<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended: June 30, 1996
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _________ to _________
Commission File Number 0-25216
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
(Exact name of the small business issuer as specified in its charter)
DELAWARE 77-0317705
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2 N. Second Street
San Jose, California 95113
(Address of principal executive offices)
Issuer's telephone number: (408) 881-1815
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act 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
--- ---
State the numbe9r of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date:
Title of Each Class Outstanding at August 9, 1996
- ------------------- -----------------------------
Common stock, par value $.01 per share 11,608,251
and Preferred Stock Purchase Rights
associated therewith.
Transitional Small Business Disclosure Format (check one):
Yes No X
--- ---
This report, including all exhibits, contains 18 pages.
<PAGE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Index
Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets as of
December 31, 1995 and June 30, 1996 3
Condensed Consolidated Statements of Operations and Other
Operating Data for the Three Months Ended June 30, 1995
and June 30, 1996 4
Condensed Consolidated Statements of Operations and Other
Operating Data for the Six Months Ended June 30, 1995
and June 30, 1996 5
Condensed Consolidated Statements of Cash Flows
for the Six Months Ended June 30, 1995
and June 30, 1996 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of
Operations 9
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 17
Item 6. Exhibits and Reports on Form 8-K 17
Signatures 18
When used in this report, the words "estimate," "project," "intend" and
"expect" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to risks and uncertainties that could
cause actual results to differ materially, including competitive pressures, new
product introductions by the Company and its competitors and changes in the
rates of subscriber acquisition and retention. For a discussion of such risks,
see "Investment Considerations" on page 14. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date hereof. The Company undertakes no obligation to publicly release updates or
revisions to these statements.
2
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<TABLE>
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Balance Sheets
<CAPTION>
December 31, June 30,
1995 1996
--------------- ----------------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents ............................... $ 146,001,200 $ 110,843,700
Accounts receivable, net of allowances for doubtful
accounts of $225,000 at December 31, 1995 and
$853,000 at June 30, 1996 ............................ 1,452,600 2,417,400
Inventory ............................................... 205,800 273,300
Prepaid expenses ........................................ 1,471,100 2,960,700
-------------- -------------
Total current assets ............................. 149,130,700 116,495,100
Property and equipment at cost, net ..................... 46,724,200 71,179,900
Product development costs, net .......................... 359,200 280,500
Deferred subscriber acquisition costs, net .............. 3,451,500 6,967,500
Deposits and other assets ............................... 3,014,400 2,048,200
-------------- -------------
Total assets ................................ $ 202,680,000 $ 196,971,200
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable .................................. $ 11,388,700 $ 17,178,700
Accrued payroll and related expenses .................... 2,154,400 3,415,100
Other accrued expenses and liabilities .................. 2,420,500 5,756,800
Deferred revenue ........................................ 1,250,500 2,756,100
-------------- -------------
Total current liabilities ........................ 17,214,100 29,106,700
Commitments and contingencies
Stockholders' equity:
Common stock, $.01 par value; Authorized shares -
40,000,000; 11,096,100 shares issued and outstanding
December 31, 1995; 11,553,400 shares issued and
outstanding at June 30, 1996 ..................... 111,000 115,600
Additional paid-in capital .............................. 203,159,800 204,637,400
Accumulated deficit ..................................... (17,777,000) (36,945,700)
Cumulative translation adjustment (27,900) 57,200
-------------- -------------
Total stockholders' equity ....................... 185,465,900 167,864,500
-------------- -------------
Total liabilities and stockholders' equity .. $ 202,680,000 $ 196,971,200
============== =============
See accompanying notes
</TABLE>
3
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<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Statements of Operations and Other Operating Data
<CAPTION>
Three Months Ended
--------------------------------------
June 30, June 30,
1995 1996
---------------- ----------------
(unaudited) (unaudited)
<S> <C> <C>
Revenues........................................... $ 10,528,100 $ 28,023,200
Costs and expenses:
Cost of revenues................................. 7,458,100 20,531,200
Product development.............................. 539,200 1,391,000
Sales and marketing.............................. 3,824,900 12,549,000
General and administrative....................... 1,944,500 6,298,800
Amortization of goodwill and intangible assets... -- 195,900
---------------- ----------------
Total costs and expenses....................... 13,766,700 40,965,900
---------------- ----------------
Loss from operations............................... (3,238,600) (12,942,700)
Loss on investment in McKinley..................... -- (1,200,000)
Interest income.................................... 360,800 1,552,100
---------------- ----------------
Loss before provision for income taxes............. (2,877,800) (12,590,600)
Provision (benefit) for income taxes............... -- 3,700
---------------- ----------------
Net loss........................................... $ (2,877,800) $ (12,594,300)
================ ===============
Net loss per share................................. $ (0.37) $ (1.09)
Shares used in computing net loss per share........ 7,762,400 11,533,600
Other operating data:
Approximate number of subscribers at............. 169,000 479,000
Number of local access areas at end of period.... 171 330
See accompanying notes
</TABLE>
4
<PAGE>
<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Statements of Operations and Other Operating Data
<CAPTION>
Six Months Ended
----------------------------
June 30, June 30,
1995 1996
------------ ------------
(unaudited) (unaudited)
<S> <C> <C>
Revenues ....................................... $ 18,026,000 $ 52,124,500
Costs and expenses:
Cost of revenues ............................. 12,454,700 37,160,800
Product development .......................... 838,900 2,643,900
Sales and marketing .......................... 5,778,800 22,283,000
General and administrative ................... 3,704,700 10,753,100
Amortization of goodwill and intangible assets -- 529,900
------------ ------------
Total costs and expenses ................... 22,777,100 73,370,700
------------ ------------
Loss from operations ........................... (4,751,100) (21,246,200)
Loss on investment in McKinley ................. -- (1,200,000)
Interest income ................................ 582,100 3,284,900
------------ ------------
Loss before provision for income taxes ......... (4,169,000) (19,161,300)
Provision (benefit) for income taxes ........... -- 7,400
------------ ------------
Net loss ....................................... $ (4,169,000) $(19,168,700)
============ ============
Net loss per share ............................. $ (0.57) $ (1.68)
Shares used in computing net loss per share .... 7,246,700 11,378,700
Other operating data:
Approximate number of subscribers at
end of period ............................. 169,000 479,000
Number of local access areas at end of period 171 330
See accompanying notes
</TABLE>
5
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<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Statements of Cash Flows
<CAPTION>
Six Months Ended
-------------------------------------
June 30, June 30,
1995 1996
----------------- -------------------
(unaudited) (unaudited)
<S> <C> <C>
Operating activities
Net income (loss).............................................. $ (4,169,000) $ (19,168,700)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization.............................. 3,010,700 11,809,000
Loss on disposal of assets................................. 110,400 123,700
Loss on investment in McKinley............................. -- 1,200,000
Changes in assets and liabilities:
Accounts receivable ..................................... (219,300) (964,800)
Inventory ............................................... (67,700) (67,500)
Prepaid expenses ........................................ (1,023,500) (1,636,600)
Deposits and other assets ............................... (193,000) (263,600)
Trade accounts payable .................................. (2,500) 5,790,000
Accrued payroll and related expenses .................... 445,500 1,260,700
Other accrued expenses and liabilities .................. 924,300 3,336,300
Deferred subscriber costs ............................... (1,575,000) (7,909,200)
Deferred revenue ........................................ 806,300 1,505,600
------------ -------------
Total adjustments ........................................... 2,216,200 14,183,600
------------ -------------
Net cash provided (used) by operating activities ................ (1,952,800) (4,985,100)
Investing activities
Purchase of property and equipment ............................ (19,612,300) (31,239,700)
Investment in McKinley ........................................ (1,500,000) (500,000)
------------ -------------
Net cash used in investing activities ........................... (21,112,300) (31,739,700)
Financing activities
Proceeds from exercise of stock options and purchases under
employee stock purchase plan ................................ 393,300 1,482,200
Proceeds from sale of common stock, net........................ 49,306,300 --
------------ -------------
Net cash provided by financing activities ....................... 49,699,600 1,482,200
------------ -------------
Net increase (decrease) in cash and cash equivalents ............ 26,634,500 (35,242,600)
Effects of exchange rates on cash ............................... -- 85,100
Cash and cash equivalents at beginning of period ................ 20,938,200 146,001,200
------------ -------------
Cash and cash equivalents at end of period ...................... $ 47,572,700 $ 110,843,700
============ =============
Supplemental disclosures of cash flow information
Interest paid ................................................... $ -- $ --
Income taxes paid ............................................... $ -- $ 7,400
See accompanying notes
</TABLE>
6
<PAGE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Notes to Condensed Consolidated Financial Statements
1. Interim Periods
The unaudited interim information has been prepared on the same basis as
the annual financial statements and, in the opinion of the Company's management,
reflects normal recurring adjustments necessary for a fair presentation of the
information for the periods presented. Operating results for any quarter are not
necessarily indicative of results for any future periods. The following
information should be read in conjunction with the financial statements and the
notes contained in the Company's Annual Report on Form 10-KSB for the year ended
December 31, 1995.
2. Deferred Subscriber Acquisition Costs
Subscriber acquisition costs are deferred and amortized over a period
determined by calculating the ratio of current revenues related to the direct
response advertising versus the total expected revenues, or twelve months,
whichever is shorter. These costs relate directly to subscriber solicitations
and principally include the production, printing and shipping of starter
packages, trade show costs, channel commissions to partners providing new
subscribers and the costs of obtaining qualified prospects by various targeted
direct marketing programs. No indirect costs are included in subscriber
acquisition costs. To date, all subscriber acquisition costs have been incurred
for the solicitation of specifically identified prospects.
Subscriber acquisition costs, which relate directly to potential
subscribers, are recorded separately from ordinary operating costs and do not
include indirect costs. The Company capitalized subscriber acquisition costs of
approximately $1,266,600 and $4,889,600 for the three months ended June 30, 1995
and June 30, 1996, respectively. Amortization of deferred subscriber acquisition
costs for the three months ended June 30, 1995 and June 30, 1996 were $467,100
and $2,423,600, respectively. The Company capitalized subscriber acquisition
costs of approximately $1,575,000 and $7,909,200 for the six months ended June
30, 1995 and June 30, 1996, respectively. Amortization of deferred subscriber
acquisition costs for the six months ended June 30, 1995 and June 30, 1996 were
$749,200 and $4,393,200, respectively.
3. Property and Equipment
<TABLE>
Property and equipment consist of the following:
<CAPTION>
December 31, 1995 June 30,1996
----------------- ------------
(unaudited)
<S> <C> <C>
Property and equipment at cost $ 54,117,500 $ 85,233,500
Less accumulated depreciation and
amortization ( 7,393,300) ( 14,053,600)
------------ ------------
Net property and equipment $ 46,724,200 $ 71,179,900
============ ============
</TABLE>
7
<PAGE>
4. Net Loss Per Share
Net loss per share is computed using the weighted average number of shares
of common stock and dilutive common stock equivalent shares from stock options
(using the treasury stock method).
5. Income Taxes
There were $3,700 and $7,400 provisions for minimum state income taxes for
the three and six months ended June 30, 1996, respectively. Other than minimum
state income taxes, no provision for income taxes is expected for 1996 as the
Company expects to incur a net loss for the year and does not expect earnings
for the foreseeable future.
6. Stockholders' Equity
<TABLE>
The components of the stockholders' equity are as follows:
<CAPTION>
Common Total
Stock Additional Cumulative Stockholders'
------------------------ Paid-In Accumulated Translation Equity
Shares Amount Capital Deficit Adjustment (Deficit)
---------- --------- ------------- ------------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 11,096,100 $ 111,000 $ 203,159,800 $ (17,777,000) $ (27,900) $ 185,465,900
Issuance under employee stock
purchase plan 16,900 200 437,400 - - 437,600
Exercise of stock options 440,400 4,400 1,040,200 - - 1,044,600
Cumulative translation - - - - 85,100 85,100
adjustment
Net loss - - - (19,168,700) - (19,168,700)
---------- --------- ------------- ------------- -------- -------------
Balance at June 30, 1996 11,553,400 $ 115,600 $ 204,637,400 $ (36,945,700) $ 57,200 $ 167,864,500
========== ========= ============= ============= ======== =============
</TABLE>
7. Investment in McKinley
In June 1995, the Company acquired shares of Series A Common Stock in The
McKinley Group, Inc. ("McKinley"), for $1,500,000, consisting of cash of
$1,200,000 and the issuance of 12,600 shares of common stock with a value of
$300,000 and certain other contingent consideration. In May 1996, the Company
loaned McKinley $500,000 in exchange for a demand promissory note convertible
into an equity interest.
On June 26, 1996, McKinley signed a letter of intent with Excite, Inc.
("Excite") subject to a definitive merger agreement. On August 6, 1996,
McKinley announced that it had signed a definitive merger agreement with Excite
pursuant to which Excite would acquire all of the outstanding shares of McKinley
in exchange for 850,000 shares of Excite common stock. Subject to a liquidation
preference of approximately $1,500,000 for McKinley's Series B Common Stock, the
holders of Series A and Series B Preferred Stock are expected to participate
ratably (on an as-converted basis) in the proceeds of the merger. Consummation
of the merger is subject to certain conditions, including approval by McKinley's
shareholders.
Based on the Company's estimated proceeds from McKinley's merger with
Excite and the risk associated with consummation of the merger, the Company
recorded a loss on investment in McKinley of $1,200,000 and reduced the
carrying value of its investment in McKinley to $800,000.
8
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following information should be read in conjunction with the condensed
consolidated financial statements and the notes thereto included in Item 1 of
this Quarterly Report, and the financial statements and the notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations contained in the Company's Annual Report on Form 10-KSB for the year
ended December 31, 1995.
Overview
The Company's revenues are derived from providing Internet access services
primarily to individuals and to a lesser extent to business subscribers.
Revenues from monthly subscriptions have increased significantly since the
Company's inception as a result of increases in the Company's subscriber base.
This subscriber growth, in turn, has resulted from the growth of the Internet
services market generally, the expansion of the Company's service offerings and
distribution channels and the increase in the number of the Company's local
access areas in metropolitan areas in the United States. The introduction of new
local access numbers in a geographic area allows NETCOM subscribers in that area
to access the Internet without incurring long distance telephone charges.
The Company believes its NetCruiser software has contributed to its strong
subscriber growth. NetCruiser is an Internet access service that features a
point-and-click graphical user interface providing subscribers with an
easy-to-use access to the Internet's applications and resources. In June 1996,
the Company introduced its NETCOMplete software which gives Windows and
Macintosh users an Internet solution that offers a complete suite of software,
access, support and service.
Currently, sales to individuals represent a significant majority of the
Company's revenues. Revenues from individuals are comprised primarily of
recurring revenues. The Company's NetCruiser accounts are billed monthly
pursuant to a pre-authorized credit card account. The Company recently underwent
a domestic pricing change that provides unlimited usage of the Company's service
for new individual accounts. Individuals are charged $5.00 for the first month
of service and $19.95 per month thereafter. The Company's international
subsidiaries have similar pricing plans. This change has adversely affected the
Company's average revenue per subscriber on NetCruiser accounts. Revenues from
dedicated connections include recurring revenue, usage charges, set-up charges
and equipment sales.
The Company's operating results have fluctuated in the past and may
fluctuate significantly in the future as a result of a variety of factors, some
of which are outside the Company's control. The Company expects that it will
continue to incur substantial net losses for the foreseeable future. In
addition, the Company has expanded its operations internationally to Canada and
the United Kingdom, and plans to continue expansion internationally which will
require significant expenditures. There can be no assurance that revenue or
subscriber growth will continue or that the Company will be able to first
achieve and then sustain profitability or positive cash flow.
9
<PAGE>
The Company may choose to adopt strategies designed to continue growth in
its subscriber base, such as aggressive promotional programs and the
implementation of new pricing programs to accomplish this objective. Such
strategies may result in an increase in costs as a percentage of revenues.
Additionally, in order to continue to realize subscriber growth, the Company
must continue to replace terminating subscribers and attract additional
subscribers. However, the sales and marketing expenses and subscriber
acquisition costs associated with attracting new subscribers are substantial.
Accordingly, the Company's ability to improve operating margins will depend in
part on its ability to retain its subscribers and there can be no assurances
that the Company's investments in its telecommunications infrastructure,
customer support capabilities, new service offerings and software releases will
ensure subscriber retention.
Acceleration in the growth of the Company's subscriber base or changes in
usage patterns among subscribers may also increase costs as a percentage of
revenues. Acceleration in the growth of the subscriber base could further
increase the Company's need to hire additional personnel and increase the
Company's expenses related to product development, marketing, network
infrastructure and customer support. An increase in peak time usage or an
overall increase in usage by subscribers could adversely affect the Company's
ability to consistently meet the demand for its access services. As a result,
the Company may need to hire additional personnel and increase expenses related
to network infrastructure capacity with minimal corresponding increases in
revenue on a per subscriber basis.
Results of Operations for the Three Months and Six Months Ended June 30, 1996
Revenues
Revenues increased by $17,495,100, or 166.2%, from $10,528,100 for the
three months ended June 30, 1995 to $28,023,200 for the three months ended June
30, 1996. Revenues increased by $34,098,500, or 189.2%, from $18,026,000 for the
six months ended June 30, 1995 to $52,124,500 for the six months ended June 30,
1996. The revenue increase in both periods was due to a significant increase in
the number of individual subscribers and dedicated connections, which the
Company attributes to the growth in the Internet market generally, the increase
in the number of the Company's local access areas and the Company's release of
enhancements to its NetCruiser and NETCOMplete software, as well as continued
expansion of the Companys sales distribution and promotional activities. The
increase in domestic revenue was adversely affected by the impact of the
Company's recent NetCruiser pricing change on the average revenue per NetCruiser
account. The Company is in the early stages of expansion into international
operations in Canada and the United Kingdom. International revenues for the
three and six months ended June 30, 1996 were not significant. Total subscribers
increased from approximately 169,000 accounts as of June 30, 1995 to
approximately 479,000 accounts as of June 30, 1996.
10
<PAGE>
Cost of Revenues
The Companys cost of revenues was $7,458,100 for the three months ended
June 30, 1995 and $20,531,200 for the three months ended June 30, 1996,
increasing from 70.8% to 73.3% of revenues, respectively. The Company's cost of
revenues was $12,454,700 for the six months ended June 30, 1995 and $37,160,800
for the six months ended June 30, 1996, increasing from 69.1% to 71.3% of
revenues, respectively. The increase in the cost of revenues was primarily
attributable to the Company's international expansion, increased network, data
communication and depreciation costs associated with the increased number of
subscribers and network improvements and with expansion of the Company's
operations and customer support staff. The Company expects that cost of revenues
will continue to increase in absolute dollars as the Company continues to expand
its international operations, increase its subscriber base and expand its
infrastructure. Domestic gross margin for the three and six months ended June
30, 1996 was 32.3% and 33.2%, respectively, as compared to 29.2% and 30.9%,
respectively, for the comparable periods in 1995. International cost of revenues
was $1,712,500 and $2,500,900 for the three and six months ended June 30, 1996,
respectively.
Product Development
Product development expenses were $539,200 for the three months ended June
30, 1995 and $1,391,000 for the three months ended June 30, 1996, representing
5.1% and 5.0% of revenues. Product development expenses were $838,900 for the
six months ended June 30, 1995 and $2,643,900 for the six months ended June 30,
1996, representing 4.7% and 5.1% of revenues. In accordance with Statement of
Financial Accounting Standards No. 86 ("SFAS 86"), software development costs
are expensed as incurred until technological feasibility is established, after
which any additional costs are capitalized until the software is commercially
available. The Company did not capitalize any software development costs in the
first half of 1995 or 1996. Amounts capitalized are amortized over the estimated
useful life of approximately three years. The Company plans to continue its
expenditures on product development as the Company develops new software
products and upgrades to existing products. Accordingly, research and
development expenses are expected to increase in absolute dollars but remain
relatively level as a percentage of revenue in the near term.
Sales and Marketing
Sales and marketing expenses increased $8,724,100, or 228.1%, from
$3,824,900 for the three months ended June 30, 1995 to $12,549,000 for the three
months ended June 30, 1996, increasing from 36.3% to 44.8% of revenues,
respectively. Sales and marketing expenses increased $16,504,200, or 285.6%,
from $5,778,800 for the six months ended June 30, 1995 to $22,283,000 for the
six months ended June 30, 1996, increasing from 32.1% to 42.7% of revenues,
respectively. The increase in sales and marketing expenses was due primarily to
increased costs associated with the Company's international expansion, growth of
the Company's sales and marketing department, the addition of management
personnel and marketing expenditures. Sales and marketing expenses are expected
to continue to increase in absolute dollars, although they may vary as a
percentage of revenues.
11
<PAGE>
Certain of the subscriber acquisition costs are capitalized and amortized
over a twelve-month period using the straight-line method. The Company
capitalized subscriber acquisition costs of approximately $1,266,600 and
$4,889,600 for the three months ended June 30, 1995 and June 30, 1996,
respectively. Amortization of deferred subscriber acquisition costs for the
three months ended June 30, 1995 and June 30, 1996 were $467,100 and $2,423,600,
respectively. The Company capitalized subscriber acquisition costs of
approximately $1,575,000 and $7,909,200 for the six months ended June 30, 1995
and June 30, 1996, respectively. Amortization of deferred subscriber acquisition
costs for the six months ended June 30, 1995 and June 30, 1996 were $749,200 and
$4,393,200, respectively.
General and Administrative
General and administrative expenses increased $4,354,300, or 223.9%, from
$1,944,500 for the three months ended June 30, 1995 to $6,298,900 for the three
months ended June 30, 1996, increasing from 18.5% to 22.5% of revenues,
respectively. General and administrative expenses increased $7,048,400, or
190.3%, from $3,704,700 for the six months ended June 30, 1995 to $10,753,100
for the six months ended June 30, 1996 at 20.6% of revenues in both periods. The
dollar increase was primarily attributable to hiring additional administrative
personnel, bad debt expense, additional corporate facility expenses and start up
of international operations. Although no assurances can be given, the Company
expects general and administrative expenses to decrease as a percentage of
revenues over time as the Company seeks to increase its revenue base without
commensurate increases in general and administrative costs.
Goodwill and Intangible Assets
On August 7, 1995, the Company completed the acquisition of Professional
Internet Consulting, Inc. ("PICnet"). The resulting consideration in excess of
assets acquired totaling $1,373,000 represents the valuation of the customer
base, other intangibles and goodwill acquired. These amounts were allocated to
intangible assets and are being amortized as an operating expense over a period
of up to eighteen months. Amortization of goodwill and intangible assets was
$195,600 and $529,900 for the three and six months ended June 30, 1996,
respectively.
Loss on Investment in McKinley
Based on the Company's estimated proceeds from McKinley's merger with
Excite and the risk associated with consummation of the merger, the Company
recorded a loss on investment in McKinley of $1,200,000 and reduced the
carrying value of its investment in McKinley to $800,000. See Note 7 to
Condensed Consolidated Financial Statements.
Interest Income
Net interest income was $360,800 and $582,100 for the three and six months
ended June 30, 1995, respectively, as compared to net interest income of
$1,552,100 and $3,284,900 for the three and six months ended June 30, 1996,
respectively. This change is primarily the result of the investment of the
proceeds from the Company's public offerings in May 1995 and November 1995. The
Company invests its cash and cash equivalents primarily in United States
treasury bills and high grade commercial paper.
12
<PAGE>
Net Loss
The higher cost of revenues and higher operating expenditures incurred for
the three and six months ended June 30, 1996 as described above, resulted in net
losses of $12,594,300 and $19,168,700, respectively, as compared to net losses
of $2,877,800 and $4,169,000, respectively, for the three and six months ended
June 30, 1995, notwithstanding the period to period revenue growth. This
primarily reflected the Company's strategy to invest in the growth of its
subscriber base and network both domestically and internationally. The
international losses for the three and six months ended June 30, 1996 were
$4,553,600 and $7,212,600, respectively.
Income Taxes
There were $3,700 and $7,400 provisions for minimum state income taxes for
the three and six months ended June 30, 1996, respectively. Other than minimum
state income taxes, no provision for income taxes is expected for 1996 as the
Company expects to incur a net loss for the year and does not expect earnings
for the foreseeable future.
Liquidity and Capital Resources
The Company has funded its operations primarily through cash generated from
operations, private and public sales of equity securities and bank indebtedness.
The Company's operating activities used cash of approximately $5,485,700 and
generated cash of approximately $38,700 for the three months ended June 30, 1995
and June 30, 1996, respectively. The Company's operating activities used cash of
approximately $1,952,800 and $4,985,100 for the six months ended June 30, 1995
and June 30, 1996, respectively. During the six months ended June 30, 1995, cash
from operations was reduced primarily by the Company's operating loss and by
increases in deferred subscriber costs, prepaid expenses and accounts
receivables partially offset by increases in deferred revenue and accrued
liabilities. During the six months ended June 30, 1996, cash from operations was
reduced primarily by the Company's operating loss and by increases in deferred
subscriber costs, prepaid expenses and accounts receivable partially offset by
increases in trade accounts payable, accrued liabilities and deferred revenue.
The Company's investing activities have consisted primarily of equipment
purchases for new local access areas, new facilities and network expansion. In
the second quarter of 1996, the Company also added a second customer support
center located in Dallas and a new headquarters site located in San Jose.
Capital expenditures were $9,325,700 and $20,510,000 for the three months ended
June 30, 1995 and June 30, 1996, respectively. Capital expenditures were
$19,612,300 and $31,239,700 for the six months ended June 30, 1995 and June 30,
1996, respectively. The Company invested $1,500,000 and $500,000 in the McKinley
Group, Inc. during the second quarters of 1995 and 1996, respectively.
13
<PAGE>
The Company's financing activities provided $49,699,600 and $1,482,200 for
the six months ended June 30, 1995 and June 30, 1996, respectively. For the six
months ended June 30, 1995, financing activities consisted primarily of proceeds
from the Company's May 1995 public offering. For the six months ended June 30,
1996, financing activities consisted primarily of proceeds from the exercise of
stock options and purchases under the employee stock purchase plan. Although the
Company has no material capital commitments (other than for its network
expansion and operating infrastructure program), a substantial portion of the
proceeds of its May 1995 and November 1995 public offerings have been used, and
are expected to continue to be used, for additional equipment purchases and for
subscriber acquisition.
As of June 30, 1996, the Company had cash and cash equivalents of
$110,843,700 and working capital of $87,388,400. The Company provided
$26,634,500 for the six months ended June 30, 1995 and used $35,242,600 of cash
in the six months ended June 30, 1996. In addition, through May 1996, the
Company had $15,000,000 available under a bank credit facility. This line of
credit expired in May 1996. The Company may chose to renew this line of credit
or secure additional funding in the future. The Company believes that existing
cash and cash equivalents, together with existing sources of liquidity, will be
sufficient to fund its operations, capital expenditures, working capital and
other cash requirements for the next year assuming no material competitive or
operating changes. There were no outstanding borrowings under this credit
facility.
Investment Considerations
The following factors, in addition to the factors discussed in the
Company's Report on Form 10-KSB for the fiscal year ended December 31, 1995 and
other information contained elsewhere herein, should be considered carefully in
evaluating the Company and its business.
Limited Operating History; Operating Losses; Fluctuations in Operating
Results. The Company was incorporated in August 1992, and accordingly has had a
limited operating history. Although the Company has experienced revenue growth
in each of its fiscal quarters since incorporation, it experienced net losses of
$100,000 for 1994, $14,063,600 for 1995 and $19,168,700 in the first six months
of 1996, and had an accumulated deficit of $36,945,700 as of June 30, 1996.
These losses are also reflected in the Company's declining operating
margins, which decreased from a loss of .9% for 1994 to a loss of 31% for 1995
and a loss of 41% for the first six months of 1996. The Company's current focus
is on increasing its subscriber base, and the Company continues to hire
additional personnel and to increase its expenses related to product
development, marketing, network, infrastructure and customer support. In
addition, the Company is seeking to expand its operations to international
markets. The costs associated with the penetration of new markets, particularly
in new international markets in which Internet services are less well
established, are likely to further impact cash flow and operating performance.
As a result, the Company expects that it will continue to incur substantial
losses for the foreseeable future. There can be no assurance that revenue growth
will continue or that the Company will in the future achieve or sustain
profitability or positive cash flow from operations.
14
<PAGE>
In view of the competitive nature of its market, the Company has adopted
strategies designed to continue growth in its subscriber base. Such strategies,
and any promotional measures the Company could adopt in the future in pursuit of
these strategies, may result in an increase in costs as a percentage of
revenues. In addition, an acceleration in the growth of the subscriber base or
changes in usage patterns among subscribers may also increase costs as a
percentage of revenues. The acceleration of the introduction of new technologies
may also increase the costs and complexities of providing acceptable customer
services. There can be no assurance that the Company's operating margins will
not be materially adversely affected in the future by adoption of these
strategies.
The Company's operating results have fluctuated in the past and may
fluctuate significantly in the future as a result of a variety of factors, some
of which are outside of the Company's control, including capital expenditures
and other costs relating to the expansion of operations, the timing of new
product announcements by the Company or its competitors, changes in pricing
strategies by the Company and its competitors, market acceptance of new and
enhanced versions of the Company's software products and services and the rates
of new subscriber acquisition and retention. Operating results could also be
adversely affected by increased competition in the Company's markets, including
price competition.
Competition. The market for Internet access services is extremely
competitive. There are no substantial barriers to entry and the Company expects
that competition will intensify in the future. The Company believes that its
ability to compete successfully depends upon a number of factors, including
market presence; the capacity, reliability and security of its network
infrastructure; ease of access to and navigation of the Internet; the pricing
policies of its competitors and suppliers; the timing of introductions of new
products and services by the Company and its competitors; the Company's ability
to support existing and emerging industry standards; and industry and general
economic trends.
The Company's current and prospective competitors include many large
companies that have substantially greater market presence and financial,
technical, marketing and other resources than the Company. The Company competes
or expects to compete directly or indirectly with the following categories of
companies: (1) other national and regional commercial Internet services
providers, such as Performance Systems International, Inc. and Bolt, Bernanek &
Newman, Inc., (2) established on-line services companies which currently offer
or are expected to offer Internet connectivity, such as America Online,
CompuServe Incorporated and Prodigy Services Company, (3) computer hardware and
software and other technology companies, such as International Business Machines
Corporation (IBM) and Microsoft Corporation, (4) national long distance carriers
such as American Telephone and Telegraph Company, MCI Communications
Corporation and Sprint Corporation, (5) regional telephone companies, such as
Pacific Bell and Bell Atlantic, (6) cable operators, such as
Tele-Communications, Inc., and (7) nonprofit or educational Internet service
providers. Most of the established on-line services companies and
telecommunications companies currently offer or will soon offer Internet access.
15
<PAGE>
Increased competition could result in significant price competition, which
in turn could result in significant reductions in the average selling price of
the Company's services. In addition, increased competition for new subscribers
could result in increased sales and marketing expenses and related subscriber
acquisition costs, which could materially adversely affect the Company's
profitability. There can be no assurance that the Company will be able to offset
the effects of any such competition or resulting price reductions through an
increase in the number of its subscribers, higher revenue from enhanced
services, cost reductions or otherwise. Increased competition, through pricing
or otherwise, could result in erosion of the Company's market share and
adversely affect the Company's operating results. There can be no assurance that
the Company will have the financial resources, technical resources, technical
expertise or marketing and support capabilities to continue to compete
successfully.
New and Uncertain Market. The market for Internet connectivity services and
related software products is in an early stage of growth. Since this market is
relatively new and because current and future competitors are likely to
introduce competing Internet connectivity and/or on-line services and products,
it is difficult to predict the rate at which the market will grow or at which
new or increased competition will result in market saturation. The novelty of
the market for Internet access services may also adversely affect the Company's
ability to retain new customers as they may be unfamiliar with the Internet and
more likely to discontinue the Company's services after an initial trial period.
If demand for Internet services fails to grow, grows more slowly than
anticipated, or becomes saturated with competitors, the Company's business,
operating results and financial condition will be materially adversely affected.
Although the Company intends to support emerging standards in the market for
Internet connectivity, there can be no assurance that industry standards will
emerge or, if they become established, that the Company will be able to conform
to these new standards in a timely fashion and maintain a competitive position
in the market.
In order to continue to realize subscriber growth, the Company must
continue to replace terminating subscribers and attract additional subscribers.
However, the sales and marketing expenses and subscriber acquisition costs
associated with attracting new subscribers are substantial. Accordingly, the
Company's ability to improve operating margins will depend in part on the
Company's ability to retain its subscribers. The Company continues to invest
significant resources in its telecommunications infrastructure and customer
support resources. There can be no assurances that the Company's investments in
its telecommunications infrastructure, customer support capabilities and future
software releases will improve subscriber retention. Although the Company's
retention rates have been stable, the Internet market is new and the utility of
available services is not well understood by new and potential subscribers. As a
result, the Company is unable to predict future subscriber retention rates.
Subsequent Event
On August 3, 1996, the Company announced that it had reached an
out-of-court settlement in its legal dispute with the Religious Technology
Center. Both the Company and the Religious Technology Center have agreed not to
comment further on any aspect of the settlement.
16
<PAGE>
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
At the Annual Meeting of Stockholders on May 29, 1996, the holders of
9,400,277 shares of common stock, representing 81.8% of the total votes eligible
to be cast, adopted the following proposals by the following margins indicated:
(1) The election of the following seven candidates for Director, to serve until
the next Annual Meeting of Stockholders:
Voted For Voted against
--------- -------------
David W. Garrison 9,335,771 64,506
Stephen J. Getsy 9,226,493 173,784
Leo J. Hindery, Jr. 9,335,163 65,114
Lawrence W. Lepard 9,335,593 64,684
Gary P. Madden 9,338,795 61,482
Ofer Nemirovsky 9,333,703 66,574
Charles C. Townsend, III 9,335,163 65,114
(2) The amendment and restatement of the Company's 1993 Stock Option Plan.
Voted For Voted Against Abstained Broker Non-Vote
--------- ------------- --------- ---------------
5,634,416 3,250,988 91,335 423,538
(3) The ratification of Ernst & Young LLP as the Company's independent
auditors for the 1996 fiscal year.
Voted For Voted Against Abstained
--------- ------------- ---------
9,377,458 14,718 8,101
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
*10.1 NETCOM On-Line Communications Services, Inc. Amended and Restated 1993
Stock Option Plan, filed as Exhibit A to the Company's Definitive Proxy
Statement dated April 29, 1996, as filed with the Commission on May 14,
1996, is incorporated by reference.
* Denotes management compensation plan or arrangement.
b. Reports on Form 8-K.
None.
Items 1, 2, 3 and 5 are not applicable and have been omitted.
17
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
NETCOM ON-LINE COMMUNICATION
SERVICES, INC.
Date: August 12, 1996 By /s/ David W. Garrison
------------------------------------
David W. Garrison
Chairman of the Board, President and
Chief Executive Officer
By /s/ Clifton T. Weatherford
------------------------------------
Clifton T. Weatherford
Senior Vice President,
Chief Financial Officer and Secretary
18
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