded $2.3 million in revenues for the six months ended June 30, 1999
compared to $82,000 in revenues for the six months ended June 30, 1998. Our
network and service costs for the six-month periods were $18.2 million in 1999
compared to $665,000 in 1998. The increases in both revenues and costs resulted
from the continued expansion of our operations, as more fully detailed above.
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RESULTS OF OPERATIONS (CONTINUED):
SIX MONTHS ENDED JUNE 30, 1999 COMPARED TO SIX MONTHS ENDED JUNE 30, 1998
(CONTINUED)
During the first half of 1999, our selling, marketing, general, and
administrative expenses were $36.1 million, which compares to $7.0 million
during the first half of 1998. This increase resulted primarily from additional
salary, overhead, marketing, and legal expenses associated with our continuing
expansion, as more fully detailed above.
Depreciation and amortization for the six-month periods was $2.1 million in 1999
and $35,000 in 1998. As we continue our expansion into additional markets and
central offices, as discussed above, we employ additional equipment and
collocation sites that we begin depreciating when we place them in service.
The increase in amortized deferred business acquisition costs between years from
zero in 1998 to $1.7 million in 1999 is a result of the Microsoft and Qwest
business relationships as discussed above.
Interest income was $8.3 million and interest expense was $19.4 million for the
six months ended June 30, 1999. This compares to interest income of $1.7 million
and interest expense of $3.2 million for the same six-month period in 1998. The
increases in 1999 resulted from our financing activities that are described
above. These financing activities included our initial public offering of common
stock and our issuance of senior debt in April 1999. We invested the proceeds
from these financings, which provided increased interest income. Interest and
issue cost amortization on the debt, however, contributed to a large increase in
interest expense for 1999.
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 each market. Capital
expenditures, including payments for collocation fees, were $87.7 million during
the first half of 1999. We expect our capital expenditures to be 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; and
- we accelerate deployment of our network services or otherwise alter the
schedule or targets of our rollout plan.
Since our primary activities 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 notes contain covenants that restrict our
ability to make certain payments, including dividend payments.
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LIQUIDITY AND CAPITAL RESOURCES (CONTINUED):
Through June 30, 1999, we have financed our operations and market build-outs
primarily through:
- issuing 12.75 percent senior notes in April 1999 for $314.5 million
in net proceeds;
- issuing common stock in April 1999 in our initial public offering for
$210.1 million in net proceeds;
- issuing 13.50 percent senior discount notes in May 1998 for $144.0
million in net proceeds;
- private placements of equity totaling $105.8 million; and
- executing equipment lease lines totaling $68.5 million.
As of June 30, 1999, we had $629.2 million in cash and investments and we had an
accumulated deficit of $105.5 million.
For the six months ended June 30, 1998 and June 30, 1999, we used cash of
$5.5 million and $45.9 million, respectively in our operating activities.
This cash was used for a variety of operating purposes including salaries,
consulting and legal expenses, network operations and overhead expenses. For
the six months ended June 30, 1998 and June 30, 1999, we used net cash of
$6.5 million and $304.3 million, respectively, for investing activities. We
used this cash primarily for purchases of short-term investments and
equipment and payments of collocation fees. Net cash provided by financing
activities for the six months ended June 30, 1998 and June 30, 1999 was
$165.2 million and $626.1 million, respectively. These funds were generated
primarily from the issuances of equity and senior debt as described above.
We believe that our existing cash and investment balances as of June 30, 1999,
together with the anticipated future revenue generated from operations, will be
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.
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RISKS AND UNCERTAINTIES:
In addition to the other risks stated in this document, you should consider
the following risks and uncertainties 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 our first market
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;
- 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
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results or profitability or generate sufficient cash flow to repay our debt. Of
the approximately 12,200 lines that are in service or that we have committed to
deliver, we installed or committed approximately 10,150 to only three customers.
None of our large business 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 large
business 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 June 30, 1999, we had an accumulated deficit of
approximately $105.5 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 1998 senior discount notes and 1999 senior notes of approximately $52.2
million in 1999 and increasing to $81.0 million in 2003. In addition, we may
incur more debt in the future. Furthermore, as a result of recent business
relationships arising from preferred stock and warrant issuances and of previous
stock option grants, we anticipate that there will be significant charges to
earnings in future periods. We estimate that these charges will total
approximately $8.5 million per year over each of the next several years. 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;
- 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. In that event, any trading price of our common stock would likely
decline.
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
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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 large businesses 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 during that period.
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.
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, the Federal Communications
Commission 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
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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. The Federal Communications Commission and state
regulatory commissions establish the 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 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, Qwest and Cisco. While
our agreements with MCI WorldCom and Qwest call for them to sell an aggregate of
200,000 DSL lines, the agreements also enable MCI WorldCom and Qwest to
terminate their respective agreements under certain circumstances and to receive
offsets and credits under other circumstances. Therefore, MCI WorldCom and Qwest
might sell significantly fewer than 200,000 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, Level 3 Communications, Inc. and Qwest, are
building and managing high bandwidth, nationwide
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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 has 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. In
addition, regional Internet Service Providers and competitive carriers,
including HarvardNet, Inc., Network Access Solutions Corp. and DSL.net, Inc.
have begun offering DSL-based access services that compete with the services we
offer. As a result of increasing competition for our services, we are
experiencing substantial price competition, particularly with respect to sales
generated through our indirect sales channels.
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.
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, through approximately
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 this document.
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
the 1998 senior discount notes and the 1999
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senior notes 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 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. For more
details about our regulatory situation.
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 June 30, 1999, we had approximately $494.3 million of outstanding
debt and $239.1 million in equity. We are not generating any meaningful revenue
to fund our operations or to repay our debt. Our substantial leverage poses the
risks that:
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- we may be unable to repay our debt due to one or more events
discussed in this document;
- 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
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
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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. 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
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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.
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.
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WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE COVENANTS
IN OUR EXISTING DEBT SECURITIES
The indentures governing our 1998 senior discount notes and 1999 senior notes
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 repay 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.
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 82.4 percent of the total voting power of our company.
Accordingly, these stockholders are 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. 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 have no
information or data to suggest 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
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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.
WE EXPECT OUR STOCK PRICE TO BE VOLATILE
The trading price of our common stock has been and is likely to continue to be
highly volatile. Our stock price could fluctuate widely in response to many
factors, including the following:
- our historical and anticipated quarterly and annual operating
results;
- announcements of new products or services by us or our
competitors or new competing technologies;
- the addition or loss of business or service provider customers;
- variations between our actual results and analyst and investor
expectations;
- investor perceptions of our company and comparable public
companies;
- conditions or trends in the telecommunications industry,
including regulatory developments;
- announcements by us of significant acquisitions, strategic
partnerships, joint ventures or capital commitments;
- additions or departures of key personnel;
- future equity or debt offerings or our announcements of such
offerings; and
- general market and economic conditions.
In addition, in recent years the stock market in general, and the Nasdaq
National Market and the market for Internet and technology companies in
particular, have experienced extreme price and volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating
performance of these companies. These market and industry factors may materially
and adversely affect our stock price, regardless of our operating performance.
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.
ANTI-TAKEOVER PROVISIONS COULD NEGATIVELY IMPACT OUR STOCKHOLDERS
Our Board of Directors has adopted a stockholder rights plan. Our stockholder
rights plan would cause substantial dilution to any person or group that
attempts to acquire our company on terms not approved in advance by our Board of
Directors. In addition, some of the provisions that may be included in our
certificate of incorporation and bylaws may discourage, delay or prevent a
merger or acquisition at a premium price. These provisions include:
- authorizing the issuance of "blank check" preferred stock;
- providing for a classified Board of Directors with staggered,
three-year terms;
- eliminating the ability of stockholders to call a special
meeting of stockholders;
- limiting the removal of directors by the stockholders to removal
for cause; and
- requiring a super-majority stockholder vote to effect certain
amendments.
In addition, certain provisions of the Delaware General Corporation Law and our
stockholder rights plan may deter someone from acquiring or merging with us,
including a transaction that results in stockholders receiving a premium over
the market price for the shares of common stock held by them. Section 203 of the
Delaware General Corporation
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Law also imposes certain restrictions on mergers and other business combinations
between us and any holder of more than 15% and less than 85% of our common
stock.
The indentures governing our 1998 senior discount notes and 1999 senior notes
require us to offer to repurchase all such notes for 101 percent of their
principal amount or accreted value, as the case may be, plus any accrued
interest and liquidated damages, 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 the senior discount notes.
THE PRICE OF OUR COMMON STOCK MAY DECLINE DUE TO SHARES ELIGIBLE FOR FUTURE SALE
Sales of substantial amounts of our common stock in the public market, or the
appearance that a large number of shares is available for sale, could adversely
affect the market price for the common stock. The number of shares of common
stock available for sale in the public market is limited by lock-up agreements
that were entered into in connection with our initial public offering. Under
such lock-up agreements, the holders of approximately 78.4% of our outstanding
shares of common stock agreed not to sell or otherwise dispose of any of their
shares until October 4, 1999. However, Merrill Lynch and Salomon Smith Barney
may, in their sole discretion and at any time without notice, release all or any
portion of the securities subject to such lock-up agreements. In addition to the
adverse effect a price decline could have on holders of common stock, that
decline would likely impede our ability to raise capital through the issuance of
additional shares of common stock or other equity securities.
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RHYTHMS NetConnections INC.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There were no material changes in our legal proceedings during the quarter ended
June 30, 1999.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) Upon the completion of our initial public offering of common stock
on April 12, 1999, all of our outstanding preferred stock automatically
converted into common stock and there remained no preferred stock
outstanding. The rights of all resulting common stockholders are equal. No
other changes in the rights of our securities occurred during the quarter
ended June 30, 1999.
(b) None.
(c) During the three month period ended June 30, 1999, we issued the
following unregistered securities:
(1) In April 1999, we completed a private offering of 12.75 percent
senior notes due 2009 in the principal amount of $325.0 million at maturity
to Merrill Lynch & Co. and Salomon Smith Barney Inc., as initial purchasers,
for resale to qualified institutional buyers. We received cash proceeds of
$314.5 million, after paying underwriting fees of $9.8 million and issue
costs of $739,000. The principal underwriters of the transaction were
Merrill Lynch & Co., Salomon Smith Barney, and Chase Securities Inc. Of the
cash proceeds, approximately $113.2 million was used to purchase a portfolio
of U.S. government securities and will be used for the first three years'
interest payments on the notes. We placed the remainder of the cash proceeds
with our operating cash and temporary investments and plan to use it for
payment of collocation fees, purchases of equipment, and funding of operating
losses. In July 1999, we filed a registration statement on Form S-4 with the
Securities and Exchange Commission for the entire principal amount of the
notes.
(2) In April 1999, we issued to U.S. Telesource, Inc. 932,836
shares of Series C preferred stock, which are convertible into 1,119,403
shares of common stock, and 441,176 shares of Series D preferred stock, which
are convertible into 441,176 shares of common stock, subject to adjustment.
We also issued to U.S. Telesource, Inc. a warrant to purchase 180,000 shares
of common stock at an exercise price of $6.70 per share. The aggregate
consideration received for this issuance was $15 million.
(3) In April 1999, we issued to Cisco Systems Capital Corporation a
warrant to purchase 75,000 shares of common stock with an exercise price per
share of $10.55 in connection with an equipment lease financing.
(4) On April 2, 1999, we granted stock options to purchase an
aggregate of 404,600 shares of common stock to employees and consultants with
exercise prices of $16.00 per share pursuant to our stock option plan.
The sales and issuances of these securities, except for those in (1)
above, were exempt from registration under the Securities Act of 1933
pursuant to Rule 701 promulgated thereunder on the basis that these
securities were offered and sold either pursuant to a written compensatory
benefit plan or pursuant to written contracts relating to consideration, as
provided by Rule 701, or pursuant to Section 4(2) thereof on the basis that
the transactions did not involve a public offering. The sales and issuances
in (1) above were exempt from registration under the Securities Act of 1933
pursuant to Section 4(2) and, in connection with the resales by the initial
purchasers of the securities described in (1) above, Rule 144A thereunder.
(d) On April 12, 1999, we completed the sale of 10,781,250 shares of
common stock priced at $21.00 per share for an aggregate offering price of
$226.4 million in an initial public offering led by an underwriting group
consisting of Merrill Lynch & Co., Salomon Smith Barney, Hambrecht & Quist,
and Thomas Weisel Partners LLC. The proceeds of the offering to us, net of
underwriting fees and estimated offering expenses were approximately $210.1
million. The Registration Statement on Form S-1 filed by us with the SEC in
connection with the offering (File No. 333-72409), as amended, was declared
effective by the Commission on April 6, 1999.
Since the completion of the offering, the net offering proceeds have
been applied to the following uses in the following approximate amounts:
- $113.2 million to purchase a portfolio of U.S. government
securities that will be used for the first three years' interest
payments on the senior notes;
- $55.0 million to fund payments of collocation fees and purchases of
equipment and furniture in our continuing development of network
services in our existing markets and our planned rollout into
additional markets;
- $28.0 million for operating activities including salaries,
consulting and legal expenses, network operations and overhead
expenses; and
- the remainder of the proceeds are invested in short-term
securities to be used for future working capital and network
build-out needs.
All of the payments indicated above were direct or indirect payments
to entities or persons other than our directors, officers or their
associates, greater than 10% owners of any of our equity securities or our
affiliates.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
No defaults upon senior securities occurred during the quarter ended June 30,
1999.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matter was submitted to a vote of security holders during the
quarter ended June 30, 1999. All share numbers are on an as-converted to
common stock basis.
1) Effective April 1, 1999, the stockholders approved by written consent an
amendment to our 1999 Stock Incentive Plan to (i) increase the number of
shares reserved for issuance under the plan, (ii) increase the plan's
automatic annual share increase percentage and (iii) increase the maximum
annual share increase permitted under the plan. A total of 37,030,188 shares
were voted in favor of this written consent. Votes were not received with
respect to the remaining 21,648,409 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
99.1*++ ACI Plus Service Agreement, dated April 6, 1999, by and
between the Registrant and Qwest Communications Corporation.
* Previously filed with the Commission as an exhibit to the
registration statement on Form S-4 (File No. 333-82637) and
incorporated herein by reference.
++ Certain confidential portions of this Exhibit were omitted by means
of redacting a portion of the text (the "Mark"). This Exhibit has
been filed separately with the Secretary of the Commission without
the Mark pursuant to the Registrant's Application Requesting
Confidential Treatment under Rule 406 under the Securities Act.
(b) Reports on Form 8-K:
There have been no reports on Form 8-K filed during the quarter ended
June 30, 1999.
25
<PAGE>
RHYTHMS NETCONNECTIONS INC.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
/s/ Scott C. Chandler
- ----------------------------------------------------
Scott C. Chandler
Chief Financial Officer and Executive Vice President
(Principal Financial and Accounting Officer)
August 10, 1999
26
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM JUNE 30,
1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> JUN-30-1999
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<SECURITIES> 218,842
<RECEIVABLES> 1,891
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0
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