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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission File No. 0-27801
DATA RETURN CORPORATION
(Exact name of registrant as specified in its charter)
Texas 75-2725998
(State or other (I.R.S. Employer
jurisdiction of Identification No.)
incorporation or
organization)
222 West Las Colinas Boulevard
Suite 450
Irving, Texas 75039
(Address, including zip code, of
principal executive offices)
(972) 869-0770
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO
------ ----
The registrant had 35,817,068 shares of Common Stock, par value $.001 per share,
outstanding as of November 8, 2000.
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PART I - FINANCIAL INFORMATION
<TABLE>
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Page
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Item 1. Condensed Financial Statements
Condensed Balance Sheets at March 31, 2000 and
September 30, 2000 (Unaudited) 3
Condensed Statements of Operations for the three and six months
ended September 30, 1999 and 2000 (Unaudited) 4
Condensed Statements of Cash Flows for the six months ended
September 30, 1999 and 2000 (Unaudited) 5
Notes to Condensed Financial Statements (Unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About Market Risk 25
Item 4. Submission of Matters to a Vote of Security Holders 25
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 26
Signatures 27
</TABLE>
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Data Return Corporation
Condensed Balance Sheets
(in thousands, except per share data)
<TABLE>
<CAPTION>
March 31, September 30,
2000 2000
--------------------------------
(Unaudited)
<S> <C> <C>
Assets
Current assets:
Cash $ 85,424 $ 9,882
Investment in marketable securities - 23,153
Accounts receivable, net of allowance for doubtful accounts
of $328 and $942 at March 31, 2000 and September 30, 2000,
respectively 5,429 9,178
Prepaid and other 1,349 2,550
--------- ---------
Total current assets 92,202 44,763
Investment in marketable securities - 21,163
Property and equipment, net 22,027 44,790
Other assets 628 681
--------- ---------
Total assets $ 114,857 $ 111,397
========= =========
Liabilities and shareholders' equity
Current liabilities:
Accounts payable $ 2,021 $ 3,011
Accrued expenses and other 2,205 2,729
Deferred revenue 2,207 4,041
Notes payable and capital lease obligations - current 5,799 8,974
--------- ---------
Total current liabilities 12,232 18,755
Notes payable and capital lease obligations - long term 11,324 21,898
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, $.001 par value; 20,000 shares
authorized, none issued or outstanding - -
Common stock, $.001 par value; 100,000 shares
authorized; 35,398 and 35,816 issued and outstanding
at March 31, 2000 and September 30, 2000, respectively 36 36
Additional paid-in capital 109,718 110,149
Pre-paid broadband services (5,000) (5,000)
Deferred stock compensation (290) (165)
Accumulated deficit including comprehensive earnings (13,162) (34,276)
--------- ---------
Total shareholders' equity 91,301 70,744
--------- ---------
Total liabilities and shareholders' equity $ 114,857 $ 111,397
========= =========
</TABLE>
See accompanying notes to Condensed Financial Statements.
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Data Return Corporation
Condensed Statements of Operations
(in thousands, except per share data)
Unaudited
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
September 30, September 30,
------------------------- ------------------------
1999 2000 1999 2000
--------- --------- --------- --------
<S> <C> <C> <C> <C>
Revenues $ 1,726 $ 12,372 $ 2,953 $ 21,619
Costs and expenses:
Cost of revenue 1,282 11,525 1,771 20,536
General and administrative 1,181 5,755 2,023 9,986
Marketing and sales 1,067 7,050 1,452 11,647
Product research and development 43 1,113 66 1,885
Stock-based compensation 158 25 297 125
--------- --------- --------- --------
Total costs and expenses 3,731 25,468 5,609 44,179
--------- --------- --------- --------
Loss from operations (2,005) (13,096) (2,656) (22,560)
Other income (expense):
Interest income 89 1,089 111 2,315
Interest expense (6) (541) (12) (986)
--------- --------- --------- --------
Net Loss $ (1,922) $ (12,548) $ (2,557) $(21,231)
========= ========= ========= ========
Net loss per common share:
Basic and diluted $ (0.07) $ (0.35) $ (0.10) $ (0.60)
========= ========= ========= ========
Shares used in computing basic and diluted net
loss per share 26,537 35,625 24,427 35,534
========= ========= ========= ========
</TABLE>
See accompanying notes to Condensed Financial Statements.
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Data Return Corporation
Condensed Statements of Cash Flows
(in thousands, except per share data)
Unaudited
<TABLE>
<CAPTION>
Six Months Ended September 30,
------------------------------
1999 2000
------------ ------------
<S> <C> <C>
Operating activities:
Net loss $ (2,557) $ (21,231)
Adjustments to reconcile net loss to net cash
provided by (used in) operations:
Noncash items included in net loss:
Depreciation and amortization 269 6,222
Stock based compensation expense 297 125
Provision for bad debts 210 789
Changes in assets and liabilities
Accounts receivable (970) (4,538)
Prepaids and other assets (678) (1,135)
Accounts payable and accrued expenses 3,508 1,514
Deferred revenue 391 1,834
------------ ------------
Net cash provided by (used in) operating activities 470 (16,420)
Investing Activities:
Capital expenditures (3,771) (10,939)
Purchase of marketable securities - (44,316)
Restricted cash 125 -
------------ ------------
Net cash used in investing activities (3,646) (55,255)
Financing activities:
Proceeds from notes payable 202 -
Payments on notes payable and capital lease obligations (44) (4,020)
Net proceeds from issuance of stock 8,875 153
------------ ------------
Net cash provided by (used in) financing activities 9,033 (3,867)
------------ ------------
Net increase (decrease) in cash 5,857 (75,542)
Beginning cash 843 85,424
------------ ------------
Ending cash $ 6,700 $ 9,882
============ ============
</TABLE>
See accompanying notes to Condensed Financial Statements.
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1. Organization and Basis of Presentation
Organization
Data Return Corporation (the "Company") was incorporated in August 1997
under the laws of the State of Texas and commenced operations on September 22,
1997 (inception). The Company primarily provides advanced Microsoft Internet
hosting services to businesses, web site developers, application service
providers, and other organizations. The Company's advanced Microsoft hosting
services enable its customers to establish and maintain e-commerce and other
applications through which they can conduct transactions and manage information
on a worldwide basis over the Internet.
The Company's computer equipment, principally servers, is primarily located
in separate facilities owned by one of its vendors. The vendor provides data
center facilities and bandwidth connectivity to the Company on a contractual
basis.
Basis of Presentation
The accompanying unaudited condensed financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) necessary to present fairly the information set
forth therein have been included. Operating results for the three- and six-month
periods ended September 30, 2000 are not necessarily an indication of the
results that may be expected for the year ending March 31, 2001.
The balance sheet at March 31, 2000 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.
The accompanying condensed financial statements should be read in
conjunction with the audited financial statements and footnotes included in the
Company's Annual Report on Form 10-K for the Year Ended March 31, 2000.
2. Net Loss Per Share
Basic and diluted net loss per share is computed using the weighted average
number of shares of common stock outstanding during each period. Common stock
equivalents are not considered in the calculation of diluted net loss per share
as the Company has incurred a loss for all periods presented and the effect of
common stock equivalents would be anti-dilutive. Thus, 8,530,456 employee
stock options and 345,910 warrants to acquire shares of common stock are not
included in this calculation.
3. Recent Accounting Pronouncements
In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition, which summarizes
some of the staff's views in applying generally accepted accounting principles
to revenue recognition in financial statements. In June, 2000, the SEC changed
the effective date of SAB 101 to require adoption of SAB 101 by the fourth
quarter of the first fiscal year beginning after December 15, 1999. As a result
the Company expects to adopt the new guidance as a change in accounting
principle effective January 1, 2001. The Company will change its method of
recognizing revenue on set up fees to defer the revenue and recognize it over
the initial term of the contracts with its customers, generally one year. The
change in accounting method will be accounted for as a cumulative effect
adjustment, which will result in (a) the financial information for the quarters
of fiscal 2001 prior to adoption of SAB 101 being restated and (b) the
cumulative effect adjustment being reflected in the first quarter of the year of
adoption of SAB 101. As a result of the cumulative effect adjustment, revenue
that has previously been recognized in the Company's financial statements will
be amortized to income in financial reporting periods subsequent to the period
of adoption of SAB 101. Had the company adopted SAB 101 as of April 1, 2000, the
effect on revenue in this quarter would not have been material.
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4. Investments
The Company has classified all of its debt securities as available-for-
sale. Available-for-sale securities are carried at fair value, with unrealized
gains and losses reported as a separate component of shareholders' equity net of
applicable income taxes. Realized gains and losses and declines in value judged
to be other-than-temporary on available-for-sale securities are included in
other income. The cost basis for realized gains and losses on available-for-sale
securities is determined on a specific identification basis.
As of September 30, 2000, the Company owned approximately $44.3 million of
debt securities (including investments in available-for-sale securities) with
maturity dates in fiscal years 2001 and 2002. The company has an unrealized
gain of $118,000, an increase of $96,000 from June 30, 2000, on its available-
for-sale securities which is recorded as other comprehensive income in
shareholders' equity.
5. Property and Equipment
Property and equipment consists of the following (in thousands):
<TABLE>
<CAPTION>
March 31, 2000 September 30, 2000
-------------- ------------------
<S> <C> <C>
Electronics and computer equipment......................... $20,910 $38,942
Computer software.......................................... 1,397 3,207
Furniture and office equipment............................. 792 4,027
Leasehold improvements..................................... 586 4,836
Other depreciable assets................................... 520 1,898
------- -------
24,205 52,910
Less accumulated depreciation and amortization............. (2,178) (8,120)
------- -------
$22,027 $44,790
======= =======
</TABLE>
Property and equipment includes assets acquired under capital leases,
principally computer equipment with a cost of $17,232,000 at March 31, 2000 and
$34,998,000 at September 30, 2000, respectively. Related allowances for
depreciation and amortization are $1,121,000 and $5,158,000 respectively.
6. Accrued Expenses
Accrued expenses consist of the following (in thousands):
<TABLE>
<CAPTION>
March 31, 2000 September 30, 2000
-------------- ------------------
<S> <C> <C>
Professional fees.......................................... $ 157 $ 180
Accrued payroll............................................ 1,013 1,533
Commissions................................................ 184 617
Other...................................................... 851 399
------ -------
$2,205 $ 2,729
====== =======
</TABLE>
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ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion of the financial condition and results of
operations of Data Return should be read in conjunction with the condensed
financial statements and the related notes thereto included elsewhere in this
Form 10-Q and Data Return's Annual Report on Form 10-K for the year ended March
31, 2000.
Forward-Looking Statements
The statements contained in this Report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934).
Forward-looking statements are typically identified by the use of terms such as
"may," "will," "expect," "intend," "anticipate," "estimate" and similar words,
or by discussions of strategy that involve risks and uncertainties, although
some forward-looking statements are expressed differently. You should be aware
that our actual results could differ materially from those contained in the
forward-looking statements due to a number of factors, including without
limitation, changes in external competitive market factors, changes in our
business strategy or an inability to execute our strategy, changes in the
hosting industry, the economy in general and changes in the use of the Internet
and the viability of Internet-focused businesses. We cannot guarantee future
results, levels of activity, performance or achievements. Our actual results
could differ materially from those anticipated in such forward-looking
statements as a result of certain factors, including those set forth in the
section entitled "Factors Affecting Future Operating Results." Readers are
cautioned not to place undue reliance on any forward-looking statements
contained in this report. All written and oral forward-looking statements made
in connection with this report that are attributable to us or persons acting on
our behalf are expressly qualified in their entirety by the "Factors Affecting
Future Operating Results" and other cautionary statements included herein. We
disclaim any obligation to update information contained in any forward-looking
statement. We undertake no obligation to publish the results of any adjustments
to these forward-looking statements that may be made to reflect events on or
after the date of this report or to reflect the occurrence of unexpected events.
Overview
Data Return provides advanced Internet hosting services based on Microsoft
technologies. We provide these services to businesses seeking to outsource the
deployment, maintenance and support of their complex web sites. Our services
include providing, configuring, operating and maintaining the hardware, software
and network technologies necessary to implement and support these web sites.
Our business is rapidly evolving, and we have a limited operating history.
As a result, we believe that period-to-period comparisons of our revenue and
operating results, including our cost of revenue and other operating expenses as
a percentage of total revenue, may not be meaningful and should not be relied
upon as indicators of future performance. We do not believe that our historical
growth rates are indicative of future results.
Currently, we derive substantially all of our revenue from advanced hosting
and managed services. Historically, we have also derived a nominal amount of
revenue from technical reviews and the resale of software and other products.
Currently, most of our advanced hosting and managed services revenues are
generated from recurring monthly fees. Substantially all of the remainder is
derived from one-time set-up fees for installation. Revenues are billed on a
monthly basis and are recognized as the service is performed.
Our expenses are comprised of:
. cost of revenue, which consists primarily of compensation and related
expenses for technical operations, broadband services expenses, space
in data centers and depreciation of equipment;
. general and administrative, which consists primarily of compensation
and related expenses and occupancy costs;
. marketing and sales, which consists primarily of advertising and
compensation and related expenses;
. product research and development, which consists primarily of
compensation and related expenses and facilities costs; and
. stock-based compensation, which relates to employee stock options
granted at prices less than fair market value.
We have incurred significant losses since our inception and, as of
September 30, 2000, had an accumulated deficit of approximately $34.3 million.
We intend to invest heavily in marketing and sales and the continued development
of our network infrastructure and technology. We expect to continue to expand
our operations and workforce, including our network operations, technical
support, sales, marketing, product research and development and administrative
resources. In particular, we intend to continue to expand our existing inside
and outside sales forces to develop new sales channels and relationships. We
expect to continue to incur substantial losses for the foreseeable future. We
may not be able to successfully execute our expansion plans.
8
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Results of Operations
Comparison of quarters ended September 30, 1999 and 2000
Revenues
Our revenues increased $10,646,000 to $12,372,000 for the quarter ended
September 30, 2000 from $1,726,000 for the quarter ending September 30, 1999.
The increase was primarily due to the addition of new customers that generated
higher average monthly revenues. Growth from some existing customer accounts
also contributed. We increased our marketing and sales personnel to 90 at
September 30, 2000 from 26 at September 30, 1999.
Cost of revenue
Our cost of revenue increased $10,243,000 to $11,525,000, or 93.2% of
revenue, for the quarter ended September 30, 2000 from $1,282,000, or 74.3% of
revenue, for the quarter ended September 30, 1999. The increase in cost of
revenue was due primarily to increases in personnel and related costs,
depreciation and communication and bandwidth expenses. The increase as a percent
of revenue was partially attributable to our incurring these costs in advance of
revenues. Personnel and related expenses increased approximately $4,910,000 to
$5,543,000, or 44.8% of revenue, for the quarter ended September 30, 2000 from
$633,000, or 36.7% of revenue, for the quarter ended September 30, 1999, as we
increased our systems and customer support personnel to 251 at September 30,
2000 from 66 at September 30, 1999. Depreciation expense increased approximately
$2,810,000 to $2,949,000 for the quarter ended September 30, 2000, as we added
approximately $34.4 million in computer and related equipment since
September 30, 1999. Our communication and bandwidth expenses increased
$1,648,000 to approximately $1,879,000 for the quarter ended September 30, 2000
from $231,000 for the quarter ended September 30, 1999 to support our increased
business activities. We expect our cost of revenue to continue to increase as
our overall business grows.
General and administrative
General and administrative expense increased $4,574,000 to $5,755,000, or
46.5% of revenue, during the quarter ended September 30, 2000 from $1,181,000,
or 68.4% of revenue, during the quarter ended September 30, 1999. The increase
is primarily due to increases in personnel and related expenses, facilities
expense, depreciation, bad debt, professional services and travel. Personnel
and related expenses increased $2,309,000 to $2,951,000, or 23.9% of revenue,
for the quarter ended September 30, 2000 from $642,000, or 37.2% of revenue, for
the quarter ended September 30, 1999. We increased our number of employees in
general and administrative functions to 138 employees at September 30, 2000 from
23 employees at September 30, 1999. Facilities expense increased $492,000 as a
result of our move into a larger facility and the growth in general and
administrative employees. Depreciation expense increased $439,000 in the
quarter ended September 30, 2000, which is a result of increased internal
equipment necessary to support the growth of our business. Bad debt expense
increased $418,000 as our customer base and revenues continued to grow.
Professional services fees increased approximately $393,000 to $455,000 for the
quarter ended September 30, 2000 from $62,000 in the comparable period in 1999.
Travel expenses increased approximately $65,000 to $134,000, or 1.1% of revenue,
for the quarter ended September 30, 2000 from $69,000, or 4.0% of revenue, for
the quarter ended September 30, 1999.
Marketing and sales
Marketing and sales expense increased $5,983,000 to $7,050,000, or 57.0% of
revenue, during the quarter ended September 30, 2000 from $1,067,000, or 61.8%
of revenue, during the quarter ended September 30, 1999. The increase was due
primarily to an increase in marketing and sales personnel and related expenses
and advertising costs, including agency fees, trade shows and promotional items.
Personnel and related expenses increased $3,874,000 to $4,620,000, or 37.3% of
revenue, for the quarter ended September 30, 2000 from $746,000, or 43.2% of
revenue, for the quarter ended September 30, 1999. Advertising costs increased
$1,738,000 to $1,995,000 for the quarter ended September 30, 2000 from $257,000
for the quarter ended September 30, 1999. Costs in this category
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include expenses for advertising, promotional items, trade shows, and fees paid
to advertising, public relations and other creative agencies. We increased our
marketing and sales personnel to 90 at September 30, 2000 from 26 at
September 30, 1999.
Product research and development
Product research and development expense increased $1,070,000 to $1,113,000
or 9.0% of revenue, during the quarter ended September 30, 2000 from $43,000, or
2.5% of revenue, during the quarter ended September 30, 1999. The increase was
due primarily to an increase in product research and development personnel and
related expenses and facilities costs. Personnel and related expenses increased
$873,000 to $916,000, or 7.4% of revenue for the quarter ended September 30,
2000 from $43,000, or 2.5% of revenue, for the quarter ended September 30, 1999.
We increased our number of employees in product research and development to 40
at September 30, 2000 from four at September 30, 1999. Facilities costs
increased $101,000 for the quarter ended September 30, 2000 as a result of our
move into a larger facility and the increase in the number of product research
and development employees.
Stock-based compensation
Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value. Amortization of stock-based
compensation totaled $158,000 for the quarter ended September 30, 1999 and
$25,000 for the quarter ended September 30, 2000. The amortization of stock-
based compensation is based on the vesting schedule of stock options held by our
employees.
Other income (expense)
Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents increased $1,000,000 to $1,089,000 for the quarter
ended September 30, 2000 from $89,000 for the quarter ended September 30, 1999.
This increase was due primarily to the closing of our initial public offering in
October 1999, which resulted in larger cash balances available for investment.
During the quarter ended September 30, 2000, we increased interest expense
$535,000 to $541,000 related primarily to equipment acquired under during the
last four quarters.
Income taxes
No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception. We have recorded a valuation allowance
against all of our net deferred tax asset, which is primarily attributable to
net operating loss carry forwards, due to uncertainty that we will generate
sufficient taxable income during the carry forward period to realize the benefit
of our net deferred tax asset.
Net loss
Net loss increased $10,626,000 to $12,548,000 for the quarter ended
September 30, 2000 from $1,922,000 for the quarter ended September 30, 1999. As
more fully discussed above, the increased net loss is primarily attributable to
increased costs as we continued to build our business for anticipated growth.
EBITDA
EBITDA, as defined below, decreased $7,679,000 to negative $9,346,000 for
the quarter ended September 30, 2000 from negative $1,667,000 for the quarter
ended September 30, 1999. The decrease is primarily attributable to costs
associated with our growth strategy. We expect to generate negative EBITDA at
least through fiscal 2002. Costs associated with our investments in marketing
and sales, the continued development of our network infrastructure and
technology and expansions of our operations and workforce, including our network
operations, technical support, sales, marketing, product research and
development and administrative resources, will continue to represent a large
portion of our expenses during our anticipated expansion.
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EBITDA for the quarters ended September 30, 1999 and 2000 consists of loss
from operations of $2,005,000 and $13,096,000 plus depreciation and amortization
of $180,000 and $3,715,000 and amortization of unearned stock-based compensation
of $158,000 and $25,000, respectively. EBITDA does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations as measured under generally accepted accounting principles.
EBITDA should not be considered as an alternative to net loss or net cash used
in operating activities, but may be useful to investors as an indication of
operating performance. This caption excludes components that are significant in
understanding and assessing the results of operations and cash flows. In
addition, EBITDA is not a term defined by generally accepted accounting
principles and, as a result, our calculations of EBITDA may not be consistent
with calculations of EBITDA used by others. However, we believe that EBITDA is
relevant and useful information that is often reported and widely used by
analysts, investors and other interested parties in the advanced hosting
industry. Accordingly, we are disclosing this information to permit a more
comprehensive analysis of our operating performance, as an additional meaningful
measure of performance and liquidity and to provide additional information with
respect to our ability to meet future working capital requirements.
Comparison of six-month periods ended September 30, 1999 and 2000
Revenues
Our revenues increased $18,666,000 to $21,619,000 for the six-month period
ended September 30, 2000 from $2,953,000 for the six-month period ending
September 30, 1999. The increase was primarily due to the addition of new
customers that generated higher average monthly revenues. Growth from some
existing customer accounts also contributed to the increase in revenues. We
increased our marketing and sales personnel to 90 at September 30, 2000 from 26
at September 30, 1999.
Cost of revenue
Our cost of revenue increased $18,765,000 to $20,536,000, or 95.0% of
revenue, for the six-month period ended September 30, 2000 from $1,771,000, or
60.0% of revenue, for the six-month period ended September 30, 1999. The
increase in cost of revenue was due primarily to increases in personnel and
related costs, depreciation, and communication and bandwidth expenses. The
increase as a percent of revenue was partially attributable to our incurring
these costs in advance of revenues. Personnel and related expenses increased
approximately $9,191,000 to $10,049,000, or 46.5% of revenue, for the six-month
period ended September 30, 2000 from $858,000, or 29.1% of revenue, for the six-
month period ended September 30, 1999, as we increased our systems and customer
support personnel to 251 at September 30, 2000 from 66 at September 30, 1999.
Depreciation expense increased approximately $4,795,000 to $5,009,000 for the
six-month period ended September 30, 2000 as we added approximately $34.4
million in computer and related equipment since September 30, 1999. Our
communication and bandwidth expenses increased $2,881,000 to approximately
$3,258,000 for the six-month period ended September 30, 2000 from $377,000 for
the six-month period ended September 30, 1999 to support our increased business
activities. The remainder of the increase in cost of revenues for the six
months ended September 30, 2000 from the six months ended September 30, 1999
equals approximately $1,898,000 and is comprised of increases related to
facilities expense, equipment costs, travel, and professional services. We
expect our cost of revenue to continue to increase as our overall business
grows.
General and administrative
General and administrative expense increased $7,963,000 to $9,986,000, or
46.2% of revenue, during the six-month period ended September 30, 2000 from
$2,023,000, or 68.5% of revenue, during the six-month period ended September 30,
1999. The increase is primarily due to increases in personnel and related
expenses, professional services, facilities and insurance expense, depreciation,
bad debt and travel. Personnel and related expenses increased $4,306,000 to
$5,469,000, or 25.3% of revenue, for the six-month period ended September 30,
2000 from $1,163,000, or 39.4% of revenue, for the six-month period ended
September 30, 1999. We increased our number of employees in general and
administrative functions to 138 employees at September 30, 2000 from 23
employees at September 30, 1999. Professional services increased approximately
$885,000 to $1,013,000 for the six-month period ended September 30, 2000 from
$128,000 in the comparable period in 1999. Facilities and insurance expense
increased $721,000 and $299,000, respectively, as a result of our move into a
larger facility and
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the growth in general and administrative employees. Depreciation expense
increased $656,000 in the six-month period ended September 30, 2000, which is a
result of increased internal equipment necessary to support the growth of our
business. Bad debt expense increased $579,000 as our customer base and revenues
continue to grow. Travel expenses increased approximately $168,000 to $277,000,
or 1.3% of revenue, for the six-month period ended September 30, 2000 from
$109,000, or 3.7% of revenue, for the six-month period ended September 30, 1999.
Marketing and sales
Marketing and sales expense increased $10,195,000 to $11,647,000, or 53.9%
of revenue, during the six-month period ended September 30, 2000 from
$1,452,000, or 49.2% of revenue, during the six-month period ended September 30,
1999. The increase was due primarily to an increase in marketing and sales
personnel and related expenses and advertising costs, including agency fees,
trade shows and promotional items. Personnel and related expenses increased
$6,444,000 to $7,434,000, or 34.4% of revenue, for the six-month period ended
September 30, 2000 from $990,000, or 33.5% of revenue, for the six-month period
ended September 30, 1999. Advertising costs increased $2,920,000 to $3,317,000
for the six-month period ended September 30, 2000 from $397,000 for the six-
month period ended September 30, 1999. Advertising costs include expenses for
advertising, promotional items, trade shows, and fees paid to advertising,
public relations and other creative agencies. We increased our marketing and
sales personnel to 90 at September 30, 2000 from 26 at September 30, 1999.
Product research and development
Product research and development expense increased $1,819,000 to $1,885,000
or 8.7% of revenue, during the six-month period ended September 30, 2000 from
$66,000, or 2.2% of revenue, during the six-month period ended September 30,
1999. The increase was due primarily to an increase in product research and
development personnel and related expenses. Personnel and related expenses
increased $1,507,000 to $1,573,000, or 7.3% of revenue for the six-month period
ended September 30, 2000 from $66,000, or 2.2% of revenue, for the six-month
period ended September 30, 1999. We increased our number of employees in
product research and development personnel to 40 at September 30, 2000 from four
at September 30, 1999. Facilities and travel expense increased $141,000 and
$53,000 respectively, for the six-month period ended September 30, 2000 as a
result of our move into a larger facility and an increase in the number of
product research and development personnel.
Stock-based compensation
Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value. Amortization of stock-based
compensation totaled $297,000 for the six-month period ended September 30, 1999
and $125,000 for the six-month period ended September 30, 2000. The amortization
of stock-based compensation is based on the vesting schedule of stock options
held by our employees.
Other income (expense)
Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents increased $2,204,000 to $2,315,000 for the six-month
period ended September 30, 2000 from $111,000 for the six-month period ended
September 30, 1999. This increase was due primarily to the closing of our
initial public offering in October 1999, which resulted in larger cash balances
available for investment. During the six-month period ended September 30, 2000,
we increased interest expense $974,000 to $986,000 related primarily to
equipment acquired under capital leases during the last four quarters.
Income taxes
No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception. We have recorded a valuation allowance
against all of our net deferred tax asset, which is primarily attributable to
net operating loss carry forwards, due to uncertainty that we will generate
sufficient taxable income during the carry forward period to realize the benefit
of our net deferred tax asset.
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Net loss
Net loss increased $18,674,000 to $21,231,000 for the six-month period
ended September 30, 2000 from $2,557,000 for the six-month period ended
September 30, 1999. As more fully discussed above, the increased net loss is
primarily attributable to increased costs as we continued to build our business
for anticipated growth.
EBITDA
EBITDA, as defined above, decreased $14,113,000 to negative $16,203,000 for
the six-month period ended September 30, 2000 from negative $2,090,000 for the
six-month period ended September 30, 1999. The decrease is primarily
attributable to costs associated with our growth strategy. Costs associated
with our investments in marketing and sales, the continued development of our
network infrastructure and technology and expansions of our operations and
workforce, including our network operations, technical support, sales,
marketing, product research and development and administrative resources, will
continue to represent a large portion of our expenses during our anticipated
expansion. EBITDA for the six-month periods ended September 30, 1999 and 2000
consists of loss from operations of $2,656,000 and $22,560,000 plus depreciation
and amortization of $269,000 and $6,222,000 and amortization of unearned stock-
based compensation of $297,000 and $125,000, respectively.
Liquidity and Capital Resources
We have historically financed our operations primarily through sales of
equity securities and capital leases. Since our inception, we have raised $15.9
million through private placements of our common stock. In November 1999, we
raised $85.9 million in net proceeds from our initial public offering. As of
September 30, 2000, we had cash and cash equivalents of $9.9 million and
investments in marketable securities of $44.3 million.
Net cash used in our operating activities for the six-month period ended
September 30, 2000 was $16.4 million. The net cash used in operations was
comprised primarily of working capital requirements and our net loss, net of
depreciation and amortization. Net cash used in investment activities was $55.3
million for the six-month period ended September 30, 2000 and was comprised of
the purchase of marketable debt securities of $44.3 million and purchases of
property and equipment of approximately $11.0 million. Our purchases of property
and equipment consisted primarily of leasehold improvements, equipment to
provide services to our customers and purchases of furniture and equipment for
new employees. We acquired $17.8 million in computer and related equipment under
capital leases for the six-month period ended September 30, 2000. Net cash used
in financing activities was approximately $3.9 million for the six-month period
ended September 30, 2000 and consisted primarily of principal payments on our
notes payable and capital leases.
Total borrowings under our notes payable and capital lease obligations as
of September 30, 2000 were approximately $30.9 million.
To help manage short-term liquidity needs without disrupting our investment
strategies, in December 1999 we entered into a revolving credit facility with
Bank One, Texas, N.A. This credit facility matures on July 31, 2001 and
outstanding balances accrue interest at the bank's base rate. We may borrow up
to $2 million under the credit facility but have not borrowed any amounts to
date. The facility is secured by all of our equipment that was unencumbered on
the date we entered into the facility and all accounts receivable outstanding
from time to time. Under certain limited circumstances, we could be required to
deposit cash with the bank to secure the loan. The credit facility contains
standard events of default and other covenants.
We believe that our current cash and investment balances should be
sufficient to meet our working capital and capital expenditure requirements for
the next 12 months. Under our agreement with Level 3 Communications, Inc.,
which we entered into in July 1999, we are required to purchase at least an
additional $9.2 million of bandwidth and colocation services over the next four
years. Our quarterly commitment is $300,000 per quarter through July 2001,
$400,000 during the next 12 months, $600,000 during the next 12 months and $1.0
million during the final 12 months of the agreement. We anticipate that further
expansion of our operations will cause us to continue to incur negative cash
flows and, therefore, require us to use our cash and other liquid resources to
support our growth. Our operating and investing activities on a long-term basis
may require us to obtain additional equity or debt financing. We have no present
understandings, commitments or agreements with respect to any acquisition of
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other businesses, products, services or technologies. However, we may evaluate
potential acquisitions of other businesses, products and technologies from time
to time. In order to consummate potential acquisitions, we may need additional
equity or debt financings in the future.
Recent Accounting Pronouncements
In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101 (SAB 101), Revenue Recognition, which
summarizes some of the SEC staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. In June,
2000, the SEC changed the effective date of SAB 101 to require adoption of SAB
101 by the fourth quarter of the first fiscal year beginning after December 15,
1999. As a result, we expect to adopt the new guidance as a change in accounting
principle effective January 1, 2001. We will change our method of recognizing
revenue on set up fees to defer the revenue and recognize it over the initial
term of the contracts with our customers, generally one year. The change in
accounting method will be accounted for as a cumulative effect adjustment, which
will result in (a) the financial information for the quarters of fiscal 2001
prior to adoption of SAB 101 being restated and (b) the cumulative effect
adjustment being reflected in the first quarter of the year of adoption of SAB
101. As a result of the cumulative effect adjustment, revenue that has
previously been recognized in our financial statements will be amortized to
income in financial reporting periods subsequent to the period of adoption of
SAB 101. Had the company adopted SAB 101 as of April 1, 2000, the effect on
revenue in this quarter would not have been material.
Factors Affecting Future Operating Results
The risks and uncertainties described below are not the only risks we face.
Additional risks and uncertainties not presently known to us or that are
currently deemed immaterial may also impair our business operations. If any of
the following risks actually occur, our financial condition and operating
results could be materially adversely affected.
Our business and prospects are difficult to evaluate because we have a limited
operating history and our business model is still evolving.
We were incorporated in August 1997 and commenced operations in September
of that year with a focus on advanced hosting services. As a result, we have a
limited operating history and our business model is evolving. We may not be able
to successfully implement our business plan or adapt it to changes in the
market. If we are not able to do so, our business, results of operations and
financial condition will be adversely affected.
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We have a history of substantial losses, and we anticipate continuing and
increasing losses.
We have experienced operating losses and negative cash flows from
operations in each quarterly and annual period since incorporating in 1997. We
experienced net losses of approximately $12.5 million, or negative 101.4% of
revenues, for the quarter ended September 30, 2000. As of September 30, 2000, we
had an accumulated deficit of approximately $34.3 million. We expect our
operating expenses to increase significantly as we attempt to expand our
business. We believe that we will need to hire over 250 additional personnel in
all areas of our business over the next 12 months. We are also required to
purchase $1.5 million of colocation and bandwidth services, primarily from Level
3, during fiscal 2001, of which we are required to purchase more than $600,000
during the remaining two quarters of fiscal 2001. We anticipate increased
expenses as we continue to expand and improve our infrastructure, introduce new
services, develop our distribution channel, fund research and development,
support and improve our operational and financial systems, broaden customer
service and support, enhance our hosting and managed services capabilities,
expand our sales and marketing efforts, expand internationally and pursue
additional industry relationships. As a result, we expect to incur operating
losses for at least the next fiscal year. We cannot assure you that we will
ever be profitable on a quarterly or annual basis or that, if we achieve
profitability, it will be sustainable.
Our quarterly and annual results may fluctuate, resulting in fluctuations in the
price of our common stock.
Our operating results may fluctuate significantly in the future on a
quarterly and annual basis. Because of these fluctuations, comparisons of our
operating results from period to period are not necessarily meaningful and
should not be relied upon as an indicator of future performance. We expect to
continue to experience significant fluctuations as a result of a variety of
factors, many of which are outside of our control. The following factors could
affect our operating results:
. size and timing of customer installations and related payments;
. fluctuations in data and voice communications costs;
. fluctuations in hardware and software costs;
. timing and magnitude of capital expenditures and other expenses;
. costs relating to operations;
. termination of customer contracts, some of which can be terminated on
30 days' notice;
. customer discounts and credits;
. changes in our pricing policies or those of our competitors; and
. economic conditions specific to the hosting industry, as well as
general economic conditions.
We plan to increase our operating expenses to develop our business. If our
revenues do not increase as quickly as our expenses, our operating results will
suffer.
For these and other reasons, in future periods our operating results may
fall below the expectations of securities analysts or investors, which could
result in widely varying stock prices and negatively affect the market price of
our common stock.
We rely on our strategic relationship with Level 3, and if this relationship is
terminated or deteriorates our business may suffer.
In July 1999, we entered into a strategic relationship with Level 3. Level
3 is a communications and information services company that is building an
advanced facilities-based communications network through which
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it provides colocation, Internet connectivity and other services. As part of our
relationship, we have committed to purchase a fixed amount of services from
Level 3, including, among other things, bandwidth, colocation space,
installation and maintenance services, over the next five years. We will incur
these expenses even if anticipated increases in sales do not materialize or, in
some circumstances, if the agreement is terminated. We have also agreed that if
Level 3 is capable of providing the services we request, and if those services
are substantially similar to other services that we purchase, we will purchase
75% of these services from Level 3 from July 2000 through December 2000 and 90%
of these services from Level 3 from January 2001 through June 2004. We are
required to purchase these services from Level 3 even if these services are
available at lower prices from alternative vendors. We route the network traffic
of our customers through multiple backbone providers to increase network
performance. To enable us to do this, we obtain Internet connectivity through a
number of providers, and Level 3 may not be able to provide all of the
connectivity services that we require. As a result, we may purchase less than
the applicable percentages of these services from Level 3.
We also currently rely on Level 3 to provide substantially all of the data
center capacity that we need to provide our hosting services, and in the future
we may be required to purchase most of our data center capacity from Level 3.
Further, Level 3 may provide personnel at these data centers to install
equipment and assist with support as necessary for us to deliver service in
these facilities. If Level 3 fails to provide this data center capacity or
perform these services in a timely or effective manner, or at all, we would be
required to make alternate arrangements. If demand for colocation space
increases, Level 3 may not be able or willing to provide the data center
capacity we require to deliver our services. If our relationship with Level 3 is
terminated or if Level 3 does not provide the data center capacity that we need,
or provide it on acceptable terms, we would be required to seek arrangements
with other data center providers or construct our own data centers. We cannot be
certain that alternate data center capacity will be available on commercially
reasonable terms or at all. We currently rely, and for the foreseeable future
will continue to rely, on Level 3 to provide a substantial part of our bandwidth
and other networking services. If we are unable to obtain these services from
Level 3, we would be required to seek arrangements with other providers of these
services, and we cannot be certain that alternate services will be available on
commercially reasonable terms or at all.
Our success depends on Microsoft's continued success, and the loss or
deterioration of our relationship with Microsoft could harm our business and
have an adverse impact on our revenues.
We focus on advanced hosting services for Microsoft-based Internet
technologies. If these technologies are not widely used building blocks for
advanced Internet sites in the future, the demand for our services would
decrease and our business would be adversely affected. The final outcome of the
antitrust case against Microsoft is uncertain, but the outcome could cause the
acceptance of Microsoft products to decrease. Except for our relationship with
Microsoft as a customer, our relationship with Microsoft is generally informal.
We believe this relationship provides us with access to developments in
Microsoft products before they are generally available, which allows us to
maintain and enhance our technical expertise. If our relationship with Microsoft
deteriorates or if we lose some of the status or privileges we currently enjoy,
our technical expertise could be adversely affected. Our ability to market our
services as a provider of advanced hosting services for Microsoft-based Internet
technologies would also be adversely affected if Microsoft does not continue to
confer certifications and designations on us, or changes our current
certifications and designations or ceases to be our customer. We do not have a
written agreement with Microsoft relating to all of these certifications or
designations. Some of our competitors also have received these certifications
and designations. Microsoft generally confers these certifications unilaterally
and in its sole discretion and could change them at any time. We cannot be
certain that we will continue to enjoy them.
If we are unable to expand our network infrastructure to meet increasing demand
for reliable and secure services, we could lose customers and our operating
results could suffer.
We must continue to expand and adapt our network infrastructure to
accommodate an increasing number of customers, the amount of information they
wish to transmit and their changing requirements. We face risks related to our
network's ability to be scaled to meet increasing customer levels while
maintaining acceptable performance levels. The continued expansion and
adaptation of our networking and hosting facility infrastructure will continue
to require substantial financial, operational and management resources as we
negotiate bandwidth capacity with existing and other network infrastructure
suppliers. If we are required to expand our network significantly and rapidly
due to increased usage, additional stress will be placed upon our network
hardware, traffic management
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systems and hosting facilities as well as our financial, operational and
management resources. The ability of our network to support a substantially
larger number of customers at high transmission speeds is unknown. Furthermore,
it may be difficult for us to increase quickly our network capacity in light of
current lead times to purchase circuits and other critical items. If the network
providers upon which we rely fail to provide reliability, capacity and
performance for our network, we could lose customers and our operating results
could suffer.
Our success partly depends upon the capacity, reliability and security of
our network infrastructure, including the capacity leased from our network
suppliers. Our network currently delivers service through Level 3, InterNap, MCI
WorldCom, Inc., including UUNET Technologies, Inc., e.spire Communications,
Inc., Sprint Corporation, Digex, Incorporated, Cable & Wireless plc and SAVVIS
Communications Enterprises, LLC. Some of these suppliers are also our
competitors. In the future, we will be required to purchase most of our network
capacity from Level 3 to the extent that it provides capacity that is
substantially similar to the capacity of other providers. We depend on these
companies to provide uninterrupted and error-free service through their
telecommunications networks. As our customers' usage of telecommunications
capacity increases, we will need to make additional investments in our
infrastructure to maintain adequate data transmission speeds, the availability
of which may be limited or the cost of which may be significant. We monitor all
network links to prevent their being utilized in excess of their recommended
capacity. If capacity is not available to us as our customers' usage increases,
our network may not be able to achieve or maintain sufficiently high data
transmission capacity, reliability or performance. In addition, our business
would suffer if our network suppliers increased the prices for their services
and we were unable to pass along any increased costs to our customers. Any
failure on our part or the part of our third-party suppliers to achieve or
maintain high data transmission capacity, reliability or performance could
significantly reduce customer demand for our services and damage our business.
Increased costs associated with our private transit Internet connections could
result in the loss of customers or significant increases in operating costs.
Our private transit Internet connections are more costly than other
arrangements commonly utilized to move Internet traffic. If providers increase
the pricing associated with utilizing their bandwidth, we may be required to
identify alternative methods to distribute our customers' digital content. We
cannot assure you that our customers will continue to be willing to pay the
higher costs associated with direct private transit or that we could effectively
move to another network approach. If we are unable to access alternative
networks to distribute our customers' digital content on a cost-effective basis
or to pass any additional costs on to our customers, our operating costs would
increase significantly.
We may not be able to deliver our services and our business may suffer if our
third-party suppliers do not provide us with key components of our network
infrastructure.
We depend on other companies to supply key components of our network
infrastructure. Any failure to obtain needed products or services in a timely
fashion or at an acceptable cost could adversely affect our business. We buy
servers, routers and switches on an as-needed basis and therefore do not carry
significant inventories of them. We also have no guaranteed supply arrangements
with our vendors. We currently only use servers from Compaq and rely on Compaq
to provide us with access to Compaq technical personnel. In July 1999, we
entered into an agreement with Compaq under which we agreed during the
immediately following three years to purchase from Compaq the lesser of 2,000
servers or the number of servers reasonably necessary to adequately operate our
business consistent with our business plan. Through September 30, 2000, we had
purchased approximately 1,100 servers from Compaq under this agreement. Our
requirement to purchase these servers is contingent upon Compaq providing
financing for the servers on competitive terms, upon the price, performance and
quality of the Compaq servers being reasonably satisfactory to us and upon
Compaq's commitment to deliver these servers on the schedule we request. In
addition, we rely on Cisco Systems, Inc. and others to supply equipment critical
to our network, but we do not have a supply agreement with any of them. If this
equipment were to become unavailable on terms acceptable to us, we would be
forced to find alternative equipment. The inability to obtain equipment or
technical services from Compaq, Cisco or others on terms acceptable to us would
force us to spend time and money selecting and obtaining new equipment, training
our personnel to use different equipment and deploying alternative components
needed to integrate the new equipment, and as a result our business could be
adversely affected. In addition, if our sole or limited source suppliers do not
provide products or components that comply with evolving Internet and
telecommunications standards or that interoperate with other products or
components we use, our
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business would be harmed. For example, we have experienced performance problems,
including previously unknown software and firmware bugs, with routers and
switches that have caused disruptions in and impairment of network performance.
Because we operate in a new and evolving market with uncertain prospects for
growth, we may be unable to sustain growth in our customer base and our
operating results may suffer.
Our market is new and rapidly evolving. Growth in demand for and acceptance
of advanced hosting services are highly uncertain. Businesses may not be aware
of the potential benefits of outsourcing or may find it cheaper, more secure or
otherwise preferable to host their web sites internally. Internet technologies,
such as e-commerce applications, which require advanced hosting, may not grow as
rapidly as we expect. If the market for advanced hosting services fails to grow
or grows more slowly than we anticipate, our business, operating results and
financial condition will be adversely affected. Growth in the demand for our
products and services may be inhibited, and we may be unable to sustain growth
in our customer base for a number of reasons, including:
. our inability to market our products and services in a cost-effective
manner to new customers;
. the inability of customers to differentiate the products and services
we offer from those of our competitors;
. our inability to strengthen awareness of our brand; and
. reliability, quality or compatibility problems with our services.
Our customer base includes a significant number of dot.com businesses that
currently face increasing difficulty in obtaining funding to support their
operations.
Many of our customers are Internet-based businesses that have traditionally
been initially funded by venture capital firms and then through public
securities offerings. If the market for technology and Internet based businesses
is not supported by the private investors who have funded these customers, we
face the risk that these customers may cease, curtail or limit web site
operations hosted by us. If this occurs, we could experience a loss of revenue
associated with these customers and will then have to increase sales to other
businesses using the Internet in order to preserve and grow our revenue.
We may not be able to adapt to evolving technologies and customer demands, which
could cause our business to suffer.
Our market is characterized by rapidly changing technology, evolving
industry standards and frequent new product announcements. These characteristics
are magnified by the recent growth of the Internet and the intense competition
in our industry. We are also subject to risks from technological changes in the
way hosting solutions are marketed and delivered. To be successful, we must
adapt to our rapidly changing market by continually improving the performance,
features and reliability of our services and modifying our business strategies
accordingly. We could also incur substantial costs if we need to modify our
services or infrastructure in order to adapt to these changes. In addition, our
internal costs to provide service to our customers could be adversely affected.
Our business would suffer if we fail to respond to these changes in a timely and
cost-effective manner or at all. Our business will suffer if Internet usage does
not continue to increase or if the Internet fails to perform reliably.
Our ability to successfully market our services could be substantially impaired
if we are unable to deploy new Internet technologies or service offerings or if
new Internet technologies or service offerings deployed by us prove to be
unreliable, defective or incompatible.
We cannot assure you that we will not experience difficulties that could
delay or prevent the successful development, introduction or marketing of
Internet technologies in the future. If any newly introduced Internet
technologies or our service offerings suffer from reliability, quality or
compatibility problems, market acceptance of our services could be greatly
hindered and our ability to attract new customers could be adversely affected.
We cannot assure you that new applications or services deployed by us will be
free from any reliability, quality or compatibility problems. If we incur
increased costs or are unable, for technical or other reasons, to offer and
deploy
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new Internet technologies or enhancements of existing technologies, our ability
to successfully market our services could be substantially impaired.
Our business will not grow unless Internet usage grows and Internet performance
remains adequate.
Use of the Internet for retrieving, sharing and transferring information
among businesses, consumers, suppliers and partners has recently begun to
increase rapidly. Our success depends in large part on continued growth in the
use of the Internet. In addition, our business plan anticipates extensive growth
in the web site hosting and application hosting markets. The growth of the
Internet, including the web site hosting and application hosting markets, is
subject to a high level of uncertainty and Internet usage and growth may be
inhibited for a number of reasons, such as:
. inadequate network infrastructure;
. security concerns, including viruses and denial of service attacks;
. uncertainty of legal and regulatory issues concerning the use of the
Internet;
. inconsistent quality of service;
. the inability of Internet-focused businesses to develop and maintain
successful business models;
. failure of Internet-dependent businesses;
. lack of availability of cost-effective, reliable, high-speed service;
and
. failure of Internet use to expand internationally.
If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by this growth, or its performance and
reliability may decline. For example, web sites have experienced interruptions
in service as a result of outages and other delays occurring throughout the
Internet network infrastructure. If these outages or delays occur frequently,
use of the Internet as a commercial or business medium could in the future grow
more slowly or decline, which would adversely affect our business.
Failure of our operating and financial systems to keep pace with the anticipated
growth in our business could result in customer dissatisfaction, operating
inefficiencies and lost revenue opportunities.
The rapid growth of our business and our service offerings has placed, and
is likely to continue to place, a significant strain on our operating and
financial resources. Our future performance will partly depend on our ability to
manage our growth effectively, which will require that we further develop our
operating and financial system capabilities and controls. If our information
systems and other infrastructure, including customer service and support, are
unable to support the demands placed on them by the rapid growth in our
business, we may be forced to implement new systems. If we fail to improve our
operational systems or to expand our customer service capabilities to keep pace
with the growth of our business, we could experience customer dissatisfaction,
cost inefficiencies and lost revenue opportunities, which could harm our
operating results. We may not be able to successfully implement these systems
when needed or they may not perform reliably.
We may not be able to successfully sustain our growth if we are unable to
attract and retain additional highly skilled personnel.
We are currently experiencing rapid growth and intend to continue
expanding. Since incorporating in August 1997, we have grown to 519 employees at
September 30, 2000. We believe that we will need to hire over 250 additional
personnel in all areas of our business over the next 12 months. If we do not
succeed in attracting and retaining new, qualified personnel and/or retaining
our current personnel, our business could suffer. We must expand our direct and
indirect sales operations to increase market awareness of our products and
generate increased
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revenues. We cannot be certain that we will be successful in these efforts. We
plan to increase our sales force significantly during the next 12 months. Newly-
hired employees will require training and it will take time for them to achieve
full productivity. Our business requires individuals with significant levels of
Internet expertise, in particular to win consumer confidence in outsourcing the
hosting and management of mission-critical applications. Competition for such
personnel is intense, and qualified technical personnel are likely to remain a
limited resource for the foreseeable future. Locating candidates with the
appropriate qualifications, particularly in the desired geographic location, can
be costly and difficult. We may not be able to hire enough qualified individuals
in the future, newly-hired employees may not achieve necessary levels of
productivity and we may need to provide higher compensation to such personnel
than we currently anticipate.
We may need additional capital to fund our operations and finance our growth,
and we may not be able to obtain it on terms acceptable to us or at all.
We believe that our existing capital resources, including the proceeds from
our initial public offering in October 1999, will enable us to maintain our
current operations for the next 12 months. However, we may require additional
funds during or after that 12-month period. In particular, if we expand our
existing business plan to focus on growth in international markets or in other
ways, we would likely require additional funding. If adequate funds were not
available or were not available on acceptable terms, our ability to respond to
competitive pressures would be significantly limited. Any required financing may
not be available or may be available only on terms that are not favorable to us.
Further, if additional funds are raised through the issuance of additional
equity securities, the percentage ownership of our shareholders would be
diluted. Any new equity securities may have rights, preferences or privileges
senior to those of our common stock.
We could experience system failures that could harm our business and reputation.
To succeed, we must be able to operate our network management
infrastructure around the clock without interruption. Our operations depend upon
our ability to protect our network infrastructure, equipment and customer files
against damage from human error, fire, earthquakes, hurricanes, floods, power
loss, telecommunications failures, intrusion (including hackers), sabotage,
intentional acts of vandalism and similar events. Our servers and network
infrastructure are located primarily in the Dallas/Ft. Worth, Texas metropolitan
area. We are continuing to develop a comprehensive disaster recovery plan and
the occurrence of a natural disaster or other unanticipatedproblems at any of
the our data centers from which we provide services could result in
interruptions in the services we provide to our customers.
Although we have attempted to build redundancy into our network and hosting
infrastructure, we have experienced interruptions in service in the past. We
have experienced partial system failures due to routing problems, hard drive
failures, database corruption and other computer failures. Our network is
subject to various points of failure, and a problem with our routers, switches
or other equipment could cause an interruption in the services we provide to
some or all of our customers. Any future interruptions could:
. cause customers or end users to seek damages for losses incurred;
. require us to replace existing equipment or add redundant facilities;
. damage our reputation for reliable service;
. cause existing customers to cancel their contracts; or
. make it more difficult for us to attract new customers.
Any of these results could damage our business.
We also often provide our customers with service level agreements. If we do
not meet the required service levels, we may have to provide credits to our
customers, which could significantly reduce our revenues. Additionally, in the
event of any resulting harm to customers, we could be held liable for damages.
Awards for such damages might exceed our liability insurance by an unknown but
significant amount and could seriously harm our
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<PAGE>
business.
Disruption of our services caused by unknown software defects could harm our
business and reputation.
Our service offerings depend on complex software, including software
licensed from third parties and our proprietary software tools. Complex software
often contains defects, particularly when first introduced or when new versions
are released. We may not discover software defects that affect our new or
current services or enhancements until after they are deployed. These defects
could cause service interruptions or performance issues, which could damage our
reputation or increase our service costs, cause us to lose revenue, delay market
acceptance or divert our development resources.
Our business and reputation will suffer if we do not prevent security breaches.
Unauthorized access, computer viruses, denial of service attacks,
accidents, misconduct resulting in disruptions and other disruptions could
occur. In addition, we may incur significant costs to prevent breaches in
security or to alleviate problems caused by breaches. We work with Level 3 to
protect our equipment and hardware against breaches in physical security and
with other vendors of software and hardware to protect other breaches in
security. We cannot be certain that they will provide adequate security. We have
experienced and may in the future experience delays or interruptions in service
as a result of the accidental or intentional actions of Internet users, current
and former employees of Data Return or others. Furthermore, inappropriate use of
the network by third parties could also jeopardize the security of confidential
information, such as customer and Data Return passwords as well as credit card
and bank account numbers, stored in our computer systems or those of our
customers. As a result, we could become liable to others and lose existing or
potential customers. The costs required to eliminate computer viruses and
alleviate other security problems could be prohibitively expensive. In addition,
the efforts to address these problems could result in interruptions, delays or
cessation of service to our customers.
Providing services to customers with mission-critical web sites and web-based
applications could potentially expose us to lawsuits for customers' lost profits
or other damages.
Because our hosting services are critical to many of our customers'
businesses, any significant interruption in our services could result in lost
profits or other indirect or consequential damages to our customers. Although
our standard terms and conditions disclaim our liability for any such damages, a
customer could still bring a lawsuit against us claiming lost profits or other
consequential damages as the result of a service interruption or other web site
or application problems that the customer may ascribe to us. There can be no
assurance a court would enforce any limitations on our liability, and the
outcome of any lawsuit would depend on the specific facts of the case and legal
and policy considerations. We could also have meritorious defenses to any such
claims, but there can be no assurance we would prevail. In such cases, we could
be liable for substantial damage awards. Such damage awards might exceed our
liability insurance by unknown but significant amounts, which would seriously
harm our business.
Our limited ability or failure to protect our intellectual property may
adversely affect our ability to compete.
Third parties may infringe or misappropriate our technology or proprietary
rights, which could have an adverse effect on our business, results of
operations or financial condition. In addition, our competitors or potential
competitors may independently develop technologies that are equivalent or
superior to our technology. We rely on a combination of copyright, trademark,
service mark and trade secret laws to protect our intellectual property. We have
filed federal registrations for the mark "Data Return" and other marks. We also
have internally developed software and other tools that are important to our
business for which we rely on copyright protection. We have entered into
contractual arrangements with some of our employees and contractors as well as
suppliers, distributors and some of our customers in order to limit access to,
and any disclosure of, our proprietary information. The steps we have taken to
protect our intellectual property may be insufficient. We may need to take legal
action to protect our intellectual property rights, which could be costly and
divert the attention of our technical and management personnel.
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<PAGE>
We may be accused of infringing the proprietary rights of others, which could
subject us to costly and time-consuming litigation.
In addition to the technologies we develop or have developed, we license
certain technologies from third parties and may license additional technologies
in the future. We could become subject to infringement actions based upon our
internally developed technologies or technologies licensed from third parties.
Any of these claims, with or without merit, could subject us to costly
litigation and divert the attention of our technical and management personnel.
In addition, third parties may change the terms of their license agreements in
ways that would prevent us from using technologies licensed from them on
commercially reasonable terms or that would prevent us from using them at all.
We may not be able to replace those technologies with technologies that have the
same features or functionality on commercially reasonable terms or at all.
Regulatory and legal uncertainties could result in significant costs or
otherwise harm our business.
The success of our business depends on the growth of the Internet. Laws and
regulations directly applicable to commerce or communications over the Internet
are becoming increasingly prevalent. However, the law of the Internet remains
largely unsettled. The adoption or modification of laws or regulations relating
to the Internet could adversely affect our business if they impose a direct cost
on us or if they curtail the growth of the Internet. If liability for materials
carried on or disseminated through their systems is imposed on service
providers, we would make efforts to implement measures to reduce our exposure to
such liability. Such measures could require us to expend substantial resources
or discontinue certain product or service offerings. In addition, increased
attention to liability issues, as a result of lawsuits, legislation and
legislative proposals, could divert management attention, result in
unanticipated expenses and harm our business. If legislation that makes
transacting business over the Internet, such as e-commerce, less favorable or
otherwise curtails the growth of the Internet is adopted in the U.S. or
internationally, our business would suffer.
We may be subject to legal claims in connection with the information
disseminated through our network which could have the effect of diverting
management's attention and require us to expend significant financial resources.
We may face potential direct and indirect liability for claims of
defamation, negligence, copyright, patent or trademark infringement, violation
of securities laws and other claims based on the nature and content of the
materials disseminated through our network. For example, lawsuits may be brought
against us claiming that content distributed by some of our current or future
customers may be regulated or banned. In these and other instances, we may be
required to engage in protracted and expensive litigation which could have the
effect of diverting management's attention and require us to expend significant
financial resources. Our liability insurance may not necessarily cover any of
these claims or may not be adequate to protect us against all liability that may
be imposed.
In addition, on a limited number of occasions in the past, businesses,
organizations and individuals have sent unsolicited commercial e-mails from
servers hosted at our facilities to massive numbers of people, typically to
advertise products or services. This practice, known as "spamming," can lead to
complaints against service providers that enable such activities, particularly
where recipients view the materials received as offensive. We have in the past
received, and may in the future receive, letters from recipients of information
transmitted by our customers objecting to such transmission. Although we
prohibit our customers by contract from spamming, we cannot assure you that our
customers will not engage in this practice, which could subject us to claims for
damages.
The loss of key personnel including our Chairman and Chief Executive Officer or
our President and Chief Operating Officer could harm our business.
We depend on the continued service of our key technical, sales and senior
management personnel, including Sunny C. Vanderbeck, our Chairman and Chief
Executive Officer, and Michelle R. Chambers, our President and Chief Operating
Officer. We have entered into employment agreements with Mr. Vanderbeck and Ms.
Chambers expiring in 2002, but any of our officers or employees can quit at any
time. Losing one or more of our key employees could harm our business.
We operate in an extremely competitive market, and our business would suffer if
we are unable to compete
22
<PAGE>
effectively.
The market for hosting and Internet services is highly competitive. There
are few substantial barriers to entry to keep new competitors from entering this
market. We expect that we will face additional competition from existing
competitors and new market entrants in the future. Many of our competitors have
substantially greater financial, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. As a result, some of these
competitors may be able to:
. develop and expand their network infrastructures and service offerings
more rapidly;
. adapt to new or emerging technologies and changes in customer
requirements more quickly;
. take advantage of acquisition and other opportunities more readily;
. devote greater resources to the marketing and sales of their services;
and
. adopt more aggressive pricing policies.
In addition, some of our competitors have entered and will likely continue
to enter into joint ventures or other arrangements to provide additional
services competitive with those provided by us. We believe that the market in
which we compete is likely to experience consolidation in the near future, which
could result in increased competition on price and other factors that could
adversely affect our business.
In an effort to gain market share, some of our competitors have offered
incentives not matched by us. In addition, some of our competitors may be able
to provide customers with additional benefits that could reduce the overall
costs of their services relative to ours. We may not be able to reduce the
pricing of our services or offer incentives in response to the actions of our
competitors without an adverse impact on our business.
The market for our services in international territories is unproven, and as a
result, the revenue generated by any future international operations may not be
adequate to offset the expense of establishing and maintaining those operations.
One component of our strategy is to expand into international markets. We
cannot assure you that we will be able to market, sell and provide our services
successfully outside the United States. We could suffer significant operating
losses if the revenue generated by any current or future international data
center or other operations adequate to offset the expense of establishing and
maintaining those international operations. Our present international strategy
is based upon the creation of alliances with companies that own or operate data
centers into which we intend to place our infrastructure and to service our
current customers. In the event that are unable to negotiate favorable
agreements with such companies, our international strategy will be significantly
impaired, curtailed or eliminated.
Because we have international customers and are beginning to operate in foreign
markets, our business may be adversely affected by foreign political and
economic conditions.
In fiscal 2000, approximately 4.1% of our revenues were derived from our
customers located in Europe and Asia. In addition, we are beginning to operate
in London, England. We expect that we will expand our operations in London
during fiscal 2001. Our success depends in part on expanding our customer base
internationally and our ability to successfully operate from data centers in
foreign markets. Because our international sales are denominated in U.S.
dollars, currency fluctuations may deter foreign customers from purchasing our
services. In addition, we face risks in operating and servicing customers in
foreign markets, such as:
. different Internet access fees;
. different technology standards;
23
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. different privacy, censorship and service provider liability standards
and regulations; and
. less protective intellectual property laws.
Any of these risks could adversely affect our ability to operate or expand
internationally, which would limit the growth of our business.
Our management will have significant flexibility in applying the proceeds from
our initial public offering and our use of proceeds may not yield a favorable
return.
We have used and intend generally to continue to use the net proceeds from
our initial public offering to fund our capital expenditures and for working
capital and other general corporate purposes. We may also acquire or make
investments in other businesses, products, services or technologies and, if we
do, we may not be able to make those acquisitions or investments on commercially
acceptable terms or we could have difficulty assimilating and integrating any
acquired businesses, technologies, services or products. We have not yet
determined all expected expenditures and thus cannot estimate the amounts to be
used for each specified purpose. Our management has significant flexibility in
applying the net proceeds of our initial public offering. We cannot be certain
that our use of the proceeds will yield a favorable return.
Our principal shareholders, directors and executive officers currently own
approximately 64.9% of our common stock, which may allow them to exert influence
over us or to prevent a change of control.
Our directors and executive officers and shareholders who currently own
over 5% of our common stock collectively beneficially own approximately 64.9% of
our outstanding common stock. These shareholders would be able to exercise
significant influence over all matters requiring shareholder approval, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership could also delay or prevent a change in control
of Data Return even if beneficial to our shareholders.
Some provisions of our articles, bylaws and rights plan and of Texas law could
delay or prevent a change of control, which could adversely affect our stock
price.
Our articles of incorporation and bylaws contain provisions that could make
it more difficult for a third party to acquire us, even if doing so would be
beneficial to our shareholders. These provisions could limit the price that
investors might be willing to pay in the future for shares of our common stock.
Some of these provisions:
. authorize the issuance of preferred stock which can be created and
issued by our board of directors without prior shareholder approval,
commonly referred to as "blank check" preferred stock, with rights
senior to those of common stock;
. prohibit certain shareholder actions by written consent;
. establish advance notice requirements for submitting nominations for
election to our board of directors and for proposing matters that can
be acted upon by shareholders at a meeting; and
. provide for a board of directors with staggered three-year terms.
We have also adopted a shareholders' rights plan that could delay, deter or
prevent a change in control of us.
In September 1999, we adopted a shareholder rights plan. This plan entitles
our shareholders to rights to acquire additional shares of our common stock when
a third party acquires 15% of our common stock or commences or announces its
intent to commence a tender offer for at least 15% of our common stock. This
plan could delay, deter or prevent a change in control of us.
24
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Future sales of our common stock could cause our stock price to decline.
At September 30, 2000, 35,816,633 shares of our common stock were issued
and outstanding. We cannot be sure what effect, if any, future sales of our
common stock or the availability of shares for future sale will have on the
market price of our common stock. The market price of our common stock could
drop due to sales of a large number of shares of our common stock in the market
or the perception that these sales could occur. These factors could also make it
more difficult to raise funds through future offerings of our common stock.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
All our customer contracts are currently denominated in United States
dollars, and we do not currently invest in derivative financial instruments.
However, we invest our excess cash balances in cash equivalents and other
investment securities and are therefore subject to market risk related to
changes in interest rates. We believe, but cannot be certain, that the effect on
our financial position, results of operation and cash flows of any reasonably
likely changes in interest rates would not be material.
Item 4. Submission of Matters to a Vote of Security Holders
Matters submitted to a vote at the Annual Meeting of Stockholders held on
September 20, 2000 and the results of such meeting are as follows:
<TABLE>
<CAPTION>
Votes Votes Votes Votes
For Against Withheld Abstained
------------------------------ ------- -------- ---------
<S> <C> <C> <C> <C>
1. Election of directors to serve
until the 2001 Annual Meeting
of Shareholders.
Robert Ted Enloe, III 25,141,783 - 913,049 -
Election of directors to serve
until the 2003 Annual Meeting
of Shareholders.
Joseph M. Grant 25,143,947 - 910,885 -
Jason A. Lochhead 25,100,273 - 954,559 -
2. Approval to increase the
number of shares of Common
Stock authorized for issuance
under the Company's Long-Term
Incentive Plan from 5,000,000
to 9,000,000 shares 22,411,106 2,863,468 - 780,258
</TABLE>
A majority of the votes present, in person or by proxy, and entitled to
vote at the meeting, were cast in favor of the two proposals.
25
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PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits:
10.1 Promissory Note to BankOne Texas, National
Association dated July 31, 2000.
10.2 FIRST AMENDMENT TO CREDIT AGREEMENTdated as of July 31, 2000,
by and between DATA RETURN CORPORATION and BANK ONE, TEXAS,
NATIONAL ASSOCIATION.
27 Financial Data Schedule (1).
(b) Reports on Form 8-K:
None
-------------------
(1) Included with EDGAR version only.
26
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SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Data Return Corporation
Dated: November 13, 2000 By: /s/ Stuart A. Walker
----------------------------------------
Stuart A. Walker, Vice President
Chief Financial Officer
(Principal Financial & Accounting Officer &
Authorized Officer)
27
<PAGE>
EXHIBIT INDEX
10.1 Promissory Note to BankOne Texas, National
Association dated July 31, 2000.
10.2 FIRST AMENDMENT TO CREDIT AGREEMENTdated as of July 31,
2000, by and between DATA RETURN CORPORATION and BANK
ONE, TEXAS, NATIONAL ASSOCIATION.
27 Financial Data Schedule (1).
-------------------
(1) Included with EDGAR version only.
