UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(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, 1997
------------------
[ ] 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 registrant 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)
Registrant's telephone number: (408) 881-3516
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 __
Number of shares outstanding of the registrant's common stock, par value $.01
per share, as of November 4, 1997 was 11,774,546.
1
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NETCOM ON-LINE COMMUNICATION SERVICES, INC.
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements . . . . . . . . . . . 3
Condensed Consolidated Balance Sheets as of
September 30, 1997 and December 31, 1996 . . . . . . . . . . 3
Condensed Consolidated Statements of Operations and Other
Operating Data for the Three Months Ended September 30, 1997
and September 30, 1996 . . . . . . . . . . . . . . . . . . . 4
Condensed Consolidated Statements of Operations and Other
Operating Data for the Nine Months Ended September 30, 1997
and September 30, 1996 . . . . . . . . . . . . . . . . . . . 5
Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended September 30, 1997
and September 30, 1996 . . . . . . . . . . . . . . . . . . . 6
Notes to Condensed Consolidated Financial Statements . . . . . . 7
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations . . . . . . 10
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . 18
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
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
customer acquisition and retention. For a discussion of such risks, see "Risk
Factors" on page 16. 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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PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<CAPTION>
September 30, December 31,
1997 1996
------------- ------------
(Unaudited)
<S> <C> <C>
ASSETS
Cash and cash equivalents ................ $ 66,733 $ 73,408
Short term investments ................... -- 849
Accounts receivable, net ................. 1,808 1,284
Prepaid expenses and other current assets 2,835 2,948
------------- ------------
Total current assets .................. 71,376 78,489
Property and equipment at cost, net ...... 77,908 84,373
Deferred subscriber acquisition costs, net 2,363 5,595
Deposits and other assets ................ 1,244 1,177
------------- ------------
Total assets ..................... $ 152,891 $ 169,634
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Trade accounts payable ................... $ 7,132 $ 7,517
Accrued payroll and related expenses ..... 4,547 3,727
Other accrued expenses and liabilities ... 9,868 10,669
Deferred revenue ......................... 5,260 2,930
Short term capital lease obligations ..... 2,342 --
------------- ------------
Total current liabilities ............. 29,149 24,843
------------- ------------
Long term capital lease obligations ...... 4,013 --
------------- ------------
Commitments and contingencies
Stockholders' equity:
Common Stock .......................... 117 116
Additional paid-in capital ............ 206,700 205,506
Accumulated deficit ................... (87,259) (62,042)
Cumulative translation adjustment and
other ............................ 171 1,211
------------- ------------
Total stockholders' equity.......... 119,729 144,791
------------- ------------
Total liabilities and stock-
holders' equity ................ $ 152,891 $ 169,634
============= ============
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)
<CAPTION>
Three Months Ended
-----------------------------
September 30, September 30,
1997 1996
------------- -------------
(unaudited)
<S> <C> <C>
Revenues ...................................... $ 40,106 $ 32,036
Costs and expenses:
Cost of revenues ............................ 29,668 24,319
Product development ......................... 1,637 1,816
Sales and marketing ......................... 11,790 14,702
General and administrative .................. 5,198 6,122
Restructuring and related charges ........... 167 --
----------- -----------
Total costs and expenses .................. 48,460 46,959
----------- -----------
Loss from operations .......................... (8,354) (14,923)
Gain on investment ............................ 641 --
Interest income and other ..................... 886 1,321
----------- -----------
Loss before provision for income taxes ........ (6,827) (13,602)
Provision for income taxes .................... -- 4
----------- -----------
Net Loss ...................................... $ (6,827) $ (13,606)
=========== ===========
Net loss per share ............................ $ (0.58) $ (1.17)
=========== ===========
Shares used in computing net loss per share ... 11,719 11,604
=========== ===========
OTHER OPERATING DATA:
EBITDA (See Note 8) ......................... $ 259 $ (6,458)
=========== ===========
Approximate number of subscribers at
end of period ............................... 542 562
=========== ===========
See accompanying notes
</TABLE>
4
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<TABLE>
NETCOM ON-LINE COMMUNICATION SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND OTHER OPERATING DATA
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<CAPTION>
Nine Months Ended
-----------------------------
September 30, September 30,
1997 1996
------------- -------------
(unaudited)
<S> <C> <C>
Revenues ..................................... $ 120,131 $ 84,161
Costs and expenses:
Cost of revenues ........................... 87,218 61,480
Product development ........................ 4,924 4,460
Sales and marketing ........................ 38,732 36,986
General and administrative ................. 16,544 17,404
Restructuring and related charges .......... 1,879 --
----------- -----------
Total costs and expenses ................. 149,297 120,330
----------- -----------
Loss from operations ......................... (29,166) (36,169)
Gain (loss) on investment .................... 1,274 (1,200)
Interest income and other .................... 2,688 4,605
----------- -----------
Loss before provision for income taxes ....... (25,204) (32,764)
Provision for income taxes ................... 13 11
----------- -----------
Net loss ..................................... $ (25,217) $ (32,775)
=========== ===========
Net loss per share ........................... $ (2.16) $ (2.86)
=========== ===========
Shares used in computing net loss per share .. 11,698 11,454
=========== ===========
OTHER OPERATING DATA:
EBITDA (See Note 8) ........................ $ (2,397) $ (17,097)
=========== ===========
Approximate number of subscribers at end
of period .................................. 542 562
=========== ===========
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,
1997 1996
------------- -------------
(unaudited)
<S> <C> <C>
OPERATING ACTIVITIES
Net loss .................................... $ (25,217) $ (32,775)
Adjustments to reconcile net loss to net
cash used in operating activities:
Write-off of fixed assets and deferred
subscriber acquisition costs .......... 992 --
Depreciation and amortization ........... 25,495 20,272
Loss on disposal of assets .............. 277 124
(Gain) loss in investment ............... (1,274) 1,200
Changes in assets and liabilities:
Accounts receivable, net .............. (524) (1,356)
Prepaid expenses and other current
assets .............................. 345 (985)
Deferred subscriber acquisition
costs, net .......................... (4,267) (11,989)
Deposits and other assets ............. (67) (534)
Trade accounts payable ................ (225) (2,400)
Accrued payroll and related expenses .. 820 3,197
Other accrued expenses and liabilities (301) 6,479
Deferred revenue ...................... 2,330 1,801
----------- -----------
Total adjustments ....................... 23,601 15,809
----------- -----------
Net cash used in operating activities ......... (1,616) (16,966)
----------- -----------
INVESTING ACTIVITIES
Purchase of property and equipment .......... (7,852) (45,438)
Proceeds from disposal of property and
equipment ................................. 253 --
Proceeds from sale of Excite ................ 1,351 --
----------- -----------
Net cash used in investing activities ......... (6,248) (45,438)
----------- -----------
FINANCING ACTIVITIES
Proceeds from issuance of debt .............. 1,578 --
Repayment of debt ........................... (1,361) --
Proceeds from exercise of stock options and
purchases under employee stock purchase
plan ...................................... 1,195 2,338
----------- -----------
Net cash provided by financing activities ..... 1,412 2,338
----------- -----------
Net decrease in cash and cash equivalents ..... (6,452) (60,066)
Effects of exchange rates on cash ............. (233) 155
Cash and cash equivalents at beginning
of period ................................... 73,408 146,001
----------- -----------
Cash and cash equivalents at end of period .... $ 66,733 $ 86,090
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid ................................. $ 274 $ --
=========== ===========
Income taxes paid ............................. $ 15 $ 11
=========== ===========
SUPPLEMENTAL INFORMATION ON NONCASH INVESTING AND
FINANCING ACTIVITIES
Purchases of equipment under capital lease
obligations ................................. $ 6,138 $ --
=========== ===========
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 consolidated 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, 1996.
2. DEFERRED SUBSCRIBER ACQUISITION COSTS, NET
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
$1,084,000 and $4,081,000 for the three months ended September 30, 1997 and
September 30, 1996, respectively. Amortization and write-offs of deferred
subscriber acquisition costs for the three months ended September 30, 1997 and
September 30, 1996 was $1,589,000 and $3,568,000, respectively. The Company
capitalized subscriber acquisition costs of approximately $4,156,000 and
$11,989,000 for the nine months ended September 30, 1997 and September 30, 1996,
respectively. Amortization and write-offs of deferred subscriber acquisition
costs for the nine months ended September 30, 1997 and September 30, 1996 was
$7,388,000 and $7,961,000, respectively.
3. PROPERTY AND EQUIPMENT AT COST, NET
<TABLE>
Property and equipment consist of the following (in thousands):
<CAPTION>
September 30, December 31,
1997 1996
-------- --------
(unaudited)
<S> <C> <C>
Property and equipment at cost $119,266 $107,476
Less: accumulated depreciation and
amortization (41,358) (23,103)
-------- --------
Property and equipment at cost, net $ 77,908 $ 84,373
======== ========
</TABLE>
7
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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).
In February 1997, the Financial Accounting Standards Board issued
Statement No. 128, ("SFAS 128") "Earnings per Share," which the Company is
required to adopt on December 31, 1997. SFAS 128 requires changes to the method
currently used to compute earnings per share and to restate all prior periods.
The new requirements for calculating primary earnings per share exclude the
dilutive effect of stock options. The impact of SFAS 128 on the calculation of
historically reported primary or fully diluted earnings per share for the period
subsequent to the Company's initial public offering is not expected to be
material, as the Company has recorded losses and has therefore excluded the
impact of stock options, as these would have been anti-dilutive.
5. STOCKHOLDERS' EQUITY
<TABLE>
The components of the stockholders' equity are as follows (in thousands,
except share amounts):
<CAPTION>
Cumulative
Common Additional Translation Total
Stock Paid-In Accumulated Adjustment Stockholders'
Shares Amount Capital Deficit and Other Equity
----------- ---------- ----------- ------------ ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1996 11,630,900 $ 116 $ 205,506 $ (62,042) $ 1,211 $ 144,791
Issuance under employee stock
purchase plan 62,600 1 705 - - 706
Exercise of stock options 51,500 - 489 - - 489
Cumulative translation
adjustment - - - - (500) (500)
Unrealized gain - - - - (540) (540)
Net loss - - - (25,217) - (25,217)
----------- ---------- ----------- ------------ ----------- ------------
Balance at September 30, 1997 11,745,000 $ 117 $ 206,700 $ (87,259) $171 $ 119,729
=========== ========== =========== ============ =========== ============
</TABLE>
6. RESTRUCTURING AND RELATED CHARGES
Restructuring and related charges of $167,000 and $1,879,000 during the
three and nine months ended September 30,1997, respectively, are the result of a
decision by management to restructure operations of the Company's subsidiary in
the United Kingdom. The restructure charge includes $1,356,000 in accrued
expenses for costs to terminate excess leased office facilities and a write-off
of office equipment, furniture and building improvements as a result of
consolidating office space, a $356,000 write-down of previously capitalized
deferred subscriber acquisition costs, and $167,000 for severance costs.
8
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<TABLE>
The following table depicts the activity in the Company's restructuring accrual
for 1997 (in thousands):
<CAPTION>
Balance at
Additions During Additions During Expenditures September 30,
Q2 Q3 During Q3 1997
---------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Payments on canceled or vacated
facilities $588 - $132 $456
Payments for legal and other
support 132 - 37 95
Payments to employees
involuntarily terminated - 167 81 86
===========================================================================
Total Restructuring Accrual $720 $167 $250 $637
===========================================================================
</TABLE>
7. INCOME TAXES
The provision for income taxes for the three months ended September 30,
1997 and 1996, in the amount of $0 and $4,000, respectively, and for the nine
months ended September 30, 1997 and 1996 in the amount of $13,000 and $11,000,
respectively, consists entirely of international and state minimum taxes since
the Company incurred pre-tax losses in each period.
8. 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.
9. SUBSEQUENT EVENTS
On October 12, 1997, the Company entered into an Agreement and Plan of
Merger (the "Merger Agreement") with ICG Communications, Inc., a Delaware
corporation ("ICG"), pursuant to which ICG has agreed to acquire the Company
through a tax-free merger (the "Merger") of a newly formed Delaware subsidiary
of ICG with and into the Company. Under the terms of the Merger Agreement, each
share of the Company's common stock would be exchanged for 0.8628 shares of
common stock of ICG ("ICG Common Stock"), subject to adjustment as described
below. The closing price of a share of ICG Common Stock on the NASDAQ National
Market on October 10, 1997 was $26.25.
The exchange ratio will be subject to adjustment as follows: If the
volume weighted average price for one share of ICG Common Stock for the ten
consecutive trading days ending two trading days prior to the closing of the
Merger (the "ICG Closing Price") drops below $22.125, the exchange ratio will be
adjusted to equal the fraction obtained by dividing $19.0625 by the ICG Closing
Price; in addition, if the ICG Closing Price drops below $19.00 per share, the
exchange
9
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ratio will be fixed at 1.0078 shares of ICG Common Stock for each share
of the Company's Common Stock.
The Merger has been unanimously approved by the Boards of Directors of
both ICG and the Company. Either party may terminate the Merger Agreement
without liability if such party's independent auditors render written advice
that the Merger will not qualify for pooling-of-interests accounting treatment,
or upon the occurrence of other specified events. The Merger is subject to the
effectiveness of a registration statement registering the shares of ICG Common
Stock that will be issued pursuant to the Merger Agreement. In addition, the
consummation of the Merger is conditioned upon approval by the stockholders of
both ICG and the Company, certain regulatory approvals, required consents and
other customary closing conditions. The parties expect the transaction to close
during the first quarter of 1998.
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, 1996.
OVERVIEW
The Company's revenues are derived from providing Internet solutions to
business and individual customers, principally through monthly dial-up,
dedicated connection and web site hosting services. Revenues from monthly
subscriptions have increased substantially since the Company's inception as a
result of increases in the Company's customer base due to the growth of the
Internet services market generally, the expansion of the Company's services and
distribution channels and diversification of the Company's product offerings.
Currently, sales to small businesses and individuals represent a majority
of the Company's revenues. Small business and individual revenues are comprised
primarily of recurring dial-up, web site hosting and dedicated connection
revenues. In addition, the Company also receives revenues from non-access
services, primarily from business customers. These revenues include virtual web
server hosting and domain name services. The Company charges set-up fees on
certain of these services. A majority of the Company's accounts are billed
monthly pursuant to a pre-authorized credit card account or are prepaid
annually.
During 1997, the Company has introduced new products designed to better
meet the needs of people using the Internet for small business applications.
These include products which provide greater dial-up access reliability and
customer support for additional monthly charges, dedicated line services to
connect to local area networks and web servers and web site hosting services.
The Company believes that these services should result in higher average revenue
per subscriber in the future.
10
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The Company is also committed to expanding its customer base by various
means, including developing relationships with corporate partners in order to
deliver new products and services to customers. The Company's ability to improve
revenues and operating margins will depend in part on its ability to attract new
customers and retain its existing customers. There can be no assurance that the
Company's investments in its telecommunications infrastructure, customer support
capabilities, new services offerings and software releases will ensure a high
level of customer retention. For more information on risks facing the Company,
see "Risk Factors" on page 16.
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
incur net losses for the foreseeable future. The Company has operating
subsidiaries in Canada and the United Kingdom and has an investment in Brazil
with Grupo Itamarati, a Brazilian conglomerate. There can be no assurance of
future revenue growth or that the Company will be able to achieve and then
sustain profitability or positive cash flow.
During October of 1997 the Company entered into the Merger Agreement with
ICG. The Merger is expected to close in the first quarter of 1998, pending
certain conditions and approval by the stockholders of both companies and
regulatory entities. On or about November 7, 1997, ICG and the Company intend to
file with the Securities and Exchange Commission a joint proxy statement-
prospectus that contains a more complete description of the proposed Merger,
including a discussion of risks associated with the proposed Merger.
RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
REVENUES
Revenues increased by $8,070,000, or 25.2%, to $40,106,000 for the three
months ended September 30, 1997 from $32,036,000 for the three months ended
September 30, 1996. Revenues increased by $35,970,000, or 42.7%, to $120,131,000
for the nine months ended September 30, 1997 from $84,161,000 for the nine
months ended September 30, 1996. The revenue increase was due to an increase in
average revenue per customer, which resulted from an increase in the mix of
dedicated and web site hosting customers relative to dial-up customers, sales of
the Company's premium dial-up products and growth in the Internet market
generally. During the third quarter of 1997, the Company experienced growth in
non-dial up services and a decrease in dial up accounts. The total number of
customers decreased to approximately 542,000 accounts as of September 30, 1997
from approximately 562,000 accounts as of September 30, 1996.
International revenues increased by $2,822,000 to $3,553,000 for the
three months ended September 30, 1997 compared to the same period in 1996.
International revenues increased by $8,057,000 to $9,046,000 for the nine months
ended September 30, 1997 compared to the same period in 1996. The increase in
international revenues is due to increased subscriber base for the Company's
international operations which began in 1996.
11
<PAGE>
COST OF REVENUES
The Company's cost of revenues was $29,668,000 for the three months ended
September 30, 1997 and $24,319,000 for the three months ended September 30,
1996, decreasing to 74.0% from 75.9% of revenues, respectively. The decrease in
consolidated cost of revenues as a percentage of revenue was primarily
attributable to network and payroll expenses increasing at a slower rate than
revenues. The increase in absolute dollars was due to increases in depreciation
and telephone expenses related to supporting the customer network. Consolidated
gross margin for the quarters ended September 30, 1997 and September 30, 1996
was 26.0% and 24.1%, respectively. Domestic gross margin for the same period was
28.2% and 30.5%, respectively. Cost of revenues was $87,218,000 for the nine
months ended September 30, 1997 and $61,480,000 for the nine months ended
September 30, 1996, decreasing to 72.6% from 73.1% of revenues, respectively.
Consolidated gross margin for the nine months ended September 30, 1997 and
September 30, 1996 was 27.4% and 26.9%, respectively. Domestic gross margin for
the same period was 30.5% and 32.2%, respectively.
11
<PAGE>
The Company's international operations cost of revenues for the three
months ended September 30, 1997 was $3,407,000, an increase of $855,000 over the
same period in 1996. International cost of revenues for the nine months ended
September 30, 1997 was $10,054,000, an increase of $5,001,000 over the same
period in 1996. The increase in international cost of revenues in absolute
dollars is due primarily to increased network and payroll related costs. The
Company expects that cost of revenues for international operations will continue
to increase in absolute dollars in the foreseeable future.
PRODUCT DEVELOPMENT
Product development expenses were $1,637,000 for the three months ended
September 30, 1997 and $1,816,000 for the three months ended September 30, 1996,
representing 4.1% and 5.7% of revenues, respectively. Product development
expenses were $4,924,000 for the nine months ended September 30, 1997 and
$4,460,000 for the nine months ended September 30, 1996, representing 4.1% and
5.3% of revenues, respectively. International product development expenses for
the three and nine months ended September 30, 1997 were $239,000 and $831,000,
respectively. The Company plans to continue expenditures on product development
as it develops new software products and upgrades 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 decreased $2,912,000 or 19.8%, to
$11,790,000 for the three months ended September 30, 1997 from $14,702,000 for
the three months ended September 30, 1996, decreasing to 29.4% from 45.9% of
revenues, respectively. The decrease in absolute dollars and in expenses as a
percentage of revenue was due to decreases in marketing programs, salaries and
wages and subscriber acquisition costs. Sales and marketing expenses increased
$1,746,000, or 4.7%, to $38,732,000 for the nine months ended September 30, 1997
from $36,986,000 for the nine months ended September 30, 1996. Although sales
and marketing expenses increased in absolute dollars during the nine months, the
expenses as a percentage of revenue decreased to
12
<PAGE>
32.2% from 43.9% for the nine months ended September 30, 1997 and
September 30, 1996, respectively. The increase in absolute dollars was primarily
attributable to increased costs associated with the Company's international
expansion and increased commissions. Additionally, during 1997, the Company
began selling disks and charging the disk costs to cost of revenues as they were
shipped. Prior to 1997, certain disk costs were capitalized as deferred
subscriber acquisition costs and amortized to sales and marketing expense over
twelve months, as the disks were distributed free of charge.
International sales and marketing expenses (including costs incurred
domestically relating to international operations) increased by $160,000 to
$3,030,000 for the three months ended September 30, 1997 and by $2,691,000 to
$9,202,000 for the nine months ended September 30, 1997 compared to the same
periods in 1996. Sales and marketing expenses are expected to continue to
increase in absolute dollars.
Certain of the Company's 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 $1,084,000 and
$4,081,000 for the three months ended September 30, 1997 and September 30, 1996,
respectively. Amortization and write-offs of deferred subscriber acquisition
costs for the three months ended September 30, 1997 and September 30, 1996 was
$1,589,000 and $3,568,000, respectively. The Company capitalized subscriber
acquisition costs of approximately $4,156,000 and $11,989,000 for the nine
months ended September 30, 1997 and September 30, 1996, respectively.
Amortization and write-offs of deferred subscriber acquisition costs for the
nine months ended September 30, 1997 and September 30, 1996 was $7,388,00 and
$7,961,000, respectively.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased $924,000, or 15.1%, to
$5,198,000 for the three months ended September 30, 1997 from $6,122,000 for the
three months ended September 30, 1996, decreasing to 13.0% from 19.1% of
revenues, respectively. General and administrative expenses decreased $860,000,
or 4.9%, to $16,544,000 for the nine months ended September 30, 1997 from
$17,404,000 for the nine months ended September 30, 1996, decreasing to 13.8%
from 20.7% of revenues, respectively. The decrease in general and administrative
expenses in absolute dollars and as a percentage of revenue for the three and
nine month periods ending September 30, 1997 was primarily due to costs incurred
during the same period in 1996 in establishing the Company's subsidiary in the
United Kingdom, moving a significant portion of the Company's operations into
new buildings and incurring bad debt expenses from writing-off accounts
receivable balances determined to be uncollectable.
International general and administrative expenses decreased by $125,000
to $571,000 for the three months ended September 30, 1997 and decreased by
$71,000 to $1,888,000 for the nine months ended September 30, 1997 compared to
the same periods in 1996. General and administrative expenses are expected to
increase in absolute dollars in the future.
13
<PAGE>
RESTRUCTURING AND RELATED CHARGES
Restructuring and related charges of $167,000 and $1,879,000 during the
three and nine months ended September 30, 1997, respectively, are the result of
a decision by management to restructure operations of the Company's subsidiary
in the United Kingdom. The restructure charge is comprised of $1,356,000 in
accrued expenses for costs to terminate excess leased office facilities and a
write-off of office equipment, furniture and building improvements as a result
of consolidating office space, a $356,000 write-down of previously capitalized
deferred subscriber acquisition costs and $167,000 for severance costs.
INTEREST INCOME AND OTHER
Net interest income and other was $886,000 and $1,321,000, respectively,
for the three months ended September 30, 1997 and 1996. Net interest income and
other was $2,688,000 and $4,605,000, respectively, for the nine months ended
September 30, 1997 and 1996. The decrease was due to the Company's lower average
cash and cash equivalents during 1997 as compared to the same period in 1996. In
addition, during 1997, the Company incurred interest expense on capital leases
of $159,000 and $311,000 for the three and nine month periods ended September
30, 1997, respectively, compared to insignificant amounts incurred during the
same periods in the prior year. The Company invests its cash and cash
equivalents primarily in high grade commercial paper and United States treasury
bills.
NET LOSS
Revenue growth and decreases in cost of revenues and operating
expenditures as a percentage of revenue, offset by international expansion and
restructuring charges related to the UK operations, resulted in reduced net
losses of $6,827,000 and $25,217,000, for the three months and nine months ended
September 30, 1997, respectively, as compared to net losses of $13,606,000 and
$32,775,000 for the three and nine months ended September 30, 1996,
respectively. International net losses for the three and nine months ended
September 30, 1997 were $4,069,000 and $15,341,000 as compared to net losses of
$5,499,000 and $12,712,000 for the three and nine months ended September 30,
1996, respectively.
The Company believes EBITDA (Earnings before interest, taxes,
depreciation and amortization) is a cash flow measure used by analysts,
investors and other interested parties in the on-line and Internet services
industries. EBITDA for the three and nine months ended September 30, 1997,
resulted in positive EBITDA of $259,000 and reduced losses of $2,397,000,
respectively, as compared to the losses of $6,458,000 and $17,097,000 for the
three and nine months ended September 30, 1996. EBITDA before restructuring and
related charges of $167,000 and $1,879,000, respectively, for the three and nine
months ended September 30, 1997 was positive $426,000 and a loss of $518,000,
respectively. Domestic EBITDA for the three and nine months ended September 30,
1997 was positive $3,211,000 and $9,179,000, respectively.
14
<PAGE>
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
$396,000 and $11,981,000 for the three months ended September 30, 1997 and
September 30, 1996, respectively. The Company's operating activities used cash
of approximately $1,616,000 and $16,966,000 for the nine months ended September
30, 1997 and September 30, 1996, respectively. During the nine months ended
September 30, 1997, cash used in operating activities was primarily affected by
the net loss, gains on investments, deferred subscriber acquisition costs and a
$2.1 million payment to the Brazilian investment made in September 1997. These
uses of cash were primarily offset by depreciation and amortization and
increases in deferred revenue. During the nine months ended September 30, 1996,
cash from operations was reduced primarily by the net loss, increases in
accounts receivable, and decreases in deferred subscriber acquisition costs and
accounts payable. These uses of cash were partially offset by depreciation and
amortization, loss on investments, and increases in accrued payroll and related
expenses, other accrued expenses and liabilities and deferred revenue.
Investing activities used cash of $1,997,000 and $13,699,000 for the
three months ended September 30, 1997 and September 30, 1996, respectively.
Investing activities used cash of $6,248,000 and $45,438,000 for the nine months
ended September 30, 1997 and September 30, 1996, respectively. The Company's
investing activities have consisted primarily of equipment purchases for new
local access areas and network expansion. Capital expenditures were $2,512,000
and $7,852,000 for the three and nine month periods ended September 30, 1997,
respectively, which were offset mainly by the sale of short term investments.
Financing activities provided cash of $1,412,000 and $2,338,000 for the
nine months ended September 30, 1997 and September 30, 1996, respectively. For
the nine months ended September 30, 1997, financing activities consisted
primarily of the exercise of stock options and proceeds from issuance of debt
relating to financing of equipment which was partially offset by repayments of
debt relating to the capital leases entered into during the period. For the nine
month period ended September 30, 1996, financing activities consisted 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 has
been used for, and the Company expects to continue to use cash for, additional
equipment purchases and subscriber acquisition costs.
As of September 30, 1997, the Company had cash and cash equivalents of
$66,733,000 and working capital of $42,227,000. The Company used $2,826,000 and
$6,452,000 for the three and nine months ended September 30, 1997, respectively.
Although the Company may seek to 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, in
the absence of material competitive or operating changes.
15
<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, 1996 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 years since incorporation,
it experienced net losses of $100,000 for 1994, $14,064,000 for 1995,
$44,265,000 for 1996 and $25,217,000 in the first nine months of 1997, and had
an accumulated deficit of $87,259,000 as of September 30, 1997. The net loss
incurred during the nine months ending September 30, 1997 included a loss of
$15,341,000 related to international operations.
These losses are also reflected in the Company's operating margins, which
decreased from a loss of 1% for 1994 to a loss of 31% for 1995 and a loss of 40%
for 1996. During the first nine months of 1997, the Company's operating margin
was a loss of 24%. The Company's current focus is on targeting the business
customer (individuals and groups), which the Company believes will result in
increased revenues per subscriber, although at reduced subscriber growth rates.
The Company anticipates increases in its expenses related to product
development, marketing, sales, general and administrative, network and customer
support. There can be no assurance of future revenue growth or that in the
future the Company will achieve or sustain profitability or positive cash flow
from operations.
Changes in the Company's customer base or in customers' usage patterns
may increase costs as a percentage of revenues. These changes 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 customers 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 customer basis.
The Company has adopted strategies designed to attract business customers
which 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.
COMPETITION. The market for Internet services is increasingly competitive
and there are few barriers to entry. 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
16
<PAGE>
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 other national and regional
commercial Internet services providers, with established on-line services
companies which offer Internet connectivity, with national long distance
carriers, with regional telephone companies, with cable operators and with other
local and regional Internet service providers.
Increased competition in general 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 customers 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 customers, 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 relatively new. 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. 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.
VOLATILITY OF STOCK PRICE. The market price of the Company's common stock
has been and is expected to continue to be subject to significant fluctuations
in response to numbers of customers, announcements of technological innovations,
new products or new services by the Company or its competitors,
quarter-to-quarter variations in the Company's operating results and other
events or factors. For example, a shortfall in revenue, in number of customers,
or an increase in losses from levels expected by securities analysts could have
an immediate and significant adverse effect on the market price of the Company's
common stock. In addition, the stock market in recent years has experienced
extreme price and volume fluctuations that have particularly affected the market
prices of many high technology companies and that in some cases have been
unrelated or disproportionate to the operating performance of companies. These
fluctuations, as well as general economic and market conditions and the adverse
performance of companies within the Internet market segment, may adversely
affect the market price of the common stock.
17
<PAGE>
ITEM 3 OF PART I IS NOT APPLICABLE AND HAS BEEN OMITTED.
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.
A current report on Form 8-K, dated October 23, 1997 was filed by
Registrant with the Securities and Exchange Commission to report under
Item 5 thereof the Registrant's execution of a definitive Agreement and
Plan of Merger with ICG Communications Inc.
dated October 12, 1997.
ITEMS 1, 2, 3, 4 AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.
18
<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 6, 1997 By /s/ David W. Garrison
------------------------------------
David W. Garrison
Chairman of the Board, President and
Chief Executive Officer
By /s/ Kurt E. Johnson
------------------------------------
Kurt E. Johnson
Chief Financial Officer
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