<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: September 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, PLAZA A
SAN JOSE, CALIFORNIA 95113
(Address of principal executive offices)
Issuer's telephone number: (408) 881-3233
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 number 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 NOVEMBER 11, 1996
- ------------------- ---------------------------------
Common stock, par value $.01 per share 11,630,851
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.
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NETCOM ON-LINE COMMUNICATION SERVICES, INC.
INDEX
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 1996 and December 31, 1995 3
Condensed Consolidated Statements of Operations and Other
Operating Data for the Three Months Ended September 30, 1996
and September 30, 1995 4
Condensed Consolidated Statements of Operations and Other
Operating Data for the Nine Months Ended September 30, 1996
and September 30, 1995 5
Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended September 30, 1996
and September 30, 1995 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 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 "Risk
Factors" 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
(In Thousands)
<CAPTION>
September 30, December 31,
1996 1995
---------------------- -----------------------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents .................................. $ 86,090 $ 146,001
Accounts receivable, net ................................... 2,809 1,453
Prepaid expenses and other current assets .................. 2,662 1,677
---------------------- ----------------------
Total current assets ................................ 91,561 149,131
Property and equipment at cost, net ........................ 80,696 46,724
Deferred subscriber acquisition costs, net ................. 7,480 3,452
Deposits and other assets .................................. 1,738 3,373
---------------------- ----------------------
Total assets ................................... $ 181,475 $ 202,680
====================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable ..................................... $ 8,989 $ 11,389
Accrued payroll and related expenses ....................... 5,351 2,154
Other accrued expenses and liabilities ..................... 8,900 2,421
Deferred revenue ........................................... 3,051 1,250
---------------------- -----------------------
Total current liabilities ........................... 26,291 17,214
---------------------- -----------------------
Commitments and contingencies
Stockholders' equity:
Common stock ............................................... 116 111
Additional paid-in capital ................................. 205,493 203,160
Accumulated deficit ........................................ (50,552) (17,777)
Cumulative translation adjustment .......................... 127 (28)
---------------------- -----------------------
Total stockholders' equity .......................... 155,184 185,466
---------------------- -----------------------
Total liabilities and stockholders' equity ..... $ 181,475 $ 202,680
====================== =======================
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
(In Thousands Except Per Share Amounts and Other Operating Data)
<CAPTION>
Three Months Ended
------------------------------------------
September 30, September 30,
1996 1995
--------------------- ------------------
(unaudited)
<S> <C> <C>
Revenues ........................................................... $ 32,036 $ 14,724
Costs and expenses:
Cost of revenues ................................................. 24,319 10,425
Product development .............................................. 1,816 786
Sales and marketing .............................................. 14,702 5,340
General and administrative ....................................... 5,996 3,174
Amortization of goodwill and intangible assets ................... 126 -
------------------- ------------------
Total costs and expenses ....................................... 46,959 19,725
------------------- ------------------
Loss from operations ............................................... (14,923) (5,001)
Interest income .................................................... 1,321 563
------------------- ------------------
Loss before provision for income taxes ............................. (13,602) (4,438)
Provision for income taxes ......................................... 4 11
------------------- ------------------
Net loss ........................................................... $ (13,606) $ (4,449)
=================== ==================
Net loss per share ................................................. $ (1.17) $ (0.49)
Shares used in computing net loss per share ........................ 11,604 9,031
Other operating data:
EBITDA (See Note 7) .............................................. $ (6,458,000) $ (2,156,000)
Approximate number of subscribers at
end of period ................................................. 562,000 233,000
Number of local access areas at end of period .................... 331 204
See accompanying notes
</TABLE>
4
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<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Statements of Operations and Other Operating Data
(In Thousands Except Per Share Amounts and Other Operating Data)
<CAPTION>
Nine Months Ended
----------------------------------------
September 30, September 30,
1996 1995
------------------ ------------------
(unaudited)
<S> <C> <C>
Revenues .................................................. $ 84,161 $ 32,750
Costs and expenses:
Cost of revenues......................................... 61,480 22,880
Product development...................................... 4,460 1,625
Sales and marketing...................................... 36,986 11,119
General and administrative............................... 16,749 6,878
Amortization of goodwill and intangible assets........... 655 -
------------------ ------------------
Total costs and expenses............................... 120,330 42,502
------------------ ------------------
Loss from operations....................................... (36,169) (9,752)
Loss on investment in McKinley ............................ (1,200) -
Interest income............................................ 4,605 1,145
------------------ ------------------
Loss before provision for income taxes..................... (32,764) (8,607)
Provision for income taxes................................. 11 11
------------------ ------------------
Net loss................................................... $ (32,775) $ (8,618)
================== ==================
Net loss per share......................................... $ ($2 86) $ (1 10)
Shares used in computing net loss per share ............... 11,454 7,841
Other operating data:
EBITDA (See Note 7)...................................... $ (17,097,000) $ (3,896,000)
Approximate number of subscribers at
end of period ........................................ 562,000 233,000
Number of local access areas at end of period ........... 331 204
See accompanying notes
</TABLE>
5
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<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
Condensed Consolidated Statements of Cash Flows
(In Thousands)
<CAPTION>
Nine Months Ended
----------------------------------
September 30, September 30,
1996 1995
---------------- -----------------
(unaudited)
<S> <C> <C>
Operating activities
Net loss ............................................................. $ (32,775) $ (8,618)
Adjustments to reconcile net income to net cash ......................
provided by operating activities:
Depreciation and amortization .................................... 20,272 5,856
Loss on disposal of assets ....................................... 124 697
Loss on investment in McKinley ................................... 1,200 -
Changes in assets and liabilities:
Accounts receivable ............................................ (1,356) (309)
Prepaid expenses and other current assets ...................... (985) (928)
Deferred subscriber acquisition costs .......................... (11,989) (2,412)
Deposits and other assets ...................................... (534) (272)
Trade accounts payable.......................................... (2,400) (1,825)
Accrued payroll and related expenses ........................... 3,197 1,123
Other accrued expenses and liabilities ......................... 6,479 2,172
Deferred revenue................................................ 1,801 1,077
--------------- ---------------
Total adjustments ................................................ 15,809 5,179
--------------- ---------------
Net cash used in operating activities .................................. (16,966) (3,439)
Investing activities
Purchase of property and equipment ................................... (45,438) (30,453)
Cash acquired from PICnet - 59
Investment in McKinley ............................................... - (1,200)
--------------- ---------------
Net cash used in investing activities .................................. (45,438) (31,594)
Financing activities
Proceeds from exercise of stock options and purchases under
employee stock purchase plan ....................................... 2,338 946
Proceeds from sale of common stock, net .............................. - 48,906
--------------- ---------------
Net cash provided by financing activities .............................. 2,338 49,852
--------------- ---------------
Net increase (decrease) in cash and cash equivalents ................... (60,066) 14,819
Effects of exchange rates on cash ...................................... 155 -
Cash and cash equivalents at beginning of period........................ 146,001 20,938
--------------- ---------------
Cash and cash equivalents at end of period ............................. $ 86,090 $ 35,757
=============== ===============
Schedule of noncash transactions
Issuance of common stock in exchange for outstanding
shares of PICnet .................................................... $ - 1,000
Issuance of common stock for investment in The McKinley
Group ............................................................... $ - 300
Supplemental disclosures of cash flow information
Interest paid .......................................................... $ - 7
Income taxes paid ...................................................... $ 11 8
See accompanying notes
</TABLE>
6
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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, which relate directly to potential
subscribers, are recorded separately from ordinary operating costs and do not
include indirect 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.
The Company capitalized subscriber acquisition costs of approximately
$4,081,000 and $838,000 for the three months ended September 30, 1996 and
September 30, 1995, respectively. Amortization of deferred subscriber
acquisition costs for the three months ended September 30, 1996 and September
30, 1995 was $3,568,000 and $717,000, respectively. The Company capitalized
subscriber acquisition costs of approximately $11,989,000 and $2,412,000 for the
nine months ended September 30, 1996 and September 30, 1995, respectively.
Amortization of deferred subscriber acquisition costs for the nine months ended
September 30, 1996 and September 30, 1995 was $7,961,000 and $1,466,000,
respectively.
3. PROPERTY AND EQUIPMENT
<TABLE>
Property and equipment consist of the following (in thousands):
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
------------- ------------
1996 1995
---- ----
(unaudited)
<S> <C> <C>
Property and equipment at cost $ 99,432 $ 54,117
Less accumulated depreciation and
amortization (18,736) (7,393)
-------- --------
Net property and equipment $ 80,696 $ 46,724
======== ========
</TABLE>
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).
7
5. STOCKHOLDERS' EQUITY
<TABLE>
The components of the stockholders' equity are as follows (in thousands):
<CAPTION>
Total
Common Additional Cumulative Total
Stock Paid-In Accumulated Translation Stockholders'
Shares Amount Capital Deficit Adjustment Equity
------------- ------------- ---------------- --------------- ------------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 11,096 $ 111 $ 203,160 $ (17,777) $ (28) $ 185,466
Issuance under employee stock
purchase plan 49 - 954 - - 954
Exercise of stock options 481 5 1,379 - - 1,384
Cumulative translation
adjustment - - - - 155 155
Net loss - - - (32,775) - (32,775)
------------- ------------- ---------------- --------------- ------------- ----------------
Balance at September 30, 1996 11,626 $ 116 $ 205,493 $ (50,552) $ 127 $ 155,184
============= ============= ================ =============== ============= ================
</TABLE>
6. INVESTMENT IN MCKINLEY
In June 1995, the Company acquired series A Common Stock in the McKinley
Group, Inc. ("McKinley") for $1,500,000, in exchange for $1,200,000 cash and
$300,000 common stock. Additionally, in May 1996, the Company loaned McKinley
$500,000 in exchange for a demand promissory note.
On June 26, 1996, McKinley signed a letter of intent to be acquired by
Excite, Inc. ("Excite") On August 6, 1996, McKinley and Excite signed a
definitive merger agreement pursuant to which Excite would acquire all of the
outstanding shares of McKinley in exchange for 850,000 shares of Excite. Based
on the Company's estimated proceeds from McKinley's merger with Excite and the
risk associated with consummation of the merger, in the quarter ended June 30,
1996, the Company recorded a loss on investment in McKinley of $1,200,000.
On August 30, 1996, McKinley merged with Excite and repaid the Company's
$500,000 demand promissory note and related interest. In September 1996, the
Company received 82,785 shares of Excite in exchange for the Company's remaining
investment in McKinley. The company is restricted from trading the Excite shares
until the first Excite earnings release including the consolidated results of
McKinley.
7. OTHER OPERATING DATA
Earnings before interest, taxes, depreciation and amortization ("EBITDA")
has been included in other operating data. The Company believes EBITDA is a cash
flow measure used by analysts, investors and other interested parties in the
on-line and Internet services industries. Accordingly, this information has been
disclosed herein to permit a more complete analysis of the Company's operating
performance.
8
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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 services to
business and individual subscribers. Revenues from monthly subscriptions have
increased substantially since the Company's inception as a result of increases
in the Company's subscriber base and diversification of product offerings. This
subscriber growth, in turn, has resulted from the growth of the Internet
services market generally, the expansion of the Company's distribution channels
and the increase in the Company's local access numbers.
The Company believes its NETCOMplete software has contributed to its strong
subscriber growth. The versatility of the NETCOMplete software offers customers
an Internet access, support, software and service solution for Windows 3.1,
Windows 95 and Macintosh users. NETCOMplete features point-and-click graphical
user interfaces providing subscribers with easy-to-use access to the Internet's
applications and resources.
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 and a decrease in margins as a
percentage of revenue. 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 services 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 demands for its 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.
9
<PAGE>
Currently, sales to small businesses and individuals represents a majority
of the Company's revenues. Small business and individual revenues are comprised
primarily of recurring dial-up revenues. The Company's dial-up accounts are
billed monthly pursuant to a pre-authorized credit card account. The Company
currently provides unlimited usage of the Company's service for most accounts.
Most dial-up accounts 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.
The Company also receives revenues from non-dial-up services, primarily
related to business customers. These revenues include dedicated connections,
virtual web server hosting and domain name services. Revenues from dedicated
connections includes recurring revenue, usage charges, web site storage charges,
and equipment sales. The Company charges set-up fees on most of these services.
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 continues to expect that
it will incur substantial net losses for the foreseeable future. The Company has
expanded its operations internationally to Canada and the United Kingdom. In
addition, on September 20, 1996, the Company announced plans to form a
joint-venture in Brazil with Grupo Itamarati, a billion dollar Brazilian
conglomerate. The Company will continue it's expansion internationally which
could require substantial 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.
RESULTS OF OPERATIONS FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER
30, 1996
REVENUES
Revenues increased by $17,312,000, or 117.6%, from $14,724,000 for the
three months ended September 30, 1995 to $32,036,000 for the three months ended
September 30, 1996. Revenues increased by $51,411,000, or 157.0%, from
$32,750,000 for the nine months ended September 30, 1995 to $84,161,000 for the
nine months ended September 30, 1996. The revenue increase in both periods was
due to a significant increase in the number of dial-up 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, the
Company's release of enhancements to its software, and continued expansion of
the Company's sales, distribution and promotional activities. Total subscribers
increased from approximately 233,000 accounts as of September 30, 1995 to
approximately 562,000 accounts as of September 30, 1996.
COST OF REVENUES
The Company's cost of revenues was $24,319,000 for the three months ended
September 30, 1996 and $10,425,000 for the three months ended September 30,
1995, increasing from 70.8% to 75.9% of revenues, respectively. The Company's
cost of revenues was $61,480,000 for the nine months ended September 30, 1996
and $22,880,000 for the nine months ended September 30, 1995, increasing from
69.9% to 73.1 of revenues, respectively. The increase in the cost of revenues
was primarily attributable to the Company's international expansion, sales tax
charges, increased network,
10
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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 nine
months ended September 30, 1996 was 30.5% and 32.2%, respectively, as compared
to 29.2% and 30.1%, respectively, for the comparable periods in 1995.
PRODUCT DEVELOPMENT
Product development expenses were $1,816,000 for the three months ended
September 30, 1996 and $786,000 for the three months ended September 30, 1995,
representing 5.7% and 5.3% of revenues. Product development expenses were
$4,460,000 for the nine months ended September 30, 1996 and $1,625,000 for the
nine months ended September 30, 1995, representing 5.3% and 5.0% of revenues.
The Company plans to continue its expenditures on product development as the
Company develops new software products and upgrades to existing products. It is
expected that product development expenses as a percentage of revenue will
remain relatively stable.
SALES AND MARKETING
Sales and marketing expenses increased $9,362,000, or 175.3%, from
$5,340,000 for the three months ended September 30, 1995 to $14,702,000 for the
three months ended September 30, 1996, increasing from 36.3% to 45.9% of
revenues, respectively. Sales and marketing expenses increased $25,867,000, or
232.6%, from $11,119,000 for the nine months ended September 30, 1995 to
$36,986,000 for the nine months ended September 30, 1996, increasing from 34.0%
to 43.9% 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 costs associated with subscriber acquisition, the addition
of management personnel and marketing programs. Sales and marketing expenses are
expected to continue to increase in absolute dollars, although they may vary as
a percentage of revenues.
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 $4,081,000 and
$838,000 for the three months ended September 30, 1996 and September 30, 1995,
respectively. Amortization of deferred subscriber acquisition costs for the
three months ended September 30, 1996 and September 30, 1995 was $3,568,000 and
$717,000, respectively. The Company capitalized subscriber acquisition costs of
approximately $11,989,000 and $2,412,000 for the nine months ended September 30,
1996 and September 30, 1995, respectively. Amortization of deferred subscriber
acquisition costs for the nine months ended September 30, 1996 and September 30,
1995 was $7,961,000 and $1,466,000, respectively.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased $2,822,000, or 88.9%, from
$3,174,000 for the three months ended September 30, 1995 to $5,996,000 for the
three months ended September 30, 1996, decreasing from 21.6% to 18.7% of
revenues, respectively. General and administrative expenses increased
$9,871,000, or 143.5%, from
11
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$6,878,000 for the nine months ended September 30, 1995 to $16,749,000 for
the nine months ended September 30, 1996 decreasing from 21.0% of revenues to
19.9%, respectively. The dollar increase was primarily attributable to
additional administrative personnel, bad debt expense, additional corporate
facility expenses and international operations. General and administrative
expenses are expected to continue to increase in absolute dollars, although they
may vary as a percentage of revenue.
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
$126,000 and $655,000 for the three and nine months ended September 30, 1996,
respectively.
LOSS ON INVESTMENT IN MCKINLEY
The nine month period ended September 30, 1996 includes a loss on
investment in McKinley of $1,200,000 to write-down the Company's investment in
McKinley to its estimated net realizable value. See Note 6 to the Condensed
Consolidated Financial Statements.
INTEREST INCOME
Net interest income was $1,321,000 and $4,605,000 for the three and nine
months ended September 30, 1996, respectively, as compared to net interest
income of $563,000 and $1,145,000 for the three and nine months ended September
30, 1995, 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 high grade
commercial paper and United States treasury bills.
NET LOSS
International expansion, higher cost of revenues and operating expenditures
incurred for the three and nine months ended September 30, 1996, resulted in net
losses of $13,606,000 and $32,775,000, respectively, as compared to net losses
of $4,449,000 and $8,618,000, respectively, for the three and nine months ended
September 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 nine months ended September 30, 1996 were
$5,499,000 and $12,711,000, respectively.
The Company believes EBITDA is a cash flow measure used by analysts,
investors and other interested parties in the on-line and Internet services
industries. EBITDA was a loss of $6,458,000 and $17,097,000, respectively, for
the three and nine months ended September 30, 1996. For the three and nine
months ended September 30, 1995, EBITDA was a loss of $2,156,000 and $3,896,000,
respectively.
12
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LIQUIDITY AND CAPITAL RESOURCES
The Company has funded its operations to date primarily through cash
generated from collection of revenues and private and public sales of equity
securities. The Company's operating activities used cash of approximately
$11,981,000 and $1,486,000 for the three months ended September 30, 1996 and
September 30, 1995, respectively. The Company's operating activities used cash
of approximately $16,966,000 and $3,439,000 for the nine months ended September
30, 1996 and September 30, 1995, respectively. During the nine months ended
September 30, 1996, cash from operations was reduced primarily by the Company's
operating loss, increases in deferred subscriber costs and accounts receivable
and by decreases in trade accounts payable partially offset by increases in
accrued liabilities and deferred revenue. During the nine months ended September
30, 1995, cash from operations was reduced primarily by the Company's operating
loss, increased deferred subscriber costs and decreased trade account payables
partially offset by increases in accrued liabilities, accrued payroll 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 $14,199,000 and $10,841,000 for the three months ended
September 30, 1996 and September 30, 1995, respectively. Capital expenditures
were $45,438,000 and $30,453,000 for the nine months ended September 30, 1996
and September 30, 1995, respectively.
The Company's financing activities provided $2,338,000 and $49,852,000 for
the nine months ended September 30, 1996 and September 30, 1995, respectively.
For the nine months ended September 30, 1996, financing activities consisted
primarily of proceeds from the exercise of stock options and purchases under the
employee stock purchase plan. For the nine months ended September 30, 1995,
financing activities consisted primarily of proceeds from the Company's May 1995
public offering. 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 September 30, 1996, the Company had cash and cash equivalents of
$86,090,000 and working capital of $65,270,000. The Company used $60,066,000 for
the nine months ended September 30, 1996 and provided $14,819,000 of cash in the
nine months ended September 30, 1995. 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 secure additional funding in the future
through facilities such as bank financing and leasing programs. 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, in the absence of
material competitive or operating changes.
13
<PAGE>
RISK FACTORS
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.
Operating Losses; Fluctuations in Operating Results. Although the Company
has experienced revenue growth in each of its fiscal quarters since
incorporation, it experienced net losses of $100,000 for 1994, $14,064,000 for
1995 and $32,775,000 in the first nine months of 1996, and had an accumulated
deficit of $50,552,000 as of September 30, 1996. The loss incurred during the
nine months ending September 30, 1996 included a loss of $12,711,000 related to
international operations.
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 43% for the first nine months of 1996. The Company's current focus
is on targeting the business customer which should result in increased revenues
per subscriber but at reduced subscriber growth rates. The Company will continue
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 with partners in select markets.
The costs associated with the penetration of new international markets where
Internet services are not well established, could 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.
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 may adopt in the future in pursuit of
these strategies, may result in an increase in costs as a percentage of
revenues. 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 these factors or 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.
14
<PAGE>
Competition. The market for Internet services is extremely competitive.
There are no substantial barriers to entry and the Company expects that
competition will continue to 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, Beranek &
Newman, Inc., (2) established on-line services companies which offer Internet
connectivity, such as America Online ("AOL"), CompuServe Incorporated and
Prodigy Services Company, (3) national long distance carriers such as American
Telephone and Telegraph Company ("AT&T"), MCI Communications Corporation ,
Sprint Corporation and Worldcomm/MFS, (4) regional telephone companies, such as
Pacific Bell and Bell Atlantic, and (5) cable operators, such as
Tele-Communications, Inc.
Increased competition such as AOL's recently announced flat pricing model
for content and access could result in significant reductions in the average
selling price of the Company's services. In addition, the Company expects to see
increased pressure to obtain and retain additional subscribers that 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 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 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 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.
15
<PAGE>
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. As a result, the Company is unable
to predict future subscriber retention rates.
16
<PAGE>
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits
27.1 Financial Data Schedule
b. Reports on Form 8-K.
None.
ITEMS 1, 2, 3, 4 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: November 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
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